Finance

SHORT TERM FINANCE AND LONG TERM FINANCE Long term financing provides businesses funds for the period over 1 year. It contrasts to short term financing because short term financing provides funds for the period of 1 year or less whether an established corporation or new business, it is common that many small and large companies have some kind of debt throughout the life of their business. These businesses normally borrows not only to expand their companies or to purchase equipment, but also to finance operating capital to even out cash flow.

What is Short Term Financing? Short term financing is essentially to provide businesses funds for a short term period of a year or less.

What is short term financing for? These funds are usually for businesses to run their day-to-day operations including payment of wages to employees, purchase of goods and supplies. An example of short tern financing could be when a firm places an order for raw materials, it pays with finance and anticipates getting back this finance by selling these goods over the period of a year.

Difference between Short term and Long Term financing In contrast long-term financing decisions are involved when a firm purchases a special machine that will reduce operating costs over, say, the next five years. Short term borrowing is used for working capital requirements for day to day operations of a business. Industries with seasonal peaks and troughs and those engaged in international trade will be heavy users of short term borrowing finance. Page

1

Commerce – Students’ Guide Computing

Department of Business and

LONG TERM FINANCE 1. By issuing shares A company can raise capital by issuing shares. There are two types of shares – ordinary or equity shares and preference shares. Features of Ordinary Shares or Equities: •

The money given for shares is never returned to the shareholders.

•

The ordinary shareholders get dividend out of profit and only if there is sufficient profit.

•

The ordinary shareholders are paid dividend after the preference shareholders are paid.

•

The ordinary shareholders can attend the Annual General Meeting and elect the board of directors.

•

The ordinary shareholders are the owners of the company.

•

The ordinary shareholders have more control over the company as they elect the board of directors by the principle of “one share – one vote”.

•

When a company closes down, the ordinary shareholders are paid last.

Features of Preference shares: •

The money given for shares is never returned to the shareholders.

•

The preference shareholders get fixed rate of dividend in return.

•

The preference shareholders are paid dividend before the ordinary shareholders.

•

The preference shareholders can attend the Annual General Meeting and elect the board of directors if they are paid in arrears.

•

The preference shareholders are the owners of the company.

•

When a company closes down, the preference shareholders are paid before the ordinary shareholders.

2

Prepared By: Emmanuel George

Finance

CALCULATION OF SHARE DIVIDEND: A company issued the following shares, which were fully paid up for: 6.5% Preference shares Ordinary shares

200,000 @ $0.50 200,000 @ $1.00

The company also issued debentures worth $150,000, which carried an interest of 8%. The net profit available for distribution before paying the debenture interest was $45,000. The company decides to distribute three fourths of the net profit to the shareholders and to keep the balance as ploughed back profit. Calculate: Rate of dividend per ordinary share. Profit

$ 45,000

Debenture interest (150,000x8/100) =

$ 12,000

Balance Net profit

$ 33,000

Profit to be distributed to shareholders: $ 33,000x3/4=

$ 25,750

Preference share dividend $100,000x6.5/100=

$ 6,500

Profit to be given to ordinary shareholders

$ 18,250

Dividend per ordinary share ($18,250/200,000) =

$ 0.09

Rate of dividend per ordinary share= Dividend per ordinary share x 100 Value per ordinary share $ 0.09 x 100 =

9%

$1.00

2. By issuing Debentures A company can also raise capital by issuing debentures. The following are the features of debentures: 3

Commerce – Students’ Guide Computing

Department of Business and

Features of Debentures: •

These are like stock or long-term loans given to the company.

•

The debentures carry a fixed rate of interest and are repayable on a fixed day.

•

The debenture holders are paid interest every year whether the company makes a profit or loss.

•

The debenture holders are secured against the property of the company.

•

The debenture holders are the creditors of the company.

•

The debenture holders can sell their claims on the stock exchange.

•

When a company closes down, the debenture holders are paid first.

DIFFERENCES BETWEEN SHARES AND DEBENTURES SHARES

DEBENTURES

1. Share capital is an investment.

Debenture capital is a loan.

2. Shareholders are the owners of Debenture holders are the creditors of the company. the company. 3. Shareholders earn dividend, which is paid out of profits. 4. Shareholders have voting rights

Debenture holders earn fixed rate of interest, whether profits are made or not.

and hence have control over the Debenture holders have no voting rights and hence have no control over the company. 5. Shareholders

cannot

face

a company.

company into liquidation. 6. Shareholders against

the

are

not

property

Debenture holders can force a company secured into liquidation on non payment of of the interest,

company. 7. When a company closes down the shareholders are paid after the debenture holders.

Debenture holders are secured against the property of the company. When a company closes down the debenture holders are paid first.

3. Commercial mortgages A mortgage is a form of loan, which is taken out against property (real estate). 4

Prepared By: Emmanuel George

Finance

The definition of property may include a house, a flat, or an apartment, although mortgages cannot be taken out against any other assets such as a vehicle, stocks and shares, or other investments. A mortgage can also be taken out against an office, a shop or a factory (this is known as a commercial mortgage), or against a property which the owner intends to rent out to other tenants (buy-to-let mortgage). Some companies may own the freehold of real estate premises in the form of factories, office accommodation or warehouses. These assets will have a value in the company’s accounts. If the business wants to raise a capital sum for investment in new assets, it could take out a commercial mortgage with a property company. Normally the maximum mortgage will be between 60% and 70% of the property value. The premises themselves are used as security, and the mortgage loan will usually be for the long term. The advantage of this arrangement is that the business can continue to use the premises as before, but must service the commercial mortgage in terms of interest payments and eventually repaying the capital sum. Another plus is that any increase in property values over time still belongs to the business and not the property company to which it has been mortgaged. 4. Bank loans All the major banks offer a range of business loans. They range from a few months to up to 25 year Some loans are at a fixed rate of interest which is agreed at the start of the loan period and applied throughout the period of the loan. Other types of loan may have a variable rate of interest. Here, the interest rate will fluctuate over the period of the loan in line with interest rates in the economy. Banks will usually tailor a loan package to suit the requirements of individual businesses and will also carry out a risk assessment on the business before going ahead with the loan. Depending upon the outcome of the risk assessment, the lender will normally require some form of security (either business or personal 5

Commerce – Students’ Guide Computing

Department of Business and

assets) to guarantee the loan and may require the business to issue a debenture to the bank. From the point of view of the business, there will be the need to meet interest payments and make provision to repay the loan itself. 5. Sale and leaseback This option relates to real estate assets. ‘Where a business owns premises and needs to raise finance, it may sell the freehold and simultaneously arrange to lease it back. The business would be converting the real estate fixed asset into cash, but will continue to be able to use the property as before. Such arrangements are generally very long term to guarantee the continued availability of the asset to the organisation. The advantage of this method, compared to the commercial mortgage option, is that 100% of the freehold value is realised, which is higher that is possible with a mortgage. However, on the other hand, the business will not enjoy any future increase in the property’s market value. Sale and leaseback may also be possible for certain types of capital equipment, such as large machinery. SHORT TERM FINANCE 1. Bank overdraft Some businesses may need to withdraw money from their accounts when there are insufficient funds in their accounts. They may request their banks to allow them to overdraw from their accounts for a short period. Interest will be charged on the amount overdrawn. This is an informal way of borrowing money from the bank.

Features of bank overdraft •

Borrower need not have a current account.

•

The borrower has to go through formal procedures for applying for a loan.

•

Interest is charged on the whole amount borrowed for the full period of the loan. 6

Prepared By: Emmanuel George

Finance

•

Money paid into the borrower’s account does not reduce the loan.

•

Lower interest is charged as the banker knows the amount of loan.

2. Invoice factoring Invoice factoring is an alternative to an overdraft in situations where there is always a time lag between the issuing of invoices and the receipt of payments, resulting in a cash flow problem for the business. In the simple cash flow example above, the business is making sales in January but is getting no cash payment for them until March. In effect, the business is allowing customers 60 days credit. It may well be that this is necessary in order to get the sales in the first place. The way in which factoring works is illustrated in Figure Selling Company

2

1

Factoring Company

Buying Company

3

The selling company sells to the buying company and invoices in the normal way (1) and for the normal credit terms of 60 days. A copy invoice is sent to the factoring company. When it receives the invoice, the factoring company will pay 80% of the invoice value to the selling company (2). In the example above, the selling company would send out £6,000 of invoices in January and will get 80% of this (i.e. £4,800) immediately. In 60 days time, the buying company makes its payment, but sends it to the factoring company (3) and not to the selling company. When the factor receives payment, it sends the 20% balance to its client, the selling company. The factoring company makes its money by charging its client a percentage of the value of the invoices it has factored. This is usually done on a monthly basis. To the selling company, this represents the cost of balancing cash flow to the issuing of invoices on a credit basis. If a particular customer fails to pay — perhaps because it have gone into liquidation — the factoring company cannot reclaim the 80% it has already paid to its client. This is known as non recourse factoring. Because of this, factoring companies always examine the credit track record of “customer” companies. If a 7

Commerce – Students’ Guide Computing

Department of Business and

particular company’s credit rating gives cause for concern, the factor will simply inform its client business that it will not factor invoices to that particular company. Invoice factoring can be seen as an alternative to an overdraft for a business. Businesses will look at the comparative costs of both before deciding which facility to choose. 3. Leasing If a business needs assets — such as a new computer system or fleet of vehicles — it has the choice of buying them outright or leasing them. In practice, leasing is a form of hire under which the business has the use of the computers or vehicles for an agreed period. The business leasing the assets is obliged to look after maintenance. Leasing is particularly advantageous in situations of uncertainty or where the business is not willing to commit large capital sums to buy assets. It can also make sense where technology changes rapidly and a business needs to update its equipment regularly. Further, leasing can have tax advantages for both the business leasing the assets and the lessor. Leasing is available to all types of business. In some cases, there may be an option to buy the assets at the end of the lease. This arrangement is called lease/purchase 4. Trade credit Another possible solution to the short run cash flow problem is to try to find ways of delaying payments to suppliers. To achieve this, a business will try to negotiate trade credit terms with its suppliers. Before being allowed such credit, a new business is likely to have to establish a credit track record by paying cash with orders for some time. When trade credit terms can be arranged, the business can order materials from suppliers and perhaps process them into finished goods for sale before it has to pay for them. 8

Prepared By: Emmanuel George

Finance

The major advantage of trade credit is that it is interest free. Some suppliers who give trade credit will also offer cash discounts to buyers who pay early. 5. Hire Purchase Agreement The customer can hire goods and can buy them at the end of the hire period. Consumer durables like freezers are sold in this way. The goods remain the property of the seller till the last payment is made. Features of Hire purchase •

The hire purchase agreement is an agreement to hire with an option to purchase.

•

Ownership lies in the hands of the seller till the buyer pays the full amount.

•

If the buyer fails to pay the installment, the goods will be repossessed by the seller.

•

Hire purchase is suitable for capital goods

Advantages of hire purchase to the buyer 1. It enables the poor people to obtain goods. 2. Goods can be bought immediately and the payments can be made in installment. 3. Good quality goods can be bought when they are needed the most. Advantages of hire purchase to the seller 1. It helps to increase the sales. 2. If the payment is not made the seller can take back the goods by low. Disadvantages of hire purchase to the buyer 1. Goods once bought cannot be sold until the last installment has been paid up. 2. Goods can be bought only from those sellers who offer hire purchase credit. 3. The prices of the goods are high. 4. Hire purchase restricts the purchase of goods to only those that are large and have a resale value. 5. Hire purchase system motivates the people to buy unnecessary luxury items. Disadvantages of hire purchase to the seller 9

Commerce – Students’ Guide Computing

Department of Business and

1. Risk of bad debts. 2. Goods repossessed may not be in a good condition and may have little resale value. 3. Hire purchase buying increases the capital required by the seller to run the business. 4. More administrative expenses insure to record and keep track of installment due. METHODS OF SELF FINANCING 1. Retained Profits and savings When a business makes a profit, a proportion will generally be paid out to the owners — in the form of drawings in the case of sole traders and partnerships or dividends on shares in the case of limited companies and PLCs. The rest of the profit will be retained in the business and can be used to finance the growth of the business in the form of new investment in plant and machinery. As we have seen, there is no obligation on a company to pay out a particular amount as a dividend or even to make such payments to shareholders at all. For sole traders and partnerships, the owners may be willing to forego any drawings in the interest of ploughing back the profits into the business in the expectation that further profits will be forthcoming in the future. Thus, retaining profits represents an important option for a business seeking additional funds. In practice, for unincorporated businesses and limited companies, retained profits are the main source of finance over both the short and long term. If these businesses are to grow, then they must earn profit and retain much of it in the business.

10

Prepared By: Emmanuel George

Finance

BUSINESS FINANCE Capital Capital refers to the value of the things owned by a business. Capital = Assets – liabilities 1. Fixed Capital This consists of the durable (long lasting) assets of a business which are used over a long period of time and are tied up in permanent use, for example, land, buildings, machinery, furniture, motor vehicle etc. 2. Working Capital Working Capital is the amount of capital, which is available to the day to day running of the business. It is the excess of current assets over current liabilities. Working Capital = Current Assets – Current Liabilities WC = CA – CL Current Assets Current assets are those assets, which can be converted into cash within a short period of time, generally one year period. Eg stock of goods, debtors, cash at bank, cash in hand etc. Current Liability Current liabilities are those liabilities of the business which has to be paid within a short period of time, generally one year. Eg. Creditors, Bank O/D, short term loans etc. Working capital is also known as circulating capital or Revolving Capital. For example, cash is used to buy raw material, which is transferred into finished goods. Then the finished goods are sold in the market and realize the cash. This process goes on in business.

11

Commerce – Students’ Guide Computing

Department of Business and

Cash

Raw materials

Advantages of working capital Sales

Sufficient working capital enables a firm to: 1. Make prompt payment to the creditors and be able to enjoy cash discounts. 2. Take advantage of change in price of raw materials by making bulk purchase of seasonal goods. 3. Obtain loans from banks and Finished other financial institutions. Goods

4. Make prompt payment of expenses like wages, salaries, rent, interest etc. 5. Ensure smooth working of the business. Ways of increasing the working capital. 1. Investing more cash capital by the owner. 2. Obtaining loans and advances from banks or other sorces of finance. 3. By making profit on it’s trading. 4. By selling some of its fixed assets for cash. 5. By issuing new shares and debentures ( in the case of Public Limited Companies) Reasons for reduction in working capital 1. The owner of the business withdraw cash for his personal use. 2. Thew company declaring a dividend, which increases the current liability of the company. 3. The company making loss on its trading. 4. The purchase of fixed assets for cash. Working Capital Ratio (Current Ratio) It is the ratio of current assets to current liabilities. It can be calculated by dividing current assets with current liabilities. This ratio is used to show the extent of the business financial stability. 2:1 is the generally accepted working capital ratio. Working Capital Ratio =

Current Assets Current Liabilities

12

Prepared By: Emmanuel George

Finance

3. Turnover Turnover is another name for net sales. Net sales mean sales minus sales returns. A business can make profit only when there is turnover. High turnover results in high profit. but increase in profits doesn’t have direct proportion to increase in turnover. Turnover = Sales – Sales Return 4. Profit Business is carried on mainly to make profit. This is done by purchasing goods at lower price and selling them at high price after charging its condition. Generally profit is calculated by deducting cost of goods sold and expenses from sales. But profits can be correctly estimated only after considering the following points: a.

Turnover Turnover is another name for net sales. Net sales mean sales minus sales returns. A business can make profit only when there is turnover. High turnover results in high profit. but increase in profits doesn’t have direct proportion to increase in turnover.

b.

Cost of Goods Sold Cost of Goods Sold includes the total cost of goods purchased for sales and all direct expenses incurred on the goods for making them ready for sale. Cost of goods sold = OP stock + net purchase + direct expenses = closing stock or Sales – Gross Profit.

c.

Gross Profit. Gross Profit is the difference between turnover and cost of goods sold. Gross profit is not true profit, because it is the profit before deducting any expenses incurred in selling the goods such as rent of premises, wages, 13

Commerce – Students’ Guide Computing

Department of Business and

interest on capital etc. High gross profit shows that there is enough profit to meet the expenses and leaves a certain amount as net profit. Gross Profit = Net Sales – Cost of Goods Sold d.

Net Profit Net Profit is the true profit obtainable from trading. It is amount remaining after deducting all expenses from the gross profit. Net Profit = Gross Profit + other incomes – expenses.

Percentage of Profit 1. Margin Margin is the gross profit as a percentage of sales (turnover). Margin is also known as Gross profit turnover or Gross profit margin. Margin = Gross Profit X 100 Sales 2. Mark- up Mark – up is the gross profit as a percentage of cost of goods sold. Mark-up =

Gross profit

X 100

Cost of goods sold 3. Net Profit Percentage or NP Turnover = Net profit X 100 Turnover

Remember: If Mark-up is 25% = ¼, then margin should be ¼ + the numerator of mark-up to the denominator of margin. Then it should be 1/5. It is equal to 20%.

Reasons for fall in Gross Profit Percentage 1. Increase in cost of goods sold. 14

Prepared By: Emmanuel George

Finance

2. Unnecessary expenses incurred. 3. Inefficiency of workers. 4. Loss or damage of stock. 5. Lower selling price. 6. Changes in fashion, taste etc. Reasons for Rise in Gross Profit Percentage 1. Decrease in cost of goods sold. 2. Increased efficiency. 3. Reduction in unnecessary expenses. 4. Decrease in loss due to theft or damage. 5. Increased selling price. How to Increase Net Profit Percentage? Net profit percentage can be increased by increasing turnover, reducing cost of goods sold and reducing expenses. Turnover can be increased by increasing selling price, using more advertising, sales promotion or by allowing more credit. Cost of goods sold can be reduced by purchasing goods in bulk at a lower price or by finding out better and cheaper suppliers Expenses can be reduced by reducing costly advertising, reducing the number of employees or reducing free services offered. Capital and Profit. A businessman can get a clear picture of the profitability of his business only when he compares the profit with the capital invested. By this he can find out the percentage of profit on the capital invested and also can compare the profit with what he could have earned by investing the money in banks or building societies. Rate of Stock Turnover or Stock Turnover Rate of stock turnover is a measurement of how immediately goods are sold in a given period of time, usually one year. This ratio is generally expressed in terms of times. Rate of Turnover may vary from firm to firm. For high quality, expensive items rate of turnover will be low because such goods are sold very slowly. But for perishables like fresh fish, vegetables, fruits, newspapers etc the rate of turnover will be high because these goods are sold quickly.

15

Commerce – Students’ Guide Computing

Department of Business and

Rate of Stock Turnover = Cost of Goods Sold Average Stock Average Stock = Opening Stock + Closing Stock 2 Importance of Rate of Stock Turnover A firm with high rate of stock turnover will be more efficient because: 1. Less capital will be tied up. 2. Expenses are spread over a large volume of sales. 3. Stocks are quickly sold off and the cash so recovered can be used to pay off creditors. 4. Frequent purchase of stock from its suppliers makes it possible to buy in more favourable terms. 5. Loss due to damage, spoilage and changes in fashion will be very low. How to improve the rate of stock turnover? 1. By reducing the size of the average stock needed. This can be done by eliminating the slow lines or by placing smaller orders with suppliers. 2. By cutting prices, especially for luxury goods, if demand is price elastic 3. By advertising and sales promotion. 4. By offering credit

16

Prepared By: Emmanuel George

Finance

QUESTIONS 1. Fig. shows several sources of finance. SOURCES OF FINANCE Long term Short Term Bank Loan Bank overdraft Debentures Hire Purchase Ordinary shares Trade Credit Use Fig. to help you to answer the following questions. (a) Distinguish between long term and short term sources of finance.

[4]

(b) Name one other source of long term finance not shown in the diagram. [1] (c) Explain three differences between a bank loan and a bank overdraft.

[6]

(d) Giving reasons for each of your choices, recommend a source of finance given in Fig. that a limited company might use to: (i)

purchase a new factory

[3]

(ii)

pay for computer software

[3]

(iii)

make repairs to its office building.

[3]

2. Fig. shows a limited company with the following sources of finance available to it.

(a) From Fig. identify: (i) two short-term sources of finance

[2]

(ii) one long-term source of finance.

[1]

(b) Explain the differences between a debenture and an ordinary share.

[4]

(c) Giving reasons for each of your answers, recommend a source of finance given in Fig. that a limited company might use: (i) to build an extension to its offices

[3]

(ii) to pay for a new computer system 17

Commerce – Students’ Guide Computing

Department of Business and

(iii) to obtain stock from a supplier.

[3]

(d) Explain two reasons why this company might prefer to use retained profits rather than any of the sources of finance listed in Fig.

[4]

3. (a) What are the main characteristics of a bank loan?

[6]

(b) In what circumstances would a building company make use of a bank loan rather than a bank overdraft?

[4]

(c) The building company wishes to obtain a loan of $600000. (i) Imagine that you are a bank manager. What information would you require from the building company before you decide whether or not to offer a bank loan?

[5]

(ii) Interest rates are 6% per year. Calculate how much interest the building company will pay each year if it obtains the $600 000 loan. Show your working.

[2]

(d) Explain why the building company might use its retained profits to finance a project.

[3]

4. A small company manufacturing garden machinery has the following three financial problems: • an immediate shortage of cash to pay some unexpected bills • the need to replace all the out-of-date office computers • expansion plans for the business over the next five years. Methods of finance available to the company are: USING RETAINED PROFITS

OBTAINING A BANK LOAN

LEASING EQUIPMENT

REQUESTING A BANK OVERDRAFT

ISSUING MORE SHARES

Using the list of methods of finance given above, answer the following questions. (a) Giving an example of each from the list above, distinguish between longterm and short-term methods of finance.

[4]

(b) From the list above, recommend the best method of finance to solve each of the company’s three financial problems. In each case give three reasons for your choice.

[12]

(c) It would be possible to use debentures to finance the company’s expansion 18

Prepared By: Emmanuel George

Finance

plans. State and explain two reasons why the company rejected this source of finance for this project.

[4]

19