The management of business finance

HND UNIT 2: Managing Financial Resources

In this unit I am going to show my understanding of the management of business finance. I will also investigate the sources of finance available to businesses and how to interpret the use of financial information for decision-making.

Sources of Finance

The core aim of any business is to survive, additionally, it may have other goals such as to make a profit or improve or expand the products or services it provides to satisfy stakeholders, either way, it will need to control its financial resources to do this. By collecting all the available financial information and recording it into various accounts, a business can assess how well it is performing. This is important both for a business internally as well as externally.

Financial resources are needed throughout a company’s life. The type and amount of finance depends on many factors e.g. type of business, the success of the firm, the economy of the state etc.

There are two main types of financial resources that a firm needs. This is:

Capital Expenditure~ this is used for buying fixed assets where large sums of money are involved and needed but this is not used for buying property or new premises

Working Capital~ this is the money used for the day to day running of the business like petty cash

When these means are not enough, or the business is not making a quick enough turnover for the business to expand, other sources of finance may be considered that are essential to fill that cleft.

Short Term Sources (0-2 years)

Short-term sources are usually to cover short-term orders or bulk orders that businesses take on that working capital can’t cover and is needed for a brief period of time. These are:

Overdraft~ if a business spends more money then it has in its bank account, we say that it is overdrawn. Businesses usually have an arrangement with the bank whereby the bank will pay the extra money provided the business will pay them back in a fairly short period of time with interest. The advantage of this source is swift availability of the funds. The disadvantages on the other hand are the expensive costs if this use is miscalculated in interest rates and bank charges.

Factoring~ businesses are often owed money and can find difficultly in collecting its debts from its customers but may need to get its hands on the money very quickly. A special factoring company may offer to handle the debt collection process for a charge. The factoring company pays the business most of the value of the debt first and would then collect the money from the debtor. The advantage of course of this method like above is the prompt availability of cash. Other benefits to this method are the saving of time, effort, resources and hassle in the debt collecting process. The disadvantages to this method are that factoring organisations would only however, take on client companies with an annual turnover of £50 000 or more and take 5% of the owed balance on your companies’ debt.

Trade Credit~ unlike me for example, a business does not normally pay for things before it takes possession of them. Instead, it will usually place an order for supplies and pay after receiving them. Usually payment is received within one month of purchases as this is considered good supplier relations. The advantages of this method is supplier relations as mentioned, allows cash to be freed up for a short period of time to cover other costs but with an added benefit of interest free credit like a credit card company gives before a payment is required. Payment days can be negotiated up to 90 days meaning these new terms could allow a business to have up to three months interest free credit to pay off its debts. In these circumstances good company credit is usually required, a good company profile e.g. strong sales, customer base etc, and good relations with the supplier are a must. The disadvantage are supplier relations can be tarnished if a business starts to have cash flow problems and finds It hard to pay its creditors, causing bad debts to form which could make the company black listed and have to look for other sources to pay off those debts.

Retained Profit~ this is the money left over at the end of the trading year. If the company has been successful enough to make a profit after taxes and overheads, it may choose to use this revenue to fund future activities. This can be a useful source of finance providing the company makes a profit every year. The advantages are no fees or charges payable and shareholders are likely to be pleased with businesses that put money back into the business for further growth. The disadvantages are that if emergencies or other financial priorities arise where retained profit could have been used, other sources have to be considered. Also, this option is only available to business trading more then one year.

Savings~ this method is mainly used by sole traders and partnerships. This is when the owners use their own money usually savings to invest as capital into the business. The advantages are the quick access to cash and the idea of knowing the investment will benefit those closest to them and no initial charges. The disadvantages are investors can lose the money the put into the business, a dividend or interest may be payable when the balance is due back to the investor, they can also have no guarantee and feel pressured to give the investment.

...

This is a preview of the whole essay

Savings~ this method is mainly used by sole traders and partnerships. This is when the owners use their own money usually savings to invest as capital into the business. The advantages are the quick access to cash and the idea of knowing the investment will benefit those closest to them and no initial charges. The disadvantages are investors can lose the money the put into the business, a dividend or interest may be payable when the balance is due back to the investor, they can also have no guarantee and feel pressured to give the investment.

Medium Term Sources (2-5 years)

Medium term sources are usually used for paying for machinery, vehicles or business assets that the business need now, can’t currently afford to pay for, but can over a long period. These are:

Bank Loan~ this is the large sums of money borrowed from banks or building societies. A loan is useful for a business that is starting up or looking to grow. Loans are often used to buy fixed assets such as machinery or assets. The business will pay back the loan in monthly instalments with interest. The advantage to this is the large sums of money that can be granted and the quickness of decisions. The disadvantages are the preparation needed with bank meetings such as business plans, time and resources. The interest added to a loan and the fact that this sort of resource is outside of the businesses control that can seriously affect the businesses performance is another disadvantage.

Hire Purchase~ this involves paying for equipment in instalments. The business will not own the items purchased until the full payment has been made. The advantages to this method are the business can have the items needed straight away and also allows cash to free up for other things, as a large amount is not being paid out all at once. The disadvantages to this method are it can work out very expensive to buy items this way and if loan repayments are not met, the items can be reposed to cover the outstanding balance.

Lease Purchase~ leasing involves business renting equipment that it may use for a few months or many years, but never own. This is used for photocopiers or photographic equipment, particularly in colleges and schools. The advantage to this method is all breakdowns and services are covered in the leasing cost, and also the deal may include replacing the product or a newer model every so often. The disadvantages to this method are the business never owns the item, but this could be classed as an advantage in terms of repair costs, if the item in hand has a high repair rate, like photocopiers and also it is never an asset to the business, therefore will never show on the balance sheet, so they don’t boost the value of the company.

Sale & Leaseback~ this is when an asset is sold and rented back from the buyer. Football stadiums, property, head offices are examples of this. The advantages to this are the substantial amount of cash this provides companies to put into other areas, usually growth and expansion and still have the use of the site. The disadvantages are the loss of the asset and high rents payable.

Long Term Sources (5 years +)

Long-term sources are usually used by established companies to invest in major company changes, For example, the development of new sites, purchasing property, improvements and changes etc.

Bank Loan~ a bank loan can be for longer periods of time of up to 20 years or more in some cases. (See medium term sources) a Debenture is the long term equivalent to a bank loan for PLC’s only. It is only borrowed form special bodies and paid over long periods of time usually several years.

Mortgages~ are usually provided by building societies but, nowadays banks are more often offering them and the difference between banks and building societies are narrowing. A mortgage is a special type of loan used to buy property. Mortgages can be offered at fixed or variable rates and can be up to 25 years long to pay back. The advantages are mortgages are a great way for businesses to get on the property ladder, they allow large sums of money to be used at lower interest rates then short term sources. They're an asset to the business, so if the value of the building goes up, so does the value of the business. The disadvantages are if variable rate mortgage is taken out, if interest rates are high, so are repayments on the property.

Shares~ (see fig 1.1 for share process diagram) are an important source of finance for limited companies. A business selling new shares that entitle the shareholders to share in the control of the business. Each share gives the shareholder a vote on the direction of the company. The advantages to this method are the substantial amounts of cash that can be raised, can make directors and mangers work harder as they can be voted off the company. The disadvantages are only PLC’s can issue shares to the public, some aspects of control are lost in this process and if the directors have a different idea to the shareholders in the direction the company should go in, it could lead to problems, particularly if shareholders own the bigger share in the organisation.

Venture Capital~ a group of people who join together and provide finance for new business that are just starting up. These individuals look for promising businesses and put investments into them. This is similar to share issuing. (See share for pro’s and con’s of method.)

Section Two: Case Study

I am advsing a small business called J.N Coolers that sells water dispensers with other benefits such as fruit juice compartments as to what sources in finace to use. The business is growing in size and needs to meet up with demands. I am going to look at the range of finance open to them, assess them and recommend a selected source explaining my reasoning for the choice.

Small businesses (SMI’s) can be defined as:

Companies not quoted on a stock exchange,
Owners are a few individuals, usually a family connection between the shareholders
The businesses is the only or main income for an individual

The small businesses sector is vital in the UK economy. In 1999, the Department for Trade and Industry (DTI) estimated that there are 3.7 small businesses in the UK. As a proportion of all businesses in the UK, small businesses account for some 55 per cent of employment and 45 per cent of turnover.

Sources of finance for small businesses

There are a number of potential sources of finance to meet the needs of small and growing businesses. These are:

Existing shareholders and directors funds (“owner financing”)
Overdraft financing
Trade credit
Equity finance
Business angel financing
Venture capital
Factoring and invoice discounting
Hire purchase and leasing
Loans

A key consideration in choosing the source of finance is to strike a balance between equity and debt to ensure that funding suits the business.

The main differences between borrowed money (debt) and equity are that banker’s request interest payments and capital repayments, and the borrowed money is usually secured on the businesses assets or personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it fails to repay its debts back to them.

Finance a Problem

The main problem for small businesses when trying to obtain funding is that of uncertainty. Small businesses rarely have a long history or successful track record that investors can rely on. This can mean they find it harder to find potential backing. Banks are particularly nervous of smaller businesses due to a perception that they represent a greater credit risk. SMI’s will need to give a business plan, list of the company assets, details of the experience of directors and managers and demonstrate how they can give providers of finance some security for amounts provided.

Prospective lenders, usually banks, will then make a decision based on the information provided. The terms of the loan (interest rate, term, security, repayment details) will depend on the risk involved and the lender will also want to monitor their investment.

Banks usually are unwilling to increase the loan without an increase in security, which SMI owners may be unable to provide.

finance can become a problem when a business is growing rapidly. Companies like these aren’t able to finance this usually from current cash flow alone. They will therefore need to consider raising finance from other external sources. To boot, stakeholders looking to buy-in to a business or buy-out from its owners, may not have the capital to get the company. They will need to raise their own finance to achieve their objectives.

Final Recommendations

Looking at the above research I recommend that J.N Coolers use a mix of sources to minimize their borrowings and maximize the resources available to them.

Owners financing is the most obvious source with a number of benefits. It wouldn’t matter how small the investment as it could decrease repayments and increase resources.

Since little information about the company is known I have to make assumptions as how the business stands. The business is growing, so I assume that a number of creditors are to be paid and recommend that terms be stretched by making the payment dates longer.

Secondly, I suggest that debtors are contacted for payments using a factoring company or their own resources to get debtors to pay.

Thirdly, taking advantage of any grants available to them would also add to the needed finance. Knowing so little about the company I couldn’t find any grants specifically available to them. If the business was to develop and build their own water cooler systems, BTG could provide a grant; otherwise I would advise the business to visit their local business link to get advice on grants and extra funding.

Taking out a loan would be a better idea then increasing their overdraft. There are many business loans available on the market, and it can be very confusing for SMI’s to decide and understand the options available to them.

I found two business loans that I recommend to J.N. Coolers to resolve their financing problem. Firstly a business loan from Clydesdale bank. The Clydesdale bank offered the best loan I could find, with the lowest APR. Below is a chart showing the savings compared to other banks on a £7 500 loan.

Taken from Clydesdale loans booklet, September 2003. Based on £7 500 over 60 months

The other loan I found, which could be more appropriate was a government-backed loan. It’s specifically designed for businesses that don’t qualify for conventional bank financing. Loans are available for periods between 2 and 10 years on sums from £5 000 to £250 000 in the case of business which have been trading more than 2 years. DTI guarantees up to 85% of the loan, in return for the guarantee the borrower pays the DTI a premium of up to 1.5% per year on the outstanding balance. Business can choose between fixed or variable rates (fixed rates currently on Gov-Backed loans are 0.5%, July 2003) repayments are made monthly or quarterly. This means the business could borrow large sums for money for its development.

Using my above recommendation the business should be able to develop, grow and meet with current demands.

Section Three: Case Study

Using the case study as provided in the assignment sheet titled, ‘How much? asked Nick in astonishment…’ I will answer the questions that follow it. Below is my answer to those questions.

Question.

How much profit does this order earn for the business?

Answer.

This order works out to be profitable for the business. This order makes £8 400 profit. This is worked out like this:

Parker & Slate are willing to pay £80 per unit and want 240 units.

£80 per unit X 240 units = £19 200

There are overheads for completing this order for Slookie. These overheads run from July to October. It works out like this:

£10 800 was the total overhead costs for the four month period.

So if you take away the overheads from the selling price you get the order profit. This works out to be:

The Selling Price – The Overheads = The Profit

£19 200 - £10 800 = £8 400

Question.

How much will the overdraft required for this order exceed the pre-arranged limit?

Answer.

The order will require the account to have an overdraft limit of £14 800 at its lowest point. Since Slookie already have a pre-arranged limit of £4 000, this means that the order will make the account £10 800 over its pre-arranged overdraft limit.

Take-away the overdraft limit from the closing balance of October and the difference is the amount of money that is needed to keep the business from financial difficulties. So this works out to be:

Closing Balance – Pre-arranged Overdraft Limit = Needed cash

£14 800 - £4 000 = £10 800

Question.

Explain the difference between cash and profit. Briefly explain how manager’s decisions will differ when considering profit made on an order and cash flow statements or forecasts

Answer.

Cash is money current money the business has. So for example if Slookie get paid for an order by a customer that is cash that has come in, but this is not profit as with every order there is costs to be paid like rent, stock, staffing or paying creditors.

Profit is however the money at the end of the financial year that is left taking away all expenses. The can be worked out by this simple equations:

Income - Expenditure = Profit

Below is an example of Abel Company Ltd balance sheet for 2001 showing the profit at the end of the financial year:

Manager’s decisions on taking on orders will differ depending on the current situation of the company. If for example, there is a profitable order, but the current cash flow of the organization is close to the red, the business may need to renegotiate the payment terms of the order or chase up debtors about payments.

Question.

When looking at this cash flow forecast, analyse whether the business should either:

Ask Parker & Slate for monthly payments, one month after each delivery?
Take out a short-term bank loan for the difference between the present overdraft and the required overdraft?

Answer.

It would be in the companies’ best interests to a) Ask Parker & Slate for monthly payments, one month after each delivery

looking at the current cash flow of the business it would make financial sense. Looking at the current cash flow, (see assignment sheet) Slookie would keep out of the red.

The chart below shows the potential cash flow if payments are taken one month in advance as the business proposes in answer a:

Bibliography

Books

Broadbent M, Managing Financial Resources, Butterworth-Heinemann, 1993, p1-16

Wood F, Business Accounting 1, Pitman, 1996, p35-37

HNC HND Business, Business and Finance, BPP Publishing, 2002, p234-253

Callaghan Pink, Core Studies for BTEC, Business Education Publishers, 1992, p227

Journals & Articles

HSBC Bank, Raising Finance, Raising Finance, 2003, p2, 6-7,

HSBC Bank, Managing Money, Managing Money, 2003, p1

Media, Video’s and Audio

TV Choice Productions, Financial Decisions, TV Choice, 1992, 30mins length