The different types of Sources of Finance

To start any business you require money and there are a variety of choices and options a company or an individual can get them from. In our case here, JS and co needs money to expand their business. They are currently running 107 stores spread all over UK and they now want to increase the number of stores to 175. They want to fulfil their plan within the next five years and JS and co will continue to building up new stores within this period of five years.

(i) Long term financial needs: 

These requirements generally refer to those necessities of funds which are for a period over 5-10 years. They may be for building or buying a plant, machinery, land, buildings, etc

Funds required to finance permanent or hard core working capital should also be procured from long term sources.

(ii) Medium term financial needs: 

These requirements refer to the kind of funds which are required for a period not more than one five years but exceeding one year. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for them are classified in the category of medium term financial needs. Sometimes long term requirements, for which long term cannot be arranged immediately, may be met from medium term sources and thus the demand of medium term financial needs are generated. As and when the desired long term funds are made available, medium term loans taken earlier may be paid off.

(iii) Short term financial needs: 

Such type of financial needs arise to finance in current assets such as stock, debtors, cash, etc. Investment in these assets is known as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully. The requirement of working capital depends upon a number of factors which may differ from industry to industry and from company to company in the same industry. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period, i.e., one year.

The basic principle for meeting the short term financial needs of a concern is that such needs should be met from short term sources, and for medium term financial needs from medium term sources and long term financial needs from long term sources. Accordingly, the method of raising funds is to be decided with reference to the period for which funds are required. Basically, there are two sources of raising funds for any business enterprise. Viz., owners capital and borrowed capital. The owners capital is used for meeting long term financial needs and it primarily comes from share capital and retained earnings. Borrowed capital for all the other types of requirement can be raised from different sources such as debentures, public deposits, loans form financial institutions and commercial banks, etc.

In our case of JS and co we already know that 50 million is available to use when needed leaving with the remaining 75% of finance to be arranged. This will be done through the long term source of finance.

Implications of different sources

Loan

Advantages

Large amounts can be borrowed

Suitable for long-term investments

The lender has no say on how the money is spent.

Need not be paid back for a fixed time period and banks do not

withdraw at a short notice.

Interest rates are lower than for bank overdrafts and are set in advance.

Disadvantages

Collateral is needed.

The amount borrowed has to be repaid at the agreed date.

Interest is charged.

Loans will affect a company’s gearing ratio

Personal Saving

Advantages

The owner would not want collateral to lend money to the business.

There is no paperwork required.

The money need not necessarily be paid back to the owner on time.

Can be interest free or carry a lower rate of interest since the owner

Disadvantages

Personal savings is not an option where very large amounts of funds are required.

Since it is an informal agreement, if the owner demands the money back in a short notice it might cause cash flow problems for the business.

 Choosing an appropriate source of finance

There are many sources of finance available to a business. Finance

is needed for several purposes and different purposes need sources of

finance which are most suitable to them. When choosing an appropriate

source of finance some factors have to be considered.

The factors that need to be considered when choosing an appropriate

source of finance are:

The amount of money needed

The urgency of funds

The cost of the source of finance

The risk involved

The duration of finance

The gearing ratio of the business

The control of the business

P2:

2.1 Costs of the sources of finance

Please refer to appendices

2.2 Importance of financial planning

Financial planning affects the terms and conditions on which the business will be able to obtain funding required to establish, maintain and expand the business. Financial planning influences the raw material a business is able to afford, the products it is likely to produce and whether the business will market its product efficiently. It will affect the resources

the business is able to acquire to operate and it will be a major determinant of the success of the business.

A financial plan not only help the business to understand what it wants to do but also helps the business understand how to achieve it.

A healthy financial plan consists of the following:

The basic financial statements are,

Ratio analysis

Budgets

Break-Even analysis

Pricing formulas and policies

Types and sources of capital available to finance business operations.

The business owner/manager who understands these concepts and uses them effectively to control the evolution of the business is practicing sound financial management thereby increasing the likelihood of success

2.3 The information needs of different decision makers

Different decision makers will want different information about the company regarding their interests in the business. A long-term lender will always want to know the gearing ratio of a company while the short-term lender will want to know about the liquidity ratio of the business. The information for different parties is all taken from financial reports, cash flow and financial statements such as the balance sheet and profit and loss account. The manager needs accounting information to take managerial decisions since all functions of an organisation are tied to the financial strength of a business. Using the financial statements, the

financial stability and profitability of an organisation can be analysed and interpreted. Using this information the interested parties make decisions regarding the business.

The business’s financial statement can be analysed in a number of ways. Some of them are horizontal analysis, vertical analysis, trend analysis and ratio analysis.

Ratio analysis:

The ratio shows the relationship between two relevant items in the financial statement. The relationship is shown as a ratio or as a percentage. Different ratios calculable on a business’s financial statements are:

Liquidity ratios

â-‹Current ratio

â-‹Quick ratio / Acid test ratio

Working capital ratios

â-‹Stock turnover ratio

â-‹Average debt collection period

â-‹Average credit taken from creditors

Profitability ratios

â-‹Return on capital employed

â-‹Gross profit margin ratio

â-‹Profit before interest and tax/Sales

â-‹Profit after tax/Sales

The above ratios being calculated the performance of the business can be assessed and necessary decisions can be taken by relevant parties. Due to limited time the ratios have not been explored in detail.

2.4) Impact of several sources of finance on the financial statements

Financial statements keep record of a business’s trading year (Trading, profit and loss account) and show the financial position of a business as at a date (Balance sheet). Obtaining finance from different sources bring about a change in the financial statements. This portion of the report investigates how each source of finance is recorded and affects

the financial statements.

Personal savings

Personal savings when lent to the business are considered as loans. The amount lent will appear as Long-term liabilities on the balance sheet. If any interest payments are to be made they will be recorded in the profit and loss account and charged against profits.

Sale of assets

Sale of assets will reduce the value of fixed assets on the balance sheet. The profit or loss made on the sale of asset will be recorded in the profit and loss account for the year. The depreciation of the asset along with its original price will be removed from the balance sheet.

Ordinary shares and preference shares

The issue of ordinary shares and preference shares increase the vale of equity capital in the balance sheet. If the issued shares market price is greater than the nominal value of the share then share premium is also increased in the balance sheet. The number of shares issued is also displayed in the balance sheet and for preference shares the rate of dividend is also shown. The dividends paid to the shareholders are recorded in the appropriation account after tax is deducted from net profit.

Debentures

Debentures are a type of debt capital. The value of debentures along with the rate of interest and the repayment date is presented in the equity and liabilities section of the balance sheet. The interest paid on debentures is reduced from profits before tax is charged.

Bank overdraft

This appears in the balance sheet as a current liability since it is a short-term debt and has to be paid back within a year. The interest charges and bank overdraft fee if charged are deducted from the profit and loss account before tax is charged.

Loan

Loans are long-term debts and therefore come under long-term liabilities in a balance sheet. The loan when displayed on a balance sheet will usually contain information about the repayment date and the interest charged on the loan. The interest is charged in the profit and loss account.

Venture capital

This is an amount of money invested in the business as equity capital and thus comes under equity capital in the balance sheet. The return for venture capitalists is a share of profits which is recorded in the appropriation account.

Factoring and invoice discounting

This does not appear in the balance sheet. However the money received from factoring and invoice discounting can show higher balances of cash. The interest charges and fee is recorded in the profit and loss account.

3.1 Analysis of budget and decision making

Refer to spread sheet please.

3.2 Calculating unit cost and making pricing decision

Refer to spread sheet please.

3.3 Viability if investment appraisal techniques.

Analysis:-

Under payback period method the investment will be recovered within 2trs 3mth

But the drawback it ignores the future cash flows which is about £187,212

Under NPV the project yields a positive NPV and therefore should be undertaken.

Under IRR is 26.5% which should be compared to the policy of your company. That is if the expected yield is lower than n the IRR only then you can accept the project.

4.1 Formats of different financial statements for different types of businesses

Sole traders –

Prepare accounts for their own use to know how much profit/loss for the year.

Partnerships –

Prepare accounts to get to the profit to be distributed among partners. There is no legal obligation to produce any accounts, but sometimes it does help if they are applying for a loan /mortgage.

Public and Private company –

They are legally obliged to be registered by the company house and to follow the required rules, policies and procedures. Therefore they are legally obliged to prepare a set of accounts for each accounting year, showing the following,

Income Statement for the period ending

Statement of movement in Equity for the period ending

Balance sheet

Cash flow statement showing operational, investing and Dividend transactions

Bear in mind management can change depreciation policy and showing less profit. The change of policy cannot be change very often and should be explain before it does. Accounts should be prepared according to saps and proper accounting conditions. Company can vary the mixture source of finance like your company but they have different area with particular risk and demand.

Analysis of Financial Statements using ratios and comparisons, both internal and external

Gross Profit Margin

The figure shows the company is very healthy and is producing a high return comparing the cost of sales to the revenue

Net Profit Margin

The figure shows a drastic decline compare to gross profit as its due to level of activity (107 to 175 Number of stores) which has increased thus reflect the increase in expenses and running cost.

Net Profit margin after tax

The decrease between the PBIT and PAIT is the effect of the debenture interest (10%) and tax incurred during the year.

Interest Cover

It shows JS and Co. is able to cover its interest charge by 2.5 times

Conclusion and Recommendations

Sources of finance is available from variety of sources but each source has its own cost and benefits. It is important to choose an appropriate and cheap source of finance for the smooth operation of the firm.

Use of working capital – Having high current assets is typically considered “safe”, as you should be able to get your hands on plenty of cash quickly if you need to. Note that care must be taken to ensure stock is not obsolete (i.e. it is really worth the value shown) and that debtors are recoverable (i.e. they will pay you).Whilst typically safe, high current assets don’t necessarily help the business become more profitable. Having lots of cash in the bank, or a warehouse full of stock is not always good use of money. High current liabilities can be considered risky. It means a lot of cash is expected to flow out of the business in the near future. If there aren’t sufficient current assets providing that cash, the business could be in trouble. Having said that, the majority of businesses are in debt. If your business makes a higher profit margin than the bank charges in interest, net borrowing is not necessarily a bad thing.

JS and co you are operating as a medium sized retailer, with the expansion plan and the business growth in your business environment it’s important to identify the triggers for the success of your business. As you are two partners, is it the cooperation between you two that supported the success. If yes having a third partner may distort the relationship and as such the business growth. On the other hand, opting for equity might involve more administration and office work. This benefit to raise money from the member of the public at less cost than debt sources as discussed above.

It’s very true the best option would to raise finance through the Stock exchange which would benefit your company more reputation and business growth. But it also means of publishing accounts, registered with the Companies House and availability of the accounts to be scrutinized by any member of the public who is interest in investing in your company.