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Research On The Implications Of Sources Of Finance Finance Essay

Cash is always considered as the ‘blood’ for a business, and how to gather and to manage it effectively, is through applying ‘Finance’. There are many sources of finance (i.e. through lease, bank, trade credit etc). However we will see that these each sources of finance is itself can be considered as an asset or something which have to be acquired first, for this, a certain type of cost is usually incurred- finance cost (example- interest payment etc). From this case we also see the various implications of the different sources of finance and how are been utilised. Also in a business project what sot of finance is actually required or beneficial is shown /given (at later pages).

Furthermore these issues are mainly dealt for a person name John Caird, who used to work in an engineering firm, now being redundant. As being so he managed to get his one time redundancy payment that is £200,000. He now wishes to open his own business.

However, we could see that he has insufficient knowledge on how to start one and to make financial decisions which is related to the issues which are briefly discussed on the top.

Now as being a specialist and an advisor several suggestions and recommendations are given below.

Finance

Chapter-1- Identifying the sources of business finance.

Introduction

In a business there are many different sources finance available. Some sources are ideal for short term and others are for long or mid term. Without having sufficient knowledge on these, the cost of finance can be unnecessarily be huge, as for instance it would be totally insane to buy stationeries or stocks on a house loan!

Also certain types of businesses cannot enjoy certain types of finance for instance in partnerships and sole proprietors cannot enjoy gaining capital through issuing shares.

First of all John should know the initiatives and legal steps to start any forms of business (Task A).

Sole trader- It is with single leadership and the owner of the business takes the full account of profit or loss that incurs. It is very easy to start one, with no such legal restrictions (in specific) like getting a trade license; however they are entitled to pay income tax on profits. Problem is that sole traders are more likely to face capital constraints than any other forms of businesses, also they are held fully liable to pay their debt either through selling their personal properties etc.

Partnerships- In here the general requirement to start is with two to twenty compared to sole trader; however profits as well as losses will be shared by the partners. For these, Partnership Act 1890* has been established. Each may also sign the Deed of Agreement*. Other than these exceptions to sole-trader, they are almost similar (i.e. partners are liable for debts also for the income taxes from the share of their profits etc).

Limited Companies- There is basically two types of limited companies; one is public limited company and private limited company. These both require ‘Memorandum of Associations’ * and Articles of Associations* and with that Company registration* have to be done as from the legislation of Act 1985 (as mended by the companies Act 1989). Other than greater complexity, the Government imposes a much higher rate tax (on profits) which is corporation tax.

As by now John should have some rough ideas on the types businesses and some tips on the legal procedures and how to start one. He should now know that the finance can be avail in three terms- short, mid and long term. Hence below his estimates classified according to what type of financial period it requires (short, mid or long term) (Task B) –

Table no: 1- Shows the terms of finance which are required to satisfy the expenditures (efficiently and effectively with explanations).

Now as John Caird is planning to start a business, there, finance cost will also be a big kind of cost like the operational and administrative costs. So there are variety sources of finances and as a business man, he should know these sources fall under which category, debt or equity. Hence below some of the sources are classified on which categories they fall under (debt or equity) (Task C) –

Some various sources of finances were identified particularly for these chapters; also they fall under which category. We also learnt in what terms (short, mid or long term these sources of finances are categorized into. The most crucial point of this chapter is that not all the sources of finance are used to pay all sorts of expenditures! Without realizing this properly the finance cost will be unnecessarily much higher. It can lead the business to danger and in more risks too.

Chapter-2- Implications of different sources of finance.

Introduction

As from earlier chapter we learn some various sources of finance. Like about bonds, debentures, leasing, bank loans etc, which are generally available in the business field. Different sources of finance have different implications. Each maintains its own uniqueness. As they are so … each has their own advantages and disadvantages over the other, hence it is up to the business to choose and select what type and sources of finances they require.

As we continue further we will find some various sources of finance as suggested to John Caird. From the case we can find, as suggested by Sandy to take the leasing contract for buying the building and fixtures rather than buying it at one shot. Hence the risks and other implications of leasing are discussed (below) (Task D).

Generally, leasing is provided by the finance houses or particularly specialized leasing companies. This ‘leasing’ is a sort of borrowing instead of purchasing an asset. By this John can save a huge amount of capital expenditure, and instead he will be entitled to pay a monthly or an annual fee. Furthermore the burden of maintenance cost will be greatly reduced on the top of it there will be tax advantages. From this perspective leasing is actually cheaper than direct purchase. Even John will have the flexibility to change and take better product instead of holding the leasing one when the leasing period expires.

However certain risks and disadvantages still involves in such leasing. For instance there will be no ownership of property; as a result the leasing company has the right to offer the contract to another party- when the existing leasing period is over. If the asset is to be used for a very long period of time like the building and fixtures, then my personal opinion will be not for the leasing but rather going for a long term bank loan. (Other implication of leasing is discussed below.)

Though for purchasing any sort of machineries like security systems or technical items like computers, in those cases leasing is particularly helpful. This is because this sort of materials depreciates really fast, on with that, new and better products for this stuff comes every year. Buying them will make the cost of changes much higher and for this kind of things, if the company ignores to keep the new and better products, then other companies can/will advance at a much faster pace and by these the ignorant company will be referred as ‘back dated’ or so. Hence purchasing for this type of goods is not the better option, than leasing.

Now John should also know and able distinguish between the implications and usage of factoring and discounting. How they are been implied is explained below (Task E).

Factoring is generally taken when a huge amount of sales is done on credit. Then the company mainly faces a liquidity crisis (i.e. short of working capital) and so it falls under debt by it’s current liabilities ex- creditors, bank interests etc. Hence to avoid such circumstances the company sells it’s debt to a financial factor (ex: commercial bank) and gets the money instantly with less service and interest charge. By this the company can pay out it’s liabilities and buy new stocks to run the business.

A formal process of invoice factoring is done on this manner for instance the selling company sells to the buying company and invoices in the normal way and for the normal credit terms of 60 days. A copy invoice is sent to the factoring company. When it receives the invoice, the factoring company will pay 80% of the invoice value to the selling company instantly.

Discounting is different from the factoring proposal. As by this way he will be able to collect his money from the debtors at a much faster pace than usual. As debtors will be more willing to pay it earlier than without this discounting because the earlier they will pay it, they will be able to enjoy higher discounts. This system is comparatively much cheaper than the earlier proposal and it is particularly effective in reducing the ‘bad debt’. However practicing this system will require hiring more employees, which is a more troublesome issue. Further more when the questions of quality and safety comes then invoice factoring is the better option. As such finance houses are much more specialized in of taking such issues.

From the case we could see Sally pointing out importance of the trade credit (Task F is discussed below). Indeed in running a business this source is used most frequently and it is also one of the most useful sources of finance- a possible solution to the short run cash flow problem. This is to done try to find ways of delaying payments to suppliers. To achieve this, a business will try to negotiate trade credit terms with its suppliers. As this allows the buyer on credit to pay on a later dates, than paying it immediately it is also an informal way borrowing where paper work is not the necessity like while acquiring the bank loan.

It’s main advantage is in it’s fastness to acquire. However the paying period is much shorter than the bank loans and it’s costs are relatively higher too. So from trade credit John can buy several things such as security system, office stationary, printing and publications.

Now he (John) wants to issue share capital or bonds/debenture to raise more capital for his business (Task G is discussed below). Not all forms of business can issue share capital or raise funds from bonds and debentures. For this particular, only public limited company is able to all these. Even the complexity level of forming such business is much higher than any other forms of businesses. As lot of paper works and regulations are needed, and have a higher start up cost too. For this ‘Associations of Memorandum and Articles of Associations from the legislation of 1985 Act (as mended by the companies Act 1989) is to be followed thoroughly. There is a significant difference between the share capital and with bonds and debentures. As one is equity and another is debt and so theirs risks and costs varies. This is show in the table (with ranks as given with- ).

Points should be taken that in the near future if the business fears to have lower profitability or loss then it is much wiser to issue shares than bonds and debentures, vice versa for an increase in profitability.

Conclusion

From this chapter some of the most basic, important and useful implication of finance were noticed. How they were used and with their usefulness and also some drawbacks were realized. As in this case various sources of finance like leasing, discounting, factoring, shares and debentures, their implications were discussed.

Chapter-3- Appropriate sources of finance for a business project

Introduction

As from the earlier chapter we have learnt the implications of finance, and here we will go into much depth of that topic. Here we will see and discuss some issues about how they affect the business and in it’s performance.

From here we could see that John is interested in sole-proprietorship business, hence from the available sources of finance (given in the case), is suggested according to the requirement of John to start his business (Task H).

Building and Fixtures- Better to buy on mortgage loan, in order to enjoy a full and fixed ownership of the property. Good side of this payment method is that it is not affected by inflations. However leasing cannot be completely ignored in the case if he is not willing to keep the building for a very long duration. By this he can save the purchasing cost of the huge asset and definitely it would reduce the tax burden and maintenance cost too.

Office Vehicle- In general it is wise to buy on mid term loan, as paying it by instalments- part by part would surely increase/ improve the flow of working capital.

Security System- It is better to take it on lease than any other forms like hire-purchase. It is because in each and every year new and better security systems are arriving and purchasing those means would reduce the option of switching to new and better ones.

Payroll Expense- For this one short term bank loan and personal savings can be used initially, however in the long run as the business is expected to become more profitable, then this sort of expenses should be adjusted with the gross profit.

Marketing Expenses- At start short term bank loan will be good, however as the business will run in the future years the retained profit will be ideal for this sort of expenses.

Office Stationary- Buying on hire purchase can be a good one, as by buying on credit John can use the product immediately. By this way he can obtain it with much lesser hassle (i.e. paper works).

Printing and Publications- This can be managed by trade credit, as it can be easily payable during the business years.

Things to take in account:

Whatever finance source you use, you should always take into the account of the cost of finance and the condition of the business.

As John finally got settled by being a sole-proprietor, he still has the utmost curiosity on the financial statements of different public limited company. Among which he mostly got attracted on the statements of Cairn Energy. Now to clear some of his confusions, the followings are given (Task I).

As Cairn Energy stated that their “Property, Plant & Equipment- Development/Producing Assets (long term asset)” has increased from $1,119.6m in 2008 to $1,828.6m. In fact their claim is true, as we can see from the balance sheet that their long term liabilities and capital has increased. For instance their loans and borrowings, retained earnings and share premium have significantly increased. How these have affected to increase Cairn Energy long term asset (is shown below)

Hence now there are other things which he likes to know from public limited company, those ares-

Deferred tax liability- [1] “ A tax liability that a company owes and does not pay at that current point, although it will be responsible for paying it at some point in the future. This is often caused by a difference in a company's balance sheet, due to the differences between accounting practices and tax regulations.” Hence any sort of deferred tax can be beneficial for the business.

Called up share capital- It is the money which drawn from the stock market or the [2] “money required to be paid by the share holders immediately”.

Share premium- It is the value which is set above the nominal/face value (-the excess amount). For examples if shares with a nominal value $2 are issued, say at $3 then the premium on each share would be $1.

As John Caird seeks to further investigations he has found diluted EPS, in the income statement part (Task J explained below). EPS stand for ‘Earnings per share’. This is the income given/distributed to the shareholders, according to the increase in number of shares they possess and dilution occurs, when the number of share increases and a result of it earnings per share and dividend per share declines. From this diluted EPS can be summarised into, EPS declines due to the effects of dilution. This happens because as more number of shares is injected into the market, whatever profit or loss is made by the company, is divided among the greater number of share holders.

Cairn’s cost of long term debt finance (finance cost) is approx $63.3m. Now if we have to analyse how Cairn’s business performance is not so satisfactory, but more horrible, finance cost with operating profit is approx 101.1% [all the workings are shown at the ‘work out’ below]. It is a red alert for the business. If we see the total debt asset ratio, it is approx 20.23% [workings given below]. This is a sign of some relief. As most probably they are busy with buying long term fixed assets. Now if we see the debt equity ratio it is an approx 29.1% [workings given below]. It is a fair warning too.

(Task K starts)With the current circumstances the business is in risky situation, even though they have bought a good numbers of long term fixed assets, however it will take a while for these assets to produce some extra revenue. Besides that if we see the income statement, we will see the revenue has fallen significantly approx 43.23% [workings given below]. Most probably this fall of revenue was unanticipated, as expenditure on the assets are significant proofs. As a result the cost of finance is becoming the key expenditure.

There are two categories of finance, one debt and another is equity. By the ‘debt’ category, expenses are paid through the form of interest payment. The finance is gathered from he liability sources. The advantage can be profit share can be higher, even when the business is performing well. However there are some drawbacks as well, such as there are interest payments, which eventually make the cost of purchase much higher and failing to pay debt means to break down the business (i.e. even selling personal properties-for sole-traders and partners) if necessary, to repay the debt.

Through equity finance, share of profit or income is paid as expense. The advantage from the equity finance can be that there is no extra payment is required like in debt payment. Though it is argued but it said that while operating with equity finance the opportunity cost is considerably higher. Further more it’s cost can go proportionally high when the business is performing well.

Hence for Cairn Energy to improve their condition finance will be required and it should be equity type of finance, like by issuing ordinary shares.

Justification for Equity

The reason Cairn should take the equity type of finance because it is been judged from the overall perspective of the business performance. As it can be observed that the business performance very shaky, if we see and compare the income statement of the two years we will notice that the revenue trend has harshly declined and on the other hand the other operating cost has sky rocketed which has resulted a fall in operating profit which is 82.9% [workings given below] and if they are unable to pay the fixed amount of finance cost on a regular basis, then his business will eventually lead to bankruptcy, or in credit crunch. It would be also irrational to think that the business will bounce back within next year. However taking equity sort of finance will bring a more favourable consequences. As the business will be able to extra capital collect form the share premium, besides that the cost of this finance will be from the retained profit or loss they have made. So by this at the present condition, this type of finance will be more favourable and hopefully this will be good move to come out from this sticky situation. Surely this will help them to gain bigger amount of capital with incurring lesser amount of finance cost.

Conclusion

From we could see that all the implications of finance are not always fixed by the size of the acquisitions, nor with the personal opinions (mostly), but in the business it is more with the condition of the business itself decides what type of finance resource will be more beneficial.

It can also be concluded that this time our client- John Caird, has some sufficient degree of knowledge on how to manage financial things and to make better decisions.

Showing the Workings and the Calculations

Calculation of finance cost and operating profit ratio in percentage-

Finance cost is $63.3m and operating profit is $62.6m

Hence, 63.3/62.6 *100=101.1%

Calculation of the total debt total asset ratio in percentage-

Total (long term) debt is $781.8m and total asset is $3863.8m

Hence, 781.8/3863.8 *100=20.23%

Calculation of the total debt and equity ratio in percentage-

Total (long term) debt is $781.8m and total equity is $2687m

Hence,781.8/2687 *100=29.1%

Showing the percentage fall in the revenue-

in 2008 it was $299.3m and in 2009 it was $169.9m

Hence, (169.9-299.3)/299.3* 100=43.23%

Showing the percentage fall in the operating profit-

in 2008 it was $366.7m and in 2009 it was $62.6m

Hence, (62.6-366.7)/366.7* 100=82.9%

Appendix

Deed of Agreement- A legal agreement states the capital contribution of each partner, what will be the rate of such capitals or on borrowings if any, salaries to be paid to partners and also states the profit sharing ratio among each partner.

Partnership Act 1890- When there is no Deed of Agreement, or a point which does not cover the point in dispute then the Partnership Act 1890 comes in action. As it that profits must be shard equally among partners, no claiming over the salaries or interest on capital and disagreements should be dissolved through voting.

Memorandum of Association- It covers the external relationship of the company with the outside world. There are several documents which have to be sent to the Registrar of the Companies. Like with the name, if it is a public limited company then ‘plc’ or ‘ltd’ for private limited company will have to be stated. Also it has to mention the reason why it has been form e.g. to manufacture books, a statement that the members of the company has limited liability and so on.

Articles of Association- It covers the internal relationship of the company with it’s members. It contains the rules relating to the voting right s of the members, methods of electing directors and procedures of calling meetings of shareholders.

Company Registration- [3] “The Memorandum of Association must be delivered to the registrar together with an application for registration of the company, the documents required by this section and a statement of compliance”.

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