New Sources of Development Finance

Question: Discuss about the Report on New Sources Of Development Finance? Answer: Sources of finance available to a business Identification of sources of finance Internal sources Owners 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. External sources 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. Assessment of implications of sources of finance 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 Evaluation of appropriate sources of finance 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. Implications of finance in a business Analysis of costs of sources of finance Owners investment: The main costs of owners 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). Assessment of importance of financial planning 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. Assessment of information needs of different decision makers 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. Analysis of impact of finance on financial statements 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 Financial decision making using financial information 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. Calculation of unit costs and pricing decisions 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. Assessment of project viability as per investment appraisal techniques 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. Financial performance of business 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. Comparison of formats of financial statements of different businesses 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 Ratio analysis and interpretation 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). 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