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Obtaining Information For Decision Making And Forcasting Finance Essay

Obtaining information for decision making

Explain the various forecasting methods and techniques used for decision making purposes, include in your explanation their advantages and disadvantages.

Choose a business you have worked for, or one you have studied and apply appropriate forecasting methods to develop a cost and revenue forecast over i year and 3 year horizons. Explain how you will adjust for price movements, for example – inflation.

Forecasting:

 The process that can be used for making decisions and a statement about the events that can happen in future is known as Forecasting. Forecasting is it self a process that is related to future events. Following are the methods & techniques that can be used fro decision making.

Fundamental methods:

Some forecasting methods use the assumption that it is possible to identify the underlying factors that might influence the variable that is being forecast. For example, sales of umbrellas might be associated with weather conditions. If the causes are understood, projections of the influencing variables can be made and used in the forecast.

Autoregressive integrated moving average.

Regression analysis using linear regression or non-linear regression

Autoregressive moving average.

Econometrics

Progressing forecast:

Is a projection into the future based on past performances, routinely updated on a regular schedule to incorporate data.

Linear prediction

Trend estimation

Moving average

Exponential smoothing

Extrapolation

Weighted moving average

Growth curve

Time series methods

Time series methods use historical data as the basis of estimating future outcomes.

Judgmental methods

Judgmental forecasting methods incorporate intuitive judgments, opinions and subjective probability estimates.

Surveys

Delphi method

Scenario building

Technology forecasting

Artificial intelligence methods

Artificial neural networks

Support vector machines

Other methods

Prediction market

Simulation

Reference class forecasting

Probabilistic forecasting 

Ensemble forecasting

Task 2

SOURCES OF FINANCE

Definition

For many businesses the issue about where to get the funds to start up the business. All businesses need investments. Sources of finance are the foundation of that money.

The Need for Finance

Finance Is the money available to spend on business requirements:

Right from the beginning someone thinks about the business idea, to consider why the business needs s to raise finance. Finance can be needed for the variety of different reasons, which will have an effect on what the most suitable source of finance will be .

Starting up a new business

Copy with a cash flow problem

Buying some new equipments or machinery

Setting up a new plant

Buying another business (a takeover or acquisition)

Copying with debts.

The money use to pay for stock and to pay the bills is called working capital. Both the working capital and money for capital expenses has to be found before the business starts to create any income. Finance to establish a new business will be more difficult to assemble than other type of finance. This because the lender has to take the risk as to whether your business wil achieve something or not.

Raising finance to buy an existing business will be easier than to spend money on fresh. The lender will look at the track record of the business that you are taking over, and if it looks sound with good .profit achieving and has assets that can be used as security than you would have high rate of victory.

Arranging finance to purchase assets is not as complicated because the assets used as a security and the amount you can make use of will depend on the estimation of assets. Raising finance to expand the business will succeed if the business already has a record of success with better cash flows and achieved profit. Expending a business is always a good purpose because it provide confidence to the lender that things a re going well. Buy out a partner or a shareholder is important as well or evens a competitor. As long as the business is successful and adequate collateral is provided to the lender, your chance of success would be good.

Sources of Finance

The sources of finance that is obtainable will depend on different factors. There are more than a few sources such as:

Private and Family (Funds from private and family sources).

Debt Financing (Borrowing money from others).

Equity Financing (By sale of an interest in then business).

Other financing (other sources such as Trust, Grants etc).

Private and Family finance

This type is known as self funding. Money is raised by you, your family and friends. It can come from private saving and family loans etc.

It’s the best type of loan because there is rarely minimum commitment to any other party (except family and friends) & interest rates are lower than other sources. Its has advantages as well as disadvantages however

.

Debt Financing

A debt is a direct compulsion that you have to pay cash to someone who has lent you the money in the first place. It’s obligation that you have to an investor or lender. The investor will expect the interest in return for the loan that they are making. The important part of the debt finance is the cost of that finance which is the interest that will be charged. If you can’t find your own finance privately or through friends or associates than you may have to look other outside party that can lend money.

What Do Lender Look For:

Are you able to repay the? That is, do you have the ability based on then cash flows and profitable of your business?

Do you have enough business and management experience to run your business profitably?

Is there enough value in the business, that is, how much equity is there that will be a cushion for the lender?

Are you able to provide responsible assets that can be used as collateral?

Advantages of Debt Financing:

The biggest advantages of debt financing is that it will allow you to keep control of your company and you’ll be liable for is to repay the loan plus interest to the lender. You are entitled to all business profits in the normal way except there will now be an interest cost involved.

Once yo have repaid the money to the lender there is no further claim on your business name and you are free to carry on without any further commitment or obligations to anyone else or having problems in running business. It’s good to be free of lender because they can cause you problems or put you in trouble if you run into difficulties with making loan repayments.

Types of Debt Finance Available From Bank:

There are different types of finance but as far as the bank is concern there are 3 common types of finance available.

Overdraft: This is the most common type of finance and is mostly for cash flow purposes. It operates on your check account and by it the bank authorize you to overdraw your bank account by a given overdraft limit. This is also considered as tide-over finance and is a fixed overdraft provided by the bank.

Term Loan: Bank seems to favor Term Loans more than overdraft Facilities. It’s a medium term loan arrangement which is commonly given 12months and up to 5year period. The requirement is regular repayment of capital and interest and a deduction from the bank account and would be used usually for the purchase of normal working capital needs.

Discount Facilities: If you have debt which are due to you at a particular time (e.g. the sale of a property has been completed but the funds are not due for say 1 month) then your bank will often agree to provide or arrange a fund in advance similar to bridging arrangements and when the money belonging to you is available these are used by the bank to repay the advance.

Disadvantages of Debt Financing:

The biggest disadvantage of debt financing is to make the repayments of principle and interest. These can be a drain on your cash flow. Some loans may be interest only with the full amount of the principle repayable at a later date. This type of arrangement would be preferable for the business if you wanted to protect your cash. The main disadvantage is the difficult of getting this type of funding in the first place.

Equity Financing:

Equity financing where someone invests capital into your business and in return where they can get share of the ownership. It’s a risky form/kind of investment or financing because there is no guarantee of the return to the financer/investor. Investors are looking for that large profit which they hope to make when their investment is realized by selling their shares at a later date.

Advantages of Equity Finance:

With the equity finance you don’t have to repay the money invested by the lender. This is important when you want to preserve your cash. You’ll lose part of the profit and part of the extra growth and value of the business because that lender owns parts of your business. But all these things will save you from returning money because the investor is investing on its own risk. Another advantage is that equity investor brings their expertise and their business contacts into your business as well as their cash, to make it better or profitable.

Disadvantages of Equity Finance:

The biggest drawback is that you’ll have to give up part ownership of your business as well as part control and decision. This is not always acceptable to many business owners because they’ll find themselves a little hampered when they want to make a decision that have the disapproval of the investor. Investor doesn’t always agree with your plans or directions for the business and this can cause friction. Another disadvantage is that the equity investor will require a large share of your profit than lender because of the risk involve or risk they are taking in investment.

Other Financing:

Customers as a source of funds

Small business investment funds

In some kind of industries, suppliers of goods and services may be paying attention in contribution as financial help so that you can purchase more of their products or services. Part of the deal would be that you have to purchase only their products which efficiently can mean a higher cost to you because of the absence of rivalry.

There are organizations that can arrange the funding for people who are about to start their or the business has already been running but need to grow.

The two main sources of finance for business come from:

Inside the business – known as Internal Finance.

Outside the business – known as External Finance.

Internal Finance

DEFINITION

The internal finance is a source of finance that come from the business, assets or activity.

Retained Profit:

When the business starts increasing sale it’ll expectantly make profit.

Or

If the business had a profitably trading year and made some profit after paying all its debt or costs, it could use some of its profit in business to finance the future activities. This can be very useful form of long term finance, providing the business in obtaining the profit. Research shows that 60% of the business investment comes from the reinvested or retained profit.

Sale of Assets:

A recognized business has assets. The business can finance new activities or by selling their assets to pay/clear debt. It’s often use as a short term source of finance (e.g. selling property or assets to pay debt) but if the assets that company is selling is more valuable than it could provide long term finance.

If the business wants to use it assets, then it may judge as sale or lease-back to pay it debt and then when the business need it may hire or rent from the business who owns the assets. And it may cost them extra money in a long term but it can help in short term to pay crisis. It was the method chosen by the Sainsbury’s and Tesco to finance their rapid growth in the 1080’s and 1990’s.

Reducing Stocks:

Stock is type of asset and can be sold to increase the finance. Stock includes the business‘holding of inputs (raw materials), little unfinished products and also finished products materials that it has not yet sold. Normally businesses hold their stocks. It can be useful if there is an unpredicted demand from customer. Stock level tend to rise during economic slowdown or recession as goods are not sold and stack instead.

Trade Credit:

Unlike a business doesn’t usually pay for the things before it takes ownership of them. Instead, it’ll probably place an order for supplies/input and will pay after receiving the item. It’s good practice to pay early often in a month and so, as this’ll help the business to build up a better relationship with its suppliers.

The source of finance becomes visible on the balance sheet as trade credit. This procedure of suspending payment or delaying to a future date is a form of very short term borrowing & helps with the problems of the cash cycle identified in the work on liquidity.

External finance

Definition:

Few companies are capable of operating the business with external finance.

This type of finance comes from outside the business. It involves the business owing money to outside entities or institutions.

Personal Savings:

This mainly is relevant to sole traders and partnerships. Owners may use some of their own money as capital to invest in the business. For example, a person may be made redundant by a company that needs to reduce in size. They would receive redundancy payment that they might use to start their own business. This is considered an external source as it’s assumed that the money lent to the business will be paid back to the private individual in the future, extra chance with an extra amount to pay off the individual for the help they gave. It can be a short or long term source of finance, relaying upon the capital invested & the decision of the person using their savings.

Commercial Banks:

We tend to consider two types of finance that banks offer to businesses, overdrafts and loans.

If a business is spending extra money than it has in its account, we Say that the account is overdrawn. Most of the businesses use to have an agreement with the bank whereby they can lend money or can go over there limit or the bank will pay the extra money provided the will pay them back in particular period of time, with interest. This is short term source of finance and is useful for small transaction. It’s often use to buy inputs.

A bank loan is considered as a long term finance and will often be for much longer sums of money. The bank loan is useful for a new business or expending. The main purpose of the loan is to buy assets or to pay debts. A business will pay the bank in monthly bases and will pay the interest as well.

Interest rate is set by the Bank of England and it varies. Higher the interest rate, the bigger the percentage of the loan that the business must repay.

Factoring services:

Businesses are often allocated money. Businesses may face difficulty in collecting or getting money back from the customers but may need to hold it quickly. A special factoring services or factoring companies may offer the business to handle the debt collecting and will charge the business or settle the price. The factoring company will pay the business most of the value of the debt 1st and would then collect the money from the debtor. This is a short term source of finance.

Share Issue:

Share issue is imperative source of finance for Ltd. companies. Share issue absorbs a business selling new shares that give the right to the shareholder to share in the control of the business. Each share gives the shareholder a vote on the direction of the company.

This normally means that the shareholder has got right to elect the board of director of the company each year. The shareholder right is to check the board of directors is running the business well or not and if the shareholder doesn’t like the way of director handling business, they can elect new directors. This is good enticement to the director to run or handle the business well and make it profitable and the profit will be paid to the shareholders in the form of shares.

If the shareholder owns more shares the control will be higher and strong. If a company wanted to take over other company, it could arrange to buy the 50% of the company’s shares. This would give them majority of control as well as ownership.

Debentures:

This is a form of finance or loan that can be borrowed or taken out by a public or financial institution for a long term of period and period of paying back is long as well. The period of paying back is with in several years. This type of loan is also called long term finance.

Venture Capitals:

Some individuals join together to provide finance for a new growing business. They look for businesses which got chance to grow and that they will make some profit.

Leasing and Hire Purchase:

This is a common way to financing the acquisition of new fixed assets. Instead of buying new assets the company can hire for a fixed term of period. Leasing involves business renting equipment that it may use for several years but never owns. It may have a deal with a company to service and repair the products or equipments. The deal may involve in replacing faulty items/products. Hire may involve paying for equipment in installments. It usually works out more expensive to buy assets.

finance and corporate strategy

Finance is a mystery to many general managers nonfinancial executives often view finance as best to experts. As a result they some times unquestioningly delegate the number aspects of decision making to their shareholders or finance colleague. Finance is, too important to be left to the experts.

The Role of Finance In Corporate Strategy.

by M. P. Narayanan (Author), Vikram K. Nanda (Author) "Finance is a mystery to many general managers ..."

Finance for Strategic Decision Making: What Non-financial Managers Need to Know (JBUMBS Series) (Hardcover)

Publisher: Jossey Bass (20 April 2004)

ISBN-13: 978-0787965174

In figure1.1 shows the role of finance in corporate decision making and its communication with corporate strategy. As figure shows, corporate managers decide value generating tactic from a set of available choices these strategies may involve strategy decisions & financing decisions.

The role of finance in functioning decisions is mainly one of estimation and monitoring. Finance helps manager estimate the operational alternatives available to them, and helps them observe the decisions that are implemented. Such implementing is critical to evaluation of corporate strategy; its helps management change or adjust its strategy based on the outcomes of earlier strategies.

cost of obtaining finance

Effective risk management can reduce the cost of obtaining fiancé. External source of finance are more costly than internal finance.(e.g. high issuing costs of equity) and may be more difficult to obtain. Hence, managing cash flow through various risk strategy may reduce the volatility of cash flows and ensure there is sufficient internal finance for the business. Fast growing businesses would benefit from hedging for this reason. In addition, managing the cash flow so that liquidity doesn’t fall below certain perceived minimum acceptable level will prevent financially attractive investments being rejected because of lack of cash.

In addition, reducing the risk of default via effective risk management can increase a firm’s debt capacity and lower the cost of capitals.

(Mr Bill Neale and Trefor McElroy (Paperback - 12 Feb 2004)

Business Finance: A Value Based Approach

Publisher: Financial Times/ Prentice Hall (12 Feb 2004),ISBN-10: 0201619040

Various costs associated with obtaining the finances

Costs that are associated with acquiring loans and finances are:

Mark-up/interest

Legal charges

Fee for professionals

Revaluation costs of securities to be pledged

Make the proposal for obtaining funds for a specific project or organisation of your choice by discussing the options available then commenting on the best available option

Possible options to obtain funds are:

Loan from banks

Leasing the assets

Personal savings

If the project is about increasing the sales everlastingly, then the best likely among the selected options would be hiring the assets, which will help the organization not to bound its running finance to a fixed asset and it would continue its operations with effortlessness. Leasing will also help the entity to counter the needs of the change of assets with the development of industry.

TASK - 3

Financial appraisal techniques used to evaluate potential investment decisions

There are certain techniques to evaluate the potential investments so that the best option may be utilized in the best interest of the organization.

Types of investment appraisal:

Payback Period

Accounting Rate of Return (ARR)

Internal Rate of Return (IRR)

Profitability Index

Net Present Value (discounted cash flow)

Payback Method/Period:

Payback is often used as a 'first screening method'. By this, we mean that when a capital investment project is being subjected to financial appraisal, the first question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target payback, and so it would reject a capital project unless their payback periods were less than that target payback period.

However, a project should not be evaluated on the basis of payback alone. Payback should be a first screening process, and if a project gets through the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique, accounting rate of return.

It should be noted that when payback is calculated, we use profits before depreciation in the calculation, because we are trying to estimate the cash returns from a project and profit before depreciation is likely to be a rough approximation of cash flows.

Advantages of Focus on early payback enhances liquidity

Shorter-term forecasts are more reliable

The longer the payback period the higher the investment risk is

Disadvantages .

It leads to too much investment in short-term projects.

It takes account of the risk of the timing of cash flows but does not take account of the variability of those cash flows.

It does not differentiate between projects with the same payback period

Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR) expresses the average accounting profit as a fraction of the capital outlay. The capital outlay may be expressed as the initial investment or as the average investment in the project. The decision rule is that projects with an ARR above a defined minimum are acceptable. Greater ARR makes the project more enviable.

The ARR method of capital investment appraisal can also be used to compare two or more projects which are mutually exclusive. The project with the highest ARR would be selected (assuming that the expected ARR is higher than the company's target ARR).

Advantages

Profits are easily traceable from the financial statements.

It constitutes the whole life of the project

Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which employs profit may be more easily understood

Comparison of multi projects is possible.

Disadvantages

It doesn’t account for the duration of the project.

Time value of money is ignored.

Internal Rate of Return (IRR):

The IRR is a relative measure (%) in contrast to the absolute (£) measure resulting from NPV calculations.

Advantages

The main advantage is that the information it provides is more easily understandable for managers, especially non-financial managers.

A discount rate does not have to be specified before the IRR can be calculated. A hurdle discount rate is simply required which is then compared with the IRR.

Disadvantages

If managers were given information about both ARR and IRR, it might be easy to get their relative meaning and significance mixed up.

It ignores the relative size of investments.

Any changes in the middle of the project life cannot be incorporated in IRR calculations.

IRR calculations are only based on cash flows, so it becomes difficult to calculate the IRR of no-profit making organizations having low conventional cash flows.

Net present value (Discounted Cash Flow):

Discounted cash flow (DCF) techniques are used in calculating the net present value of a series of cash flows. This measures the change in shareholder wealth as a result of accepting a project.

Advantages

All the cash flows are considered in the calculation

Time value of money is taken into account.

Risk of future cash flows is also considered.

Disadvantages

Estimate of cost of capital is required is required to calculate it

Outcome is represented in terms of money, not as a percentage.

Payback Period:

The time required for the cash inflows from a capital investment project to equal the initial cash outflow(s).

Payback is often used as a 'first screening method'. By this, we mean that when a capital investment project is being subjected to financial appraisal, the first question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target payback, and so it would reject a capital project unless their payback periods were less than that target payback period.

However, a project should not be evaluated on the basis of payback alone. Payback should be a first screening process, and if a project gets through the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique, accounting rate of return.

It should be noted that when payback is calculated, we use profits before depreciation in the calculation, because we are trying to estimate the cash returns from a project and profit before depreciation is likely to be a rough approximation of cash flows.

Advantages

Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which employs profit may be more easily understood

Comparison of multi projects is possible.

Disadvantages

It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment

It doesn’t account for the duration of the project.

Time value of money is ignored.

Task 4

KwikFit Motors

Profit and Loss Accounts

For the years 2008 & 2009

Particulars 2009 2008

£ £

Sales 650,000 490,000

Cost of Sales

Opening stock 90,000 87,000

Purchase 300,000 250,000

Closing stock (58,000) (60,000)

(332,000) (277,000)

Gross profit 318,000 213,000

Administrative expenses (90,000) (50,000)

Distribution cost (33,000) (25,000)

Operating profit before tax 195,000 138,000

Taxation (20,000) (25,000)

Profit after tax 175,000 113,000

Proposed dividend (45,000) (42,000)

Retained profit for the year 130,000 71,000

Retained profit B/F 50,000 8,000

Retained profit C/F 180,000 79,000

Average stock =

2009 = 119,000 2008 = 73,500

Equity = Fixed assets + working capital (Working capital = current assets – current liabilities)

KwikFit Motors

Balance sheet

For the years 2008 & 2009

Particulars 2009 2008

£ £

Fixed Assets

Land and building 95,000 45,000

Fixtures and equipments 30,000 20,000

Motor vehicles 68,000 49,000

Total Fixed Assets 193,000 114,000

Current Assets

Stocks 58,000 60,000

Debtors 140,000 135,000

Cash at bank 2,500 -

Current assets 200,500 195,000

Total Assets 393,500 309,000

Capital and Liabilities

Paid up Capital 60,000 35,000

Profits for the year 180,000 79,000

Liabilities

Short term finance - 35,000

Creditors 130,000 135,000

Taxation 15,000 16,000

Proposed dividend 55,000 45,000

Current liabilities 200,000 231,000

Total Capital & Liabilities 440,000 345,000

LIQUIDITY RATIOS

1. Current Ratio

2009 2008

= 1.00 times = 0.844 times

As current ration of 2009 is higher than the previous year 2008.

It’s considered as a favorable ratio.

But the CR is less than the expected average industry ratio of 2 times.

This ration is not considered as good ration.

Change in ratio =

=

= 18.48 %

The change in ratio is higher than the previous year by 18.48%.

The entity is able to clear its shot term debt more effectively in 2009.

2. Solvency Ratio/ Quick Ratio/ Acid Test Ratio

2009 2008

= 0.71 times = 0.58 times

The quick ratio of 2009 is higher than 2008.

So the company is taking more time to convert assets in to money.

The company can now face the unexpected demands fro the current assets more effectively.

LONG TERM SOLVENCY/ DEBT RATIOS

1. Debt Ratio

2009 2008

=50% = 74.75%

If the company has less debt ratio better it is.

The debt ratio of 2009 is less than 2008 so the company is doing well.

The ratio is favorable.

And the company is not deterioration.

The debt ratio of 2009 is less than 2008; company has done well in debt.

As it measures percentage of assets provided by the creditors so company is generating funds at its own more in 2009.

And the change is -33.11%.

2. Equity Ratio

2009 2008

= 49.1% = -31.57%

As the equity ratio shows higher percentage in 2009 we can clearly judge the shareholders contribution/interest in the company.

It means that the company is doing well in 2009 as compare to 2008.

That’s why shareholders are investing money in the company.

As it measures the percentage of assets provided by shareholders, the percentage is more in 2009 this means company is reliable as shareholders are investing more in 2009.

PROFITABILITY RATIOS

1. Return on capital employed =

2009 2008

= 3.25 = 3.94

2. Return on Total Assets

2009 2008

X 100 =49.55 % X 100 = 44.66%

As the percentage of profit earning from the assets is greater in 2009 this means company is employing its assets more effectively in 2009.

3. Profit Margin Ratio

2009 2008

X 100 = 48.92% X 100 = 43.46%

In 2009 the cost of sales are lesser then in 2008 which enhances the profitability of the company.

4. Net Profit Ratio

2009 2008

X 100 = 26.92% X 100 = 23.06%

The company is effectively using its resources and hence its net profit percentage is more in 2009 as compared to 2008.

5. Operating Profit Ratio

2009 2008

X 100 = 30.0% X 100 = 28.16%

The openings expenses in 2009 are lesser then in 2008 which implies that company is applying its manufacturing cost efficiently.

EFFICIENCY RATIOS

1. Debtors Turn over

2009 2008

= 4.62 = 3.62

The company is collecting the receivable balances in excess in 2009 as compared to 2008.

2. Debtors in No. of days

2009 2008

X 365 = 78.61 days X 365 = 100.56 days

Amounts from debtors are received in less days in 2009 which means that company is increasing its cash flow activities

3. Creditors Turn over

2009 2008

= 2.30 = 1.85

The company is paying the amounts to the creditors more times in the year as compared to 2008.

4. Creditors in No. of Days

2009 2008

X 365 = 158.16 days X 365 = 197.1 days

Company is clearing its debt in lesser No. of days as compared to 2008

5. Stock Turn over

2009 2008

= 5.72 = 4.61

Company is selling its stock more times as compare to previous years

6. Stock in No. of Days

2009 2008

X 365 = 63.76 days X 365 = 79.06 days

The stock was sold in less number of days as compare to the last year.

If the company is selling stock quickly it means that the chance of growing and success is better.

Just because the company is doing well in taking stock out quickly the value of the shares may go high in stock market.

The stock is sold in lesser no. of days that means company is working efficiently.

7. Total Assets Turn over

2009 2008

= 1.65 = 1.58

The entity is efficiently using its assets to earn profit.

8. Fixed Assets Turnover

2009 2008

= 3.22 = 4.44

The fixed assets are not used efficiently by the entity in generating sales.


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