Sources Of Finance For Organization – Internal And External

Equity Shares

Questions:

1. Prepare a report and focus on sources of finance available to the business and discuss internal and external sources separately. Assess the positive and negative implication of the different sources of finance identified. Select a project that is typical to your organisation then identify and discuss various sources of finance appropriate for that business project. You need research the costs of each of sources of finance you have identified.

2. You need to analyse a suitable budget period at least six months and comment on performance and the behaviour over that that period .Also comment on what action should have been taken.

You need to give the formula and explain the link between unit costs and selling price decisions using relevant example. Also explain the importance of information on fixed cost, variable cost and break even point. In addition, assess and evaluate the viability of a project using different investment appraisal techniques (Payback period, NPV,IRR,ARR)to ensure project is properly funded and it will be profitable.

3. You need to discuss the main financial statements by explaining what they contain, their purposes And who makes use of them. Describe and compare the formats (structure, content, detail) of main financial statements for different types of business.

Analyse three consecutive years of financial statements of your chosen organisation by using appropriate ratios and comparisons , (both internal and external).

There are various sources of finance available to an organization. They are the internal sources of finance and the external sources of finance.  The expansion plan will help the organization to meet the future demand of the customers. The external sources of finance can be for a period of short term and for a period of long term capital. North Midland Construction PLc will use external and internal sources of finance to finance its expansion plan. The company will require 60% of the total requirements to finance their expansion plan. The sources of finance are discussed below –

Equity Shares – Equity shares are also known as the ordinary shares. It provides ownership rights to the equity share holders. The equity share capital is considered as a permanent source of capital. The company has to pay a share of profit as dividend to the share equity share holders. This is an external and long term source of finance for the organization. The equity share holders will have legal ownership of the company. The shareholders have to bear the risk is the company faces severe turmoil. But the share holders will also enjoy higher dividend amounts when the organization will earn huge profits. The shareholders has claim over the profitability of the organization (Kumar, 1994).

Preference shares – It is long term source of finance for the organization. The organization can raise capital by issuing preference shares. The preference share holders will get a fixed rate of dividend and enjoy their preferential right. The presence share holders will be repaid first on liquidation of the company. The source of capital has the characteristics’ of both the equity capital and debt capital. The preference shares are of various types on the basis of the amount of dividend payment, redemption of the divided and convertibility of the shares. The convertible preference shares can be converted into equity shares after a stipulated duration of time.

Preference Shares

Debenture – Debenture is an external source of finance which is taken for a longer period of time. The company can raise capital or borrow money from the market by issuing debentures. The debenture is the acknowledgement of the debt that has been issued by the firm.  There are certain terms and conditions of the contract. The conditions are based on the repayment of the principle amount within a specific period of time and company has to pay a fixed rate of interest to the owner of the debentures. The debentures are of two categories. They are redeemable debentures and irredeemable debentures. There are other types of debentures like naked, registered, mortgage and collateral securities.

Term Loans – The term loans are raised by the business organizations for a short term or medium term basis. The short term or medium term requirement of the organizations can be met by issuing term loans. The term loans are issued by the organization to finance their fixed assets and requirements of working capital. The term loan can be raised for the purpose of expansion of the organization. The term loan can also be raised for the purpose of redemption of the preference share capital, debenture and bonds. The term loan can be taken on payment of a fixed rate of interest which is paid by the owners of the organization to the lenders of the organization. The loan is taken by the owners of the organization against the security of the assets of the company (Levy, Berry and Nugent, 1999).

Commercial banks – The organization can take loan from the commercial banks for raising capital for a short term or medium term basis. The commercial banks provide loan to the organization for a fixed rate of interest.

Public deposits – Public deposit is another means of raising capital. The organization can borrow fund from the public at a rate of interest that has been specified depending upon the period of deposit (Bhaird, 2010).

Retained earnings – Retained earnings is an important source of internal capital for the organization. It is a long term source of finance for the organization. The profit of organization is utilized by the business organization for its expansion. The Retained earnings will be used by the organization for purchasing the assets. The retained earnings are also used for making improvements within the organization (Sofat and Hiro, 2015). The retained earnings are used for asset purchasing. The retained earnings are the cheapest source of capital for the organization. The organization will not pay any fixed rate of interest. The retained earnings will be an important source of capital for strengthening the capital structure of the organization (Nikbakht, Nikbakht and Groppelli, n.d.).

The other internal sources of finance for the organization are commercial papers, deposits etc.

The various sources of finance are equally important for the business organization to raise capital. The two major sources of finance for an organization will be the equity shares and the debentures.

The company can issue equity shares to raise funds so that they can finance their expansion plan. The company can raise the capital without making any charge against the assets of the organization. The company will have to pay the shareholders only at the time of liquidation of the business organization. Thus the company has no burden on it. During financial crisis the company is not liable to pay the divided to the equity share holders. The company will be liable to pay the dividends only if it earns huge profits. The dividend is paid at first to the preference share holders. Then the remaining part is distributed among the equity share holders. The payment of dividend on a regular basis enhances the value of the organization. The credit worthiness of the organization will increase. The equity shares are issued by the organization to raise funds from the market for the expansion of their business.

Debenture

Debentures are another source of finance for the organization. The short term and medium term financial requirements of the organization can be met by raising money via debentures. The company can raise funds by issuing debentures but the share of the company will not be distributed among the share holders. The rate of interest payable to the owner of the debentures is less than the rate of dividend payable to the equity share holders. The interest paid is tax deductible. The redemption of debentures can be done in case of overcapitalization. The possibility of trading equity is enhanced by which the organization can hedge against the problems of inflation.

Therefore on analysis of the various implications of the debentures and the equity shares it can be said that it will be advisable to North Midland Construction PLc . to raise money by issuing equity shares as well as by raising debentures to promote the plan of expansion of the organization.

The appropriate source of Finance for North Midland Construction PLc . is by issuing debentures by the organization. The issue of debentures will be cost effective for the organization. The organization has to pay a fixed amount of interest on debenture. The rate of interest paid on the debenture is lower than the dividend that is payable to the equity share holders. The interest that is paid to the owner is tax deductible. Thus issuing debentures will not be a burden on the organization. The company can pay high rate of dividend to the existing equity share holders as the burden of the company will be less. Debenture will be a stable source of finance for the organization. The company will be able to raise funds by issuing debentures. The risk of the organization will be reduced (Small Business – Chron.com, 2015). The investment of the organization in issuing debentures is also low. The company can hedge against inflation. This is due to the fact that the company will pay fixed amount of interest as termed during the time of issuing the shares. Thus the appropriate source of finance for Quality Window Ltd. will be by issuing debentures. This will be any ideal source to raise money for the expansion of their business (Bbc.co.uk, 2015).

The company will raise £1, 00,000 by issuing debentures. The money will be invested in various projects for the purpose of expansion of the business. The company will be able to raise money from appropriate source by effective financial planning. Financial planning is important for rational decision making of the owner of the organization. It will help the organization to use its resources in an efficient manner. The current and future financial position of the company can be evaluated by financial planning (Small Business – Chron.com, 2015). It is an important aid to take major financial decisions of the organization. The future cash flow of the organization can be decided on the basis of present financial position of the organization. The financial plan can be referred to as an investment plan for making the investment decisions of the organization. The financial plan for North Midland Construction PLc will be made by focusing on the specific areas of the risk management. The financial planning also includes preparation of budget to organize the finances of the firm (Levy, Berry & Nugent, 1999).

Term Loans

 2. 

		North Midland Construction PLC
Expenses and Source of Funds	February	March	April	May	June	July
Operations and Maintenance Expenses	£     30,000.00	£     30,900.00	£     31,827.00	£     32,781.00	£         33,765.00	£     34,760.00
Power and Utilities	£        2,500.00	£        2,575.00	£        2,652.00	£        2,731.00	£           2,813.00	£        2,970.00
Fees Regulatory	£           500.00	£           515.00	£           530.00	£           545.00	£               562.00	£           575.00
Materials supplies and Parts	£           150.00	£           154.00	£           158.00	£           162.00	£               168.00	£           172.00
Total Operation and Maintenance Expenses	£     33,150.00	£     34,144.00	£     35,167.00	£     36,219.00	£         37,308.00	£     38,477.00
General and Administrative Expenses
Engineering and Professional Expenses	£           500.00	£           515.00	£           520.00	£           575.00	£               546.00	£           562.00
Insurance	£        1,000.00	£        1,030.00	£        1,060.00	£        1,092.00	£           1,125.00	£        1,156.00
Existing contribution to CIP	£     16,712.00	£     16,712.00	£     16,712.00	£     16,712.00	£         16,712.00	£     16,712.00
Total General and Administrative Expenses	£     18,212.00	£     18,257.00	£     18,292.00	£     18,379.00	£         18,383.00	£     18,430.00
New Funding Project Cost	£     50,000.00	£     50,000.00	£     50,000.00	£     50,000.00	£         50,000.00	£     50,000.00
Total Expenses	£   101,362.00	£   102,401.00	£   103,459.00	£   104,598.00	£       105,691.00	£   106,907.00
Revenues Received
Cash Revenues	£   120,000.00	£   122,000.00	£   123,000.00	£   123,500.00	£   1,237,000.00	£   123,800.00
Other Fund Sources : Interest	£           200.00	£           200.00	£           200.00	£           200.00	£               200.00	£           200.00
Total Revenue	£   120,200.00	£   122,200.00	£   123,200.00	£   123,700.00	£   1,237,200.00	£   124,000.00
Net Loss or Gain	£     18,838.00	£     19,799.00	£     19,741.00	£     19,102.00	£   1,131,509.00	£     17,093.00

The budget for 6 months has been prepared. The budget shows that cash outflow for the expansion project will £10,000 each month. The total outflow for a period of six months will be £60, 000. The inflow from the project for a period of six months is   £    352,782. Fixed cost, variable cost and breakeven point are essential to analyze the budget. The volume of product to be manufactured can be ascertained from the various costs and the breakeven point (Balakrishnan, Sprinkle and Sivaramakrishnan, 2015).

Calculation of NPV

		Calculation of NPV
Month	Inflow	PVF	PV
1	£    58,838.00	0.909	£    53,483.74
2	£    59,799.00	0.826	£    49,393.97
3	£    59,741.00	0.751	£    44,865.49
4	£    59,102.00	0.683013	£    40,367.46
5	£    58,209.00	0.620921	£    36,143.21
6	£    57,093.00	0.564474	£    32,227.51
	PV of cash inflow	£  256,481.39
	NPV = £256481.39 – £60,000
		£196481.39

 

IRR
Cash Outflow	-£60,000
Month 1	£    58,838.00	-1,162
Month 2	£    59,799.00	58,637
Month 3	£    59,741.00	118,378
Month 4	£    59,102.00	177,480
Month 5	£    58,209.00	235,689
Month 6	£    57,093.00	292,782
IRR	97%
Payback Period	1.02	month

 

The financial statements provide information about the liquidity position of the organization, profitability of the organization. The company will be able to make proper economic decisions on analysis of the financial statements. The financial statement comprises of the income statement, balance sheet and the cash flow statement. The financial statement analysis helps the organization in the process of decision making. The financial health of the organization can be determined from the information gathered from the financial analysis. The main financial statements of the organization are –

1. Balance sheet – The balance sheet is a statement of the financial position of the organization. It reports on the assets, liabilities of the organization. Information of the amount of equity ownership can be determined from the financial statement.

2. Income Statement – The income statement provides an idea of the profitability of the organization. The major income and expenses of the organization can be determined from the income statement. It provides a report of the profit and loss of the organization. The income and expenses of the organization over a period of one year can be determined from the income statement.

3. Cash Flow Statement – The cash flow statement determines the flow of cash of the organization in various activities. The flow of cash of the organization in the operating, investing and financing activities can be determined from the cash flow statement.

The complexity of the financial statements can vary according to the type of organization and the size of the organization. The financial statement is presented in the annual report of the company which provides a detail of the performance of the organization in the particular year.

Financial Ratio Analysis

The ratio analysis of North Midland Construction Plc has been conducted. The profitability ratios, liquidity ratios, efficiency ratios and ratios of financial structure have been calculated to analyze the financial performance of the organization. The ratios have been calculated for the year 2013, 2012 and 2011. The external comparison of the financial position of the company has been done with another construction company ORASCOM Construction Industries.

Ratio Analysis of North Midland Construction Plc

		2013	2012	2011
Profitability Ratios
Return on capital employed	Net Operating Income/ ( Total Assets – Current liabilities)	-0.05053	0.00688	-0.00648
Return on Equity	Net Income / Equity	-0.49331	0.029557	-0.03397
Net Profit Percentage	Net Income / Net Sales	-0.03323	0.003197	-0.00383
Gross Profit Percentage	Gross Profit / Net Sales	-0.03323	0.003197	-0.00383
Operating Profit Percentage	Operating Income / Net Sales	-0.033	0.004203	-0.00466
Liquidity Ratios
Current ratio	Current Asset/ Current Liabilities	1.034918	1.18726	1.211314
Quick Ratio	Quick Assets / Current Liabilities	1.005238	1.155305	0.971834
Efficiency ratios
Inventory Turnover Ratio	Cost of Goods Sold / Inventory	119.9477	112.1467	108.3871
Stock Holding Period ( Days)	365/ Inventory Turnover	3.042993	3.254667	3.36756
Debtor’s Payment Period( Days)	Net credit sales / Average Debtors	3.782488	3.435631	3.778983
	In Days	96.49732	106.2396	96.58683
Financial structure
Interest coverage ratio	EBIT / Interest Expense	-49.75	8.875	-8.66667
Price/ Earnings ratio	Current Share Price / Earnings Per share	-2.28	30	-18.13
Dividend Yield	Dividend per share / Current Share Price	3.02%	3.16%	6.07%

 

	ORASCOM Construction Industries
Profitability Ratios
		2013	2012	2011
Return on capital employed	Net Operating Income/ ( Total Assets – Current liabilities)	0.001631	0.000945	0.100304
Return on Equity	Net Income / Equity	-0.02939	-0.02407	0.013597
Net Profit Percentage	Net Income / Net Sales	-0.54521	-0.40697	0.008218
Gross Profit Percentage	Gross Profit / Net Sales	0.057502	0.09279	0.176255
Operating Profit Percentage	Operating Income / Net Sales	0.040515	0.022054	0.205801
Liquidity Ratios
Current ratio	Current Asset/ Current Liabilities	1.204694	1.081639	-1.42112
Quick Ratio	Quick Assets / Current Liabilities	0.730774	0.402723	-1.28353
Efficiency ratios
Inventory Turnover Ratio	Cost of Goods Sold / Inventory	0.117076	0.104938	10.52577
Stock Holding Period ( Days)	365/ Inventory Turnover	3117.631	3478.26	34.6768
Debtor’s Payment Period ( Days)	Net credit sales / Average Debtors	0.871208	0.639605	2.215178
		418.9585	570.6646	164.7723
Financial structure
Interest coverage ratio	EBIT / Interest Expense	-3.75907	-4.40595	5.113374
Price/ Earnings ratio	Current Share Price / Earnings Per share	-4.51264	-7.33138	0.11
Dividend Yield	Dividend per share / Current Share Price	0.00%	0.00%	619.47%

 

Profitability Ratios – The financial performance of the organization can be determined from the profitability ratios (Finkler and Ward, 1999). The ratios that determine the profitability of the organization are the return on equity, return on capital employed, net profit margin, gross profit margin and operating profit margin.

1. Return on capital employed – The return on capital employed is calculated by comparing the earning before income and tax with the total funds of the business. The return on capital employed has been declining for North Midland Construction from the year 2012 to the year 2013. The company is not being able to maximize its return from the various investments (Desai et al., n.d.).

Commercial Banks

On external comparison of the ratio with ORASCOM Construction Industries, it shows that the return on capital employed for this company has been increasing. The company is being able to earn positive return from its various investments.

2. Return on Equity – This ratio shows the earnings available to the equity share holders on net sales of the organization. The higher the return on equity, the equity share holders will receive greater return. For North Midland Construction Plc the return on equity has been declining. As the company is suffering from loss, the equity share holders are not being able to get positive returns.

On comparison of the return on equity with ORASCOM Construction Industries, it is seen that the return on equity has been declining for ORASCOM Construction Industries due to political unrest of the country in which the organization operates.

3. Net Profit Percentage – The net profit percentage shows the income of the organization on the net sales of the company. Midland Construction Plc has been showing decline in the profit margin from 2013 to 2012. The construction sector has been underperforming which has marked the reduction in profit margin.

On comparison of the net profit percentage with ORASCOM Construction Industries, it is seen that the company has been showing decline in the profit margin from 2011 to 2013.

4. Gross Profit Percentage – The gross profit margin of the company determines the total income of the organization on net sales. The gross profit margin of North Midland Construction Plc has declined from 2011 to 2013.

ORASCOM Construction Industries has shown a decline in gross profit margin from 2011 to 2013.

5. Operating Profit Percentage –The ratio shows the percentage of operating profit that is earned from net sales. The operating profit is calculated after payment of the variable costs.

The operating profit percentage of North Midland Construction Plc has been declined from 2011 to 2013 due to poor performance of the construction sector. For ORASCOM Construction Industries, there has been significant decline in the operating profit.

Liquidity Ratios

The liquidity ratio determines the capacity of the organization to meet its short term liabilities.

1. Current Ratio – The current ratio for North Midland Construction Plc has been stable. The company is using its current assets efficiently to manage the current assets.

ORASCOM Construction Industries shows stability in managing its current liabilities by using its current assets.

2. Quick Ratio – The quick ratio of North Midland Construction Plc is stable. It is efficiently managing its current liabilities using the current assets (Brigham & Gapenski, 1988).

For ORASCOM Industries the quick ratio has been increasing. It has maintained the 1:1 standard.

Efficiency Ratios

The efficiency ratio shows the ability of the company to manage its inventory. It is shown by the Inventory Turnover ratio. The debtor’s turnover ratio shows the repayment period of the debtors (Tamari, 1978).

North Midland Construction Plc has been efficiently managing its inventory (Khan and Jain, 2007).

The debtor turnover ratio has been stable.

For ORASCOM Construction Industries, it is seen that the debtor’s turnover ratio is increasing. But the company has been managing its inventory efficiently (Peterson Drake and Fabozzi, 2006).

Financial Structure

The financial structure of the company can be determined by the following ratios –

1. Interest Coverage Ratio – The ratio shows the ability of the company to repay its interest with the profit. North Midland Construction Plc is not being able to repay its interest regularly (Bhattacharyya, 2011).

2. Price – Earnings Ratio – The price earnings ratio shows the earning of the shareholders on the price of each share. It is also negative for North Midland Construction Plc (Grier, 2007).

3. Dividend Yield Ratio – It shows the ability of the organization to pay the dividend. NMC Plc is unable to pay the dividend regularly to the share holders as it is in loss (Vandyck, 2015). 

References

Balakrishnan, R., Sprinkle, G. and Sivaramakrishnan, K. (2015). Managerial Accounting. pp.400-500.

Bbc.co.uk, (2015). BBC – GCSE Bitesize: Sources of finance.

Besley, S., Brigham, E. and Aberwald Clark, D. (2002). Essentials of managerial finance. Mason, OH: South-Western.

Besley, S., Brigham, E. and Besley, S. (1999). Principles of finance. Fort Worth: Dryden Press.

Bhaird, C. (2010). Resourcing Small and Medium Sized Enterprises. Dordrecht: Springer.

Bhattacharyya, D. (2011). Management Accounting. pp.10-80.

Brigham, E. and Gapenski, L. (1988). Financial management. Chicago: Dryden Press.

Desai, R., Palepu, K., Gibson, C., Healy, P., Bernard, V., Wright, S., Bradbury, M. and Lee, P. (n.d.). Analysis of financial statement information.

Finkler, S. and Ward, D. (1999). Cost Accounting for Health Care Organizations: Concepts and Applications.

Grier, W. (2007). Credit Analysis of Financial Institutions. pp.70-100.

Khan, and Jain, (2007). Management Accounting.

Kumar, P. (1994). Internal sources of development finance. Westport, Conn.: Quorum Books.

Levy, B., Berry, R. and Nugent, J. (1999). Fulfilling the export potential of small and medium firms. Boston, Mass.: Kluwer Academic.

Nikbakht, E., Nikbakht, E. and Groppelli, A. (n.d.). Finance. New York: Barron’s.

Peterson Drake, P. and Fabozzi, F. (2006). Analysis of financial statements. Hoboken (N.J.): J. Wiley.

Small Business – Chron.com, (2015). The Advantages & Disadvantages of External Financing. 

Small Business – Chron.com, (2015). What Are Internal Sources of Finance?.

Sofat, and Hiro, (2015). Basic Accounting. pp.300-350.

Tamari, M. (1978). Financial ratios. London: P. Elek.

Vandyck, C. (2015). Financial Ratio Analysis: A Handy Guidebook. pp.10-100.