Advanced Finance and Decision Makers

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Advanced Finance and Decision Makers

Table of Contents

Introduction

Therelationshipbetweenfinancialanalysisandbusinessriskassessmentindecision-making

Thepurposeandstructureoffinancialstatementsinrelationtodecision‐making

Sourcesoffinanceforshortandlongtermbusinessdecisions

Waysinwhichdifferentownershipstructuresinfluencethemeasurementoffinancial performance

Importance of ethical, governance and accounting standards in financial reporting business decision making

Case Study - Application

Conclusion

References

Introduction:

Finance has become one of the major functional departments in an organization. Every organization, irrespective of its size and industry in which it operates, will prepare financial statements to report the financial information. This assignment focuses on evaluating the important aspects of the finance and financial statements of the organization. This research paper focuses on analysing the relationship between the business risk involved in an organization and the financial analysis that a financial manager carries out every year. The paper also identifies the financial sources available for both short-term and long-term business decisions. In addition to that, the paper focuses on analysing the influence of various ownership structures on the measurement of the financial performance and role on ethical, governance and accounting standards in financial reporting.

Therelationshipbetweenfinancialanalysisandbusinessriskassessmentindecision-making:

It is important for the managers to very frequently analyse the business risks and implement the risk mitigation techniques. The business risk can be in many forms. Some of the major risks that put the organization into trouble are operational risk, financial risk and solvency risk etcetera (Fruhan, 1979). Normally, the financial managers will try to conduct the financial analysis to identify the risks that the organization has been facing in current business environment. In simple terms, the financial analysis helps the financial manager to evaluate the profitability, solvency and stability levels of the organization in a particular financial year.

By analysing the profitability, the financial manager can easily recognize the ability of the organization to make profits and the capability to gain the retained earnings for future investments. If the profitability analysis makes it clear that the organization is making good profits, it can be concluded that the organization is not suffering from any kind of financial risk and vice versa. If the business manager does not analyse the profitability of the organization before taking important decisions such as procuring advanced technologies or hiring additional employees, it might suffer due to financial risk (Streuly, 1994).

In the same manner, the financial manager can also identify if the organization is suffering from the operational risk or not. The operational risk occurs when the organization is unable to clear the short-term obligations such as office rent, employee salaries and administrative expenses etc. (Streuly, 1994). If the financial manager identifies the impending operational risk, he or she will take right decisions such as controlling the operational expenses or changing the credit terms in such a way that the organization receives money from the customers quickly.

Finally, it is important for the financial managers to regular check if the organization has been maintaining right kinds of assets to clear the long-term obligations to avoid the solvency risk. Yes, the inability of the organization to clear the long-term obligations might lead to solvency risk which ultimately make the organizations insolvent and go bankruptcy (Williams et al, 2008). By conducting the financial analysis, the business manager can identify the solvency risk and make appropriate decisions to reduce the same. Thus, one can conclude that the financial manager should carry out financial analysis to identify risks for effective decision making.

The purpose and structure of financial statements in relation to decision making:

Generally, every organization will prepare three financial statements to report the financial information of the organization to important stakeholders. The first important financial statement is balance sheet, which is also known as statement of financial position (Williams et al, 2008). With the help of the information provided in the balance sheet, the stakeholders would be able to understand the financial position of the organization in a particular financial year. Normally, balance sheet contains information about assets, liabilities and owner’s equity (Al-Ajmi, 2007). The concerned persons can compare the financial information provided in the balance sheet of current year with the previous year to understand the financial health of the organization.

Income statement is another financial statement that provides information for decision making. The income statement provides information on net profit/net loss, operational profit, operational expenses, taxes and interest rates etc. (Streuly, 1994). With the help of the information provided in the income statement, stakeholders would be able to understand if the organization is enjoying the profit or suffering from losses. Another financial statement that is prepared in organizations is cash flow statement. This is used to see how changes in the financial statements will impact the cash the organization has in hand.

The information reported in these financial statements would help all the stakeholders of the organization in important decision making (Fruhan, 1979). Different stakeholders will use the information provided in the financial statements for different purposes. For instance, the business managers will try to make use of the financial statements for making informed decisions. In the same way, investors would analyse financial statements to check if the organization has the ability to pay both long-term and short-term obligations. When it comes to regulatory bodies, they will try to analyse financial statements to check if they are prepared by following ethical principles and accounting standards (Williams et al, 2008).

While preparing these financial statements, the accounting or financial managers will follow the accounting standards and ethical mechanisms etc. Though the structure of the financial statement varies from one type of organization to another organization or country to another country, all these organizations will provide similar kind of information (Foster, 1978). For instance, the private limited companies and public limited companies will report owner’s equity because it has multiple stakeholders but the financial statements of sole proprietary and partnership organizations will not carry the column called ‘owner’s equity’.

Sources of finance for short and long term business decisions:

The sources of finance can be classified into two types. They are short-term financial sources and long-term financial sources (Al-Ajmi, 2007). The short-term financial sources would be used to finance the short-term business decisions. The business manager should be very careful in choosing the suitable financial source because an inappropriate financial source may increase the financial risk, operational risk and solvency risk for the organization. Thus, while choosing a financial source, the business manager should analyse its risk levels and capacity to generate the investment etc. (Fruhan, 1979).

When it comes to the short-term financial sources, the business manager can choose sources such as personal savings, retained earnings and back loan. The personal savings are the money saved by the owners of the company. The business owners can use the personal savings to financial short-term business decisions such as procuring small-scale software applications and renting premises etc. (Bierman, 1980). The best part of the personal savings is that the business owners might not feel the pressure of repaying the money. Moreover, the business owner can enjoy the complete control over revenues and operations. On the other hand, retained earnings are the earnings remained with the organization after clearing the short-term obligations. Since the retained earnings belong to the organization, the business owner can use it for short-term business decisions. The business owner can also approach banks to finance the short-term projects. When the business owner takes bank loan, he or she might feel the pressure of repaying the interest in regular intervals and principal on loan maturity date (Al-Ajmi, 2007).

On the other hand, business owners can find numerous of long-term sources to finance the long-term business decisions. The sources such as venture capital, long-term bank loan, angel investment and Share Capital belong to the long-term financial sources category (Foster, 1978). The angel investment is the investment fund invested by an individual on the profitable projects or ventures. Since the money gathered from the angel investors can be huge, the business managers can use angel investments for long-term business decisions. Similarly, venture capital is the fund gathered from multiple individuals and maintained by the professional agency. These agencies would not only invest money on the business projects but also help the business owners in decision making. In most of the cases, the long-term business decisions need huge capital investment (Fruhan, 1979). At this juncture, the business manager can go ahead with offering shares of the organization to the public through Initial Public Offering.

Ways in which different ownership structures influence the measurement of financial performance:

Different types of organizations will measure the financial performance differently. This is majorly because of the changes in the ownership structures. In today’s corporate market, predominantly, there are five ownership structures. They are sole trading ownership structure, partnership organization, private limited organization, public limited organization and non-profit organization (Zane et al., 2004). With regards to the sole training ownership structure, the financial performance would be measured in terms of the profit made by the business owner. As there is very little bit of difference in between the net profit and gross profit for sole trading organizations, the net profit or gross profit are said to be the major measurements of financial performance. In the same way, the partnership ownership structure influences the measurement of the financial performance in terms of the gross profit wherein the profit is shared between the two partners. Since the efforts kept in the partnership organization are more, the partners would want to measure the financial performance of the organization in terms of the turnover generated.

On the other hand, the private limited organization is formed by minimum of two shareholders and maximum of 50 shareholders (Fruhan, 1979). Since all the stakeholders are concerned about the earnings of the organization and protect the money that they have invested in the organization, the primate limited structure would influence the measurement of financial performance in such a way to check in terms of the growth rates of the organization. Apparently, the higher are the growth rates of the organization, the better would be the share value of the organization. The same is in the case of the public limited structure too. Since there are more shareholders in public limited organization, the financial performance of the public limited company would be measured in terms of increase in the share value (Bierman, 1980). Finally, for non-profit organization, the profit would be measured in terms of the donations generated.

Importance of ethical, governance and accounting standards in financial reporting business decision making:

Today, business owners have been giving high important to ethical, governance and accounting standards while reporting the financial information. Normally, ethics would help the organization to guide the behaviour of the employees or the stakeholders for that matter. Similarly, the governance principles would emphasize on the organizations to follow the equal distribution procedures while treating the customers or employees (Foster, 1978). Finally, the accounting standards majorly emphasize on following specific pre-defined procedures to disclose the financial information about the organization.

The ethical, governance and accounting standards would focus three important aspects of the financial reporting decision making. One of these three important aspects is long-term success of the organization (Foster, 1978). When the organization tries to be ethical and follow the governance/accounting standards, it might not make the stakeholders happy in the short-term but definitely excels in the long-run. Numerous of the organizations have gone bankrupt just because of not following the ethical, governance and accounting standards while reporting the financial information. Some of the best examples for such organizations are Enron, Lehman Brothers and Morgan Stanley.

The second important aspect is that the organizations can easily avoid the business risk by following ethical, governance and accounting standards. Since the accounting standards and governance principles demand employees to follow the right code of conducts, they will stay away from the illegal or non-ethical activities such as price fixing which automatically leads to business risk (Bierman, 1980). The third important aspect is that the organization can easily avoid costly fines for wrongdoings of the workers. Numerous of organizations have been paying huge penalties for not following the accounting standards. For instance, paid a penalty of $100 million in 20120 and Fannie Mae has paid approximately $400 for similar issues.

Case Study – Application:

The investment of the project as given in the case study is £158,000.

The below table clearly shows the cash inflows and cash outflows provided in the case study.

Year

Cash Inflows

Cash Outflows

Year1

£43,000

£8,000

Year2

£50,000

£8,000

Year3

£56,000

£8,000

Year4

£59,000

£8,000

Year5

£47,000

£8,000

The summation of the cash outflows for given 5 years is £255,000

Similarly, the summation of the cash inflows for given 5 years is £40,000.

The net cash flow = cash outflows – cash inflows = £215,000.

As mentioned in the description of the case study that the business would like to ensure that every project will give at least 10% ROI every year. If we calculate the ROI’s for the project with 10% ROI, the figures look like this.

For 1st Year, the ROI would be around 158,000 *10% = £15,800

For 2nd Year, the ROI would be around = £17,380

For 3rd Year, the ROI would be around = £19,118

For 4th Year, the ROI would be around = £21,029.8

For 5th Year, the ROI would be around = £23,132.78.

The summation of the ROI for five years is £96,460. This clearly shows that the net cash with the organization at end of the five years at 10% ROI is £254,000. Since the ROI generated by the project with the given details is a bit lesser than the ROI that can be generated at 10%, it can be concluded that the project is not a viable option.

Conclusion:

To understand the stability and profitability of the organization, the financial manager will carry out the financial analysis. With the help of the financial analysis, the financial manager will be able to identify the business risks such as operational risk, financial risk and solvency risk. Normally, organizations will prepare three kinds of the financial statements. They are balance sheet, income statement and cash flow statement. The sources of finance can be classified into two types. They are short-term financial sources and long-term financial sources. When it comes to the short-term financial sources, the business manager can choose sources such as personal savings, retained earnings and back loan. The sources such as venture capital, long-term bank loan, angel investment and Share Capital belong to the long-term financial sources category. Though the structure of the financial statement varies from one type of organization to another organization or country to another country, all these organizations will provide similar kind of information.

References:

Al-Ajmi, J., 2007. The use of accounting information by investors in Bahrain. Working Paper, University of Bahrain, Bahrain

Bierman, H. 1980. Strategic Financial Planning. New York: The Free Press.

Foster, G. 1978. Financial Statement Analysis. Englewood Cliffs, New Jersey: Prentice-Hall, Inc.,

Fruhan, W. E., Jr., 1979. Financial Strategy: Studies in the Creation, Transfer and Destruction of Shareholder Value. Homewood, Illinois: Richard D. Irwin, Inc.

Giacomino, D.E. and Mielke, D.E, 1993. Cash Flows: Another Approach to Ratio Analysis. Journal of Accountancy 175, 55-8.

Streuly, A.C., 1994. The Primary Objective Of Financial Reporting: How Are We Doing? The Ohio CPA Journal 53, 15-22

Williams, J. R., Susan F. H., Mark S. B. and Joseph V. C., 2008. Financial & Managerial Accounting. McGraw-Hill Irwin. pp. 266.

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