Understanding Of Finance Within A Business Environment Finance Essay - Free Essay Example

As we are aware, finance is the lifeblood of business or it can be said as the most important part of all the business enterprises. To understand finance, you need to know the entire business indeed. Finance can be used for various reasons like expanding the business, investing and purchasing fixed assets like land and building, machinery so on. In order to survive in this competitive world every organisation need to have a good strength of finance available to their business or else they will not be able to survive in this world. Hence, it is very important to select the correct sources of finance available to the company. Finance can be in two types external sources or internal sources. Sources of Finance: Finance are arranged from external sources or internal sources. A fund, which comes from outside the business, is External sources of finance. Here the business are getting loans from individuals or for example banks that do have business relations directly. External finance examples are: Overdraft facility from bank. Getting Loans from building society or banks. Selling the new shares for sales. These types of finance are divided as Short term and Long term. Payback period for this Long-term finance will be longer. Long term has two main sources i.e. share capital loan capital. Day-to-day businesses are being covered by short-term finance, its payback period will shorter, hence less risky for lenders which are bank overdraft, hire purchase, trade credit etc. Long-term finance sources Short-term finance sources Shares Debentures Public deposits Retained earnings Loan from financial institution Term loans from bank Bank overdraft Hire purchase Trade credit leasing Cash inflows to a business Cash outflows from a business (Revenue from sales, loans, Payment for raw materials, stock, interest, sales of assets etc, labour, insurance, rent, rates etc.) Short term Sources of finance: Short-term sources it is mostly used by the small business to cover their day-to-day running cost. The most important aspects of the entrepreneur or the venture are to satisfy the commercial credit, which is also known as creditworthiness in order to be granted for any short term financing in the business. Eventually there are few aspects of short-term sources like Overdraft, Trade creditors etc. 1. Bank Overdraft facilities Most of the business use this type of facility as it is short-term finance and when no longer required it can be paid back easily. Interest is charged only on the amount overdrawn so it is quiet cheap. 2. Trade credit Trade Credit is a period given to a business to pay for goods that they have received. It is often 28 days and 90 days but some businesses might not pay for 6 months and on some occasions even a year after they have received goods. 3. Leasing A lease means that the business is paying for the use of a product but does not own it. It is also called hiring. An agreement between two parties are called as lease, the lesser and the lessee. It can be cheaper to arrange a lease rather than having to buy equipment outright. Advantages and disadvantages of Trade Credit: Advantages: In trade credit you have more time to pay the creditor with no interest It usually results in more customers than a cash trade. Easy cash flow as you can pay after 28-30 days Disadvantages: It involves a huge Risk of Bad Debt. When the customers of trade credit cant afford to repay the amount then it involves a risk of Bankruptcy. High administration expenses People can buy more than they afford it. Long term Sources of finance: These sources are normally used for a long period where in a long term loan is given by a specialist banks. However, for this type of loan securities are required, which is assets n properties like Plant and machinery, building etc. There are some long-term sources, which are normally used by the big companies like equity shares, debentures, bank loan, preference shares etc. 1. Shares These are issued to the public. These may be of two types: (i) Equity and (ii) Preference. The holders of shares are the real owner of the business, they may or may not get dividend regularly. They are also paid at last in case of wind-up of business. 2. Debentures These are also issued to the public. The holders of debentures are the creditors of the company. Debentures holder has to paid interest regularly. They also get preference of being paid first in case of wind-up of the company. 3. Public Deposits General Public also like to deposit their savings with a popular and well-established company which can pay interest periodically and payback the deposit when due. 4. Term loans from banks Banks are important for both short-term finance and long-term- finance. Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. If there is a rise in interest rate, it is added to the business cost. Advantages and disadvantages of Preference shares: Advantages: You get regular income and fixed dividend coming in even if the company is making profit or not it does not matter. With this share, you do not have any interference in the management. There is Flexible Capital structure in this share. Preference shares are given first preference at the time of liquidation or wind-up. Disadvantage: In these shares, you are not eligible for extra dividend even if the Company make high profit. At the time of liquidation, no extra money is paid to the preference shareholders. These shareholders cannot participate in any of the management activities. As they get fixed dividend so they are a burden on the company. Internal Finance Internal sources are finance, which comes mainly from its own funds, profits and depreciation.i.e Retained Profit, Squeezing Working Capital, and Sale of Assets. The main internal sources of finance for sole proprietors are as follows:  · Owners funds  · Selling personal assets  · Profits  · Depreciation As JS and company have market valuation of property or goodwill of more than 130 million, so bank can easily lend them bank overdrafts facility. Borrowed funds can easily pay back when no longer required, as their costs are effective and flexible. Moreover, interest is only paid on the amount overdrawn. In addition, fund of 200 million can be also raised through capital, debenture, or long-term loan, which also cost effective for the company. TASK 2 JS and company can arrange source of finance through external or internal sources. Whereas the company can raise the finance only through external source i.e. long-term or short-term sources. Short-terms of finance are those that are needed for less than a year whereas long-term sources of finance are needed over a longer period. Short term of finance that JS and company can use is bank overdrafts. As the company require finance for next five years, so short-term source will be not suitable. Hence, the company will need long-term source of finance. In long term, finance company can raise through share -capital, debenture, or long-term loan. Firstly, the company can use its 50 million in short term investment, by using it in dividend forgone. Thus using its own funds will help it in borrowing less from external sources, thus saving on dividend or interest, which has to be paid. The option available for raising finance is; If company take Long-term, loan from bank to fianc them. The implication of borrowing from a bank will result in interest rate to be payable whether they makes profit or not. In addition, the loan from have a fixed maturity date, i.e. they have to be repaid by given time. The company may not get the require amount from the bank due to current financial position of the company. On the other hand, JS and company have an option of either going as a private limited company or public limited company. Minimum two members and maximum of fifty members own a private limited company. In this method, they can contribute funds together to starts a new business. The shares of the company can be sold privately to known people, thus this will save advertisement cost i.e. inviting public to buy. Thus, they will have final and complete claim on profits after paying all debts. On the other hand, a public limited company were minimum member is seven and maximum limit of member is unlimited. The public company raises its capital by selling shares to public. These shares are quoted by the stock exchange. It able the company to raise large capital compare to private limited. It is therefore suitable for very large businesses for which the scope of expansion is very large. The public company raises capital through share-issue. People who buy shares are called shareholders. There are various types of shares; the most common one is ordinary and preference shares. An ordinary share makes the shareholder the owner of the firm. They get a part of profits of the firm in the form of dividends. If the company does not make any profits, ordinary shareholders get nothing. However, if company make huge profits then they can receive good dividend. A preference share gives the shareholder the right to get a fixed rate of dividend every year. They are paid before ordinary shareholders and their dividend are cumulative in nature i.e. if they did not receive any dividend in any one year, they would get two-year dividends in the following year, it get accumulated until they are paid. Whether the public company makes high or low profits, but they receive, they fixed percentage dividend. Preference shareholders do not have voting right. Debenture are special finance lend to company by bank and finance houses against fixed rate of interest. Payable in equal instalment or intervals. Lenders against assets of the company hold debenture stocks. If company default in payment assent are seized and sold for recovery. From the above, it can be noticed the issue of shares is far better than long-term loan and debentures. As the required capital will be easily available to JS and compared to them. 2) IMPORTANCE OF FINANCIAL PLANNING Financial planning can refer to the primary financial statements created within a business plan. Financial plan can be said as an annual projection of income and for a company. On the other hand, financial planning will help to get the estimate amount needed, such as issuing addition shares or borrowing shares in a company. E.g. the company which decides to expand e.g. by fitting out a new factory and buying will manually create the financial plan which will describe the sources needed or cost of finance, sources of finance developing the project cost, as well as the profits and revenues to justify the expansion programme. To maximise new ideas and opportunities, regular reviews will ensure that you remain on track to achieve your goals. Long and short term plans Example for one, three or five years are the time given for financial planning. The time required for this particular length depends on the importance of projecting in the future. Long-term plans are formed for business such as: Take over and merger activity. Expansion of capacity. Development of new products. Overseas expansion. Short-term financial plan provides targets for junior and middle organization, and determine actual performance, which can be controlled and monitored. Additionally, businesses that can prepare normal practices plan for three- or five-year plan with less detail and the budget is a short-term financial plan. At times, it refers to plans that are expressed in money. Following tasks involves the Financial planning activity:- Assessing business environment Confirming business vision and objectives For achieving these objectives it identifies the types of resources Analyze the amount of resource (labor, equipment, materials) Calculate the total cost of each type of resource Describe the costs to create a budget Identify any risks and issues with the budget set To meet the objectives within the budget set it give a great help to CEO to set financial targets for the organization, and reward staff. These are the three categories of financial planning which includes: Strategic role of financial management, Objectives of financial management and planning cycle. 3) Identify the Decision-makers It is the responsibility of business decision-maker to identify the needs. The technical decision maker gets the job of business requirement, as they need to find solution research and evaluation. For the approval and purchase, it goes back to the business decision maker. When the product is ready to come in the market, channel partners and decision-makers are involved in this decision. Three main audiences are influenced: The business decision makers : Business decision-makers handle business growth and competitive pressure, and face evaluation with their peers. They need to come up with solutions for business problems. Nevertheless, they might be not aware about your company as well as negative technical knowledge. 2) The technical decision maker: They may not have all knowledge about your products but they may be familiar with the company. In order to benefit the business you need to provide examples of how different products work. The channel partner: Channel partners work straight with your target businesses, advising them on the solutions. Winning the hearts and minds of your channel partners and educating them will allow them to create a preference for your products. Investment appraisal methods The capital budgeting cycle have an important step for working out the benefits of investing large capital of these investments. The methods that business organisation use is classified in two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method: discounted cash flow (DCF) methods now use as Net Present Valve (NPV) and Internal Rate of Return techniques. These four techniques and all involve a comparison of the cost of the investment with the expected return in the future. Payback methods: The time taken to recover the cost of the investment. The shorter the payback period, the better the investment. Payback period = Initial payment / Annual cash inflow. Advantages Because of simplicity and easy to calculate it is famous technique. Today business environment need rapid technological change, thus PM need to be replaced sooner than in the past, so quick payback on investment is important. Today investors demand that they are rewarded with fast return, so long term investment is overlooked, due to longer wait for revenues. Disadvantages Its lacks objectivity i.e. it is decided by pitting one investment against another. Cash flows are treated as either pre-payback or post-payback, but latter they are ignored. As it is sole concern is cash flow, so it does not consider the effect on business profitability. Accounting rate of return: Profits earned on investment here is express as a percentage of the cost of the investment. ARR = (Average annual revenue / Initial capital costs) * 100 Advantages The chief advantage with ARR is its simplicity, as it is easy to understand. The ARR is similar to the Return on capital Employed in its construction, thus this makes the ARR easier for business planner to understand. The ARR is expressed in percentage terms, thus this make easier for managers to use. Disadvantages The ARR does not account of the project duration or timing of cash flows over the course of the project. The concepts of profit are very subjective, different accounting practice and capitalisation of the project costs. Thus, ARR calculation for same projects would have different result in different outcome from business to business. The ARR does not give any definitive signal to its managers to decide whether to invest or not. This lack decision making. Net present valve: The present valve of net cash flows received in the future less the initial cost of the investment. NPV is a technique where cash inflows expected in future years are discounted back to their present value. Advantages: NPV gives the correct decision way assuming a perfect capital market. It also provide correct ranking for mutually exclusive projects. NPV gives an absolute value. NPV allows for the time value of the cash flows. Disadvantages: In NPV, it is difficult to identify the correct discount rate. NPV as method of investment appraisal requires the decision criteria to be specified before the appraisal can be undertaken. Internal rate of return: Discount rate causes the net present valve of an investment to be zero. The return achieved by projects is the annual percentage of IRR, discounted cash inflows above the life of the project is equal to the sum of the capital invested. Advantages: In IRR method, the investment on the original money valve shows the return. IRR shows rate of return of a project, so one can find the discount rate. Thus, it leads to no risk of loosing the money as the required rate is return is equal or higher. IRR gives you the rate at which you are safe. The IRR illustrates the overall returns from an investment in a clear and direct manner that leads to an easy decision-making process for companies to find, which investments is to be selected. Disadvantage In IRR, it is difficult of finding the internal rate of return accurately. The IRR method, can give you conflicting answer when compare to NPV for mutually project. As JS and company have market valuation of property or goodwill of more than 130 million, the fund of 200 million can be raised through capital, debenture, or long-term loan through any of four investment appraisal techniques. Payback method or Accounting rate of return will be suitable technique. TASK 3 FINANCIAL DECISIONS: An organisation needs to have to an appropriate plan to succeed in the competitive business world. Various decisions need to make effecting the organisation, which requires in-depth view of the finances available within the organization. These finances needs to be allocated and used in appropriate way so as to have a strong balance sheet which shows the success of the organisation during that financial year. Financial decision depends on the preparation of financial statements prepared which affects people such as stockholders, suppliers, bankers, employees, government agencies, owners and other stakeholders. Therefore, the financial statement is important to any organization as the decision is mainly depending on the report submitted to the management Financial Accounting serves three purposes: Producing general-purpose financial statements. Provision of information used by management of a business entity for decision making, planning and performance evaluation. For meeting regulatory requirement. Task 4 1) Show me the money! financial statement shows you the money. They show you details like where the money came from, where its gone, and presently where it is. There are four types of financial statements (1) Balance sheets shows the detail that how money the company made and spent over the time period (2)Income statement shows the income of the company (3) Cash flow statement shows money exchanging between the company and out world for a given time period (4) Statement of shareholders equity shows the companys shareholder changes in the interest rate. Now let us have what financial statement does. Balance sheet: a balance sheet provides complete detail of assets, liabilities, and shareholders shares. Assets: assets are the thing in terms of value, thus it mean that it can be used, sold or can provide service that are sold out. It consist of physical property, such as plants, equipment etc. It also includes things that cannot be touched or seen but on the other hand, which exist and have value, such as trademarks etc. In addition, cash itself is an asset. Liabilities: A liability means the money owed by the company to others. This include all money borrowed from a bank, rent of a property, pending money of suppliers for materials, etc. Thus, Liabilities is debt burden on the company. Shareholders equity: shareholders share is called capital or net worth. They are the owner of the company. In case the company winds-up, the money that would be left over will be used pay off all its liabilities. Moreover, after paying off the liabilities the money left belongs to the shareholders, or the owners of the company. Income statement: It refers to profit and loss statement (PL), it shows reports of companys profit, expenses and income over a period. PL accounts gives information on the operation of the enterprise. Thus, its shows the earnings and expenses incurred during the given period. Cash flow statements: it gives inflows and outflows cash report of a company. This is very important because to pay its expenses and to purchase assets the company needs to have enough cash. Thus, increase and decrease in cash for a period can be seen in the cash flow statement. Normally, cash flow statements are divided into three main parts. (a)  Operating activities; (b)  investing activities; and (c)  financing activities. Statements of Shareholders equity: shareholders share is called capital or net worth. They are the owner of the company. If the company winds-up, the money which are left over will be used to pay off its liabilities and after the liabilities are paid off the left over money will belong to the shareholders or the owners of the company.Thus, financial statements main objective is to give information about the performance and changes in financial position of the company, which is useful to make economic decisions. Hence, financial statements should be easy to understand, appropriate, consistent and equivalent. Following ways can help the financial statement: For Internal use: statements can be internally by the company for better decision-making, bargaining in management, raking and promoting the employees. It helps the owners and managers to make important business decisions that would affect its continued operations. These statements are also used in annual report to the stockholders. 2) Employees also need these reports for making collective bargaining with the management; it is also used for discussing their compensation, promotion and rankings of the labours of the company. External Users: External users are the investors, banks, government agencies and other parties who are outside the business, thus they need financial information about the business for following reasons. To assess the viability of investment in a business it is really important to have a financial statement. It is used to provide the basic for making investment decision which is mostly used by investors and prepared by professionals (financial analysts). Banks and other leading companies are the financial institution that uses them to decide whether to grant a company or to extend debt for expansion and other expenditures. It helps the Government tax departments to make sure that the taxes, duties and payments are made correctly by the company. Media and the public also have a interested in financial statements for a different of reasons. The unique aspect of financial accounting is that despite all the form of ownerships, and different types of business activity, there is one single format for the financial statement of all types of business. They may differ in some specific detail and descriptions, but the basic formats remains the same. Assets are classified as financial assets or non-financial assets and are shown on the Statement.   There is no difference between current and non-current; Liabilities are not classified as current or non-current but are listed. Internally Prepared: Company is following some accounting rules to make its own books and prepares its interim and annual financial statements. The internal member of management prepares the financial statements which is considered as the lowest quality of financial statements. For the small businesses and businesses with sophisticated internal accounting professionals, this might be the highest grade of financial statement a company needs. Compiled: Complied financial statement is prepared by Certified Public Accountant (CPA). The statements prepared by CPA have information which is given by the business clients. It is mostly prepared with rules. Generally, banks and other lenders consider compiled statements of greater value than internally prepared statements. Reviewed: Reviewed financial statements are one step up; CPA perform inquiries and analytical procedures to seek in depth understanding of clients business and financial information. Financial statement helps to make business decision. Organization depends on accurate data and information which is used by Board of directors, management, external auditors etc. Financial analysis helps internal auditors to provide information on companies operation. Auditors should asked area management after obtaining the chart, which accounts are used to record their transactions. They should also determine how and where the accounts is summarized in the financial statements There are two types of analysis to assess financial statements such as comparison and ratio analysis. Ratio analysis is the most widely known and most commonly used type of financial statement analysis. It is a basis for financial statement, which helps to provide information on effectiveness and efficiency of operation. The resulting ratios are usually expressed in percentages, which can be used for comparing the ratios from one period to another. This comparison allows the internal auditor to determine whether significant changes in the ratios from period to period are caused by poor performance. The type of analysis varies according to the specific interests of the party involved: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Trade creditors or suppliers are interested in the liquidity of a firm ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ The bankers or other creditors are more interested in the cash-flow ability of the firm to service debt over a long period ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Management also requires financial analysis for the purpose of internal control and to seek suppliers.