Debt Factoring – Sale of a ' to a . The third party is charged with the invoices, and the business the invoices is to based on the expected on the invoices. ( – visited 23 march 2015)
Advantages:
- Quick way to boost cash flow releasing up to 85% of invoice total
- Outsourcing sales ledger freeing your time to manage the business
- Ongoing source of cash as sales grow
Disadvantages/costs:
- Reduction of the profit from the orders sold
- Could have an adverse effect on future orders
- Debt factoring company will want to vet the clients before accepting them
- Exiting the agreement might be difficult
- Cost of fees for debt factoring company
- Time cost as need to keep a good order book
- Pressure cost to perform so that order book can be kept full
- Customer loss as some may prefer to deal with you and not a debt company
Hire Purchase – buying an asset over a period of time with instalments but being able to use the item. Item ownership is transferred on final payment.
Advantages:
- Spread the cost of an asset
- Able to manage cash flow as instalments are fixed
Disadvantages/Costs:
- Ownership is sellers until final payment
- Defaulting on payment mean asset repossessed
- If asset breaks then the company needs to replace it and still pay the Hire Purchase agreement
- Pay more than item is worth due to interest on instalments
- Time cost of preparing paperwork for the finance to be agreed
- Pressure as payments need to be paid regardless of company performance
- Opportunity Costs – what could the money for the interest be paying for instead
Finance Lease- payment of a hire charge for assets like machinery, computers, cars and vans
Advantages:
- No large outlay
- Set fee each month
- Lease and pay for equipment for when you require it
- Often tax deductible
- Upgrading is easier with less financial cost
Disadvantages/Costs:
- Long Term financial strain - have to keep paying until the end of the lease agreement
- Equity costs – do not own the asset
- Interest/Leasing charges could be high
- Time cost of providing information required/research
- Operation Costs - may pay more for higher usage (e.g. more copies on a photocopy machine than in the contract)
Sale and Lease Back - Selling assets or property to an investment company and then leasing it back over a long period of time.
Advantages:
- Quick cash flow release
- Easy cash flow
- Tax benefits
Disadvantages/Costs:
- Equity costs - Losing equity
- Monetary costs - Maybe more expensive in long term
Business Grants: Monetary payments from Governments/EU to businesses for development of certain products, or for establishing themselves in a particular area, taking on apprentices, employee training.
Advantages:
- Don’t have to pay back
- No loss of ownership
Disadvantages/costs:
- Very few businesses qualify
- Control cost - strings attached, need to do certain things
- Usually for specific projects so unlikely to raise the required amount
- Large amount of competition for these
- Monetary cost - Usually have to match the funds you are rewarded
- Time costs - Application process can be time consuming
All business projects require appropriate finance. A charity I worked for required a new till system for its charity shops due to expansion and the need for a computerised system for stock control and banking.
The finance options appropriate for this would be as follows:
Finance Leasing
- Upgraded cheaply when needed. More practical in the long term.
- Maintenance could be included saving on the costs.
- Budget for the monthly payments.
- Maybe tax deductible so can offset the tax payable for the business – healthy balance sheet therefore better when applying for grants etc.
Bank Loan
- Payment could be made over a longer period of time
- Fixed cost and interest rate.
- There would no down payment required. This would mean more cash available.
- Tax advantages offsetting some of the costs, healthy balance sheet
Hire Purchase
- Spread payments over a fixed term
- Tax benefits for the balance sheet
- Fixed costs
Retained Profit
- No repayments for the business
- No interest payable
- Quick finance
- System would be owned outright by charity
Donations
- No repayment required
- No interest payable
- Outright ownership of the system
Financial planning is fundamental to any business. This is “ process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a company.” ( – visited 29 March 2015)
Financial planning can be short, medium or long term. Short term usually 1 year maximum and considers the working capital of a firm. Medium term up to 5 years, where assets, research and development will be taken into account and long term longer than 5 years will take into consideration the long term objectives of the company.
A good financial plan will include a good budget. Budget will help project the finance required to set up, grow and how much is required to turn a profit. The budget will help look at expenses and cut them if not making the projected profits. The use of ratios and budgets help determine the success of the company and enable investors make financial decisions. Ratios include gross profit margin, ROI and return on owner's equity. Ratios provide information about a company's liquidity, profitability, debt, operating performance, cash flow and investment valuation.
Also involved in financial planning is a good debt collection policy and also spending policy.
Without financial planning a business will not know what it can achieve, afford and where it’s able to cut costs and operate more efficiently in the future and grow.
The main users of the financial information are:
- Shareholder/Investors
- Employees
- Lenders
- Suppliers and Customers
- Government
- Managers
Internal customers:
Managers - require full disclosure to make decisions about resources and operations. They require budgets, profit and loss sheets and other financial statements. Enabling them to analyse and strategically plan for the future along with the Board of Directors.
Project managers - require this information to help them make the correct decisions on which projects need what and also where they will get the funds from.
Employees - interested in improving working conditions i.e. pay and keeping their jobs. They will be interested in profitability and growth of the company.
External Customers:
Shareholders and investors – interested in 2 aspects, ROI and increasing value of their investment. Focus will be on the profitability and growth of the company. They will be interested in the Profit and loss accounts and the overall balance sheet.
Lenders: Want to ensure that loans are going to be repaid. They will be interested in the stability and liquidity of the company. Cash flow and the balance sheets.
Suppliers: A supplier will need information to ensure that they are not supplying to a company which cannot pay. They will require financial statements and possible future cash flow predictions (budget) before they will supply resources. They will be interested in the liquidity of the company.
Customers: Would like to know that the company is able to supplier the goods it promises and that they can keep doing so. Customers would like to see the end of year statements and this will include the profit and loss accounts.
Government – Published accounts for the purpose of tax and VAT. Also if applying for grants then they will require budgets, previous accounts and proof that company has a sound business and financial plan in hand. They would be interested in the profits and sales of the business so as to ensure that the correct taxes are being paid.
Financial statements give a record of all the financial undertakings and include the profit and loss account, the balance sheet and the cash flow statement.
An influx of funds affects the income statement, as it indicates the profit generated based on expenses and income. When there is a lot of cash in the business, the income will increase which will also lead to an increase in the expenses. However, the increase in revenue may not necessarily lead to the proportionate increase in profits if the cash is exceeding the capital mix.
The influx of funds affects the balance sheet more, as the balance sheet is responsible for recording assets and liabilities of the business as well as the capital and debt. As such, it is largely affected by the changes in equity from the surge of capital. When there is an increase in funds in the business, the total assets increase, but also the liabilities since both sides of the balance sheet have to balance. There will be more current assets than current liabilities which means that the business will have a lot of cash at hand in the short run.
Mismanagement of such funds and the cost of long term loans will have a long term impact on the company’s balance sheet. This is because an influx of funds - loans, grants, share issue income, retained profits indicates an ease with which money enters the business which means that it is very easy for the money to move out the business in the same way. While there are huge benefits to a company when it is sufficiently liquid, the volatility the influx of funds will bring to the company can be challenging as it requires improvement in the management practices (Brealy, Richard & Stewart, 2003).
The influx of funds makes the management try to limit the excessive liquidity in the company as this can lead to financial imbalances such as the prices of the long term assets. Moreover, if the funds are not properly managed, they can increase the current and long term liabilities of the company. As such, organizations must be transparent about this by providing more information regarding the performance of the business so as to expose the type and extent of risks the company is facing with respect to the influx of cash. More information about the cash dealings increases transparency as well as certainty to the investors. When financial statements are prepared from fully updated reports, the company minimises the risks that are unforeseen since interpretation of the data is made easier. It is prudent to note that companies that are always transparent are very eager to publicise their capital and earnings as it is a reflection of their performance. This enhances good financial conduct which prevents mismanagement of funds or unforeseen volatility (Brigham & Ehrhardt, 2005).
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3. Making Financial Decisions Based on Financial Information
Budget analysis is important to ensure that the budget is working and the business is on track.
The above budget can be analysed as follows:
There was a loan paid to the business in January which gave a temporary cash boost to the company. However there was then a number of large outgoings. These were for equipment and purchases. The fixed costs of wages and rent also had to be paid resulting in a loss at the end of the month. The company should’ve budgeted better for all expenses and even with a loan payment being received they were still overspending. In February they started with a negative balance and the cash sales dropped although credit sales increased. This would be good except for the fact that the credit sales will not be in the cash flow yet and so the company needs to bear that in mind. The company should have budgeted better knowing they had a deficit to start the month although they did manage to cut the deficit by £1000.
In March the wages bill increased. The company either increased staff for a month or paid overtime. This would be due to increased sales revenue for the month. The company maybe should have looked more closely at the unit cost and worked out the elasticity of demand for the product therefore helping stop the fluctuations in the sales figures. However within 3 months the company was turning a small profit the sles figures are still erratic and the purchases of the company too.
The unit cost is the price of delivering a single unit of a product or a service and is important for a business. Unit costs can be used in identifying economies of scale, establishing fee policies, and help with determining break even points.
Unit Costs = (total fixed costs+ total variable costs)/total number produced
The unit cost should reduce as the number produced increases as variable costs should reduce due to bulk buying materials etc. Unit cost is used to determine selling price in many methods. For example full price plus pricing which is when the unit price is taken and a percentage markup is added for the pricing. Marginal cost pricing which is where a percentage is added onto the marginal costs of production or sale. This is sometimes called mark-up pricing.
Fixed Costs: doesn’t vary with level of activity or volume of production (EG rent, wages)
Variable Costs: varies with level of activity or volume of production. (EG materials, direct labour)
When making a pricing decision finding the breakeven point is very important. This is the point where revenue received is equal to the cost of producing the item. The break-even analysis also helps the business to identify excessive fixed costs. Since the break-even point is directly related to the fixed costs, reducing and controlling these costs aids the business in achieving a lower break-even point for quicker profitability.
Example:
Company C wants to know breakeven point for its product.
Product total variable cost per unit is £12, and fixed costs per year are £8,000 and the product can be sold for £20.
Selling price per unit £20 – variable costs per unit £12 = £8 (contribution to Fixed costs)
So breakeven is fixed costs £8000/£8 (contribution to fixed costs)
Breakeven is 1000 units
So:
£
Sales (1000 x £20) 20000
Variable Cost (1000 x £12) (12000)
Contribution 8000
Fixed costs (8000)
Profit/Loss 0
All pricing decisions are based around the fixed and variable costs of a product and if you do not know these figures then you will not be pricing the product properly and will be taking longer to reach breakeven or worse still cause the company to have a cash flow problem and maybe close due to under selling the product. If you do not get the fixed price information and variable cost information right then the other analysis and unit costs will not be correct. (411)
Projects need to be assessed for viability, to ensure the project is properly funded and will be profitable. There are a number of investment appraisal methods which can be utilised to do this.
Accounting Rate of Return (ROI)
Estimated average profits
ARR = Estimated average investments x 100%
E.G.
An investment is expected to yield cash flows of £10,000 annually for the next 5 years. Initial cost of investment is £20,000, Total profit is therefore £30,000
Annual profit = £30,000/5
= £6,000
ARR = 6,000/20,000 x 100 = 30%
Payback Period:
Initial Investment
Payback Period = Net Annual Cash Flow
The project that has the shortest payback period is the most desirable. The figure is usually in years.
Example:
Machine costs £600,000 and produces 60,000 units a year with a £5 profit per unit.
Annual income is £300,000 therefore payback period will be 2 years
Discounted Cash Flow (DCF)
Uses the time value of money (the notion that a £ now is worth more than a £ in the future) It’s the present value of a company’s future cash flows.
DCF can be used in two ways: Net Present Value (NPV) and Internal Rate of Return (IRR)
Net Present Value (NPV)
Takes into account that money values change with time. How much would you need to invest today to earn x amount in x years? NPV helps show what money could earn in other investments.
A
Present Value = (1+r)n
A = the actual sum of money concerned
r = the rate of discount (called the 'Discount factor')
n = the number of years
If NPV is positive, then it’s a viable project.
Internal Rate of Return
Involves 2 steps:
- Calculating the rate of return which is expected
- Comparing this rate of return with the cost of capital
If project earns higher rate of return than the cost of capital, it will be worthwhile (NPV would be positive)
a x (B-A)
IRR = A + a+b
Where:
A is discount rate which provides the positive NPV
a is amount of positive NPV
B is discount rate which provides negative NPV
b is amount of negative NPV (minus sign ignored)
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4. Evaluate the Financial Performance of a Business
Financial Statements - Records that outline the financial activities of a business, an individual or any other entity. ( visited 30 March 2015)
The main statements are the Balance Sheet and the Profit and Loss Statement.
The balance Sheet presents the financial position of the company at a given date. It is made up of 3 main components: Assets, liabilities and capital. A Balance Sheet always balances (Assets = Liabilities + Equity)
- Assets: business owns or controls (e.g. cash, inventory, plant and machinery)
- Liabilities: Business owes to someone (e.g. creditors, bank loans)
- Equity: Business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities.
Balance sheet helps assess the financial health of the business. When analysed over a few periods they may assist in identifying trends. Particularly helpful in determining liquidity risk, financial risk and credit risk.
If used with competitor’s statements it may help identify trends and show potential problem areas and where improvements can be made. Analysis of Balance sheet could assist in predicting the amount, timing and stability of future income.
Creditors and interested stock investors use the balance sheet to determine a company's financial standing. The Board and Managers use to help make business decisions.
The profit and loss account illustrates all the business transactions over a time period (usually one year).
Divided into sections:
- Trading account
- Profit and loss account
- The profit and loss appropriation account
The Trading Account
The trading account shows income from selling products (turnover) and the cost of sales.
This allows the calculation of Gross Profit
Gross Profit = turnover - cost of sales
Profit and loss account
This allows the calculation of Profit on ordinary activities before tax
- Operating profit (Net Profit) = Gross profit – expenses (administration and Distribution costs)
- Profit on ordinary activities before tax = Profit on ordinary activities before interest + non-operating income - interest payable
Profit and loss appropriation account
Highlights how the company’s profit or loss is distributed. This section highlights the profit after tax (financial year profit).
- Profit for the Financial year = profit on ordinary activities before tax - taxes
Profit and Loss account allows performance to be measured over the course of an accounting period. Can see how sales revenue is changing, what is happening to the cost of production, how well the business is controlling its fixed costs and what is happening to its profit.
Many different groups of people will use these to make a judgment on the success or otherwise of the business and how it is performing. Potential investors to decide whether to buy shares. Suppliers whether the business might be worth doing business and a host of other stakeholders including banks, employees, customers and other firms, who might be interested in taking over or merging with the business, whether it’s worth it. It will also help the Management and Board of Directors decide the way forward for the next accounting period and help them make big business decisions.
Different types of business use different formats of financial statements.
A sole trader or Partnership:
- No need to publish accounts.
- The annual accounts for personal tax returns, usually a profit and loss statement (very simple). No balance sheet is required.
- Still need to be prepared in accordance with the accounting standards.
Limited company:
- needs to prepare accounts (in accordance with accounting standards) these must include:
- all money received and spent by the company
- details of assets owned by the company
- debts the company owes or is owed
- stock the company owns at the end of the financial year
- the stocktaking’s you used to work out the stock figure
- all goods bought and sold
- who you bought and sold them to and from (unless you run a retail business)
(Full set of profit and loss accounts and balance sheet)
- HMRC will require full accounts these must include all money:
- spent by the company, e.g. receipts, petty cash books, orders and delivery notes
- received by the company, e.g. invoices, contracts, sales books and till rolls
- Need to be audited and be lodged with Companies House for public record.
Charity:
- Keep accounting records (e.g. cash books, invoices, receipts, Gift Aid records etc.) in accordance with HMRC guidance.
- Make the accounts available to the public on request.
- Make the Annual Report available to the public on request where one is required to be prepared.
- Full Balance sheet and profit loss statements required for larger charities
- Need to be audited for larger charities or charities who have a trading subsidiary.
Local Authorities:
- A full set of accounts including all expenses, losses, income, donations must be produced
- Need to be audited
- Available to public
- Annual report to be made available to public
(828)
Financial statement play a significant role in determination of a company’s financial health. They aid in identification of issues that require the company management to effectively address them.in addition, financial ratios provide insights in regard to the risks companies encounter as well as how to address those risks. The internal ratio are used to compare the performance of the company over years. The company may compare itself with others in the industry identification another company in the same industry using the external ratios (Whyte and Lohmann 2015).
Internal ratios
a) Gross profit margin or profit margin on sales:
profits before tax+interest
sales
This ratio measures the direct production costs of the firm.
b) Net profit margin:
profit after tax
sales
c) Return on assets:
Profit before tax + interest
Issued capital+reserves+debt capital
This ratio measures how effectively the firm assets are used to generate profits net of expenses. This is an important comparison among the company performance since the work of a manager is to ensure that he/she utilise the assets of the firm to produce profits.
d) Return on equity
profit after tax
total equity
This ratio measures net return per dollar invested in the firm by the owners, common shareholders,
Year 2011
Gross profit margin= (679+161)/9987=0.0841
Net profit margin=672/9987=0.06729
Return on assets= (679+161)/ {290+207+5539} =0.1392
Return on equity=672/1634=0.4113
Year 2012
Gross profit margin= {(139) +173}/10827=0.00314
Net profit margin= (70)/10827=-0.006465
Return on assets= {(139) +173}/ {290+ (359) +5670} =0.00607
Return on equity= (70)/1068=-0.06554
Year 2013
Gross profit margin= (300+176)/11421=0.04168
Net profit margin=284/11421=0.02487
Return on assets= (300+176) / (290+453+4839) =0.08527
Return on equity=284/2455=0.1157
From the profitability ratios of British Airways, you can measure how effectively the managers are in generating the profit of the company. In 2011, the gross profit margin is 0.0841. The higher the gross profit margin the higher the profit the company is receiving in selling the inventories. In 2012, the gross profit margin is 0.00314 and in 2013 it is 0.04168. This means that British Airways received high profits from inventories in 2011 than any other year. From return on assets, the company managers utilised the company assets well in 2011 than any other year. This is because the company return on assets is higher in 2011 than in 2012 and 2013.
The liquidity ratios are measures that indicate firm ability to repay short term debt (Banerjee 2015).
.
- Current ratio
Current assets
Current liabilities
This is the ability of the firm to pay its short term liabilities with its current assets. A higher current ratios is more favourable since it shows that company can more easily make current debt payments.
b) Quick (liquidity or acid test ratio):
current assets – inventories
current liabilities
This is the ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. A higher quick ratio is more favourable to a company.
c) Inventory to net working capital:
Inventories
Current assets – current liabilities
Year 2011
Current ratio=2774/3683=0.7531
Quick ratio= (2774-139)/3683=0.7154
Inventory to net working capital=139/ (2774-3683) =-0.1529
Year 2012
Current ratio=2634/4398=0.5989
Quick ratio= (2634-117)/4398=0.5723
Inventory to net working capital=119/ (2634-4398) =-0.06746
Year 2013
Current ratio=2915/4627=0.63
Quick ratio= (2915-110)/4627=0.6062
Inventory to net working capital=110/ (2915-4627) =-0.006425
From the internal ratios of British Airways, it can be deduced that the company is at risk of meeting its short term obligations. The current ratio and quick ratio have a value of below 1. In year 2011 the current ratio is equal to 0.7531. In 2012, the current ratio reduces to 0.5989 which increases risk of the company in meeting its short term obligations. In 2013, the current ratio increases again to 0.63. Therefore, the higher the current ratio, the more favourable the company is in meeting short term obligations using current assets. For the quick ratios, it excludes the inventories but the higher it is, the more favourable the company is in meeting short term obligations.
External ratios
Comparison of Vueling Airlines with Vueling Airlines Financial Ratios
Year 2013
a) Gross profit margin or profit margin on sales:
= Profit before tax + interest
Sales
= (132.607+16.622)/ 1.394.201
=0.1070
British Airways
Gross profit margin= (300+176)/11421=0.04168
From the computations of 2013, it is clear that Vueling Airlines is performing better than the British Airways. Its gross profit margin of 0.1070 is higher than the gross profit margin of 0.06699.
b) Net profit margin:
= profit after tax
Sales
= 93.393/1.394.201
=0.06699
British Airways
Net profit margin=284/11421=0.02487
From the computations of the year 2013, British Airways was 0.02487 while Vueling had 0.06699 hence Vueling performance in 2013 was better
c) Return on assets:
= profit before tax + interest
Issued capital +reserves+debt Capital
= (132.607+16.622)/(29.905+4.450+256.858)
=149.229/291.213
=0.5124
British Airways
Return on assets= (300+176) / (290+453+4839) =0.08527
From year 2013computations it was clear that Vueling Airline management was more effective in managing the firm than British Airlines in 2013. Its return on assets is higher than the British Airways.
d) Return on equity:
= Profit after tax
Total equity
=93.393/311.870
=0.2995
British Airways
Return on equity=284/2455=0.1157
From year 2013, it was clear that Vueling airline management was performing better than British Airways. Wealth maximization in Vueling airline was higher as depicted by the higher return on equity.
- Liquidity ratios year 2013
Vueling Airlines
- Current ratios
=667.855/373.984
=1.7857
British Airways
Current assets=2915/4627=0.63
The British Airways current ratio was 0.63 in the year 2013 compared to 1.7857 of Vueling Airlines. Therefore, the Vueling Airlines is more favorable because of its high current ratio.
- Quick Ratios
Vueling airline
= (667.855-104.544)/ 373.984
=1.5062
British Airways
Quick ratio= (2915-110)/4627=0.6062
Vueling Airlines has a quick ratio of 1.5062 while British Airways has 0.6062 in the year 2013. Hence, Vueling is more preferable due to its higher quick ratio.
- Inventory to net working capital:
=104.544/(667.855- 373.984)
=0.3557
British Airways Year 2013
Inventory to net working capital=110/(2915-4627) =-0.006425
Vueling Airlines is more preferable compared to British Airways. British Airways inventory to net working capital has not reached its optimal since it is negative.
Conclusion
It was noted that company owners and investors use financial ratios to analyses company performance. Ratios of current period are compared to ratios of previous years to determine the developing trends of the company. Ratios are also compared to industry surveys of other similar company to assess company performance in the industry sector. British Airways was compared with Vueling Airlines which are in similar industry. This shows the performance of the company in the market as compared to other industries. Investors invest in a company that perform well in the market.
References
Websites and dates visited :
- visited 10 March 2015
- visited 11 March 2015
- Visited 11 March 2015
- Visited 11 March 2015
- visited 15 March 2015
- visited 17 March 2015
– Visited 17 March 2015
– Visited 17 March 2015
- visited 18 March 2015
– visited 18 March 2015
- Visited 23 March 2015
- visited 23 March 2015
- visited March 26 2015
- visited March 26 2015
– visited March 29 2015
www.Google Books - Business for Foundation Degrees and Higher Awards – Unit 6 – visited March 29 2015
- visited March 31 2015
– visited March 31 2015
– visited April 2, 2015
Books and Other References
Brigham, E. F., & Ehrhardt, M. C. eds. 2005, Financial Management Theory and Practice. Ohio: South-Western.
Brealy, Richard A., & Stewart C. M., eds. 2003. Principles of Corporate Finance. Boston: McGraw-Hill/Irwin.
Banerjee, S. (2015). An analysis of profitability trend in Indian Cement Industry. Economic Affairs, 60(1),171-179.
Michael, R. (2015). Ratios Overview. In Financial Ratios for Executives (pp. 1-5). Apress.
Whyte, R., & Lohmann, G. (2015). The carrier-within-a-carrier strategy: An analysis of Jetstar. Journal of Air Transport Management, 42, 141-148.
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