Discuss about the Report on New Sources Of Development Finance?
Identification of sources of finance
Owner’s investment:
This is personal funds or savings of a business owner or his or her family and friends which is invested in the business.
Retained profits:
Retained profits are earnings that remain after payment of all sorts of obligations and get reinvested in the business (Bodie and Merton, 2011).
Sale of assets: An organisation can sale its assets such as product inventories, unused lands and equipments for raising funds.
Bank loans: Bank loans are funds borrowed from banks against set rate of interest and set date of repayment.
Purchase of shares: Public limited companies have the option to sell shares via stock exchanges to raise funds from the public (Jarrow et al., 2011).
Grants: Some business has access to local and central government grants for purchasing certain types of businesses.
Sources of finance |
Advantageous implications |
Disadvantageous implications |
Owners investment |
Quick access, no interest burden, no application forms |
Money cannot be used on other items |
Retained profits |
No need to borrow funds and hence, no question of interest payment, no loss of control or ownership (Bishop, 2004). |
Money is not available or scarcely available for alternative spending |
Asset sale |
Quick and easy access, no loss of ownership or control |
Sale of too much assets may reduce company assets and hamper operations |
Bank loan |
Asset guarantees and interest obligations removes pressure from the borrowing organizations as well as from the bank. The organisation retains ownership and control |
Presence of interest burdens and obligation to pay the principle on fixed date. Considerable high credit score is required (Newlyn, 2005) |
Shares |
Large funds can be obtained with no interest burden |
Loss of ownership and control |
Grants |
No repayment is required |
Only available under highly necessary conditions |
For evaluation of appropriate sources of finance, an expansion project has been selected that involves public limited company retailing grocery products opening of two new stores in London. Upon evaluation, it has been found out that the most suitable sources of finance for the company are bank loan which is a debt finance and sale of shares, which is equity finance.
These two sources of finance has been considered as appropriate sources because of the flowing reasons
Bank loan
Bank loan is a cheaper source of finance and more debt provides cost advantage (Newlyn, 2005). Moreover, it does not lead to loss of ownership or control and the time required to use the loan fund can be kept within the loan period. However, taking in to consideration the fact that debt financing is associated with interest obligation and put the company on to interest rate risk, it has been decided to keep debt financing below 40% in the capital structure of the expansion project.
Shares
Issue of shares is costlier than debt financing and leads to dilution of ownership and control. However, taking in to consideration the fact that it is easily available, free from interest burdens and a large amount of fund can be obtained, the company has decided to cover 60% of its capital structure with equity financing.
Analysis of costs of sources of finance
Owner’s investment: The main costs of owner’s investment are costs of providing financial reports, conducting audits, share flotation and administrative and legal costs.
Retained profit: Retained profit is connected to opportunity cost i.e. cost of losing the opportunity of using the funds for alternative expenditures (Groppelli and Nikbakht, 2011).
Sale of assets: Sale of assets is costly in the sense that it leads to loss of company value and organisational efficiency.
Bank loan: The main costs associated with bank loan are interests, factor charge and costs of providing lender information
Sale of shares: Costs associated with sale of shares are issuing costs and dividends.
Grants: The major costs connected to grants are administrative, fund application and application form filling costs (Groppelli and Nikbakht, 2011).
Financial planning is helpful to an organisation in many different ways. Financial planning aids an organisation in appropriately funding its own activities through identification of financial priorities, allocation of funds for meeting expenses, reduction of credit use, uncertainty and financial affairs related conflicts and facilitating investments and savings to reach financial goals.
Along this line, it can be stated that financial planning streamlines the process of management and monitoring of incomes and expenses, creating investment opportunities, saving funds and creating a long – term capital base.
Internal decision makers
Shareholders: Shareholders of an organisation require considerable amount of information regarding profitability, asset base, net worth and cash availability.
Managers: Managers require wide range of information regarding profit performance, growth, planning, controlling and organizing activities.
External decision makers
Government: The government needs wide range of information to know whether an organisation complies with regulatory bodies, creates employment, contributes to economic growth, supports environment addresses green issues and climate change and pays income tax.
Funding organizations: These organizations require considerable amount of information regarding profitability, liquidity, fixed and current asset base, interest cover and gearing ratios.
Customers: The information requirements of customers are lesser in comparison to that of others however; they require considerable information regarding quality of goods and services of an organisation and extent of ethical compliance.
Finance |
Impact on balance sheet |
Impact on income statement |
Owners investment
|
Increases owners equity fund |
Increases net income |
Retained profits |
Increases owners equity |
Increases net profit after tax |
Asset sale |
Decreases current on long – term assets depending on the type of asset sold (Atkinson, 2005) |
Increases non – operating income |
Bank loan |
Increases short – term – long term asset and liability by the same amount liability depending upon the type of loan taken (Finney, 2011) |
Increases interest expense |
Shares |
Increases owners equity |
Increases non – operating income |
Grants |
Increases short – term – long term assets |
Increases non – operating income |
Analysis of budgets with appropriate decisions
Calculation of cash budget
The following cash budget has been prepared for forecasting cash inflows and outflows from a new grocery soap during the first six months of its operation
Particulars (£) |
April |
May |
June |
July |
August |
September |
Cash inflow |
||||||
Credit sales |
693000 |
762300 |
838530 |
922383 |
1014621 |
1116083 |
Cash sales |
77000 |
84700 |
93170 |
102487 |
112736 |
124009 |
Total cash inflow |
770000 |
847000 |
931700 |
1024870 |
1127357 |
1240093 |
Cash outflows |
||||||
Cash purchases |
650000 |
520000 |
416000 |
332800 |
266240 |
212992 |
Credit purchases |
60500 |
48400 |
38720 |
30976 |
24781 |
19825 |
Rent payment |
30000 |
30000 |
||||
Bank loan repayment |
16500 |
13200 |
10560 |
8448 |
6758 |
5407 |
Other expenses |
88000 |
70400 |
56320 |
45056 |
36045 |
28836 |
Total cash outflow |
845000 |
652000 |
521600 |
447280 |
333824 |
267059 |
Net cash flow |
-75000 |
195000 |
410100 |
577590 |
793533 |
973034 |
Opening cash balance |
50000 |
-25000 |
170000 |
580100 |
1157690 |
1951223 |
Net cash flow at the end of the month |
-25000 |
170000 |
580100 |
1157690 |
1951223 |
2924257 |
Analysis of cash budget
Analysis of the above cash budget reveals that in the month of April, there will be a cash deficit of £-25000. This cash deficit can be managed and converted to cash surplus by stringent credit policies, bank reconciliations and negotiation of flexible credit terms with suppliers.
Analysis also reveals that after the month of April there will be cash surpluses for the next five months and the figures are expected to be £170000, £2924257, £1157690, £1951223 and £580100 for the months of May, June, July, August and September respectively. This surplus cash can be used for paying current debts and for investing in profitable projector expansions.
Unit cost
Unit cost is the total cost incurred in the process of manufacturing and delivering one unit of a product.
The formula for calculation of unit cost is
Per unit cost = (total variable cost + total fixed cost) / total number of units sold
Another formula is
Per unit cost = (Selling price – profit) / number of units sold.
From the above formula, it is clear that unit cost is obtained by deducting mark up profit from selling price.
Pricing decisions
Since variable costs change as per changes in level of operations and fixed cost do not change as per the same, variable cost is more relevant in the context of pricing decisions. This is mainly because of the fact that variable cost act as an important determinant of breakeven point i.e. the point at which income and expense is same for a business.
Different investment appraisal techniques
Some of the most important project appraisal techniques have been described below
Project appraisal technique |
Definition |
Decision rule |
Advantages |
Disadvantages |
Net present value (NPV) |
NPV is present value of future cash flows – present value of initial investment (Johnson, 2009). |
A project is accepted when NPV is positive |
Time value money and entire life cycle of a project is considered |
Method is complex and sensitive to cost of capital (Wilkes, 2010) |
Payback period |
It is the time taken to recover initial investments |
A project is accepted when calculated payback period is shorter than targeted payback period |
Simple and easily understandable technique. |
Over – simplified and ignores time value of money |
Internal rate of return (IRR) |
It is the rate of return at which initial investment is equal to present value of future cash flows |
A project is accepted when IRR is greater than cost of capital (Johnson, 2009). |
Takes in to consideration time value of money |
Fails to give accurate results in case of mutually exclusive projects. |
Application of the NPV technique
In the following table, NPV of an expansion project has been calculated
Cash flow (£) |
Project A |
Discounting rate |
Discounted cash flows |
Investment (cash outflow) |
143000 |
||
Year 1 – cash inflow |
38500 |
1 |
34997 |
Year 2 – cash inflow |
49500 |
1 |
40887 |
Year 3 – cash inflow |
60500 |
1 |
45436 |
Year 4 – cash inflow |
71500 |
1 |
48835 |
Total discounted cash flow |
170154 |
||
NPV |
£27154 |
Since NPV of the project is positive, the project can be considered feasible and profitable and thus, the same should be accepted.
Discussion on the main financial statements
Balance sheet: Balance sheet is important because it is the statement of financial position on a particular date. It aids in depicting what is claimed and owned against assets. The main elements of a balance sheet are assets, liabilities and owners equity (Foulke, 2006).
Profit and loss account: Profit and loss account is important in the sense that it depicts income and expenditure (Fridson and Alvarez, 2007). It serves the purposes reflecting earning capacity. Main elements of this statement are incomes and expenses.
Criteria |
Sole trader |
Partnership |
Limited company |
Representation |
Financial statements reflect age records and audit trail |
Financial statements represent profit, loss and capital contributions |
Main forms of financial statements are balance sheet, income statement and cash flow statement |
Focus |
Financial statements depict income tax and NI |
Cash balances of partners are represented |
Profitability, liquidity, efficiency and solvency |
Complexity |
Least complex |
Moderately complex |
Highly complex |
Requirement |
Not mandatory |
Not mandatory |
Mandatory |
Calculation, analysis and interpretations of ratios have been done in the context of BA
Ratio |
Calculation |
2012 |
2013 |
2014 |
Analysis |
Interpretation |
Profitability ratios |
||||||
Gross profit margin |
Gross profit / net sales x 100 |
16 |
15.4 |
15.4 |
Gross profit margin shows a decreasing trend |
Overall profitability of BA is decreasing |
Net profit margin |
Net profit / net sales x 100 |
4.77 |
5.29 |
6 |
The trend of net profit margin is increasing |
Profit from operating activities and pricing strategies of BA is increasing (Horrigan, 2010) |
Liquidity ratios |
||||||
Current ratio |
Current assets / current liabilities |
1.27 |
1.26 |
1.2 |
The trend of current ratio is decreasing |
Short term liquidity position is deteriorating |
Quick ratio |
(Current assets – inventories) / current liabilities |
0.43 |
0.42 |
0.37 |
The trend of quick ratio is also decreasing (Palmer, 2006) |
Short term liquidity position is deteriorating |
Gearing ratios |
||||||
Debt to equity ratio |
Total debt / total equity |
1.53 |
0.54 |
0.94 |
Debt to equity ratio shows a shows a decreasing trend |
The percentage of debt in capital structure of BA is decreasing thereby indicating reduced exposure to interest rate risk and bankruptcy risk (Weston and Brigham, 2006). |
References
Atkinson, A. (2005). New Sources Of Development Finance. Oxford: Oxford University Press.
Bishop, E. (2004). Finance of international trade. Amsterdam: Elsevier.
Bodie, Z. and Merton, R. (2011). Finance. 3rd ed. Upper Saddle River, NJ: Prentice Hall.
Finney, R. (2011). Office finances made easy. New York: AMACOM.
Foulke, R. (2006) Practical financial statement analysis. New York: McGraw-Hill.
Fridson, M. & Alvarez, F. (2007) Financial statement analysis. New York: John Wiley & Sons.
Groppelli, A. and Nikbakht, E. (2011). Finance. 3rd ed. Hauppauge, N.Y.: Barron’s.
Horrigan, J. (2010) Financial ratio analysis. New York: Arno Press.
Jarrow, R., Maksimovic, V. and Ziemba, W. (2011). Finance. 3rd ed. Amsterdam: Elsevier.
Johnson, R. (2009) Capital budgeting. Belmont, Calif.: Wadsworth Pub. Co.
Newlyn, W. (2005). Finance for development. 4th ed. [Nairobi]: East African Pub. House.
Palmer, J. (2006) Financial ratio analysis. New York, N.Y.: American Institute of Certified Public Accountants
Weston, J. & Brigham, E. (2006) Managerial finance. Hinsdale, Ill.: Dryden Press.
Wilkes, F. (2010) Capital budgeting techniques. London: Wiley.
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