Financial Principals And Techniques In Real Business Environments Finance Essay - Free Essay Example

As a student for my study subject Managing Financial Principles and Techniques I am going to try to share my knowledge through this assignment what I have learn from the my Unit and what I have achieved. Through this assignment I want to show the understanding on the Financial Principles and Techniques which are used in real business environment. Forecasting is base on the assumptions that the condition on the which forecast has been done remain same at the time of implementation of the period or time for which forecast has been done. In the business forecasting of cost and revenue are mostly done for future picture of the organization can be view on basis of that. Fixed costs are those that do no change in the budget year with changes in the volume of output or sales. Fixed cost remains constant during a specified period of time and over a specified range of output. This means that when the level of output is decreased the fixed cost per unit of output increases, and conversely when the level of output increases the fixed cost per unit decreases. This is the problem with allocating fixed costs to unit product costs. The fixed cost per unit will depend upon the number of units produced. Some examples of fixed costs are business rates, insurance premiums, management salaries, rent, taxes and depreciations etc. Variable Cost: Variable costs change in relation to change in the level of output or sales. This type of cost will vary with any change in production. If the factory stops production it will not use materials or power for the plant. The direct labor costs will also fall away, although perhaps not in direct relationship with a change in production. Some examples of variable costs are direct material, direct labor and plant power usage. Total Cost: This is the total of all costs, fixed and variable, at a certain level of output. For example, if a factory has fixed overhead costs of 200,000 p.a. and the cost of direct materials and labour is 9 per unit of production then the total cost when the level of production is 35,000 units will be: Fixed costs 200,000 Variable costs (9 X 35,000) 315,000 Total cost 515,000 Unit cost (515,000/35,000) 14.71 If production is increased to 40,000 units then: Fixed costs 200,000 Variable costs (9 X 40,000) 360,000 Total cost 560,000 Unit cost (560,000/40,000) 14.00 Contribution: Contribution is the value of sales less variable cost of the sales. For example, if a company sells 20,000 units for 15 each when the variable cost of sales per unit is 7 and fixed costs are 90,000 p.a. the result would be: Sales (20,000 X 15) 300,000 Variable costs (20,000 X 7) 140,000 Contribution 160,000 Fixed costs 90,000 Net profit 70,000 The contribution towards overheads and profits is equal to 20,000 X unit contribution. That is 20,000 X (15 7) = 160,000. Since the fixed overheads are only 90,000 the net profit is 70,000. Break-even point: In the example above we have a unit contribution of 8. Therefore, to break even and cover the 90,000 fixed costs we would need to sell 11,250 units. This is simply the fixed costs divided by the unit contribution (90,000/8 = 11,250). By selling 11,250 units with a unit contribution of 8 we will make a total contribution of 90,000 towards fixed overheads. Then, since fixed overheads are also 90,000, we will make neither a profit nor a loss but will break even. Sales (11,250 X 15) 168,750 Variable costs (11,250 X 7) 78,750 Contribution 90,000 Fixed costs 90,000 Profit/(loss) 0 The break-even point occurs when 11,250 units are sold. If more units than this are sold then company will make a profit of 8 per units. For example, in another 10,000 units were sold (21,250 in total) the profit would be 80,000 (10,000 X 8). Proof below: Sales (21,250 X 15) 318,750 Variable costs (21,250 X 7) 148,750 Contribution 170,000 Fixed costs 90,000 Profit 80,000 Marginal Cost: Selling prices are determined by the interaction of the market forces of supply and demand. When setting selling prices the sale director will be mindful of competitive prices and the choices that customers have in terms of alternative suppliers and products. However, knowing the unit contribution that a certain selling price brings can help an organization make better pricing and business decisions. It is close to the end of year for a company that has so far made sales of 500,000 against variable cost of 300,000. Fixed costs for the year are 900,000, so it will make a profit of 110,000. It has just received an order for 10,000 units of a product that has a variable cost of 6 and a full/total cost of 10. The best price the salesman can get is 9. Should it accept the order? In this case the answer is yes, it should accept the order. This is because it will obtain a contribution of 30,000, being 10,000(9 6). It will be 30,000 better off even though it is selling each unit at less than its total cost. The conclusion that the order should be accepted is based on the assumption that the company has no other orders to accept before the year end. Even though the unit selling price of 9 produce a contribution towards overheads of 3 per unit. Accordingly, the company is better off accepting the order than declining it. At this point any selling price above the variable cost of 6 will improve the bottom line. Advantages: Show the relative contributions of products. Shows clearly the exact relationship between cost, selling price and volumes. Helpful in pricing and outsourcing decisions. Shows how to overall profit can be maximized. Separates variable and fixed costs so that better business decisions can be made. Does not arbitrarily allocated fixed or indirect overheads to products in an unrealistic way. Disadvantages: Does not show the full (fully absorbed) cost of a product. Does not enable the profit (after all costs) of a product to be determined. Discounted payback: This method still asks when does payback happen? but it takes an additional factor into account the so-called time value of money. It considered a further option: that instead of using the money to finance a capital expenditure project, the business could simply put it in the bank, or into a safe, predictable investment to produce a return which, for the sake of argument, we will assume to be in the form of interest. In other words, given that the business could be earning, say, 8 per cent interest any way, it asks What are the future inflows really worth as an alternative use of the money? After all, if the business can earn 8 per cent with little or no risk, the proposed project must offer a return of at least 8 per cent! Otherwise why bother with it? In the discount payback method, the future cash flows are discounted at a pre-determined interest rate (basically at the rate that could be earned elsewhere, with minimal risk), the effect of which is to strip out the presumed interest, leaving the principal element of the net cash inflow. Matrix Plc Interest rate is 12% Discout rate = (investment / [1.0 + Rate of Interest/100] x 100 = (1,10,000 / [1+0.12] x 100 Year Cash inflow Cash Outflow Net cash flow Cost of capital Present value 0 110,000 (-110,000) (-110,000) 1 40,000 40,000 x 0.893 = 35,720 2 35,000 35,000 x 0.797 = 27,895 3 30,000 30,000 x 0.712 = 21,360 4 25,000 25,000 x 0.636 = 15,000 5 20,000 20,000 x 0.567 = 11,340 112,215 NPV = 2215 ( 110,000 112,215) = 2,215 As per the above example 5 years measured but as per the criteria of the assignment three years to be calculate as per that 84,975. Task 2: Sources of Finance: For all the businesses, maintaining enough finance is very crucial for their existing and potential operations. The organizations have to deals with day to day expenses along with to find the potentials of the new ventures. There have many options for getting finance. There are two types of finance (1) Internal (2) External and they are: Overdraft: Organization has an option of using overdraft facility which is an external source of finance and cannot be used for a longer span. Whenever the company is in need of, it can interact with their bank and avail the overdraft facility given by their bank. Interest on overdraft is mainly on daily basis. The main advantage of this source is bank will charge the interest on the amount that company withdraws as per its requirement. If it borrows less money, the interest too will be less. But disadvantage of this source is the company can use it only for a short term period. Company can use overdraft financing if their requirement is for short term. Debentures: Debentures are the company can consider for long term and the company can pay back this loan by several years. The main advantage of this option is they are more secure and there would not be any changes in interest and hidden charges as well. In most of the cases, debentures are given by tying to the financing of any asset. When the company choose this option, gets loan on assets like land or building, it is known as mortgage debenture. Debentures are usually manageable by the debenture holder. The preferable aspect of debentures is that debenture holders can not be having any voting rights and the interest paid to them is considered as the expenses in the companys financial statements. If company has assets like buildings, land, machines they can go for this option. Line of Credit from creditors: This is one of the easiest and bit chipper sources of finance. The organization can buy goods or raw materials on credit and pay it later. Line of credit means the supplier the one who supplies raw materials to the company. If the company uses the cash from line of creditors, it can use that cash to pay for other expense. I suggest this is one of the most considerable options as the company will not have to pay an interest up to certain time limit. Grants: Grants also can be considered as an option if the company has specific problems or they are dealing with some specified areas which are entitled some grants from the government, and then they can apply for grants in the local council or other government bodies. Local councils will help the company to sort out certain issues by financial aids. This is the most preferable option as the company will have to pay nothing in return. Venture Capital: Venture Capital is a kind of private equity available to the company to create return through trade sale of that respective company. There are chances of failure and the success both or it could provide average returns as well. In this way it is highly risky option. It gets increased in exchange of shares. Leasing: Company can choose the option of taking a lease which is of two types operating lease and finance lease. Lease is a contract between two parties and the person or company who takes lease has to pay an agreed amount to the leasing company. Company can use external source of finance to extend their business. Personal Savings: It is an internal source of finance if it is available to the company. Most of the companies spare money as provision for their new potential ventures to increase their business areas or to start a new venture. If the company is planning to start a new business, using their current savings, that money can be counted as personal savings. Bank Loan: Company has an option of taking a commercial loan from a bank by using stock or property as a security. It can get an unsecured loan for small amount. Taking a loan from a bank is bit expensive in terms of interest and the processing charges and an organization must consider all the other options before choosing this option. Selling useless assets: The organization can sell useless fixed assets or scrap e to fulfill its requirement for finance. This is one of the best options for acquiring finance as the company will get the finance without raising extra financial burden and can get rid of the useless assets. From the point of view of the share holder of the company debentures are fixed rated borrowing from the general public. When company takes overdraft means that company have short of working capital and its give negative effect on their creditors that company is running out of money. Line of credit company gets if there is a good relationship with suppliers means that company can use cash received money to their daily expenses rather than pay to their creditor. When company get a grant for any social welfare programme which relate to general public it shine companys image. Venture capital changes the company position and their profitability and it also affect the shareholder if company fail in capital venture it create loss and ultimately companys reputation. Leasing for long term means company has to pay fixed amount every decided term interval to whom has lease. Bank loan is the long term and company has to pay interest on it and also payback the principal amount of the loan to the bank in desire time period. Alpha plc is planning to make their own production units for that they need 250,000. For this they cant be relay on sources like personal savings, overdraft, bank loan can be acceptable but as per the terms and condition decided through the discussion at the banks policy. Debenture can be issued for the amount and fixed interest should be given to the debenture holders. As well as new equity shares can be brought by the board of directors through AGM agenda and get green signal from AGM to take new IPO or Rights issue of share to get the amount. In my opinion to get the big amount for years to cover (in form of profit) so it is advisable that in form of equity or rights issue or IPOs form of finance is the best because it does not make any fixed expenditure after getting the money or to give return on that money regular basis but it is also risky because if company cant perform well on the project companys prestige and share prices both will effect in negative. Task 3: Investment appraisal techniques: There are many investment appraisal techniques are being used some of them are Accounting rate or return, Discounting future cash flow, Net present value and internal rate of return. Accounting rate of return (ARR): The accounting rate of return is a way of comparing the profits you expect to make from an investment to the amount you need to invest. Advantage: The only advantage that can be claimed for ARR is simplicity of calculation. Disadvantage: 1. ignores the timing of outflows and inflows. It will not calculate separate for each project just calculates without considering time factor. 2. Uses a measure of return the concept of accounting profit. Profit has subjective elements, is subject to accounting conversions and is not as appropriate for investment decision making as the cash flows generated by the project. 3. There is no universally accepted method of calculating ARR. Discounted future cashflow (DCF): Money has a time value. If you have money now, you can use it for example, by putting in deposit. Conversely, if you want money now but will only get it in the future, you would have to pay to borrow it. The further you look ahead, the greater the risk are, if you expect an investment to return 1,000 in a years time, you may well be right. If you are looking ten years into the future, things might well have changed. Advantages: Clear, consistent decision criteria for all projects. Same result regardless of risk preferences of investors. Quantitative, decent level of precision, and economically rational. Not as vulnerable to accounting conventions (depreciation, inventoruy valuation, and so forth). Factors in the time value of money and risk structures. Relatively simple, widely taught, and widely accepted. Simple to explain to management: If benefits outweigh the costs, do it! Disadvantages: The use of DCF overcomes some of the disadvantages of the traditional techniques but it must be stressed that DCF itself has problems and contains many assumptions so thsat it should be used with care and with an awareness of its limitations. Net present value (NPV): The NPV calculates the present value of all cashflow associated with an investment; the initial investment outflow and the future cashflow returns. The higher the NPV the better. Advantages: Gives consideration to the time value of money. Considers all relevant cash flows. Commonly uses and understood. Disadvantages: Makes assumptions as to the cost of capital. More difficult to calculate; needs table of discount factors. Internal rate of return (IRR): Work out the discount rate that would give an investment an NPV is zero. This is called the IRR. The higher the IRR the better. IRR can compare to the own cost of capital, or the IRR on alternative projects. Advantages: Like NPV, it deals with discounted cash flows and is based upon the time value of money. Although percentage nature of the IRR may make it more acceptable. The cost of capital is required for use as the discount rate with NPV but, as has been indicated its calculations is difficult. Calculations of the IRR does not require a precise cost of capital discount rate and a projects IRR can be compared with an approximation of the cost of capital, avoiding dispute about the precise discount rate to use. The board can decide whether the IRR is sufficiently above the approximate cost of capital for the project to be acceptable. The difference between the IRR and the cost of capital indicates the additional return for risk that the project provides. Disadvantages: If there are negative annual net cash flows later than year 0, this may lead to more than one possible IRR. In this situation IRR must be used with great care. If company has to rank mutually exclusive projects, choosing the project with the highest IRR may result in a suboptimal outcome. Class Exercise: 1. Return on Capital employed = Profit before interest tax X 100 Capital employed Year 2008 Year 2009 = 22,428 X 100 = 30,270 X 100 71,121 18,81,137 = 31.53 % = 1.6 % 2. Profit Margin = Profit before interest tax X 100 Sales Year 2008 Year 2009 = 22,428 X 100 = 30,270 X 100 5,50,664 6,58,860 = 4.07 % = 4.59 % 3. Asset turnover = Sales____ Capital employed Year 2008 Year 2009 = 5,50,664 = 6,58,860 71,121 18,81,137 = 7.47 : 1 = 0.35 : 1 4. Current ratio = Current Assets Current liabilities Year 2008 Year 2009 = 2,53,753 = 5,76,984 2,12,813 3,62,420 = 1.19 : 1 = 1.59 : 1 5. Quick ratio = Current assets Stock Current liabilities Year 2008 Year 2009 = 2,53,753 336 = 5,76,984 865 2,12,813 3,62,420 = 1.19 : 1 = 1.59 : 1 6. Debtors collection period = Trade Debtors X 365 Credit Sales Year 2008 Year 2009 = 63,533 X 365 = 4,07,474 X 365 5,50,664 6,58,860 = 42 Days = 226 Days 7. Creditors payment period = Trade Creditors X 365 Credit Purchase Year 2008 Year 2009 = 4,049 X 365 = 3,559 X 365 75,120 1,18,926 = 20 Days = 11 Days 8. Stock days or inventory = Stock X 365 Cost of sales Year 2008 Year 2009 = 168 X 365 = 600 X 365 74,784 1,18,397 = 0.82 Days = 1.85 Days 9. Debt ratio = Total debt Total Assets Year 2008 Year 2009 = 2,12,813 = 19,99,458 2,83,934 22,43,557 = 0.75 : 1 = 0.89 : 1 If we think over the liquidity ratio, basically current ratio is 2:1 then it means company has 2 assets and against that 1 liability which shows good condition of the company. In Alpha Plc current ratio is 1.19 : 1 that means company has 1.19 assets and 1 liability and in 2009 the ratio rise up and becomes 1,59 : 1 which shows companys better condition in 2009. As per efficiency ratio Alpha plcs debtors collection period is 42 days in 2008 that means whatever company sale to its customers that it can cover its money within 42 days but in comparison of that in 2009 rise up 226 days which is not good for the future of company. Task 4: Payback: This is the time that it takes for the cash flows an investment project to cover or equal the cash outflows. Although, as we shall see, this method has certain inadequacies, it is used as a quick and simple measure of a projects viability. The pay-back period is measured in years or months and obviously the shorter the period, the more attractive the project will be in pay-back terms. Advantages: Easy to understand and calculate Looks for breakeven point Bias towards short payback and therefore lower risk. Forecasting long term is difficult so focus breakeven and early project result. Disadvantages: Limited to B/E on payback not overall investment return. Does not consider time value of money. Scale of project. Low risk of do nothing option. ROCE: ROCE can be useful in investment appraisal. This measure of return shows the percentage that profits earned on an investment compared with the cost of the investment. There are several different definitions of ROCE, profits and investment. Advantages: Full investment returns not only B/E. Widely used popular. % is easily understood. Company assessment based on this project assessment is appropriate. Disadvantages: No time value for money. Complex, different way of calculating. % does not look at scale of investment. Accounting return not cash flow. Calculating different ratios: M.K Plast Plc Particulars Value ( m) Stock 3.2 Debtor 0.9 Bank 3.5 Credit 5.0 Long team loan 5.0 Ordinary share capital 7.4 Reserves 2.5 Sales for years 30.7 Purchase for year 25.5 Cost of sales for year 28.2 Ordinary dividend 7.5 Corporate tax 0.75 Number of ordinary share bleach 0.50 Current market price 1.08 Net profit after tax and profit dividend 15 Debtors collection period (days) = Debtors Credit sales X 365 days = 0.9 30.7 x 365 days = 10.70 days Creditors payment period days = Trade creditors Credit purchase x 365 days = 5.0 25.5 x 365 days = 71.56 Stock turnover (days) = Average stock x 365 days cost of sales = 3.2 28.2 x 365 days = 41.41 days Capital gearing percentage = Long-term loans (including preference shares) Capital (Ordinary shares + reserves) x 100 1 = 1.8 x 100 50+3.7 = 3.35 Earnings per share = net profit corporation tax and preference dividends Number of issued ordinary shares = 15, 00,000 50, 00,000 = 0.3 Price earnings ratio = Market price of ordinary share (in pence) Earnings per ordinary share (in pence) = 108 30 = 6 pence Dividend cover = Net profit after corporation tax and preference dividends Ordinary dividends = 15 000 00 7, 50,000 = 2 As show in the above equation debtor get 10 days credit and company get 71 days credit for that company will not need any extra working capital for their purchases also they can purchase more and sale them through that rotation or turnover they can create big amount of profit. Stock turnover is 41 days means company sales all of their stocks in 41 days they need another stock after that. Earning per share is a barometer for investor to invest in a company how the company earn per their investment and how much it is profitable or advisable to invest in such kind of company in this company EPS is 30 pence per share which is low so, investor might not attract the investor and company has to perform better for their sustainability. Companys price earning ratio is 6 pence, Means Company earning is not so good in terms of current price which is 108 pence. Dividend cover is 2 it means company get more profit in terms of their dividend given policy they are not making reserves and they pass their profit to the shareholder directly it is not advisable to do.