The Vital Role Behind Financial Management Finance Essay

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A business needs money for their day to day business and other expenses. Businesses have to find ways to finance the business. For that there are so many sources of Finance. Also there are different classifications of sources of finance. The main classification is external and internal.

Sources of Finance

Internal Sources of Finance External Sources of Finance

Personal Savings Share Capitals Retained Earnings Preferential Share capital Working Capital Management Ordinary Share Capital Sales of Assets Debentures Bonds Overdraft Facilities Hire Purchase Leasing

Internal Sources:

Personal Savings

In very lament terms personal savings means the money that the proprietor or the business owner disposal. If he has invested that money then that money categorized under personal savings. He can reinvested that money either his own or in any other business.

Retained Earnings

The total earning that the company retained at their disposal without paying to the share holders as dividend. Most companies invest that retained earnings in their own. Retained earnings are recorded in the Balance Sheet.

Working Capital Management

Working Capital is how much a company has liquid assets in order to develop its business. And the working capital management is a managerial strategy in order to manage current liabilities and current assets of the organization.

Sales of Assets

An organization can make funds with the proceeds of sale of an asset. Although it is not a recommended source of finance still the business can make fund.

External Sources:

Share Capital

This is a very common fund raising method of a company. Company issues common or preferential shares to the public. Buyers of the Share capital become owners of the company and they have the right over the company's operation up to certain limits. This is also known as Equity Financing. There are two main aspects in Share capital Preferential Share Capital Preferential Share holders also get the ownership to the company and they have the privilege of dividend. Ordinary Share Capital Ordinary share holders get the equity ownership to the company and these are the most common shares in business world. These ordinary share holders have the right to vote at the company's Annual General Meeting. But they are the people who get their shares at last at the time of liquidation of a company. Therefore in that manner ordinary share holders falls under high risk category.

Debentures

Debentures are unsecured debt instrument. That means it has not been secured by collateral or any other physical asset. These debentures are categorized under medium and long term liabilities. Debenture holders have no right in voting and they are entitled for a debenture interest.

Bonds

Bonds are commonly known as securities and those are fixed income securities. Bonds are just like loans and bonds provide the borrowers with external funds to invest in the long term investments. Bonds must be repaid.

Overdraft Facilities

An overdraft is a short term source of finance. Overdraft is a facility provided by a bank for the company under their company current account. Banks allow the business to pay an agreed sum certain excess amount through their account. Usually banks charge high interest rate on overdrafts and they consider several things before granting facility. The business has to go under an credit risk evaluation process to get the overdraft facility approved.

Hire Purchase

Goods can be purchased under a fixed period installment loan. The purchased item is kept on under lien and it is the only security has over the loan. During the installment period the buyer has the possession of the item where only can use it but not the ownership.

Leasing

Leasing is a some sort of a contract. This can be used to obtain some fixed assets. There are mainly two parties involved. In a contract it's lesser and Lessee. In a tenancy its tenant and landlord. The consideration to a lease is rent. b).

Advantages

Disadvantages

Personal Savings - Reliance on external unforeseen events is very less. - There are restricted source of capital Retained Earnings - Easy and direct access. - There is no requirement of repaying as in debts. - No operating cost involved as in other sources of finance. - It takes long time to generate funds. - Reduces the liquidity of the company. -There is an opportunity cost involved. Working Capital Management - a ready source of quick funds - adverse effect on the cash flow Sales of Assets - less operational fee and cost - would be incur many losses Share Capital - No fixed interest responsibility - Easily available in initial stages of business - In case of small businesses good advice can be obtained from equity share holders - Dilution of Control - Some (IOP) initial public offering are expensive to administer Debentures - Maintain ownership - Tax Deduction - Lower Effective Interest Rate - Repayment even in difficult business situation - Even after tax advantage interest rates can still be inflated - Impacts on credit rating due to undue debt Bonds - Bond holders get interest and are paid principal on a fixed date - Some bonds don't get interest as an alternative they are issued at a discount and redeemed at par They are normally issued by underwriters Overdraft Facilities - In case of a loan interest is paid on the total amount weather utilised or not, however in the case of an overdraft it is limited only to the amount really used - Flexible- accessible when you want it - facilitates keep up cash flow - speedy source to increase finance - immediate recall by banks (if terms and conditions apply) in case borrower fail to pay, bank amends plan or there is a break of condition by the borrower - require to sheltered against business assets Hire Purchase - extend the cost of finance so companies don't have to take big loans for investments - free of charge credit - Higher approval rates because of present of a guarantee protection - clients can get benefits of a sale or discount still with inadequate funds - Put extra monthly debt weight on clients - No ownership title till last payment is paid - Needs credit checks which can reject some clients from benefitting - The seller can retrieve goods if less than 1/3rd has been paid. Seller be also able to take court consent for those goods on which more than 1/3rd has been paid to reclaim them Leasing - No massive investment - Less extra guarantee needed - Tax compensation Its trouble-free to budget a steady amount paid towards a lease then to funds a lump sum amount - No right to the goods - No long term cost - Accountable for any maintenance expenses Ms.Raman Grewal's lecture notes c). Constructing a high way in Sudan is a vast project which the company will have to spend a lot of money in that. There for the company may be given to seek for necessary financial support from others. That mean the company should be financed by third party financial institutions or companies. In this case should not use any short term financial sources like band overdrafts and shout term loans. Because the company will get the proceeds and benefit of construction the highway in Sudan only after some times. Therefore if the companies go for a short term financial method the company may run out or money and they might face many difficulties to paying it back. There for company should always go for long term financing methods such as venture capital, grants, loads, retained earnings, hire purchase (Long term) and share holders capital.

Venture capital:

This would be categorized under the best method of financial the company for the project. In this case a wealthy Entrepreneurial company or an individual would invest on the project. This large company normally well experienced and wealthy companies. Since our company is new to the trade and this is our first international project we can seek for venture capitalists help in order to proceed with the project Getting networking opportunities and helping in getting initial public offering would be advantages to the company. But most of the venture capitalists are more expensive and very hard to effort such amount at the initial stages.

Grants:

Grants could be getting from local or national governments. Since this and international project government could be able to finance on this. They can provide the command with large monetary rewords. Also if the company would make grants available from the governments other private sources would be willing the reward the company with financial supports. But most of the time governments are reluctant to finance on these type of projects and there is a very lengthy procedures. Also government would come out with some predefined rules and regulations when hard to meet with.

Loans:

Getting a loan from bank for this type of project would be hard. Because in this case you will have to provide collateral in order to get the loan granted. Also Sudan is categorized under high risk country and based on the country risk bands may not willing to grant the company on the project. But the company may seek opportunities to get a loan from a organization like world bank or from any (NGO) Non Government Organization.

Hire Purchase (Long Term):

Company may go for long term hire purchasing in buying machinery and equipments for the construction project. All those machineries are heavy and big machineries and sometimes they will have to look for foreign hire purchases in order to fulfill their requirements. Rather buying those complex and big equipments and machineries company may hire those from another constructing company which proceed these type of vast projects would be a best method of acquiring equipments. Also this would be a good method in monetary terms.

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QUESTION 2

a). Source of finance Cost to the Company share capital Dividend Company may have to pay dividend from their earnings or profits to the ordinary share holders and preferential share holders Retained earnings/Personal savings Opportunity cost There will be an opportunity cost of retained earnings. In most of the cases retained earnings are in the mean of bank money or invested in any other means. So there will be a debit tax or withdrawal tax on that amount Loans/ Long term loans/ Bank OD/ Short term loans/ Debentures/ Bonds Interest The company has to pay an interest to the bank/ mortgage company or financial institution for the facility that they have obtained Leasing Monthly installment Company will have to pay a predetermined fixed monthly installment covering the principal amount and the interest component b). A company is basically done financial planning before the financial year starts. In every year they allocate some funds for expenses and invest money in different money generating financial sources in order to produce more money by looking at the last financial year's profits and expenses. Basically most companies prepare cash budget in order to monitor their income and expenses. In other words to monitor their cash inflows and cash outflows. If the company is keen to do proper financial planning at the beginning of the financial year company can run their business during the whole year without any hazel. Overtrading Means: Performing more business other than the company's working capital be able to usually continue, therefore damages on insolvency, or cash flow will be reduced. Securities' trading means extreme buying and selling actions by an agent in an effort to take out more charges or fees from customers. http://www.businessdictionary.com/definition/overtrading.html, date accessed19/07/2010 Also having a proper financial planning would lead the company to have proper cash budgeting and avoid overtrading. c). Information needed for decision makers would be as follows, Gross and net profit of the company Expenses paid out and the pattern of the spending money Liabilities taken from third party companies and individuals Value of assets that the company have under them Total earnings of the company Value of debts and amount paid as dividend for them Retained earnings Investments or the company d). Sources of finance, shows up in the balance sheet Working capital Share capital Sale of assets Debentures Bonds Sources of finance, shows up in profit and loss account Overdrafts Hire purchases

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QUESTION 3

a). Angus Ltd Cash Budget For the period of September to February Figures in £ Particulars September October November December January February

Cash Inflow

Cash Sales Credit Sales Tot. Cash inflow

Cash Outflow

Vehicles Overheads Purchases Tot. Cash outflow Opening Balance Cash Inflow Cash outflow Loan / Deficit

-

-

-

-

3,000 3,250 4,000 3,250 4,500 3,250 4,500 3,250 0

-

2,200

-

0

-

2,200

-

6,250

-

2,200 2,500 7,250 3,500 2,200 2,500 7,750

-

2,200 2,500 7,750

-

2,200 2,500 (2,200) 25,000 0 (2,200) (2,200) 22,800 0 (2,200) (4,700) 20,600 6,250 (4,700) (8,200) 22,050 7,250 (8,200) (4,700) 21,100 7,750 (4,700) (4,700) 24,150 7,750 (4,700) 22,800 20,600 22,050 21,100 24,150 27,200 b). Prada Manufacturing Fine Jewelry Per one silver ring Silver 8 grams Cost of Silver £ 15 per gram Labor time taken 2.5 hours Labor cost £ 20 per hour Polishing time 40 min Polishing labor cost £ 8 per hour Total factory direct cost(for 500 rings) £ 10,000 Direct cost per ring £ 10,000 / 500 £ 20 Price to produce one ring Silver cost 8 x 15 = £20.00 Labor cost 20 x 2.5 = £50.00 Polishing Cost 8 x 40/60 = £ 5.33 Direct cost 10,000 / 500 = £ 20.00 £195.33 Cost to produce 60 rings 195.33 x 60 = £ 11,719.80 c).

The Sunrise Ltd

Year 1 Year 2 Year 3 Year 4 Sales unit SP / Unit Sales Direct Mat cost p/unit 5.75 VC / unit 5 FC / unit 4.5 Total Direct Material Cost Gross Profit Total Variable Cost Total Fixed cost Advertisement Depreciation (750,000/4) Net Profit Tax Net Profit after Tax Depreciation Cash Flow 100,000 30 3,000,000 575,000 2,425,000 500,000 450,000 550,000 187,500 737,500 147,500 590,000 187,500 777,500 80,000 25 2,000,000 460,000 1,540,000 400,000 360,000 230,000 187,500 362,500 725,000 290,000 187,500 477,500 70,000 20 1,400,000 402,500 997,500 350,000 315,000

-

187,500 145,000 29,000 116,000 187,500 303,500 55,000 15 825,000 316,250 508,750 275,000 247,500

-

187,500 (201,250)

-

(201,250) 187,500 (13,750) Net presented value for the year 1 for 10%: = 0.909 x 777,500 = 706,747.5 Net presented value for the year 2 for 10%: = 0.909 x 477,500 = 434,047.5 Net presented value for the year 3 for 10%: = 0.909 x 303,500 = 275,881.5 Net presented value for the year 4 for 10%: = 0.909 x (13,750) = (12,498.75) 706,747.5 + 434,047.5 + 275,881.5 + (12,498.75) = 1,404,177.80 If the net presented value is greater than 0 is accepted and if the net presented value is smaller than 0 then the project is a waste and pointless of investing on the project. That means, if NPV > 0 , accepted and if NPV < 0 rejected.

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QUESTION 4

A). Profit and loss account: Profit and loss account shows an income and expenses for particular financial period. This is also known as income statement or Trading profit and loss account. Ex: for the period of 1st January 2010 to 31st December 2010 Balance Sheet Balance sheet shows the financial position of the business at the particular point of time and it shows exact values of assets and liabilities the company has with their possession. Ex: As at 31st December 2010 Cash flow statement Cash flow statement is an indication of the cash inflow and outflow of the company during a particular period of time. B). Under accrual based financial accountancy system businesses prepare two different types of financial statement. Income statements Balance Sheet And cash flow statements are mostly prepared in a small medium businesses also if they have different type of pay roles then they always temp to prepare cash flow statements for their easy reference. C).

Current Ratio / working capital ratio:

Current ratio is a method of testing of financial power of the company. It computes how many amounts of assets are probable to be changed in to cash inside a year in order to pay debts. 2008 2007 Current Ratio = Current assets / Current Liabilities = 125,000 / 100,000 = 140,000 /70,000 = 5 : 4 = 2 : 1

Gross profit margin:

Although this is not an exact guess of the company's costing policies it gives a better understanding of the company's financial stability. Company may find difficulties in paying out of future expenses of the company's day to day operations without a sufficient gross profit margin. 2008 2007 Gross profit margin = Net Sales - Cost of sales / annual sales return = 600,000 - 300,000 / 600,000 = 650,000 - 400,000/650,000 = 0.5 = 0.38 Generally gross profit margin of a company ought to be constant. If it is fluctuating time to time it will not be a good indication of the pricing or costing strategies adopted by the company. Also this would directly affect for the cost of sales.

Equity Turnover :

This ration is to calculate the company's capability of creating sales out of total amount of equity invested. Equity means the share holders wealth (basically ordinary and preferential share holders) invested in the business. Owners equity = Share capital + Retained profits + Net profit If the company's equity turnover ratio is 3 that mean the company will generate 3 pounds of sales for each and every pound invested as equity. 2008 2007 Equity Turn over = Net sales / Average total Equity = 600,000 /170,000 = 650,000 / 220,000 = 3.5 = 2.9 Source - http://www.investopedia.com/exam-guide/cfa-level-1/financial-ratios/operating-efficiency-ratios.asp, date accessed 21/07/2010

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Appendices / Reference

Lecturer Raman Grewal's Notes www.investopedia.com www.googlesearch.com www.businessdictionary.com
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