Business of Fun for Kids Limited - Assignment Example

Fun For Kids Limited Background Fun for Kids Limited was established by Sue Wantage on 14 January 2007 primarily to provide a safe place for children to play for a fee. Ms. Wantage leased an empty warehouse for £60,000 a year and converted it to a colourful play park, where she expected minimum monthly revenue of £15,000 beginning May 2007. A cash flow worksheet was constructed where her projections of cash inflow and outflow were indicated in order to determine cash requirements on a monthly basis. The following tasks are then required in order to come up with a good financial plan for the company: Tasks 1. Complete a cash flow forecast for the period May 2007 to December 2007. A cash flow forecast for the period of May 2007 to April 2008 has been constructed using Excel format for ease of computation. See attached table in excel. 2. If the cash flow forecast is correct, the business will need short-term finance. During which time period will this be necessary? Based from the cash flow forecast, the critical times where short-term financing would be necessary would be in June, when there will be a deficit of £21,750. This is largely brought about by the large cash requirement to pay for the semi-annual rental fee of £30,000. The month of June is also the time for the quarterly payment of electric, gas, and other costs as projected by Ms. Wantage. June also signals the start of season of high wage payments. 3. Explain two ways in which Fun for Kids Ltd might improve its cash flow. Ms. Wantage can improve the cash flow of the company by enticing customers to pay cash instead of a thirty day credit sales on party bookings. This can be done by giving more incentives to cash paying customers, such as giving extra freebies to kids or small gifts to parents, or extending extra hours of use of facilities. Probably a differential in party package price can also be offered between cash sales and credit sales customers. Another way of improving cash flow is reducing the number of days for credit sales. Instead of 30 days, the company can probably shorten it to 15, 20, or 25 days. Aside from the revenue side, the expense side can also be adjusted in order to improve the cash position of the company. For example, lump sum payments on rent, utilities, and other expenses paid on quarterly basis can be spread during months when there are cash surpluses. From the cash flow constructed for May to December 2007 for the company, one would notice that in June 2007, cash expenses such as the semi-annual rent payment and quarterly payment on electricity and gas consumption contributed to huge demand for cash, at a time when the company is just starting to build up its cash reserves from sales revenues. What could be done is to have a proper timing for large payments so that cash disbursements do not occur simultaneously on a single month alone. Another strategy is for Ms. Wantage to get credit lines from suppliers. By extending credit privileges, suppliers will be able to give Ms. Wantage some leeway in her cash management, thereby easing the cash required on a particular month. There is no better way to improve cash flow than by increasing cash sales revenues to further offset the cash expenses. Ms. Wantage can probably sell membership cards with extra privileges. These membership cards are paid in advance, hence helping to raise more funds for the company. Such activities can raise more cash and thus improve cash flow of the company. 4. Analyse two arguments that Sue could use to persuade a bank manager to provide a bank overdraft where necessary. Ms. Wantage could tell a bank manager that a bank overdraft may be needed to “carry the firm through seasonal peaks in financing needs” of the company (Gitman 269). She could explain that extra-ordinary expenses need to be financed in anticipation of a cash build-up in the following months when bank overdrafts can easily be paid for. During the succeeding peak months, funds which could be used to retire loans would easily be generated. Ms. Wantage could borrow the argument of Gitman when he said that “the use to which the borrowed money is put provides the mechanism through which the loan is repaid” (269). Ms. Wantage could present to the bank manager the company’s cash budget, pro forma financial statements, and revenue projections. She could explain that the amount of bank overdraft, while necessary, is required only on a particular month, and is needed only as a temporary measure to shore up its cash requirements. She could persuade the bank by telling it that she does not see a continuing need for the bank overdraft, and the nature of the requirement is really only temporary. Moreover, while the bank overdraft is quite small compared to the total investment that the company is making in putting up the play park, it can be secured, if required, by other assets of the company. The large cash outflows in the month of June do not necessarily spell trouble for the company. According to Brealey et al, such things occur as “…they reflect the capital investment made…” in the early stages of business establishment. This is a seasonal pattern, and the company “should have no trouble borrowing to help it get through the slow months” (523). 5. Evaluate the main reasons why this cash flow forecast may be inaccurate. One of the components of cash inflow is proceeds from credit sales where Ms. Wantage projected that credit sales revenues can be converted to cash exactly one month after the services were rendered. This could be an inaccurate assumption since it discounted any allowance for bad debts. The projection was probably made on the assumption that all credit sales could be collected on time (exactly one month after). This may not be a reliable assumption since accounts receivable are more often aged and are not totally realized as cash on due dates. What could be done to make the projection more or less reliable is to allocate only a percentage of the accounts receivable as being able to generate cash on a particular month. Another reason why the cash flow forecast may be inaccurate is that it does not show cash generated from short-term financing such as accruals and accounts payable. These short-term financing options arise from the “normal business operations of the firm” (Gitman 262). If Ms. Wantage would be financially adept in her cash management, she might use this as a financing strategy to raise more cash. Accruals for example, can generate extra cash from wages and taxes, especially if the company has a large personnel complement. Accounts payable, on the other hand, can provide a respite from cash demands, by allowing the firm to pay its obligations to suppliers at a much later time, say 30 to 45 days. This is sometimes called “stretching the payables” (Brealey 525). Accounts payable usually arise from purchases made from suppliers who extend credit terms to the company. 6. Sue estimates to open an even bigger play park she would need to raise £900,000. Discuss the most suitable way of raising this sum of money. There are several sources of funds that can be tapped to finance the expansion of the play park. According to the Information Industries Bureau website, among the sources of external financing include banks and credit unions, venture capitalists, business angels, friends and family. The types of external financing that can be secured from the said sources include debt, equity, grants, gifts and services. (See Table 1) For the company, Ms. Wantage’s first attractive option is to raise money through business angels, friends, and family. In this way, there is possibility that cost of money would be a little lower than commercial rates, since rates can be negotiated in a more personal manner, without setting aside a formal business negotiation or arrangement to finance the project. If she is ready to share ownership of the business, Ms. Wantage could also consider raising funds by seeking out investors who would be willing to provide capital in exchange for equity in the business. The advantage of this is that the burden of loss, in case the business fails, is shared by business owners. The third option for Ms. Wantage is to raise funds through bank loans. A medium to long-term loan can be applied from a bank at a specified interest rate. This option requires payment of fixed interest rates at a fixed period of time, whether the business succeeds or fails. Cost of capital or the interest rate must be carefully studied against the expected increment revenues to be generated by the expansion of the play park. Table 1. Sources of external financing External finance type External finance sources Debt Financial institutions such as retail and commercial banks (including merchant banks) and credit unions, friends and family Equity Venture capital, business angels, merchant banks, friends and family, employees Grants Federal, state, local governments, and some private sources such as the yellow pages. Gifts Friends and family, employees, educational institutions (e.g. universities) Source: www.iib.qld.gov.au 7. If the present play park was to expand using internal sources of finance what problems might arise? Technically, internal sources of funds refer to retained profits or earnings of the company. According to BusinessDictionary.com, however, it is also being used to refer to funds raised by companies or organizations from member contributions, employee contributions, sale of assets, sale of goods and services. Retained earnings are the profits of the business available to the firm after deducting all operating expenses and taxes. For Fun For Kids Limited, however, its retained earnings based on the cash flow constructed cannot possibly finance the required amount of £900,000 for the expansion plan, since the company is just starting to generate revenues. Its cumulative net cash flow by the end of its first year of operations is only about £40,000. This is way too small for the projected investment required to finance the expansion. If the funds will be sourced internally, it means Ms. Wantage will have to put in more money from her own personal savings. Assuming that Ms. Wantage indeed has this amount of funds in her personal account, it may be an attractive option since at first glance it seems to be a cheaper option than borrowing. On the other hand, one of the problems that may arise from this mode of raising funds is the personal risk involved. If the business does not prosper, she risks losing all her personal money in the business. For big companies, it is a common practice to use retained earnings to finance expansion. It is also sometimes used as a tax shield in order to save the company from huge taxes imposed on corporate earnings. For a start-up company such as Fun for Kids Limited, however, it would be a wiser move to finance its expansion through external sources, rather than exerting undue pressure on personal resources by raising the required funds through internal means. Works Cited Brealey, Richard, Stewart Myers, and Alan Marcus. Fundamentals of Corporate Finance. New York: McGraw-Hill, 2007. Gitman, Lawrence. Basic Managerial Finance. New York: Harper & Row, 1987. Business Dictionary. 2007. Internal Sources of Financing. 13 December 2007. http://www.businessdictionary.com/definition/internal-sources-of-financing.html Queensland Government. January 2007. Information Industries Bureau. 13 December 2007. http://www.iib.qld.gov.au/business/Finance/External_Finance.asp Read More