Financial management is both an art and science of managing finances of a business. It deals with creating wealth, cash and adequate returns on investments for the business. The sources of finance available to the board of directors of Dragon Limited are-
1) Long Term financial sources - This source of finance is required for a longer period of time which is generally more than a year. It is usually required for expansion of business and involves huge amounts of money. Some examples of long term financial sources are:
Shares - A share is a part ownership of a company. Whenever a company is short of finances, it issues its shares in the market and the people who buy these shares are called shareholders. Shareholders are paid some part of the profit made by the company which is known as dividend. Shares are one of the most common way of raising money from the public.
Loans - Loans are one of the most important source of long term finance. Loans are granted on the basis of company's assets. Banks can lend huge sums of amount over a very long period of time. Banks also charges interest on the money it lends, which is to be paid with the original amount of money lend by bank.
Selling Assets - A company can sell off its assets to raise funds. Any machinery, land, equipment, subsidiary companies etc. which a company doesn't require, it can sell it to raise money or to fund its other projects.
Debentures and bonds - The company can also borrow money from public by issuing its debentures and bonds. It is a contract between two parties, in which the debenture or bond holder is entitled to receive interest on his money and his full money on maturity of his debenture or bond.
2) Short Term financial sources - This source of finance is for a shorter period of time which is generally less than a year and the money involved here is not as huge as long tern finances and in this case interests are also higher. Some examples of short term financial sources are:
Leasing - Instead of buying new land and machinery for business, Dragon Limited can lease it from someone else. Company just have to pay the lease for the machinery and land which won't be as large as the original cost of the land and machinery which in turn will save lot of money and it can be used for some other purposes in the business.
Bank Overdraft - Overdraft is a facility given by a bank to its customers depending on their goodwill and credit history. With overdraft facility a person can withdraw more money than the original amount he had in his account. The bank also charges some interest on the overdraft.
Trade Credit - Here, a business can buy goods without actually paying for it at that time and the business has to pay for it after some time. This time period is usually 28 days but many businesses allow up to 6 months and even 1 year.
Promissory Notes - Promissory notes are almost similar to debentures and bonds, the only difference is that the amount is smaller, time period is less than a year and minimum interest rates are offered.
Solution 2
(i)
Year
0
1
2
3
4
Sales
168000
188160
210739
236027
Materials
(52500)
(55125)
(57881)
(60775)
Labours
(36000)
(43200)
(51840)
(62208)
Variable Over heads
(22000)
(24200)
(26620)
(29282)
Machine Cost
(120000)
Sales of Machine
2000
Net Cash Flow
(120000)
57500
65635
74398
85762
Cost of Capital at 15%
1
0.870
0.756
0.658
0.572
Present Value
(120000)
50025
49620
48953
49055
Working Notes:
1) Sales:
Year 1 = 15*1.12*10000 = 168000
Year 2 = 15*1.12*1.12*10000 = 188160
Year 3 = 15*1.12*1.12*1.12*10000 = 210739
Year 4 = 15*1.12*1.12*1.12*1.12*10000 = 236027
2) Material Cost:
Year 1 = 5*1.12*10000 = 52500
Year 2 = 5*1.12*1.12*10000 = 55125
Year 3 = 5*1.12*1.12*1.12*10000 = 57881
Year 4 = 5*1.12*1.12*1.12*1.12*10000 = 60775
3) Labour Cost:
Year 1 = 3*1.12*10000 = 36000
Year 2 = 3*1.12*1.12*10000 = 43200
Year 3 = 3*1.12*1.12*1.12*10000 = 51840
Year 4 = 3*1.12*1.12*1.12*1.12*10000 = 62208
4) Variable Cost:
Year 1 = 15*1.12*10000 = 22000
Year 2 = 15*1.12*1.12*10000 = 24200
Year 3 = 15*1.12*1.12*1.12*10000 =26620
Year 4 = 15*1.12*1.12*1.12*1.12*10000 = 29282
Net Present Value = Total cash Inflow - Total Cash Outflow
NPV = 197653 - 120000
NPV = 77653
Therefore, NVP is £77653 and since its positive, the project is acceptable.
(ii)
If we calculate Net Present Value at 46% cost of capital, we will get:
Year
0
1
2
3
4
Sales
168000
188160
210739
236027
Materials
(52500)
(55125)
(57881)
(60775)
Labours
(36000)
(43200)
(51840)
(62208)
Variable Over heads
(22000)
(24200)
(26620)
(29282)
Machine Cost
(120000)
Sales of Machine
2000
Net Cash Flow
(120000)
57500
65635
74398
85762
Cost of Capital at 46%
1
0.685
0.470
0.321
0.220
Present Value
(120000)
39388
30848
23882
18868
Net Present Value = Total cash Inflow - Total Cash Outflow
NPV = 112986 - 120000
NPV = (7014)
IRR = R1+[NPV1/NPV1 - NPV2*(R2-R1)]
IRR = 0.15+[77653/77653-(7014)*(0.46-0.15)]
IRR = 0.15+[0.917*0.31]
IRR = 0.15+0.28
IRR = 0.43*100
IRR = 43%
Therefore, Internal Rate of Return is 43%.
(iii)
If the cost of machine is changed to £100000:
Year
0
1
2
3
4
Sales
168000
188160
210739
236027
Materials
(52500)
(55125)
(57881)
(60775)
Labours
(36000)
(43200)
(51840)
(62208)
Variable Over heads
(22000)
(24200)
(26620)
(29282)
Machine Cost
(100000)
Sales of Machine
2000
Net Cash Flow
(100000)
57500
65635
74398
85762
Cost of Capital at 15%
1
0.870
0.756
0.658
0.572
Present Value
(100000)
50025
49620
48953
49055
Net Present Value = Total cash Inflow - Total Cash Outflow
NPV = 197653 - 100000
NPV = 97653
Therefore, NVP after changing the cost of machine will be £97653, which is £20000 more than the original NVP. So now the acceptability of the project would be even more.
Solution 3
(a) (i)
Current Ratio = Current Assets/Current Liabilities
For Ali Plc - 853/422.4 = 2.019:1
For Baba Plc - 816.5/293.11 = 2.785:1
Baba Plc has a higher current ratio and therefore it has higher liquidity position than that of Ali Plc.
(ii)
Acid Test Ratio = Current Assets - Stock/Current Liabilities
For Ali Plc - (853-592)/422.4
= 261/422.4 = 0.62:1
For Baba Plc - (816.5-403)/293.11
= 413.5/293.11 = 1.42:1
Acid test ratio of Baba Plc is higher than that of Ali Plc, so the creditors would be more interested in giving credit to Baba Plc.
(iii)
Gearing Ratio = Total Long term Loan/Capital Employed x 100
Capital Employed = Current Assets - Current Liabilities
For Ali Plc - 190/(1300-422.4)x100 = 190/877.6x100
= 21.65%
For Baba Plc - 250/(1417.7-293.1)x100 = 250/1124.6x100
= 22.23%
Gearing Ratio Of Baba Plc is higher than that of Ali Plc so it is more risky as the burden of interest is higher which is to be paid.
(iv)
Interest Cover Ratio = Profit before Interest and Tax/Interest
For Ali Plc - 151.3/19.4 = 7.798
For Baba Plc - 166.9/27.5 = 6.069
Interest cover ratio of Ali Plc is higher than that of Baba Plc which means that it can pay off the interest it has borrowed and it can offer more debts.
(v)
Dividend Payout Ratio = Dividend per Share/Earnings per Share
Dividend per Share = Dividend paid to equity shareholders /Average no. of issued equity shares
Earnings per Share = Profit available to ordinary shareholders/No. of shares in issue
For Ali Plc - (135000/320000)/(99900/320000) = 0.421/0.31
= 1.36:1
For Baba Plc - (95000/250000)/(104600/250000) = 0.38/0.42
= 0.90:1
Ali Plc has a higher dividend payout ratio which means that it has more cash returns on the shares invested than that of Baba Plc.
(vi)
Price/Earnings ratio = Market price per share /Earnings per Share
Earnings per Share = Profit available to ordinary shareholders/No. of shares in issue
For Ali Plc - 6.5/(99900/320000) = 6.5/0.31
= 20.97:1
For Baba Plc - 8.2/(104600/250000) = 8.2/0.42
= 19.52:1
Ali Plc has a better price/earnings ratio which means that the market has more faith in it regarding future earnings.
(b)
Gross profit percentage determines the profit of a company after reducing the variable costs from revenues. In year 2007, gross profit percentage was 23 whereas it was 19.4% in 2008 compared to industry average of 21% so it means the performance of the company has gone down in terms of profit.
Quick ratio is company's ability to use its quick assets to retire its current liabilities. In 2007, quick ratio was 1.41:1 and in 2008 it was 1.83:1 which is lower than the industry average of 2.1:1 which means that the company's credit rating is very low.
Return on equity measures a company's efficiency at generating profits from shares. In 2007, ROE was 19.24% whereas in 2008 it went down further to 16.39% and in both the years it was below the industry average of 20% which means company has not been efficient enough to attract more shareholders and increase its profit.
Return on capital employed measures the effectiveness of capital employed. Compared to industry average of 16% ROCE was low in both 2007 and 2008, i.e., 15% and 13% which means the capital employed by the company is not effective in generating profits for the company.
Earnings per share are the profit available for the share holder. In 2007 EPS was 20p and in 2008 it was 17p, when compared to industry average of 19p it is below par which means that the shareholder is losing his money on his investment in this company and in the future company could face a downfall in share market.
Debtors collection period is the time taken by the company to recover its debts. In 2007 it was 40 days and it increased to 54 days in 2008. Compared to industry average of 35 days, the time taken in both the years was not good and its getting even worst which is not a good sign for the company.
(c)
In case of gross profit percentage, the company should consider reducing direct expenses like wages, material, labour etc. to get better results in the future.
In case of quick ratio, the company should increase the flow of cash into the bank. After doing this creditors may take interest in the company and it would eventually help the company to improve its low credit rating.
In case of return on equity, the company should try to cut-off the unwanted costs and increase its profit and returns on equity as higher returns on equity would take the company to a better position.
In case of return on capital, the company should use its capital in an effective manner to generate more returns. The company can do this by monitoring its employed capital and use it in an effective way.
In case of earnings per share, number of shares in the market should be reduced or profits within the organisation should be increased.
In case of debtors collection period, the company should speed up its credit sales transaction.
(d)
"The balanced scorecard is a strategic planning and management system that is used extensively in business and industry, government, and non-profit organizations worldwide to align business activities to the vision and strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals." (www.balancedscorecard.org 25.01.2010)
Kaplan and Norton describe the innovation of the balanced scorecard as follows:
"The balanced scorecard retains traditional financial measures. But financial measures tell the story of past events, an adequate story for industrial age companies for which investments in long-term capabilities and customer relationships were not critical for success. These financial measures are inadequate, however, for guiding and evaluating the journey that information age companies must make to create future value through investment in customers, suppliers, employees, processes, technology, and innovation." (www.balancedscorecard.org 25.01.2010)
Asda Group Limited is one of the largest food retailers in the United Kingdom. Asda's stores sell a variety of merchandise including food, apparel, house wares, music, videos, electrical, flowers, furniture, mobile phones, books etc. Asda has always been famous for its low prices. The key to success to Asda is their excellent customer relationship and their low and affordable prices. Asda have well trained and highly motivated employees who are always ready to help the customers and this boosted its success even more. Asda has grown and developed a lot in last decade through its continuous market research and development. Asda which started as a small town store has now become United Kingdom's second largest departmental store with its successful strategy. Asda operates in the whole United Kingdom, which shows how effectively it can expand the ideal vision and statement it has propounded. On the conclusion of all the above information, Asda has been able to successfully quote its mission statement and has been able to achieve it regularly.
