Unit 2: Managing Financial Resources and Decisions

Submitted by: Muhammad Danyal Aziz Noor

To
SIR MUHAMMAD EHTISHAM
Course: HND BUSINESS

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Contents

LO 1.1 Identification of Sources of Finance Available (Short and Long

term): ......................................................................................................... 3
LO 1.2 Assess the implications of the different sources ....................... 9
LO 1.3 Evaluation of sources of Finance .............................................. 11
LO 2.1 Cost of different sources of Finance ......................................... 13
LO 2.2 Importance of Financial planning .............................................. 17
LO 2.3 Needs of different decision makers ........................................... 20
LO 2.4 Impact of Finance on the Financial statements ........................ 21
LO 3.1 Budget and Analysis of different Budgets ................................ 25
LO 3.2 Explanation and Calculation of unit cost .................................. 32
LO 3.3 Investment appraisal techniques ............................................... 33
LO 4.1 Discussion of Main F/S of an organisation ............................... 35
LO 4.2 Different types of companies and their Financial Statements
................................................................................................................. 39
LO 4.3 Calculation and explanation of ratios ........................................ 42
Reference ................................................................................................ 44

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Unit Description:

This is HND business MFRD assignment in which we discuss management of

financial resources and decision making in an organization.

Introduction:

For an organization being successful is really important and for that it

requires a number of resources such as material, labor, human resources,
infrastructure etc. The most important resources are the MONETARY
resources. There are several sources of finance for different organizations,
depending on the type and environment of the business, types of process and
products or services provided by it.

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1.1: Identify the sources of finance available to business?
Finance
Finance is a simple task of providing the necessary funds
(money) required by the business of entities like companies,
firms, individuals and others on the terms that are most
favourable to achieve their economic objectives.
Financial management
Financial management refers to the efficient and effective
management of money (funds) in such a manner as to
accomplish the objectives of the organization. It is the specialized
function directly associated with the top management.
Financial Resources
The money available to a business for spending in the form of
cash, liquid securities and credit lines. Before going into business,
an entrepreneur needs to secure sufficient financial resources in
order to be able to operate efficiently and sufficiently well to
promote success.
Why Business Needs Finance
Business needs finance:
Startup Capital
Business might need finance to at the start in the form of Capital.
This is known as startup capital. Startup capital is used up for
initial investment such as land, building, machinery, employee
people etc.

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Expansion
A business might need additional source of finance when it needs
to expand. This expansion may include
 extension of present facilities such as purchasing additional
machinery and extending capacities.
 a business might also need to go in for inorganic expansion
such as purchase of another business through a takeover.
Usually a business will have to arrange huge amount of
additional finances for these purposes.
 entering new markets. It involves huge investments in
research and development and aggressive marketing
campaigns.
Research and Development
Businesses need finance to develop new products. Multinational
businesses usually spend millions of dollars every year in
Research and Development purposes. R & D is carried out
regularly in big businesses as a mean to get a competitive edge
over its competitors.
Running of the business
Apart from investment at the initial stages a business needs a
constant flow of capital in the form of working capital. A shortage
of working capital might lead to serious consequences for the
business or cash flow problems.

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During trouble times
A business might need additional dose of capital or financial help
during troubled times such as a recession, or when the sales of
the business are fall temporarily due to market conditions.
There are different sources of finance.
Some sources of finance are short term and must be paid back within a
year. Other sources of finance are long term and can be paid back over
many years.

Internal sources of finance are funds found inside the business. For
example, profits can be kept back to finance expansion. Alternatively, the
business can sell assets (items it owns) that are no longer really needed to
free up cash.

Internal sources include:

Retained profit
Retained earnings refer to the percentage of net earnings not paid out as
dividends, but retained by the company to be reinvested in its core
business, or to pay debt. It is recorded under shareholders' equity on the
balance sheet.

Sale of assets
An asset sale is a non-recourse cash sale of assets from a bank or
government agency to a third party. The purpose of an asset sale is
generally to increase cash flow, reduce bad debt risk and liquidation of
assets.

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Working Capital
Working capital is a measure of both a company's efficiency and its short-
term financial health. Working capital is calculated as:

Working Capital = Current Assets - Current Liabilities

External sources of finance might include taking on new business

partners or issuing equity or bonds to create long term obligation, or
commercial paper to take on shorter term debt. External sources are than
categorised in two sections mainly:

Some sources of finance are short term and must be paid back within a
year. Other sources of finance are long term and can be paid back over
many years.

Sources of external finance to cover the short term include:

Overdraft facility, where a bank allows a firm to take out more money than
it has in its bank account.

Banks offer overdrafts as a form of short-term finance. These are available

to companies that have business current accounts. They are a good way of
covering any fluctuations of money coming in and going out of your
business

Term loans

- Loans are designed to help you buy equipment and supplies for your
business. They are best if you need to buy fixed assets, such as machinery
or office equipment, where the amount you need is not going to change.

Trade credits

Where suppliers deliver goods now and are willing to wait for a number of
days before payment.

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Factoring

Where firms sell their invoices to a factor such as a bank. They do this for
some cash right away, rather than waiting 28 days to be paid the full
amount.

Own finance
 Owners who invest money in the business. For sole traders and
partners this can be their savings. For companies, the funding invested
by shareholders is called share capital.
 You may choose to start your own business using your own financial
resources. This may be from savings accounts or other investments that
you have. Typically, it is not advised that you should fund your start-up
from personal overdrafts, loans or credit cards as these are not
necessarily tailored to your business needs or requirements.

Family and friends

You may have family and friends who wish to invest in your business. This
is often convenient and may allow you to get finance on favorable terms.
However, make sure you have a formal agreement of loan terms in place
so you or your family and friends are not left unprotected in the event that
you are unable to repay the loan.

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Long-term sources of external finance
Sources of external finance to cover the long term include:

Grants from charities or the government to help businesses get started,

especially in areas of high unemployment. These are a good option for
businesses looking for financial assistance for specific projects. Typically,
funding comes from EC and UK government sources, including local
authorities, charitable trusts and corporate sponsors.

Loans

It is not just banks that can provide a loan. Business support organizations
such as enterprise and development agencies can help businesses looking
for loans.

Business Angels

Often high net worth individuals, Business Angels invest in high growth
businesses on their own or as part of a syndicate. In addition to providing
finance, Business Angels often make available to companies their own
skills, experience and contacts.

Community Development Finance Association (CDFA)

The association represents a network of regional Community Development

Finance Institutions (CDFIs). CDFIs provide loans and support to
businesses, social enterprises, community, organizations or charities. They
are mostly based within the UK‟s most disadvantaged communities.

Mortgage

Is a special type of loan for buying property where monthly payments are
spread over a number of years.

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Hire Purchase OR Leasing.

where monthly payments are made for use of equipment such as a car.
Leased equipment is rented and not owned by the firm. Hired equipment is
owned by the firm after the final payment.

1.2 Assess the implications of the different sources

Each type of financial source has a set of implications. I could be legal or
financial or in terms of dilution of controls. In terms of debt financing,
companies must pay the interest on the continuous time basis and any
failure to pay back the interest and loans may turn into legal action resulting
in bankruptcy.
In third party investments, there will be a legal agreement between the
buyer and the seller; however, sometimes, these agreements are simply
verbal contracts. The implication of not having a written legal contract
between both parties can be serious when one side fails to live up to his or
her obligations.
Moreover, when a company takes loans from the banks, they have to put
some assets to banks as mortgage. This means that the company would
not be able to sell the asset without the lender's prior agreement. In
addition, the lender will take priority over the owners and shareholders if
the business should fail and the cost will have to be repaid even if a loss is
made.

In terms of share capital, different dividends and amenities have to be

provided to the stock holders. Moreover, shareholders have to be entitled
with the voting rights in the important decisions of the company. With every
share of stock, you sell to investors, you dilute, or reduce, your ownership
stake in your small business. Because equity investors typically have the
right to vote on important company decisions, you can potentially lose
control of your business if you sell too much stock.

Each and every financial resource has a set of implications that may cause
an unfavorable situation to arise in the business processes.

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Bank loan
The implications associated with this finance source are the interest to be
paid through the tenure of the loan and the guarantee of personal assets in
terms of mortgage and any other form. This means the organization has to
pay a lot more than the principal amount it took from the bank as a loan.
(Manigart, 2000).

Angel Equity
The implications associated with this finance source are the loss of control
of the organization on several key business processes as the investors
would have a major opinion about it which impacts the decision taken by
the organization.

Government bonds
The implications associated with this finance source are the additional
interest amounts of the financing scheme provided by the govt & the
guidelines to be followed which are presented by the govt.

Economic development organizations

These organizations also provide several guidelines and regulations under
which the organization must operate which sometimes cause adverse
effect on the operation of the organization (Mayer, 2005).

Smart leases.
The implications associated with this finance source is the loss of control of
the organization, due to the components of the assets leased to various
organizations, go out of control of the main organization.

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1.3 evaluate appropriate sources of finance for a
business project
Choosing the Right Source of Finance
A business needs to assess the different types of finance based on the
following criteria:
Amount of money required - a large amount of money is not available
through some sources and the other sources of finance may not offer
enough flexibility for a smaller amount.
How quickly the money is needed - the longer a business can spend
trying to raise the money, normally the cheaper it is. However it may need
the money very quickly (say if had to pay a big wage bill which if not paid
would mean the factory would close down). The business would then have
to accept a higher cost.
The cheapest option available - the cost of finance is normally measured
in terms of the extra money that needs to be paid to secure the initial
amount - the typical cost is the interest that has to be paid on the borrowed
amount. The cheapest form of money to a business comes from its trading
profits.
The amount of risk involved in the reason for the cash - a project which
has less chance of leading to a profit is deemed more risky than one that
does. Potential sources of finance (especially external sources) take this
into account and may not lend money to higher risk business projects,
unless there is some sort of guarantee that their money will be returned.
The length of time of the requirement for finance - a good entrepreneur
will judge whether the finance needed is for a long-term project or short
term and therefore decide what type of finance they wish to use.
assess the different types of finance based on the following
criteria:
Amount of money needed
How quickly the money is needed
The cost of financing

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 Duration of time for finance
risk involved in the financing
Advantages and disadvantages of share capital: the main
advantage of share capital is company has no obligation to make
interest payments or to repay equity investors’ initial investment.
Although you might distribute some of your profits as dividends to
equity holders, you can skip these payments if necessary. On the
other hand the main disadvantage of share capital is it typically has
higher cost of capital and more time consuming. (Atrill P. 2012)

Advantages and disadvantages of retained

earnings: Though the use of retained earnings does not involve
any acquisition cost. The company has no obligation to pay anything
in respect of retained earnings, Conservative dividend policy leads
to huge accumulation of retained earnings leading to over-
capitalization.
Advantages and disadvantages of debt: When a business use debt
financing, they have to fully utilize their resources because they will
have to pay back the debt and interest to their creditor. Moreover,
getting debt financing in these days are quite easy foe existence of
different private banks. The main risk involved with the debt
financing is failure of paying back loan and interest may turn into
bankruptcy. Moreover, the bank interest rates are pretty high in
recent times. (Atrill P. 2012)

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LO2 Understand the implications of finance as a resource
within a business
2.1 analyze the costs of different sources of finance
Different sources of finance are involved with different types cost.
Some of them are as follows:
What is Finance cost:
International Accounting Standard 23 defines finance costs as “interest and
other costs that an entity incurs in connection with the borrowing of funds”.

Finance costs are also known as “financing costs” and “borrowing costs”.
Companies finance their operations either through equity financing or
through borrowings and loans. These funds do not come for free. The
providers of funds want reward for against there funds. The equity
providers want dividends and capital gains. The providers of loans seek
interest payments. Interest cost is the price of obtaining loans and
borrowings.

Finance cost could be tangible or intangible. We would focus on Equity and

Debt Finance are these are the main options.

Tangible costs of equity

Cost straightforwardly related with the issue of equity shares which can be
evaluate is tangible cost of issuing equity debt. Cost types include:

Direct Costs: stock exchange fee, broker commission, Issuing fee etc.

Implementation costs: Are transaction fee or cash transfer fee, Govt

taxes etc.

Ownership costs: payment of dividends to the shareholders over the life

of the shares held.

Intangible Cost: Which cannot be measured straightforwardly but rather

still are part of the cost.
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Opportunity cost of equity:
Expected return that is forgone by investing in a project rather than in
comparable financial securities.

On account of equity issue only opportunity cost could be venture of share

continues in a spare speculation rather putting resources into the venture
which may fail in future and can prompt to the misfortune.

Debt could have been more cheap than this so paying lots of dividends
could have been kept away from by picking debt finance.

Tax affect
No additional duty cost emerges at the issue of shares a little amount of tax
may arises and the time of making transfer

Cost of Debt Finance

Tangible Costs includes:

Direct Costs: Bank charges, firm charges and endorsing charge etc.

Implementation costs: transaction fee, legal contract fee, or a transfer

charges.

Ownership costs: This includes continues payment of interest over the

period of debt.

Intangible Cost: It may produce cash flow problems as more debt means
more continues payment of interest needed.

Control Issue: Typically secured by resources so cannot sell the assets

regardless of the possibility that need to, earlier consent frame the debt
issuer required.

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Opportunity cost: By issue of equity finance the constant cost of interest
payments could have been avoided. Have to repay the loan as well again
this could have been avoided by the equity finance issue.

Tax Affect: Diminish the general duty rate as it is a tax permitted cost. Pay
tax after less the interest payment to decrease the overall rate of the
interest charged for the finance.

Cost of Debt or loans is the overall average rate an

organization pays on all its debts, typically consisting primarily of
bonds and bank loans. Cost of debt is expressed as an annual
percentage. Costs of debt are basically paid in the form of interest.
[Watson,D, 2012]
Cost of Equity shares is a part of a company's capital structure.
Cost of equity measures the returns demanded by stock
market investors who will bear the risks of ownership. Cost of
equity is usually paid in the form of dividends to the shareholders.
Cost of retained earnings: cost of retained earnings used as a part
of the capital structure of a business firm, is that part of the earnings
available to common shareholders not paid out as dividends or the
earnings plowed back into the firm for growth. The main cost of
retained earnings is that company could have invested this capital in
other sectors. [Watson,D, 2012]
Opportunity costs: Opportunity cost is the cost of a foregone
alternative. If you chose one alternative over another, then the cost
of choosing that alternative is an opportunity cost. Opportunity cost
is the benefits you lose by choosing one alternative over another
one. The opportunity cost of choosing one investment over another
one. [Watson,D, 2012]

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All lenders charge interest on their loans and this is the major element in
the cost of the finance. Building societies and banks have variable interest
rates which may vary according to the size of the loan.
However, there are other charges that are normally involved in arranging a
mortgage:
Arrangement fees
Banks and building societies do not always charge arrangement or setup
fees, but many lenders do charge them, particularly for some of the
specialist mortgages described later in this guide. Arrangement fees are
typically in the range of £100 - £400.
Valuer's report
In order to protect its security, the lender will want to be sure that the house
is worth the sale price, so will always insist on a valuation for mortgage
purposes. This will be carried out by a qualified surveyor, who will charge a
survey fee, paid by the borrower.
The lender's survey aims to establish if the value of the house is enough to
protect the lender's security. It does not mean that the property is free from
any defects. It is therefore recommended that house buyers obtain a
homebuyer's report or a full survey to ensure that they are aware of any
problems. This will increase the cost but could prove to be a wise
investment.
Indemnity guarantee fee
Some lenders insist on an indemnity guarantee policy if the loan exceeds
75 percent of the property value. This protects the lender in the event of the
borrower defaulting on the mortgage and the sale price of the property not
being enough to repay the loan. However, this policy is paid for by the
borrower and often, the premium has to be added to the loan. In recent
times, the threshold for mortgage indemnity guarantees has increased -
many lenders now set the level at 90 percent.
Stamp duty
This is a tax charged by the Government on the document transferring
ownership of the house, paid by the purchaser. The rates are:
Nil - up to £60,000
1% over £60,000 but not more than £250,000

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3% over £250,000 but not more than £500,000
4% over £500,000
Legal fees
There will be legal fees payable to the solicitor or licensed conveyancer
handling the transaction. The legal fees will include the local search fees
(carried out to reveal matters affecting theproperty) and land registry fees,
as well as the lawyer's own charges.
Other charges
All mortgage lenders will have a tariff of other charges that you may incur in
certain circumstances at various points during the life of your loan. These
are not universal charges - lenders will vary in terms of which ones apply,
but all should be able to provide details on request.

2.2 explain the importance of financial planning

Financial Planning is the way toward assessing the capital required

and determining its competition. It is the process of framing
financial policies in relation to procurement, investment and
administration of funds of an enterprise. Financial planning
indicates taking the future arrangement with respect to which sorts
of financial decision will be taken for the associations later on. The
main importance of financial decisions are as follows:
Ø Financial Planning helps in reducing the uncertainties which can
be a hindrance to growth of the company. This helps in ensuring
stability an d profitability in concern
Ø It facilitates the expansion programs of business through proper
forecasting of business.
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Ø It facilitates the company to set its goal and helps to achieve it
easily
Ø It helps to maintain a balance between cash inflow and outflow of
organizations.
Ø It help firm to find out best possible alternatives.
Ø A strong capital base can be built with the help of efficient
financial planning
Ø The financial planning process helps gain an understanding about
the current financial position of the market.
What are the objectives of Financial Planning:

 Determining capital requirements- This will depend upon

factors like cost of current and fixed assets, promotional
expenses and long- range planning. Capital requirements have
to be looked with both aspects: short- term and long- term
requirements.
 Determining capital structure- The capital structure is the
composition of capital, i.e., the relative kind and proportion of
capital required in the business. This includes decisions of
debt- equity ratio- both short-term and long- term.
 Framing financial policies with regards to cash control, lending,
borrowings, etc.
 A finance manager ensures that the scarce financial resources
are maximally utilized in the best possible manner at least cost
in order to get maximum returns on investment.

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Importance of Financial Planning:
Financial Planning is process of framing objectives, policies, procedures,
programmes and budgets regarding the financial activities of a concern.
This ensures effective and adequate financial and investment policies. The
importance can be outlined as-

 Adequate funds have to be ensured.

 Financial Planning helps in ensuring a reasonable balance between
outflow and inflow of funds so that stability is maintained.
 Financial Planning ensures that the suppliers of funds are easily
investing in companies which exercise financial planning.
 Financial Planning helps in making growth and expansion
programmes which helps in long-run survival of the company.
 Financial Planning reduces uncertainties with regards to changing
market trends which can be faced easily through enough funds.
 Financial Planning helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring stability
and profitability in concern.

Link between Investment and Financing Decisions:

Investment Decision are one of the most important finance functions is to
intelligently allocate capital to long term assets. This activity is also known
as capital budgeting. It is important to allocate capital in those long-term
assets so as to get maximum yield in future. Following are the two aspects
of investment decision

1. Evaluation of new investment in terms of profitability

2. Comparison of cut off rate against new investment and prevailing
investment.

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Investment decision not only involves allocating capital to long term
assets but also involves decisions of using funds which are obtained
by selling those assets which become less profitable and less
productive. It wise decisions to decompose depreciated assets
which are not adding value and utilize those funds in securing other
beneficial assets.
Financial decision is yet another important function which a
financial manger must perform. It is important to make wise
decisions about when, where and how should a business acquire
funds. Funds can be acquired through many ways and channels.
Broadly speaking a correct ratio of an equity and debt has to be
maintained. This mix of equity capital and debt is known as a firm’s
capital structure.
A firm tends to benefit most when the market value of a company’s
share maximizes this not only is a sign of growth for the firm but
also maximizes shareholders wealth. On the other hand the use of
debt affects the risk and return of a shareholder. It is more risky
though it may increase the return on equity funds.
2.3 assess the information needs of different decision makers
For taking important decisions, managers have to seek different types of
information from different sources. For taking financial decisions, managers have
to go through this type of decisions makers:
Government: even though government is not a part of the company, still
government needs the information of the company doing business on that
particular region. The basic information needed for government are related to
taxation policy, environmental issues, value added to the people life and so on
Stock holders: stockholders or share holders are the owner of the company. For
taking different financial decisions, they have to go through important financial
information of the company.
Suppliers: suppliers need to know different prospective analysis on the sources of
different raw materials and products.
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Creditors: Creditors may want to track down the loan they provided to the firm
and they also seek information related to capability of the firm.
Employees: the person working within the organization may also seek information
for different reasons.

Sources of information
Governments require Financial Statements to determine the correctness of
tax declared in the tax returns. Government also keeps track of economic
progress through analysis of Financial Statements of businesses from
different sectors of the economy. - See more at: http://accounting-
simplified.com/purpose-of-financial-statements.html#sthash.a5rPVc4X.dpuf

Suppliers need Financial Statements to assess the credit worthiness of a

business and ascertain whether to supply goods on credit. Suppliers need
to know if they will be repaid. Terms of credit are set according to the
assessment of their customers' financial health.

Employees use Financial Statements for assessing the company's

profitability and its consequence on their future remuneration and job
security.

2.4 Explain the impact of finance on the financial statements

The amount of debt a company takes on has an impact on its balance

sheet. In particular, it affects the relationships between several
components of the balance sheet. Analysts, investors and bankers all
rely to a certain extent on the balance sheet to determine the risk
profile of the business. An increase in debt could signal that a
company is moving toward shakier financial ground.
When organization raises funds through equity financing, there is a
positive item in the cash flows from financing activities section and a
positive increase of common stock on the balance sheet.
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On the other hand, If Organization raises funds through debt
financing; there is a positive item in the financing section of the cash
flow statement as well as an increase in liabilities on the balance
sheet. So a change in the financing substantially changes both
income statement and the balance sheet of the Organization.
Appearance of source of finance and its cost on F/S.

The interaction of assets and liabilities

We will understand the link between income statement and balance
sheet and its affect on the assets or liabilities side of F/S

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Relationship between Income Statement & Balance Sheet

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3.1 analyze budgets and make appropriate decisions
What is Budget
An estimate of costs, revenues, and resources over a specified
period, reflecting a reading of future financial conditions and goals.
One of the most important administrative tools, a budget serves also
as a
(1) plan of action for achieving quantified objectives,
(2) standard for measuring performance, and
(3) device for coping with foreseeable adverse situations
What is cash budget
The cash budget contains an itemization of the projected sources
and uses of cash in a future period. This budget is used to ascertain
whether company operations and other activities will provide a
sufficient amount of cash to meet projected cash requirements. If
not, management must find additional funding sources.
If we look at the cash budget of the Blue Island Restaurant, notice
except October and November, we have to go through a negative
balance of cash. And that is not a very good sign for any firm.
Moreover, we also notice Blue Island Restaurant have to expense a
lot of money in the inventory which also leads to a negative balance
of cash.
The basic reason behind negative cash balance is because Blue
Island Restaurant expenses more money in variable and fixed cost.
On the other hand the net sale of the firm is not very satisfactory

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comparing with the variable and fixed cost shown n the cash
budgets.
To rectify this faulty cash budgets we could follow two approaches:
1. Increasing the net sales
2. Decreasing the costs
If we could take measures to increase the net sales in this 4 month, it
can hope that the net cash balance will show positive results. For
example if we can change first month net sales into $60000. We can
expect a positive balance of $19150. On the other hand, we can also
reach our desired goal through cutting down unnecessary variable
and fixed cost. For example we can turn down first month cost into
$10000 we can expect a profit of $5000.

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Operating Budget:
An operating budget is a combination of known expenses, expected
future costs, and forecasted income over the course of a year.
Operating budgets are completed in advance of the accounting
period, which is why they require estimated expenses and revenues.
Why prepare operating budgets?
Prepare an operating budget for a one-year financial cycle. Similar in nature,
albeit more in-depth than a cash budget,

the operating budget consists of sub-budgets that generally address sales and
production, utility costs and loan payments, as well as salaries and tax
liability.

Capital outlays are not included in an operating budget because the one-year
operating budget is considered a short-term budget, while capital outlays are
long-term budget items.

It provides information on department basis so can easily see the success or

failure of any department or its contribution in overall success of the
company.

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Marketing Budget
An estimated projection of costs required to promote a business' products
or services. A marketing budget will typically include all promotional costs,
including marketing communications like website development, advertising
and public relations, as well as the costs of employing marketing staff and
utilizing office space.

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Capital Expenditure Budget:

The capital expenditures budget identifies the amount of cash a company

will invest in projects and long‐term assets. Companies are constantly
looking for ways to expand their operations or make them more
competitive, but doing so requires a certain amount of planning.

The planning for such capital expenses, or those expenses that make a
company more competitive or have great abilities, are recorded in
the capital expenditure budget.

For a company that is looking to overhaul its equipment or make major

changes to its scope of potential operations, the capital expenditure budget
is one of the most important documents that can be produced.

Although funds for expenditures may be identified and approved in total

during the budget process, most companies have a separate process for
approving funds for the specific items included in a capital expenditures
budget.

Reasons for capital budgeting

Capital budgeting helps a company to understand various risks involved in

an investment opportunity and how these risks affect the returns of the
company.

It helps the company to estimate which investment option would yield the
best possible return.

A company can choose a technique/method from various techniques of

capital budgeting to estimate whether it is financially beneficial to take on a
project or not.

It helps the company to make long-term strategic investments.

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It helps to make an informed decision about an investment taking into
consideration all possible options.

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3.2 Explain the calculation of unit costs and make pricing
decisions using relevant information

If we look at the meal cost of the firm, we notice the company have
to expense $8 as fixed cost and $2 as variable cost. So the total cost
of per meal stands at $10. The firm wants to make 40 % profit per
meal that makes $4 per meal. And the firm also has to pay value
added tax for 20 % per meal which stands $2 per meal. So the net
sale value of the per meal stands at $16

To analyze the pricing strategy, we will follow the breakeven point

analysis:
We know Breakeven Point = Fixed Costs/ (Unit Selling Price -
Variable Costs)
So in terms of Blue Island Restaurant we have,
Fixes cost =$8
Variable cost = $2
Unit selling price = $16
So breakeven point of Blue Island Restaurant will be 8/ (16-2) =
$0.5714
That also means to achieve a net sale of $15000; the firm also has to
sell about 938 meals per day.
32
3.3 Assess the viability of the two projects using investment
appraisal techniques

For proposal A

Year Cash flow Cumulative cash flow

0 -£1200 -1200

1 800 -400

2 600 200

3 400 600

4 200 800

5 50 850

So payback for proposal A = 1 + 400/600 = 1.667

For proposal B

Year Cash flow Cumulative cash flow

0 -£1200 -1200

1 300 -800

2 400 -400

3 500 100

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4 600 700

5 550 1250

So payback for proposal B = 3 years.

So comparatively proposal A seems better cause it gains investment
earlier than the proposal B.
NPV for proposal A = -1200+ 800/1.1+ 600/1.21+ 400/1.33
+200/1.46+ 50/1.61
=$ 491.1934
NPV for proposal B = -1200+ 300/1.1+ 400/1.21+ 500/1.33
+600/1.46+ 550/1.61
=$ 530.28
So , if we consider net present value of two options proposal A
seems batter cause it have invest less amount of money to achieve
more profit

34
LO4: Be able to evaluate the financial performance of a
business.

4.1 Discuss the main financial statements

The main elements of financial statements are discussed below:

Income Statement: Income Statement, also known as the Profit and
Loss Statement, reports the company's financial performance in
terms of net profit or loss over a specified period. Net profit or loss
can be obtained by deducting expenses from income. The basic
components of an income statement are revenues, expenses and
profits.
Balance Sheet: balance sheet presents the financial position of an
entity at a given date. It is comprised of assets, liabilities and
owner's equity.

Statement of Cash Flow: statement of cash flow shows net cash

came in the firm and net cash outflow from the firm, it deals with
different cash related transactions.
Statement of Owner's Equity: The statement of owner's equity
reports changes in owner's or partners' equity between accounting
periods. The key components are the beginning equity balance,
additions and subtractions during the period, plus an ending
balance

35
36
37
38
4.2 Compare appropriate formats of financial statements for
different types of business

Format for income statement: The basic format for an income

statement states revenues first, followed by expenses. The expenses
are subtracted from the revenue to calculate the net income of the
business. This is the most simplified version of an income statement
that would be used by most service providers and others that do not
have a cost of goods sold for the services they use to create a profit.
If there is a cost of goods sold, the income statement is a more
involved statement.
Format for balance sheet: For a small company, the organization
may have a very simple balance sheet as described above. For a
larger company, the business often will break it down to current and
long-term assets and current and long-term liabilities. Current
assets refer to any assets that can quickly be converted to cash, such
as short-term investments or checking accounts. Long-term assets
are those things that would take longer to convert to cash, such as
equipment or real estate.
Current liabilities are those debts that are due within the next year.
Long-term liabilities are those due more than one year from the date
of the balance sheet.

Format for cash flow statement: it shows the actual flow of cash in
and out of the business. It helps investors and others to determine if
the business is having difficulty managing its cash flow. It starts with
the cash flow from operations, followed by cash flow from investing
39
and cash flow from operations. Each category shows incoming and
outgoing cash from the business. The ending cash flow should be
equal to the amount of cash the business has on hand

The major differences that will be discussed here are for the
partnership and sole proprietorship for the financial statements.
These differences are relatively significant according to the industry
and the type of business. These can be explained in a tabulated form
generally:

Sole trader Partnership

Single capital account exists, There has to be more than one

which belongs to the one and only capital account. The number of
owner of the company. capital account depends on the
number of partners in the
Partnership contract.

All of the profits generated by the Profit & loss is distributed among
company’s performance belong to the partners’ capital account
the single owner. according to the decided ratio in
the agreement.

The income statement does not The income statement of the

need to show the distribution of Partnership shows the plan on
capital. how the net profit/loss is
distributed among the partners.

40
Balance Sheet also depicts only The balance sheet shows the
one capital account which belongs balance of the capital account of
to the single owner of the each partner classified under
company. owner’s equity.

The changes in owner equity are Besides the income statement and
only restricted to single owner. the balance sheet, a Statement of
No other shareholders have to be Partner’s Equity is also prepared
shown in the equity. to show the CHANGES in equity of
each partner since the beginning
of the year.

41
4.3 Analyses financial statements using appropriate rations
and comparisons, both internal and external.

1. Current Ratio :
Formula for current ratio = current assets/ current liability
For Sweet Menu Restaurant C.R = 68000/3800 = 1.78
For Blue Island Restaurant= 41000/65000 = 0.63
Usually A ideal current ratio is 2:1. So, Sweet Menu Restaurant
is not in satisfactory stage.
2. INTEREST COVERAGE RATIO:
The ratio between EBIT and Interest is known as interest cover
For Sweet Menu Restaurant INTEREST COVERAGE RATIO
=116000/10000 =11.6

For Blue Island Restaurant INTEREST COVERAGE RATIO=

71200/3000=23.37
Interest coverage ratio is better if it is higher. So Blue Island is in
sound position.
3. DEBT EQUITY RATIO:
Debt equity ratio = long term debt / Shareholder’s funds
For Sweet Menu Restaurant: 31000/ 164000=0.18

42
For Blue Island Restaurant: 5000/118000=0.042

4. PROPRIETARY RATIO:
The ratio between shareholders equity and entire assets is known as
proprietary ratio.
Proprietary ratio = Shareholders Equity/ Total Assets
For Sweet Menu Restaurant: 164000/171800=0.954
For Blue Island Restaurant: 118000/106000=1.11

5. Net profit ratio

Net profit ratio = (Net profit / Net sales) x 100
For Sweet Menu Restaurant: 85000/350000 =24.28%
For Blue Island Restaurant: 94800/199000 =47.63%
So, Blue Island is in sound position
Conclusions
Financial decision is important function which a financial manger
must perform. It is important to make wise decisions about when,
where and how should a business acquire funds. Funds can be
acquired through many ways and channels. A sound financial
structure is said to be one which aims at maximizing shareholders
return with minimum risk. In such a scenario the market value of
the firm will maximize and hence an optimum capital structure

43
would be achieved. Other than equity and debt there are several
other tools which are used in deciding a firm capital structure.

References
1. http://www.investopedia.com/terms/s/sharecapital.asp#ixzz
3upe80kKH accessed at 19. 12. 2015
2. http://www.fao.org/docrep/w4343e/w4343e08.htm accessed
at 19. 12. 2015
3. J. Downes, J.E. Goodman, "Dictionary of Finance & Investment
Terms", Baron's Financial Guides, 2003
4. Atrill P. (2012), Financial Management for Decision
Makers. 6th Edition, Harlow: Pearson Financial Times/Prentice Hall.
5. Watson,D. and Head, A. (2012), Corporate Finance Principles
and Practice. 6th edition, Harlow: Pearson
6. http://smallbusiness.chron.com/format-financial-statement-
3768.html [Accessed: 19. 12. 2015
7. Anthony, L. (2012), Formant of a financial statement [online

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