Financial Information in the Business Plan - Essay Example

?Accounting for Service Industries Assignment Business Organisation and Sources of Funding/Finance Financial Information in the Business Plan A business plan can serve many functions which will determine the financial information required. If the owner is funding the business him/herself, then it is a plan for the business to achieve specified objectives. Usually the business plan serves as a “sales” document, in that it is selling the business to a prospective investor or to a finance provider such as a bank as a good investment/risk. The basic requirements for this function are the same, although the former will focus on a rate of return for the investor, while the latter will focus on the affordability of the loan required. According to Birt (2004) the financial plan should show income, less outgoings, the amount of anticipated profit and a breakeven analysis, before moving on to outline the borrowing proposal, and forecasted financial statements (income (or profit and loss account), balance sheet and cash flow forecasts). Business Link (2011d) provide information that covers both new and existing businesses. They also indicate that financial forecasts are required, as well as past financial statements if they are available. A balance sheet provides a snapshot of the assets and liabilities of a business on a particular date. It allows a potential investor/lender to calculate ratios relating to use of assets, creditor and debtor payment periods and liquidity. A lender may also be interested in the fixed assets of the business as these might be used to provide security for any loan granted. An income statement (or profit and loss account) covers an accounting period (usually twelve months) and identifies sales revenues, how much it cost to make those sales and administrative expenses. It also shows both gross and net profit figures. A potential investor/lender can assess how profitable the business is, together with the amount of sales required to breakeven. Single statements on their own are of limited use. It is best to have at least three years’ financial statements so that investors/lenders can calculate the different ratios across a period of time and establish trends. A decreasing net profit margin would be a cause for concern, for example, as would a decreasing liquidity ratio. The cash flow forecast (or budget) is an estimate of the monthly cash and credit inflows to the business, the monthly expenses and the effect on the bank account. It indicates which months have extra expenses (for example, annual rent payments or tax liabilities) and whether there is sufficient to cover them, or whether additional funds are needed. It allows investors/lenders to see how well the cash within the business is managed as, without cash, the business will cease trading. Breakeven analysis provides an indication of the point at which a business is expected to start making a profit. An additional calculation provides an indication of the margin of safety for the business – how far sales can fall short of the projected figure before a loss results. Investors/lenders will find this information useful as it also provides an indication of how much room for error exists before the business cannot pay a dividend or meet any loan obligations (interest and/or capital repayment). The dividend must be paid from profits after tax, whereas a loan repayment is allowed as an expense of the business. A lender therefore has a larger margin of safety as any loan repayments must usually be paid before any dividends (usually in the terms and conditions of the loan to prevent owners paying themselves at the expense of the lender). If any assumptions are made, these should be clearly stated. All projected figures must be reasonable, otherwise the investment/loan proposal will not be taken seriously and the management of the business will be questioned. (615 words) Partnerships and Limited Companies Martha and Michael have three options to consider: continuing with the partnership they have, or change the legal structure of the firm to either a limited company or a limited liability partnership. The advantages of a normal partnership are that it is easy to set up, and no paperwork needs to be completed and registered at Companies House. Unless the partnership agreement says otherwise, profits are split equally between the partners. Each partner is considered self-employed, so must register with HM Revenue and Customs and supply annual self-assessment returns. They pay income tax on their share of the profits and national insurance contributions (both class 2 and class 4). The partners usually run the firm together, so it is a good idea for them to get on well with each other, even if they disagree about things, otherwise working together becomes impossible. The partnership is required to keep records of income and expenditure, and these are kept private. The biggest disadvantage of a partnership is that each partner is liable for the whole partnership debt (if there is one), in the event that the business fails. Because the partnership is not a legal entity in its own right, creditors can claim the personal assets of the partners up to the value of any claim made, whether the debt was created by them or not (for example, if a new partner joins a firm after another partner has left). This can mean that homes are sold to pay debts. There is also a potential problem if one of the partners dies, resigns or leaves the partnership: unless the partnership agreement says otherwise, the partnership must be dissolved. (Based on Business Link 2011c) The alternative to a normal partnership is a separate legal entity that confers limited liability. This can be in the form of either a limited company or a limited liability partnership. Both involve a greater degree of formality that a normal partnership and require registration at Companies House. A limited liability company is a separate legal entity to the shareholders, who are the owners. For Martha and Michael, the type of limited company to consider is a private limited company (the alternatives include a public limited company and a private unlimited company, but both have issues that make them unsuitable for this situation). For a private limited company, at least two shareholders are required and the shares they purchase cannot be offered to the public, as happens with a public limited company or plc. There must be at least one director aged at least 16 years old who is an individual rather than another company. In this situation, Martha and Michael could be both shareholders with equal shareholdings, and also be directors, responsible for running the company. A limited company must be registered at Companies House and there are a range of administrative tasks associated with a limited company that involve completing returns that must be sent to Companies House for registration. The information concerning a limited company is publicly available, although a fee is payable for detailed information. Accounts are usually audited before being submitted to Companies House, although there are exemptions from this requirement. Companies must also register with HM Revenue and Customs (in practice, Companies House advise HM Revenue and Customs who then contact the company directly) as they are likely to generate profits on which corporation tax is payable, as well as dealing with VAT accounting and paying income tax and national insurance contributions in respect of their employees, if any. Profits are either retained by the business to facilitate continued trading (they may be represented by stock, debtors or fixed assets) or paid out to shareholders as a dividend (when the company must account to HM Revenue and Customs for the tax paid on the dividends). Limited companies are subject to companies legislation and must comply with it at all times. It can be complicated, requiring professional advice to ensure compliance is achieved. The biggest advantage of a limited company is the limited liability conferred. Directors, unlike partners, are not liable for the debts of the company. Shareholders are only liable up to the nominal value of their shareholding (if Martha and Michael purchased a single share each with a nominal value of ?1, that would be the limit of their liability) in the event that the company ceases trading. Directors can be required to give security to lenders such as a guarantee or a charge over property, but that is the only way for a director to become liable for company debt. The biggest disadvantage is the associated costs and paperwork of setting up and running a limited company, although this is being made easier by online filing, where charges are somewhat cheaper than using paper forms. (Based on Business Link 2011a) A limited liability partnership (LLP) combines the features of a normal partnership with the idea of limited liability for the partners. Because of the limited liability aspect, an LLP must be registered at Companies House and partnership documentation is publicly available. But the administration associated with the LLP is far less than that associated with a limited company, although partners within an LLP will need to keep an eye on companies legislation as this can affect LLPs as well. There must be at least two partners known as designated members who have greater responsibilities than “normal” partners. (Based on Business Link 2011b) This final option might be the best option for Martha and Michael, as it allows them to continue trading as a partnership, while limiting their liability to potential increased financial obligations. A full assessment of their current and potential future circumstances would be required before a definitive recommendation could be made. (956 words) Generating Income: Capital and Cash Management Options for Raising New Capital Finance for new capital can be raised as either equity or debt (McLaney, 2009, p.217), with different options being available for private and public limited companies and partnerships. For Martha and Michael, the options available to private limited companies and partnerships will be considered as their decision regarding the legal status of the business has yet to be finalised. Martha and Michael need to consider several things when looking for new finance: How much cost and paperwork is involved in raising the new finance How much servicing the finance will cost (e.g. interest rates) What obligations exist to make interest payments and repay the finance Whether the costs of finance are tax deductible, and How the new finance affects the control of the business (based on McLaney, 2009, p.218) If Martha and Michael decide to create a limited company, they have the option of finding additional equity shareholders, assuming that they themselves decide to hold shares. This would give the new shareholders the opportunity to receive dividends on an annual or six-monthly basis, which would form their rate of return. However, it would also give the new shareholders power within the company in proportion to their investment. If, say, Martha and Michael invested ?10,000 each in shares and found two additional investors willing to invest ?10,000 each, they would gain twice the capital, but lose half of the control. For the investors, there would be a limited market in selling the shares on, and it is likely that an arrangement would be put in place to compel the company to repurchase the shares in the event that a buyer could not be found. This might cause problems connected with cash flow for the business, at a time when cash is not available to make the payment. An alternative to equity shares would be to issue preference shares, which have a fixed rate of return and no control over the company. The dividend could be paid annually or six-monthly and would have to be paid before a dividend could be paid to Martha and Michael. Again, there would be issues regarding the transferability of the shares. Preference shares act more like loan capital than equity shares, including the possible right for the shares to be redeemed at a fixed future date, which would require the company to budget for that redemption. As Martha and Michael would be setting up a private limited company, trading the shares on the Stock Exchange is not an option. Dividends are not tax deductible, so would reduce the amount available to both Martha and Michael and the business, if additional investment were needed. If the preference shares were cumulative, then dividends missed one year would have to be paid the next, along with the dividend for that year. Overall, the case for using equity to raise finance for the company (if created) would not work well for Martha and Michael, so this option is not recommended for them. An alternative method of raising equity finance is to retain profits within the business. These funds would be equity because they are classed as shareholders’ funds on the balance sheet, thus would increase the (paper) value of the shares held by Martha and Michael. It would depend on how well the business did and how much Martha and Michael needed to pay themselves in dividends as to how much the company could afford to retain. If Martha and Michael pay themselves a salary from the business, their need for a dividend payment might be reduced, making retained profits a very cost-efficient way of raising finance for the business. This would be a favourable option for Martha and Michael, but would be dependent upon successful trading, which cannot be guaranteed. Depending upon why the finance is required, a further option might be available to Martha and Michael, in the form of leasing or hire purchase. If a specific asset is required it can either be leased with monthly or annual payments and the asset never belongs to the business, or it can be purchased with monthly or annual payments and become a business asset upon payment of the final instalment. Both would be reflected in the balance sheet, and for the hire purchased asset, capital allowances may be available. Sometimes, with leasing, for a nominal additional payment, the asset can be acquired by the business at the end of the leasing term. Whether leasing or hire purchase would be suitable methods for acquiring fixed assets would be determined by the fixed assets required, if any, and whether it would cost less to lease the item, purchase the item using hire purchase, purchase the item using other finance or purchasing the item outright using business funds if they are available. It is difficult to recommend this alternative without more detailed information as to the specific asset requirements of the business and whether they would warrant a leasing or hire purchase agreement. There may also be government grants available to help the business expand, although with the current austerity drive, many sources of funds are disappearing, with no replacements being made available. It is therefore highly unlikely that Martha and Michael will be able to take advantage of government grants or funding in the short to medium term. Business angels represent a source of funds which tends to be aimed specifically at small businesses (McLaney, 2009, p.442). A business angel is someone who takes an equity shareholding in a small business of up to 40% of the company’s equity, and take a close interest in the management of the business. Many business angels have set up and run their own businesses, so can provide some useful advice and guidance as well as finance. Martha and Michael could use the National Business Angels Network to identify potentially investors, if this is something that interests them. They would have to become a limited company for this to be possible and that has yet to be decided. It is useful information for them to have available to them, as it may help them to make a decision. The business is not large enough to consider a listing on the Alternative Investment Market, and it is unlikely that either Martha or Michael would wish to pursue this option at the moment, but again, it is something that may prove useful in the future. Cosh and Hughes (2007, in McLaney 2009, p.444) identified the sources for small business finance from 2002 to 2004 and the biggest source, by far, were the banks, who provided 57% of financing. Bank loans are considered difficult to obtain and, following the global economic crisis in 2007, it is reported that the banks are just not lending (even the Prime Minister has spoken to the banks about this but has not been able to change their stance – see Mulholland and Watt 2010). However, this should not stop Martha and Michael considering approaching their bank to discuss the possibility of borrowing funds. If their proposal is sound, then the bank should at least consider it. Things that Martha and Michael would need to consider include how much they would need to borrow, over what period and what sort of interest rate they would hope to achieve. When considering the term, Martha and Michael should ensure that the term is not so short that making repayments becomes an issue, nor so long that the purpose of the loan is completed years before the funds are repaid. While interest rates are currently at an historic low of 0.5% (Bank of England 2011), banks are taking the opportunity to increase their margins, so Martha and Michael may find that they are charged something like 5-6% above the Bank of England rate, or quoted a managed rate that lasts for the length of the loan. This can make budgeting easier, as the repayments are fixed, but managed loan rates tend to be higher than a margin over the Bank of England rate and only available for a short period. Although a bank loan is still an option, Martha and Michael will need to thing very carefully about how much they are prepared to pay for a bank loan and whether the investment is worth it. Working Capital Management Efficient management of the working capital cycle can also be used to generate funds albeit on a short-term basis. The assumptions behind using the working capital cycle to generate funds are that credit taken from creditors by the firm is greater than the credit given to customers and that customers pay promptly. Figure 1: Working Capital Cycle for the Salon (Based on McLaney 2009 p.351) However, the salon is a cash business, meaning that customers pay in cash for the service they receive. Debtors, therefore cannot be used as a means of generating cash by asking them to pay faster: cash is the fastest payment possible. It is possible, though, that they purchase their supplies on credit. If so, this can be used to help generate cash by delaying payment of creditors to the last minute, unless paying early confers a discount that is worth more than the cash would be worth in the bank. For Martha and Michael, there is little room for manoeuvre in the working capital cycle. Surplus cash should be held in an interest bearing account (although with such low interest rates available at present, it is debateable whether this is worth that much to the business in terms of interest earned). In addition, being a small business gives Martha and Michael very little bargaining power when dealing with their creditors. Their working capital profile will not mirror that of larger cash retailers (McLaney, 2009, p.448) as they cannot match economies of scale. They are likely to find that they hold more stock (in this case, shampoos and other hair treatments) and this would work to their advantage for the new outlet as they would not necessarily need to double the quantities of items held to have sufficient to undertake their business properly; most wholesalers or suppliers insist on minimum quantities to make the order viable from their perspective, so smaller retailers will be left with a higher initial level that reduces gradually over time; and although ideas like just-in-time would work well for them, Martha and Michael are unlikely to find a supplier to provide such a service with such small quantities involved. Although the business is run on a cash basis, creditors will expect to be paid promptly and are likely to grant a shorter time period to Martha and Michael, requiring them to pay more quickly, which potentially negates any benefit accruing from being a cash business. When assessing their borrowing requirements, they will need to remember to factor in a higher working capital requirement than a larger business would, otherwise they may find they run out of cash and the business fails (ibid, p.449). (1,830 words) References Bank of England (2011) ‘News Release: Bank of England Maintains Bank Rate at 0.5% and the Size of the Asset Purchase Programme at ?200 Billion’ 13 January available online at http://www.bankofengland.co.uk/publications/news/2011/001.htm [accessed 13th January 2011] Birt, I. (2004) Writing Your Plan for Small Business Success (3rd edn.) Pearson Prentice Hall, Frenchs Forest, NSW Business Link (2011a) Legal structures: the basics Limited liability companies available online at http://www.businesslink.gov.uk/bdotg/action/detail?=en&itemId=1073789612&lang=en&topicId=1073865730&type=RESOURCES [accessed 21st January 2011] Business Link (2011b) Legal structures: the basics Limited liability partnership available online at http://www.businesslink.gov.uk/bdotg/action/detail?=en&itemId=1073789611&lang=en&topicId=1073865730&type=RESOURCES [accessed 21st January 2011] Business Link (2011c) Legal structures: the basics Partnership available online at http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073789609&lang=en&type=RESOURCES [accessed 21st January 2011] Business Link (2011d) Use your business plan to get funding available online at http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073791579&lang=en&type=RESOURCES# [accessed 21st January 2011] McLaney, E. (2009) Business Finance: Theory and Practice (8th edn.) FT Prentice Hall, Harlow Mulholland, H. and Watt, N. (2010) ‘David Cameron admits difficulties in getting banks to lend more’ The Guardian 1 November available online at http://www.guardian.co.uk/politics/2010/nov/01/david-cameron-difficulties-banks-lend-more?INTCMP=SRCH [accessed 22nd January 2011] Read More