BUSINESS FINANCE

BUSINESS FINANCE -A study of finance is concerned with the effective acquisition and management of the monetary resources of a business. -The objectives of a business in not necessarily to maximize profit, firms may pursue other objectives such as survival, growth, social responsibility, acceptable ROI, market share etc. -Businesses can raise finance through internal/external sources, that is, through savings and borrowings. This money is needed for expansion of the business or the continuation of existing operations. Investment Capital is finance to acquire new fixed assets Working Capital is finance needed for the day-to-day running of the business -Finance is needed at each stage in the life cycle of the business as follows: 1. Start up –for the establishment of a business 2. Expansion –to achieve higher targets set 3. Consolidation –owners take stock before proceeding to the next stage 4. Development –a movement into new products and markets 5. Maturity –the business is established as a secure and diversified business 6. Decline –depends on management’s ability to respond to changing conditions Financial Management -The main financial objective of a firm is to maximize the wealth of its present shareholders, the expected returns and risks involved in the use of funds or important considerations. Other Financial Objectives/Needs -to develop new products -to develop new markets -to deal with uncertainties -to finance export trade -to provide working capital Sources of Finance 1. Borrowed Funds –must be paid with interest –borrowed from creditors 2. Equity Finance –provided by the existing owners of the business when they increase Their investments by new partners who bring in additional capital and by individuals in the general public who buy new shares issued by the firm 3. Internally generated finance –consists of retained profits and accumulated funds. Factors Affecting Choice of Finance 1. Availability of different sources of finance 2. Relative cost of different methods 3. Consequences for control of the business 4. The implications of shareholder dividends 5. Tax implications 6. The risk element involved 7. Terms and repayment periods for loans Debt Finance Characteristics 1. Takes preference in liquidation 2. Interest is an expense and must be paid before dividends 3. Rate of interest is either fixed or based on current rate 4. Interest payments are tax deductible 5. May be secured against specific assets Long term Debt Finance 1. Debenture -An ‘acknowledgement of debt’. A debenture holder has lent money to the company therefore is a creditor, not a shareholder; debentures confer no right of ownership and are usually redeemed after a fixed period. They can be issued at different price to the nominal value on which the interest rate is fixed. They can also be secured against specific assets or float as a charge on all assets. 2. Mortgages -Available from banks and building societies, and are used to purchase property –loans secured against land and buildings. Medium term Finance -covers a period of 3-10 years and serves the purpose of purchasing machinery with a corresponding life, to provide working capital requirements of a business. 1. Loans -Flexible with the possibility of early redemption. The firm has to make fixed regular payments of part of the principal plus interest to the creditors. Firms are usually required to pledge certain assets as securities or collateral, that is, in the event that the firm fails to meet its commitment the creditors have first priority to the proceeds obtained from sale of the assets pledged. 2. Hire Purchase -A method of paying for assets by installment. The firm does not become the legal owner until all installments have been paid. -Used for equipment and machinery. Advantages 1. The firm obtains assets when it needs them even before it has sufficient funds to purchase them 2. Maintenance is provided with the package 3. The equipment can be updated to avoid obsolescence 4. The firm’s capital is not tied up –can be employed productively elsewhere 5. Fixed installments are of advantage during periods of rising prices Disadvantages 1. Cost of buying is higher in the long-run 2. Assets can be repossessed if the firm fails to pay the installments 3. Leasing -Allows the firm the use of an asset without having to buy it. Office and factory space, motor vehicles, machines and equipment are examples of assets that can be leased. -The firm (the lessee) pays the leasing company (the leasor) fixed regular rental payments for the right use of the asset. The leasor remains the legal owner of the asset but the leasee assumes responsibility for maintaining it. Advantages 1. Capital is not tied up in fixed assets 2. Lease rental payments are deductible expenses 3. Firm can easily replace outdated equipment Disadvantages 1. Cost of leasing is higher than cost of borrowing 2. User does not benefit from residual value when the equipment is upgraded Short term Finance -Used to provide working capital. They are financed by debt and have shorter repayment periods and lower interest rates, hence less risk is involved. 1. Overdraft -Is an arrangement between the business and its bank to draw more money from the current account, to an agreed limit, than is deposited in it. Advantages 1. Flexible, unsecured and cheap 2. Renewable 3. repayable on demand and interest rates reflect current market rates rather than pre- fixed rates. 2. Trade Credit -When suppliers allow delayed payment for materials purchased, suppliers encourage prompt payment by offering a cash discount. 3. Factoring A/C receivable -This is when a firm sells its account receivables to a factor (factoring company) in exchange for immediate cash. The factor also assumes responsibility for the collection and credit risk to these receivable books. Advantages 1. All sales effectively become cash sales 2. Firm can offer its customers increased credit terms 3. By paying its debts promptly, the firm will be able to improve its credit rating 4. Helps relieve the firm of the burden of debt collection 5. Helps reduce (clerical) costs because the firm has got only one customer – the factor Stock Market Share Capital -Companies issue shares primarily to raise finance for expansion. This is done by subscribing (floating) the shares to the public through the Zimbabwe Stock Exchange (ZSE) -Shares are issued either at par (nominal value) or at a premium -Shares are not sold directly from a company to the public but through the agency of a stock broker. The investment in shares will earn a dividend for the investor (individual or corporate). Investment in shares also gives part ownership of the company to the investor. -For a company to go public, it must have a good trading record. It should issue out a minimum of 10 million shares worth at least $50 million and the shares must be freely transferable -There are mainly 2 types of shares, ordinary and preference shares which can be offered; 1. Ordinary Shares -most common form of share ownership -receive the benefits of dividend distribution -acquire voting rights at meetings -receive benefits of capital growth -if the company is liquidated they rank least in priority 2. Preference Shares -have a fixed dividend rate expressed as a % of the nominated value of the share -the dividends are paid before ordinary share dividends -may be convertible to ordinary shares a) Participating Preference Shares –have fixed dividend and additional dividend if firm’s profits are large enough b) Redeemable Preference Shares –can be bought back by the company at a specified future date c) Deferred Shares –carry high voting rights, dividends are paid after ordinary and preference shareholders have been paid d) Cumulative Preference Shares –receive a fixed dividend and unpaid dividends when profits improve 3. Rights Issue -existing shareholders are given the option to buy additional shares at a lower price, raises capital 4. Bonus Issue -these are issued free to shareholders. It does not raise additional finance for the company, but is a capitalization of accumulated reserves. Equity finance is the sale of shareholders by a firm for cash or other things of value to the operation of the corporation. Advantages of Equity/Stock/Share Finance 1. Suitable for companies whose capital requirements outstretch their net cash flows -allows firms to move away from debt financing 2. It is a permanent form of capital 3. The company is able to raise more capital without a negative impact on its gearing ratio 4. Share capital enhances a company’s credit rating, and suppliers and creditors are willing to deal with listed companies Disadvantages 1. When a company is advertising for shares it makes available certain information which may be taken advantage of by competitors 2. Quite an expensive process due to the elaborate ZSE listing requirements Capital vs. Revenue Expenditure Capital Expenditure -Made when a firm spends money either to buy fixed assets or add more value to an existing fixed asset. -it includes such costs as: A) Acquiring fixed assets b) Bringing them into the firm c) Legal costs of buying buildings d) Carriage inwards on machinery bought e) Any other cost needed to get the fixed asset ready for use Revenue Expenditure -This is expenditure incurred in the day-to-day running of a business. -The major difference between capital and revenue expenditure is that revenue expenditure is chargeable to the trading/profit and loss account, while capital expenditure will result in increased figures for fixed assets in the balance sheet. -The above expenditure determines the type of financing to use, whether short-term or long-term. -Long-term funds are used to finance fixed assets and the permanent part of working capital (normal ‘permanent’ operations). Working Capital -This is the lifeblood of a business. Working capital is the excess (or deficiency) of current assets minus current liabilities. -From its holdings of cash together with short-term loans and overdrafts, the firm is able to purchase stocks of raw materials. -Managing the level of working capital is an important aspect of financial management. In most cases, cash outflows are usually greater than inflows. -However, inflows must be in excess of outflows because of the need to pay interest, dividends, and taxes and to acquire additional capital assets. -The temporary needs of the firm cause its working capital needs to fluctuate. -A firm’s total financial requirements can be summarized as follows; Financed by: 1. Temporary working capital (e.g. for expansion long/short term funds and seasonal variation in production and sales) 2. Permanent working capital (business activities long term funds carried out in the firm’s normal operations) 3. Fixed assets long term funds -There are 2 main approaches to the optimum level of working capital that a firm should maintain: 1. Maintain the minimum/permanent level of working capital with long-term funds and acquire short term funds as and when they are needed. This approach is adopted if firms can raise short-term finance at short notice. 2. Maintain the maximum level of working capital when long term financing. This approach may result in excess working capital during certain periods. Since liquid assets earn no returns, this may not be an efficient use of funds. Control of Working Capital -Working capital management is concerned with monitoring the cashflow of a business to ensure that it has access to cash to finance normal operations. -It involves monitoring creditors, stocks and debtors. 1. Creditors -Although some credit is both necessary and desirable for any business, it is important to monitor the level of indebtedness by the firm to outsiders. A high creditor figure will lead to problems in payment. One way to check the position is by calculating the length of time taken by the firm to pay its creditors. AV payment period = AV trade creditors x 365 Purchase of stock on credit -A firm should extend its credit means if it has access to means of payment for long periods. -Another technique for monitoring the creditor figure is to rank creditors in terms of length of credit – those owed money for longest periods can be identified to ensure that they are dealt with as soon as possible. 2. Stock -It is necessary to maintain sufficient stock levels to continue production and satisfy demand. Capital should not be tied up in stock. -Ratios can be employed to evaluate stock levels e.g. Stock turnover = Cost of goods sold in a year Average cost -It tells us how many times the average stock level is sold during a 12month cycle. A rise in turnover ratio suggests an increase in efficiency or rise in level of activity. 3. Debtors -In most businesses credit sales are unavoidable. It is necessary to offer credit facilities, especially if competitors offer goods on credit. -Generous credit terms are likely to increase the volume of trade but they also increase the expense of the seller, therefore it is necessary to strike a balance between good terms and a strict collection policy to minimize cash outlay. Costs associated with credit 1. Lost interest –opportunity cost involved in an interest-free loan 2. Loss of purchasing power as prices rise 3. Cost of assessing customer credit worthiness 4. Administrative costs 5. Bad debt 6. Discounts for prompt payment Costs of denying credit 1. Loss of customer goodwill 2. Loss of sales 3. Inconvenience of cost of collecting cash -The debtor position can be monitored by a ratio Debtor collection time (debtor days) = Average debtors x 365 Total credit sales -A lengthening of a debtor payment time over a period of time means a growing delay in the receipt of cash. -Another technique of monitoring debtors is to rank them in terms of age of debt. The aim is to identify longstanding debts to recover the money. -The control of debtors will involve the encouragement of prompt payment and the minimizing of bad debt. 4. Cash -A period of cash outflow will deplete the cash reserves and vice-versa. By monitoring the cash position it is possible to make better use of resources available so that there will not be cash shortage or even excess cash. -A shortage of cash can be tackled by: a) A reduction in debtors b) A reduction in stock c) An increase in creditors -A surplus of cash is an opportunity cost especially if the cash is held in a zero or low interest account. Any surplus should be: a) Used to make early payments to creditors in order to claim discount b) Deposited in interest bearing accounts c) Used to buy marketable securities e.g. shares d) Lent profitably to others e) Used to make forward purchases of raw materials in situations of expected price rises