Pearson BTEC Level 4/5 HNC/D Diploma Business – Unit 2 : Managing Financial Resources and Decision
Success Ltd is a medium-sized private limited liability company producing furniture for the retail sector and private homes. Currently it employs 50 staff and has been in business in the last 5 years, mainly in a domestic market. The business was set up by 3 young carpenters, Billi kid, Bengazy and Lee Jones. Whilst their ability and enthusiasm to design the furniture is largely undiminished, other business functions such as marketing strategy, administration and sourcing materials at the best prices are not well integrated as neither are particularly interested in the business strategy. This Managing financial resources decisions assignment report has highlighted company’s financial position and identified sources of finance available. In addition, this paper would also help to understand implications of finance as a resource within a business for Success Ltd. Impact of finance in the financial statements would also be detailed.
1.1. Source of Finance Available for Success Ltd
From the case, it is very clear that company has going through a tough financial conditions and facing challenges of quality issues. Product range is very limited and restricted to single market. Moreover, intense completion has also become an important issue for the company as competitors are offering wide range of products using innovative technologies. In order to overcome such issues, Mathew who was appointed as Operations Director has suggested purchasing of 2 new machines for the production department. In order to buy these machines, company needs £4 million pounds but Cecil Jones, the Finance Manager is not comfortable with Mathew’s suggestion as he thinks the company has not got the money to buy those machines. More so, the cost of capital is 10% if they should borrow money to purchase equipment.
Success Ltd is not in the position to use retained earnings as financial resources because cost is very high. Moreover, funding from equity share is also not possible due to down market performance of the company. Now the only option is left to buy machines using debt financing at a cost of 10%.
1.2. Impact of Debt Financing
Borrowing or debt financing would make the company to speed up producing range of products and enhance product quality in short term. This will help Success Ltd to improve customer’s satisfaction towards their product quality and reduce product return percentage. Ultimately, this decision will make company to experience increased profitability. However, it will directly impact on company’s expenses as there would be high interest charges to be paid annually. In addition, company’s liability will be increased. Shareholders of the company will also be affected as high interest rates would result in reduction in Earnings per Share (EPS). Moreover, it will have a negative impact on stock price as well. If in any care, Success ltd come in a situation of not able to repay to such a huge amount and goes bankrupt, stakeholders will be the last to be paid.1
1.3. Evaluation of Debt Financing for Success Ltd
For task 1.3 there is an excel sheet made.
2.1. Cost of Debt Financing
As we know that only option to source of financing is debt financing, we will find out cost of debt financing here.
From the above findings, it is clear that Machine A is more useful and feasible as compared to machine B. Therefore, from Mathew’s suggestion, buying machine A only can be considered. Single machine will cost £2,000. Cost of capital or interest rate is 10%.
Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.
Actual Cost of Debt Financing = Interest Rate (1-tax rate)
= 10% (1-0.4447)
= 10 (0.5553)
Therefore, cost of debt financing would be 5.55%.
2.2. Importance of Financial Planning
Financial planning is very important not only for an individual but also for any business. For Success Ltd, good financial business planning can resolve all the issues with their profitability and make them to focus more on improve productivity of wider range of products. Cecil Jones who is the Finance Manager is not comfortable with Mathew’s suggestion to buy machines, but when it comes to enhance producing wider range of products, it can be considered to buy only one machine A. in the short run, success ltd will gear up its customer’s satisfaction by offering good range of products and make market value as well. For this purpose, it becomes important to make effective financial planning so that all resources can be utilized to the optimum level. Following are few importance that company can have from financial planning:
- managing profitability more efficiently
- To monitor operational cost and expenses
- To build a long term capital-base and shape future position of the company
- To cover up future shortcoming or urgencies
- To identify potential investment opportunities
- To improve cash flows of the company
2.3. Information required for decision makers
As per the case, Billy and Bengazy who are the partners in the firm, strongly feel that global expansion of the business would certainly help to increase market value and profitability of the company. However, they being the decision makers are not aware of the technological advancements those should be considered. There are competitors who are offering wider range of products at lower price and with better quality. Most significant reason is the use of technology in production, effective marketing strategy and branding of the product & company. Therefore, first of all, decision makers of the company must look for new technologies to enhance production level and quality of products. In addition, they must also make a market survey of their target market and target audience to find out taste and preference of customers. This will help them to find out exact market requirement and produce accordingly. They must get the information on competitors designs of products in a way that new trend or concept furniture could be offered in the market to attract customers.
2.4. Impact of the sources of finance on the financial statements
There are several sources of financing but majorly debt and equity financing is largely used as sources of financing. In equity financing company exchanges the ownership of the business looking for a financial investment. Such kind of financing allows the investor to receive a share in company’s profit. It increases equity capital of the firm that is reflecting in balance sheet.
On the other hand, debt financing is other important source that is used here in this case to achieve organizational goals. Debt financing affects company’s profitability in short run with low net profit. For success ltd., debt financing would make an extra burden of meeting the cost of interest expenses. In addition, it also affects debt equity ratio which is used as the decision making ratio by stakeholders or investors before investing in to the company. High debt cost would increase high debt equity ratio. It means, if success ltd is not able to repay the loan, its assets will be used for repayment and payments to stakeholders would be at the end. It is not a good sign from stakeholder’s point of view.
3.1 Cash Budget
3.2 Cost of Chairs
3.3 Feasibility of Investment in Machines
As per the case, company will use two machines for five year time to enhance the production of wide range of products. In order to find out feasibility of cash flows from these two machines, we will first find out present value of all the cash flows to compare it today’s price of the machine using discounted cash flow method. As cost of financing is 10%, this will be used as discount rate. Net Present Value is used here as the investment appraisal method to find out feasibility of the investment in machines.
= [800/(1+0.10)1 ]+ [800/(1+0.10)2 ]+ [800/(1+0.10)3 ]+ [400/(1+0.10)4 ]+ [100/(1+0.10)5 ]
= 727.27 + 661.16 + 601.05 + 273.21 + 62.09
NPV = Present Value of Future Cash flows- investment
= £2324.78 – £2000
Now, it is clear that net present value of future cash flows is higher than machine cost of £2,000. Therefore, it is a feasible option to buy machine A.
= [500/(1+0.10)1 ]+ [500/(1+0.10)2 ]+ [500/(1+0.10)3 ]+ [500/(1+0.10)4 ]+ [100/(1+0.10)5 ]
= 454.55 + 413.22 + 375.66 + 341.51 + 62.09
NPV = Present Value of Future Cash flows- investment
= £1647.03 – £2000
On the other hand, it is also clear that present value of future cash flows is lower than machine cost of £2,000. Therefore, it is not a feasible option to buy machine B.
4.1. Main financial statements of a company
In order to understand company’s position, it is important to evaluate or assess financial position of the company. Especially from investment point of view, it is important to judge company performance of financial statements available. There are basically three main financial statements those are considered at the time of investment or providing financing to the company. First statement is profit & loss statement that gives an idea about overall expenses and profitability of the company. Reviewing profit & loss statement can enable an individual or analyst to find out how company is focusing on improving profitability. Second financial statement is cash flow statements that give an idea about all sources of income of a company. There are three important element of cash flow from where income is generated; one is income from operational activities, second is income from financing activities and third is income from investing activities. These three parts of cash flows helps to understand how a company is managing its resources to the most optimum level to generate income. Third important financial statement is balance sheet that helps us understand the actual position of the company at the end of every year. Balance sheet makes us clear on what are company’s existing liabilities and what are its total assets. All the final position of fixed assets is mentioned in the asset side of balance sheet. In addition, current assets help us to know that how company is going to meet its current urgencies and to manage cash. On the other hand, liabilities side, long term liabilities present an idea of how company has used financing. In addition, these financial statements are very important to evaluate financial ratios of a company to make an investor able to decide before investing into company; make a financer to decide before financing to any project of the company or enables a shareholder to decide before investing into market share of the company.
4.2. Comparison of Financial Statement of a company and sole trader
It is must to prepare financial statement for all type of business whether it is a partnership, private limited company, sole trader or any other business. There are not basically many differences in financial statements of sole trader and company; however usability of final accounts makes difference. Financial statement of a sole trader is just used for its internal accounting purpose and record of financial positions. However, for a company it is must to get its financial statements audited by the external accountants. It gives more transparency in the data provided. Company’s financial statements are used widely for investment purpose whereas for sole traders are not.
4.3. Ration Analysis and Interpretation
Net profit margin (NPM)
= Net Profit/Turnover
= 110,000 / 2,217,000
NPM ratio is used to find out margin of profit on sales. Industry NPM is 10 % whereas Success ltd has very low at 4.6% only. It means other competitors are performing excellent and making higher profit as camper to this company.
Gross profit margin (GPM)
= Gross Profit/Sales
GPM represents trade profit margin of the company.For Success Ltd. it is almost equal to industry ratio so it can be said that almost all the companies has similar percentage of direct expenses to their sales.
= Current Assets/ Current Liabilities
= 966,240/ 427,270
Current ratio represents company’s position of how current assets are able to meet current liabilities of the company. If this ratio is higher than 1, it is considered that company is in good position to meet out its urgent pay-outs. Here, for Success ltd current ratio is 2.26 which is even higher than industry’s current ratio. It means, success ltd has good stability to pay-out its current or urgent liabilities if required.
Quick ratio (1)
= Current Assets-Inventories/ Current Liabilities
= (966,240-496,240)/ 427,270
Quick ratio states that how a firm is able to meet out urgent requirement of cash liabilities or cash payable. It represents how quickly company can convert current assets into cash to make urgent cash payments. For Success Ltd. Quick ratio is 1.1 which is higher than industry’s quick ratio of 1. It means, this company is in good position to convert current assets into cash.
Return on Capital Employed (ROCE)
= Earnings before Interest and Tax (EBIT) / Capital Employed
= 284,500/ 21,74,080
A higher ROCE indicates more efficient use of capital. ROCE should be higher than the company’s capital cost; otherwise it indicates that the company is not employing its capital effectively and is not generating shareholder value. For Success Ltd. ROCE is positive and near to industrial ratio. It means company is quite likely using its capital in accordance to generate profit.
= Debt/ Equity
= 1,146,280/ 1,027,800
D/E ratio for Success ltd is 1.11 which is lower than that of industry average. It means company has lower debt ratio as a source of finance and funding as compared to equity financing which is a good sign. Company’s equity capital can be used to repay the debt part if needed at the time of any urgency.