Managing financial resources and decisions
As we are aware, finance is the lifeblood of business or it can be said as the most important part of all the business enterprises. To understand finance, you need to know the entire business indeed. Finance can be used for various reasons like expanding the business, investing and purchasing fixed assets like land and building, machinery so on. In order to survive in this competitive world every organisation need to have a good strength of finance available to their business or else they won't be able to survive in this world. Hence, it is very important to select the correct sources of finance available to the company. Finance can be in two types' external sources or internal sources.
Sources of Finance:
Finance can be arranged from external sources or internal sources. External sources of finance are funds that come from outside the business. Here the business are getting loans from individuals or institutions that do have business relations directly e.g. banks.
Examples of external finance are:
- An overdraft from the bank.
- A loan from a bank or building society.
- The sale of new shares through a share issue..
External sources of finance can be divided into two parts short term and long term. Long-term finance is required on large projects that will pay back over a longer period of time. Long term has two main sources i.e. share capital & loan capital. Short-term finance is needed to cover the day to day running of the business. It will be paid back in a short period of time, so less risky for lenders. This is divided into bank overdraft, hire purchase, trade credit, leasing, etc.
Long-term finance sources
Short-term finance sources
Loan from financial institution
Term loans from bank
Cash inflows to a business Cash outflows from a business
(Revenue from sales, loans, (Payment for raw materials, stock, interest, sales of assets etc) labour, insurance, rent, rates etc.)
Short term Sources of finance:
Short term sources basically it is mostly used by the small business to cover their day-to-day running cost. The most important aspects of the entrepreneur or the venture are to satisfy the commercial credit which is also known as creditworthiness in order to be granted for any short term financing in the business. Eventually there are few aspects of short term sources like Overdraft, Trade creditors etc.
1. Bank Overdraft facilities -
One of the most common used sources of short term of finance because of its cost and flexibility. When borrowed funds are no longer required they can quickly and easily be paid. It is also comparatively cheap because Interest only paid on the amount overdrawn.
2. Trade credit -
This is a period of time given to a business to pay for goods that they have received. It is often 28 days and 90 days but some businesses might not pay for 6 months and on some occasions even a year after they have received goods.
3. Leasing -
A lease means that the business is paying for the use of a product but does not own it. It is also called 'hiring'. A lease is an agreement between two parties, the "lesser" and the "lessee". It can be cheaper to arrange a lease rather than having to buy equipment outright.Leases can be very flexible with the payments made are generally fixed A lease agreement on a van, for e.g. might mean that the firm pays out £350 per month for a three year lease. At the end of the three years the vehicle returns to the owner provides the opportunity to secure the use of capital without ownership effectively a hire agreement.
4. Hire purchase -
Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods. Business can use hire purchase as a source of finance. A business obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by business on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery and so on.
Advantages and disadvantages of Trade Credit:
- In trade credit you have more time to pay the creditor with no interest
- It usually results in more customers than a cash trade.
- Increases the number of sales also Stimulates agricultural and industrial production and commerce.
- Can charge more for goods to cover the risk of bad debt.
- You can buy the stock and pay later when you have sold the stock and made enough money to pay them back
- Easy cash flow as you can pay after 28-30 days
- It involves a huge Risk of Bad Debt.
- When the customers of trade credit can't afford to repay the amount then it involves a risk of Bankruptcy.
- High administration expenses
- People can buy more than they afford it.
- If you do not pay them back on time you can build up a bad credit history
- Only companies with good credit history can be accepted the trade credit grant
Long term Sources of finance:
These sources are normally used for a long time period where in a long term loan is given by a specialist banks. However, for this type of loan securities are required, which is assets n properties like Plant and machinery, building etc. There are some long-term sources which are normally used by the big companies like equity shares, debentures, bank loan, preference shares etc.
These are issued to the general public. These may be of two types: (i) Equity and (ii) Preference. The holders of shares are the real owner of the business, they may or may not get dividend regularly. They are also paid at last in case of wind-up of business.
These are also issued to the general public. The holders of debentures are the creditors of the company. Debentures holder has to paid interest regularly. They also get preference of being paid first in case of wind-up of the company.
3. Public Deposits
Public also like to deposit their savings with a popular and well-established company which can pay interest periodically and payback the deposit when due.
4. Retained earnings
The company may not distribute the whole of its profits among its shareholders. It may retain a part of the profits and utilize it as capital. The company may use its retailed earning as long-term investment i.e. expanding business, purchasing machinery, etc.
5. Term loans from banks
As with short-term finance, banks are an important source of longer-term finance. Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. For businesses, using bank loans might be relatively easy but the cost of servicing the loan (paying the money and interest back) can be high. If interest rates rise then it can add to a businesses cost.
Advantages and disadvantages of Preference shares:
- You get regular income and fixed dividend coming in even if the company is making profit or not it does not matter.
- With this share, you do not have any interference in the management.
- There is Flexible Capital structure in this share.
- Preference shares are given first preference at the time of liquidation or wind-up.
- In these shares, you are not eligible for extra dividend even if the Company make high profit.
- At the time of liquidation, no extra money is paid to the preference shareholders.
- These shareholders cannot participate in any of the management activities.
- As they get fixed dividend so they are a burden on the company.
Internal Finance can be profit that has been retained, squeezed out of working capital, or can be cash from sale of assets. This money was already within the business.
Internal sources are finance, which comes mainly from its own funds, profits and depreciation.i.e Retained Profit, Squeezing Working Capital, and Sale of Assets.
The main internal sources of finance for sole proprietors are as follows;
· Owner's funds
· Selling personal assets
3) As JS and company have market valuation of property or goodwill of more than £130 million, so bank can easily lend them bank overdrafts facility. It is cost effective and flexible because when borrowed funds are no longer required they can quickly pay back. Moreover, interest is only paid on the amount overdrawn. In addition, fund of £200 million can be also raised through capital, debenture, or long-term loan, which also cost effective for the company.
JS and company can arrange source of finance through external or internal sources. Were as the company can raise the finance only through external source i.e. long-term or short-term sources. Short-terms of finance are those that are needed for less than a year whereas long-term sources of finance are needed over a longer period. Short term of finance that JS and company can use is bank overdrafts. As the company require finance for next five years, so short-term source will be not suitable. Hence, the company will need long-term source of finance.
In long term, finance company can raise through share -capital, debenture, or long-term loan.
Firstly, the company can use its 50 million in short term investment, by using it in dividend forgone. Thus using its own funds will help it in borrowing less from external sources, thus saving on dividend or interest, which has to be paid. The option available for raising finance is;
If company take Long-term, loan from bank to fiancé them. The implication of borrowing from a bank will result in interest rate to be payable whether they makes profit or not. In addition, the loan from have a fixed maturity date, i.e. they have to be repaid by given time. The company may not get the require amount from the bank due to current financial position of the company.
On the other hand, JS and company have an option of either going as a private limited company or public limited company. Minimum two members and maximum of fifty members own a private limited company. In this method, they can contribute funds together to starts a new business. The shares of the company can be sold privately to known people, thus this will save advertisement cost i.e. inviting public to buy. Thus, they will have final and complete claim on profits after paying all debts.
On the other hand, a public limited company were minimum member is seven and maximum limit of member is unlimited. The public company raises its capital by selling shares to public. These shares are quoted by the stock exchange. It able the company to raise large capital compare to private limited. It is therefore suitable for very large businesses for which the scope of expansion is very large. The public company raises capital through share-issue. People who buy shares are called shareholders. There are various types of shares; the most common one is ordinary and preference shares.
- An ordinary share makes the shareholder the owner of the firm. They get a part of profits of the firm in the form of dividends. If the company does not make any profits, ordinary shareholders get nothing. However, if company make huge profits then they can receive good dividend.
- A preference share gives the shareholder the right to get a fixed rate of dividend every year. They are paid before ordinary shareholders and their dividend are cumulative in nature i.e. if they did not receive any dividend in any one year, they would get two-year' dividends in the following year, it get accumulated until they are paid. Whether the public company makes high or low profits, but they receive, they fixed percentage dividend. Preference shareholders do not have voting right.
- Debenture are special finance lend to company by bank and finance houses against fixed rate of interest. Payable in equal instalment or intervals. Debenture stocks are held by lenders against assets of the company. If company default in payment assent are seized and sold for recovery.
From the above, it can be noticed the issue of shares is far better than long-term loan and debentures. As the required capital will be easily available to JS and compared to them.
2) IMPORTANCE OF FINANCIAL PLANNING
In business, a financial planning can refer to the primary financial statements created within a business plan. Financial plan can be said as an annual projection of income and for a company. On the other hand, financial plan can also be an estimation of cash needed and a decision on how to raise the cash, such as through borrowing or issuing additional shares in a company. E.g. a company that decide to expand e.g. by buying and fitting out a new factory which will create a financial plan which will consider the resources required or source of finance , cost of finance, cost of developing the project, as well as the revenues and profits to justify the expansion programme.
The process involves gathering relevant financial information, setting life goals, examining your current financial status and coming up with a strategy or plan on how you can meet your goals given your current and projected situation. Only through regular reviews can you ensure that you remain on track to meet your goals and maximise new ideas and opportunities.
Long and short term plans
Financial plans are made out for a given time period, e.g. one, three or five years. The length of the time requires depends on the importance of projecting in the future.
Long-term plans are created for business such as:
- Take over and merger activity.
- Expansion of capacity.
- Development of new products.
- Overseas expansion.
A short-term financial plan provides targets for junior and middle management, and a measure against actual performance, which can be monitored and controlled. In addition, it is normal practice for a business to prepare a three- or five-year plan in less detail. A budget is a short-term financial plan. It is sometimes referred to as a plan expressed in money.
The Financial Planning activity involves the following tasks;-
- Assess the business environment
- Confirm the business vision and objectives
- Identify the types of resources needed to achieve these objectives
- Quantify the amount of resource (labor, equipment, materials)
- Calculate the total cost of each type of resource
- Summarize the costs to create a budget
- Identify any risks and issues with the budget set
It also helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within the budget set.
The role of financial planning includes three categories: 1. Strategic role of financial management: 2. Objectives of financial management: 3.Planning cycle.
3) Identify the Decision-makers
The identification of the need is usually the responsibility of a business decision-maker. They pass this business requirement to the technical decision maker for solution research and evaluation. This solution then goes back to the business decision maker for approval and purchase. If you market your products through channel partners, they may also be involved in working with decision-makers. The influence three main audiences:
1) The business decision makers :
Business decision-makers are driven by business growth and competitive pressure, and they face comparison with their peers. They look for solutions to business problems. However, they may not have any technical knowledge and they may not be aware of your company.
2) The technical decision maker:
Technical decision-makers may be familiar with your company but may not be aware of all your products. You need to help them understand how different products work and provide examples of how solutions could be benefits to business
3) The channel partner:
Channel partners work directly with your target businesses, advising them on the solutions. You need to win the hearts and minds of your channel partners, educating and allowing them to create a preference for your products.
Investment appraisal methods
The capital budgeting cycle have an important step for working out the benefits of investing large capital of these investments. The methods that business organisation use is classified in two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method: discounted cash flow (DCF) methods now use as Net Present Valve (NPV) and Internal Rate of Return techniques. These four techniques and all involve a comparison of the cost of the investment with the expected return in the future.
Payback methods: The time taken to recover the cost of the investment. The shorter the payback period, the better the investment.
Payback period = Initial payment / Annual cash inflow.
- Because of simplicity and easy to calculate it is famous technique.
- Today business environment need rapid technological change, thus P&M need to be replaced sooner than in the past, so quick payback on investment is important.
- Today investors demand that they are rewarded with fast return, so long term investment is overlooked, due to longer wait for revenues.
- Its lacks objectivity i.e. it is decided by pitting one investment against another.
- Cash flows are treated as either pre-payback or post-payback, but latter they are ignored.
- As it is sole concern is cash flow, so it does not consider the effect on business profitability.
Accounting rate of return: Profits earned on investment here is express as a % of the cost of the investment.
ARR = (Average annual revenue / Initial capital costs) 100
- The chief advantage with ARR is its simplicity, as it is easy to understand.
- The ARR is similar to the Return on capital Employed in its construction, thus this makes the ARR easier for business planner to understand.
- The ARR is expressed in percentage terms, thus this make easier for managers to use.
- The ARR does not account of the project duration or timing of cash flows over the course of the project.
- The concepts of profit are very subjective, different accounting practice and capitalisation of the project costs. Thus, ARR calculation for same projects would have different result in different outcome from business to business.
- The ARR does not give any definitive signal to its managers to decide whether to invest or not. This lack decision making.
Net present valve:
The present valve of net cash flows received in the future less the initial cost of the investment. NPV is a technique where cash inflows expected in future years are discounted back to their present value.
- NPV gives the correct decision way assuming a perfect capital market. It also provide correct ranking for mutually exclusive projects.
- NPV gives an absolute value.
- NPV allows for the time value of the cash flows.
- In NPV it is difficult to identify the correct discount rate.
- NPV as method of investment appraisal requires the decision criteria to be specified before the appraisal can be undertaken.
Internal rate of return: The discount rate that causes the net present valve of an investment to be zero. The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.
- In IRR method, the investment on the original money valve shows the return.
- IRR shows rate of return of a project, so one can find the discount rate. thus it leads to no risk of loosing the money as the required rate is return is equal or higher.
- IRR gives you the rate at which you are safe.
- The IRR illustrates the overall returns from an investment in a clear and direct manner that leads to an easy decision-making process for companies to find, which investments is to be selected.
- In IRR, it is difficult of finding the internal rate of return accurately.
- The IRR method, can give you conflicting answer when compare to NPV for mutually project.
As JS and company have market valuation of property or goodwill of more than £130 million, the fund of £200 million can be raised through capital, debenture, or long-term loan through any of four investment appraisal techniques. Payback method or Accounting rate of return will be suitable technique.
An organisation needs to have to an appropriate plan to succeed in the competitive business world. Various decisions need to make effecting the organisation, which requires in-depth view of the finances available within the organization. These finances needs to be allocated and used in appropriate way so as to have a strong balance sheet which shows the success of the organisation during that financial year.
Financial decision depends on the preparation of financial statements prepared which affects people such as stockholders, suppliers, bankers, employees, government agencies, owners and other stakeholders. Therefore, the financial statement is important to any organization as the decision is mainly depending on the report submitted to the management
Financial Accounting serves three purposes:
- Producing general-purpose financial statements.
- Provision of information used by management of a business entity for decision making, planning and performance evaluation.
- For meeting regulatory requirement.
1) “Show me the money!” That's what financial statements do. They show you the money. They show you where a company's money came from, where it went, and where it is now. There are four financial statements (1) Balance sheets, (2) Income statement, (3) Cash flow statement, and (4) statement of shareholders' equity. A balance sheet shows how much money a company made and spent over a period of time. Cash flow statement show the exchange of money between a company and outside world for given period of time. Statement of shareholder' equity” shows changes in the interest of the company's shareholder over time.
Now let us have what financial statement does.
1) Balance sheet:
a balance sheet provides complete detail of assets, liabilities, and shareholders shares.
- Assets: assets are the thing the owns in terms of valve, thus it mean they can be sold by company or used by the company to make products or to provide services that can be sold. Assets consist of physical property, such as plants, equipment and inventory etc. It also includes things that cannot be touched or seen but nevertheless exist and have value, such as trademarks and patents etc. In addition, cash itself is an asset.
- Liabilities: liabilities are the amounts of money that a company owes to others. This include all money borrowed from a bank, rent of a building, money owed to suppliers for materials, etc. Thus, Liabilities is debt burden on the company.
- Shareholder's equity: shareholders share is called capital or net worth. They are the owner of the company. In case of wind-up, the money that would be left after company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.
2) Income statement:
It is also referred to as Profit and Loss statement (or a "P&L"), it gives reports on a company's income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. Thus, its shows the sales and the various expenses incurred during the given period.
3) Cash flow statements:
Cash flow statement gives a report of a company's inflows and outflows of cash. This is vital because a company needs to holds enough cash on hand to pay its expenses and purchase assets. Thus, the cash flow statement shows the net increase or decrease in cash for the period. Generally, cash flow statements are divided into three main parts. (a)Operating activities; (b)investing activities; and (c)financing activities.
4) Statements of Shareholder's equity:
shareholders share is called capital or net worth. They are the owner of the company. In case of wind-up, the money that would be left after company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.
"Thus the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise which is useful to make economic decisions. So financial statements should be understandable, relevant, reliable and comparable.
Financial statement can help the in following ways.
For Internal use:
statements can be internally by the company for better decision-making, bargaining in management, raking and promoting the employees.
- Owners and managers needs financial statements to make important business decisions that would affect its continued operations. These statements are also used in annual report to the stockholders.
- Employees also need these reports for making collective bargaining with the management; it is also used for discussing their compensation, promotion and rankings of the labours of the company.
External users are the investors, banks, government agencies and other parties who are outside the business, thus they need financial information about the business for following reasons.
- Investor needs financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
- Financial institutions (banks and other lending companies) use them to decide whether to grant a company or to extend debt for expansion and other expenditures.
- Government tax departments need financial statements to make sure the accuracy of taxes and other duties declared and paid by a company.
- Media and the public also have a interested in financial statements for a different of reasons.
2) The unique aspect of financial accounting is that despite all the form of ownerships, and different types of business activity, there is one single format for the financial statement of all types of business. They may differ in some specific detail and descriptions, but the basic formats remains the same. Assets are classified as either financial assets or non-financial assets and are reflected on the Statement as such. There is no distinction between current and non-current; Liabilities are not classified as current or non-current but are listed.
A company that prepare its own books and prepares its interim and annual financial statements itself may accurately follow some accounting rules. The internal member of management preparing the financial statements may prepared financial statements internally may be considered as the “lowest” quality of financial statements. For small businesses, and businesses with sophisticated internal accounting professionals, this may be the highest grade of financial statement a company needs.
Certified Public Accountant (CPA) prepares Compiled financial statements. The CPA prepares these statements with information provided to them by the business client. They prepare them mostly in accordance with rules. Banks and other lenders generally consider compiled statements of greater value than internally prepared statements.
Reviewed financial statements are one step up, a CPA performing a review will seek a more in depth understanding of the client's business and financial information through inquiries and analytical procedures. These added procedures are performed in an order to obtain a basis for reporting whether or not the statements are free from any material modifications.
An audited financial statement is the highest level of financial statement an accountant can prepare. Many private companies with numerous shareholders often obtain audited statements and if your business is of decent size and having a set of audited financial statements might make sense to increase the value of the enterprise. Audited financial statements are also required by some third parties whom your business works with. For private companies taking their stock public, the various stock exchanges require at least 3 years of audited financial statements.
Audits require considerable time and work on the part of the auditor and can be quite expensive.
3) Financial statement analysis provides the basis for understanding and making business decisions. Those who use the analyses are Boards of directors, management, external auditors etc, depend on accurate data and controls to help determine how best to run the organization. To serve the organization effectively, internal auditors should use financial analysis to provide information on company profitability and the effectiveness of operations. Financial statement analysis is accomplished largely by examining ratios derived from the financial statements.
After obtaining the chart, the auditors should ask area management or appropriate accounting personnel which accounts they use to record their transactions. They should also determine how and where the accounts are summarized in the financial statements
An organization generally uses two types of analysis to assess financial statements --comparison analysis and ratio analysis. Comparison analysis consists of a simple analytical procedure that helps in finding expectations from one period to the next. It can be applied to actual account balances from current and prior periods.
Ratio analysis is the most widely known and most commonly used type of financial statement analysis. It provides information on the effectiveness and efficiency of operations in industry. Ratio analysis involves examining the financial statements. The resulting ratios are usually expressed in percentages, which can be used for comparing the ratios from one period to another. This comparison allows the internal auditor to determine whether significant changes in the ratios from period to period are caused by poor performance.
The types of analysis varies according to the specific interests of the party involved
- Trade creditors or suppliers are interested in the liquidity of a firm
- The bankers or other creditors are more interested in the cash-flow ability of the firm to service debt over a long period of time
- Management also requires financial analysis for the purpose of internal control and to seek suppliers.
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