The Different Sources Of Finance And Its Implications Finance Essay
The assignment attempts to explore the different sources of finance and its implication it describes how different structures and cultures affect the business performance of the organization. It identifies the cost of finance as a resource, budgeting and financing adequately. The application of investment appraisal technique and long term decisions. Shows the understanding of basis business and accounting terminology.
Theoretical studies from different books and Handouts from our tutor. Personal academic knowledge about business finance.ACCA background. JS AND Co. medium sized retailer scenario.
Sources of Finance
Js and Co. must be very aware of the importance to use the appropriate sources of financing meeting the needs of your company.
Sources of finance to business
There are different sources of finance, namely:
Short term finance-
Commercial banks -overdraft
Fixed deposits for a period of 1 year or less
Advances received from customers
Various short-term provisions
Medium term finance-
Public deposits/fixed deposits for duration of three years
Commercial banks – Short term loans <5yrs
Lease financing / hire purchase financing
External commercial borrowings
Long term finance -
Share capital or equity share
Loan – loan secured/loan covenants
Debenture/loan note-Fixed interest, tradable
Convertibles – value shares debt can be converted into a discount to the market value of the debt.
Very high returns expected
Very significant amounts
Very high growth potential
Leases- Finance lease
Implication of sources
Failure to use appropriate source of finance may lead to a firm being over-reliant on short term finance or on long-term debt.
There are two main reasons for raising funds namely:
Purchase of fixed assets, or the buying out of another firm
The need for more working capital: for debtors, stocks or cash, i.e. an increase in current assets.
From the information in the scenario the short term finance of 50 million is almost finalized and would be available when needed. Therefore there will be the need to finance the 75% by long term source of finance. A matching policy involves the using the long term finance to fund permanent current assets and non current assets
There are implications with the different source of finance.
Amount repayable at intervals is fixed from the beginning of the agreement
Amount not repayable on bank demand.
Safeguards on asset in case you default from payment
Normal interest rate applies as per agreement.
Special fees would be added in case borrower breaks Loan Covenant (Limitations on Financial Position).
Legal costs, commitment fees and Insurance
Term of loans would not exceed the usefulness of the asset.
A financial instrument (Shares or loan stocks) which a company may issue and which can be traded.
Debenture – written acknowledgment of a debt incurred by your company
Fixed rate of interest with option to convert into ordinary shares
The least risky form of finance, the investor has the highest return for highest risk. The return at the discretion of the directors who can declare payment for dividend or hold back as retained earnings for further investment and development. Shareholders maximization wealth may be ignored to further development of the business.
Choosing appropriate source of finance
As your company is a medium size with two partners you are limited to various source of finance because the structure of the business. You may consider to
Inject more capital from both of you as partners, since the business is looking promising and expanding at a fast rate.
Introduce new partners which will boost the capital of the business but there is drawbacks as well:
Dilution of ownership
Profits to be share among more partners
Some of the source of finance needs you to be registered by the stock exchange thereby adhering to some rule and regulations. Stock exchanges are mediums where investors can purchase equity (shares) in a company and participate in the fortunes (or failures) of the company. The need for financing your investment expands business.
In addition to attracting a larger base of potential investors, companies can increase your business image and notoriety and attract better employees
There is the extra cost of reporting to SEC. and the risk of disclosure of information. Competitors can analyse the F.S. and conclude your trend of doing business. Partners might not want their worth to be disclosed.
Finance as a resource
Assess and compare the costs of source of finance
Please refer to excel worksheet for cost of finance
Importance of financial planning
Helps monitoring the cash flow and the spending pattern
Helps to built a strong capital
Enable smooth management of income.
It helps in secure decision making for the company
As it considers all the income and expenditure, help for the right investment
The savings through planning helps in difficult times.
Helps to understand the current financial position
Effective decision making through planning safeguard your business from assets being a burden in the future
Investment with high liquidity.
Information needs for decision makers
Within the business organization there are two types of users of information.
Internal users –Those who have direct bearing with the organization.
Managers and owners.
To make business decisions
To facilitate financial analysis
Formulate contractual terms between your company and other organization.
Current debt equity ratio vital in raising finance
Financial statements of other companies provide the appropriate guidelines for channeling resources.
Use for collective bargaining agreements.
Discussing promotion, rankings and salary hike.
External users – any stakeholders or general public outside the organization.
Assess the financial strength of your company. A long-term lender will
always want to know the gearing ratio of a company while the short-term
lender will want to know about the liquidity ratio of the business
Raising finance, like in your situation to raise a loan you would need to produce the F.S. so that the bank can verify the liquidity and debt level in your company...
Investigation of tax payment and validity of profit declared.
General Mass and Media
General public, students.
Impact of finance on Financial Statements
Ordinary shares and preference shares –
Increases the value of equity capital in the balance sheet. If the issued shares market
price is greater than the nominal value of the share then share premiums also increased in the balance sheet. The number of shares issued is also displayed in the balance sheet and for preference shares the rate of dividend is also shown. The dividends paid to the shareholders are recorded in the appropriation account after tax is deducted from net profit.
Debentures – Debt capital
The value of debentures along with the rate of interest and the repayment date is presented in the equity and liabilities section of the balance sheet. The interest paid on
debentures is reduced from profits before tax is charged.
Bank overdraft –
This appears in the balance sheet as a current liability since it is a short-term debt and has to be paid back within a year. The interest charges and bank overdraft fee if charged are deducted from the profit and loss account before tax is charged.
Loans are long-term debts and therefore come under long-term liabilities in a balance sheet. The loan when displayed on a balance sheet will usually contain information about the repayment date and the interest charged on the loan. The interest is charged in the profit and loss account.
Policies and Accounting procedures
1. The going concern concept: an assumption that the business will continue to trade into the foreseeable future.
2. The consistency concept: that the same principles for constructing accounts will be maintained from one set of accounts to the next.
3. The concept of prudence: that in valuing a transaction, a conservative approach will be used, i.e. not to value at highest possible estimate.
4. The accruals concept: that revenues and costs are recorded when they occur rather than when the cash is received or paid.
5. The materiality concept: that financial transactions should be shown separately if by lumping them together with other transactions the user of the accounts might be misled.
The financial statement should be reliable, understandable, comparable and relevant. Any events after balance sheet date should in the notes and if any mistake or error is found before issuing the F.S., it should be hold back and do the necessary correction. Disclosing any facts that can impair the interpretation of F.S. stressing the fact that the F.S. is reliable and show a fair view of the state of the company at the stated date.
Analysis of budget and decision making
Calculating unit cost and making pricing decision
Refer to Excel spreadsheet -attached
Viability if investment appraisal techniques.
Under payback period method the investment will be recovered within 2trs 3mth
But the drawback it ignores the future cash flows which is about £187,212
Under NPV the project yields a positive NPV and therefore should be undertaken.
Under IRR is 26.5% which should be compared to the policy of your company. That is if the expected yield is lower than n the IRR only then you can accept the project.
Purpose of financial statements
Financial statements are formal presentations of the flow of money into; through and out of a business each statement is part of the framework for financial statements. This framework is called the Generally Accepted Accounting Practices, or GAAP. Each area of a financial statement has a purpose and provides specific information about a company's financial stability.
The balance sheet's purpose is to show the assets of the company. Balance sheets are based on a fix point called a reporting period
Income statements show the revenue earned during a reporting period. Included in this report are the expenses and cost of creating the revenue. Once the expenses and costs are removed from the total revenue, the bottom line of the report reveals whether or not the company lost money or made money
Cash flow statements track the inflow and outflow of cash. They reveal whether or not cash was generated by the business. The data for a cash flow statement comes from an income statement and the balance sheet. The cash flow statement reveals net decreases or increases of cash for the reporting period.
Retained earnings are broken down and explained in the statement of retained earnings. This statement reveals what the company keeps and does not distribute to the owners and how that amount changes over the reporting period. Losses are called accumulated losses, retained losses or accumulated deficit.
The financial statements can be used for loan applications, fund-raising or to place a value on a business. But they are typically used for making business decisions that will affect operations. The numbers and calculations in the financial statements are also used to calculate ratios and make further analysis. Common figures derived are operating margins, debt-to-equity ratio, P/E, working capital and inventory turnover. (Refer to appendix 1 and 2 for references)
Read more: The Purpose of Financial Statements | eHow.com http://www.ehow.com/about_5047231_purpose-financial-statements.html#ixzz0zECnVqzY
Formats of different financial statements ffor different typr of business
Sole traders –
Prepare accounts for their own use to know how much profit/loss for the year.
Prepare accounts to get to the profit to be distributed among partners. There is no legal obligation to produce any accounts, but sometimes it does help if they are applying for a loan /mortgage.
Public and Private company –
Legally binded to be registered by the companies house and to follow the required rules, policies and procedures. Therefore they are legally binded to prepare a set of accounts for each accounting year, showing the following-
Income Statement for the period ending…….
Statement of movement in Equity for the period ending……
Balance sheet as at …….
Cash flow statement showing operational, investing and Dividend transactions.
Bear in mind management can change depreciation policy and showing less profit. The change of policy cannot be change very often and should be explain before it does. Accounts should be prepared according to ssap’s and proper accounting conditions. Company can vary the mixture source of finance like your company but they have different area with particular risk and demand.
The format of the FS is being standardized like international papers for acca. To improve the reliability and effectiveness the ssap are to be followed and adopted accordingly. With the International accounting formats need to be standardized.
Analysis of Financial Statements using ratios and comparisons, both internal and external
Gross Profit Margin –
The figure shows the company is very healthy and is producing a high return comparing the cost of sales to the revenue
Net Profit Margin-
The figure shows a drastic decline compare to gross profit as its due to level of activity (107 to 175 Number of stores) which has increased thus reflect the increase in expenses and running cost.
Net Profit margin after tax –
The decrease between the PBIT and PAIT is the effect of the debenture interest (10%) and tax incurred during the year.
Interest Cover: - It shows JS and Co. is able to cover its interest charge by 2.5 times
Conclusion and Recommendations
Sources of finance is available from variety of sources but each source has its own cost and benefits. It is important to choose an appropriate and cheap source of finance for the smooth operation of the firm.
Use of working capital - Having high current assets is typically considered "safe", as you should be able to get your hands on plenty of cash quickly if you need to. Note that care must be taken to ensure stock is not obsolete (i.e. it is really worth the value shown) and that debtors are recoverable (i.e. they will pay you).Whilst typically safe, high current assets don't necessarily help the business become more profitable. Having lots of cash in the bank, or a warehouse full of stock is not always good use of money. High current liabilities can be considered risky. It means a lot of cash is expected to flow out of the business in the near future. If there aren't sufficient current assets providing that cash, the business could be in trouble. Having said that, the majority of businesses are in debt. If your business makes a higher profit margin than the bank charges in interest, net borrowing is not necessarily a bad thing.
JS and co you are operating as a medium sized retailer, with the expansion plan and the business growth in your business environment it’s important to identify the triggers for the success of your business. As you are two partners, is it the cooperation between you two that supported the success. If yes having a third partner may distort the relationship and as such the business growth. On the other hand, opting for equity might involve more administration and office work. This benefit to raise money from the member of the public at less cost than debt sources as discussed above.
It’s very true the best option would to raise finance through the Stock exchange which would benefit your company more reputation and business growth. But it also means of publishing accounts, registered with the Companies House and availability of the accounts to be scrutinized by any member of the public who is interest in investing in your company.
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