The Importance of Credit Control within a Finance Department - Essay Example

?P1 (02 01 Evaluate the importance of credit control within a Finance Department Answer: Such policies that increase sales revenue, by increasingcredit to customers, and such policies that minimise the risk of loss from increasing bad debts are called as credit control policies (business dictionaries (2011)).Credit control means controlling the level of credit. By using the credit policy, an organisation sells its goods on credit to the customers. And after a certain period of time, the customers are required to pay back the credit amount to the organisation. But, sometimes, there are certain customers who are either unwilling to pay back money to the organisation. If the number of such customers is growing, then, there may be chances that the company may have the problem of shortage of cash. And undoubtedly, for organisations, cash is a lifeblood, without them, businesses will not be able to sustain and continue doing business. Businesses that are too short of cash will not be able to succeed and eventually fail no matter how profitable they may be. It is the policy of credit control that ensures that the smooth flow of cash is constantly occurring and the given amount of credit is within limits. Some credit policies are used to control credit. For instance, some companies ask their customers to repay the amount of credit within a particular period of time. On repaying the amount of credit, these customers will be given some benefit in the shape of additional reduction on the credit amount. Many customers avail the option of this credit policy. And in this way, company becomes able to adjust their control of credit in the most appropriate way. If a company does not control its credit, in the long term, the credit may be changed into bad debts. And when a credit amount is changed into the shape of bad debts, it becomes difficult for the company to ensure the repayment of that amount. Subsequently, this would not be a good sign for the company. And this would put some more pressure on the financial statements of the company in the long term. It is this opportune time for the company to highlight those causes that have contributed in the occurrence of bad debts for the company. P2 (02.1.02): Calculate the WACC of a company, and explain its uses WACC = ke [(market value of equity/A)] + kd [(1-t) (market value of debt/A)]. (Where as A=market value of equity + market value of debt) Market value of total equity = $12*1500 shares; = $18000. Ke = [$0.2 / $12] + 25% Ke = 26.67% Kd (1-t) = 10% . Where A = $18000+$200 A = $18200 WACC = 26.67%($18000/$18200) + 10%($200/$18200) WACC = 26.51% Uses of Weighted Average of Cost of Capital Schweser(c) (2010, p. 34) mentions that weighted average cost of capital is the discount rate which is used to discount the cash flows associated with a capital budgeting project. Weighted average cost of capital is the average cost of finance. Company arranges and uses different means and methods to arrange capital for the purpose of investment in different projects. Equity’s ordinary shares, preferred shares and short term and long term debt are collected with the help of different sources. Undoubtedly, these are important sources and company is required to pay different interests. Collectively, these different interests are paid on different debts obtained by the company, are called as cost of capital. Weighted average of cost of capital takes into account all the relevant factors that have influence on the capital structure of company. By taking into account, company with the help and use of weighted average of cost of capital more exactly achieve the actual and exact cost of finance. Furthermore, weighted average of cost of capital can be used to appraise of some of possible investments. Some companies have different projects for the purpose of investment in them. On the face of it, it becomes difficult for them to make profitable decision. And in order to know which project is going to be more profitable than the other projects available under the investment appraisal process. It is the use of weighted average of cost of capital that helps to highlight and identify that investment project which is more lucrative and attractive in terms of inflows. P3 (02.2.01): Propose two sources of debt financing for a medium sized company for both the short term and the long term and evaluate the risks involved in each. Answer: Debt financing means raising and availing funds to be used in business. Gonenc (2005) defines some of the most important determinants of debt financing are amount of fixed assets, growth opportunities, risk, profitability, and firm size. Additionally, Grossman and Hart (1982) was of the view that the debt can create an incentive for managers for working hard, consuming fewer perquisites and making some informed decisions. business cannot run and continue to run without having the required level of finance. And for the debt and equity financing, banks are the most immediate source of finance for SMEs and other institutions (Berggren et al., 2000).The two sources for short term finance are bank loans and bank overdraft. In the first source, bank loans can be requested from the banks. By availing bank loans, medium size company can fulfil their short term cash and non-cash requirements. The non-cash requirements can be buying a small machine or other capital expenditure required to increase the efficiency of the medium size company. After applying and receiving bank loan, the subsequent interest payments are made on a monthly basis. And these interest payments are fixed and inflexible. Under any condition, these payments are payable to the bank. Another source is bank overdraft, which is normally used and availed by the medium size companies. To fulfil its small and short term business requirements, like the working capital is not sufficient, hence the medium size company uses the facility of overdraft to fulfil the needs of working capital. But there are certain risks involved in this kind of facility. For instance, over the facility of overdraft, some banks charge quite high interest rates. Additionally, the medium size company is not allowed to exceed the provided limit of overdraft. If the medium size company is exceeding the overdraft limit the bank might refuse to pay cheques to creditors. Consequently, this would directly and negatively influence the business goodwill. The modern theory of capital structure was devised and developed by Modigliani and Miller (1958).Equity and debt are the two sources of obtaining long term finances for the medium size company. In equity financing, the company can issue ordinary shares, preference share for the purpose of raising finance. As for the debt financing, debentures, bank loan, unsecured loans, Mezzanine finance and traded securities can be availed for the purpose of raising long term finance. But there are certain risks of raising finance by using the equity: the shareholders may expect higher return. Additionally, there are higher costs involved in procedures. There is a risk of not fulfilling the regulations and this may increase the chances for penalties and fines. There would be a risk that shareholders may interfere in the daily and routine business operations. With the shareholders interferences, the efficiency of business operations may be hit. Also, some risks are also associated with the financing raised by the use of debt. In many cases, the debt must be repaid. In some of this context, Myers (2001) says that there is no universal theory of debt-equity choice and one should not expect one. P4 (02.2.02): Propose ways a company can raise finance by equity financing. Answer: Financing is very important input in every business (Papadimitriou & Maourdoukoutas, 2002)To finance the business requirements, companies use equity for that purpose. There are certain ways to raise finance. For instance, Initial Public Offering, known as IPO, sales of new shares, rights issues, placing. The IPO is done when a company goes first in to public for the purpose of raising finance. It provides all related details to the public through the medium of advertising. First, a company raises its required details like its head office, total shares, per share price and so on. The rights issues are those shares which are given to the existing shareholders for the purpose of increasing finance. There are two types of equity: Ordinary and preference share. Both can be used and both are the appropriate and practical ways to generate and raise finance. P5 (02.3.01): Explain in detail the process involved in making a major investment decision Answer: The process of decision making is not an easy for companies. Any wrong investment decision may heavily bring serious financial and non-financial implications. And business may have to face some serious financial losses and financial problems. In order to avoid the chances of improper or wrong investment or financial decisions, it is highly important to use an approach that could minimise the level of risk and increase the chances of better and attractive current and future returns from the projects. The following is the sequence required to find a profitable investment project: First, it is important to determine which project is going to be availed: A new machinery, new product line or new branch. Second, after making this important financial investment decision, some methods like Discounted Cash flows, Internal Rate of Return, Payback period ARR, sensitivity analysis and ranking projects, are available to help making a right investment decision. P6 (02.3.02): Evaluate a proposed investment by using payback ratio and the NPV method explaining the difference between them Answer: YEARS 0 1 2 3 4 5 6 OUTLAY (71000) RESIDUAL VALUE 11000 Expected Profits 22100 22100 22100 17100 17100 17100 Net cash flows (71000) 22100 22100 22100 17100 17100 28100 Discount Rate @ 26.5% 1 0.79 0.62 0.49 0.39 0.31 0.24 (71,000) 17,459 13,702 10,829 6,669 5,301 6,744 NPV = (10,296) Conclusion: Net present value of this project is negative. Hence, it is not recommended to carry out this project for the purpose of future investment. Year cash flow Cumulative cash flow 0 -71000 1 22100 -48900 2 22100 -26800 3 22100 -4700 4 17100 12400 5 6 Payback period = 3+ [(4700)]/17100 Payback period = 3.275 years Difference between payback period and Net Present Value Net present value is the present value of expected cash inflows associated with the project less the present value of the project’s expected cash outflows, discounted at appropriate cost of capital Schewser(b),(2010, p. 134). Net present value takes into account all cash flows that result from the probable and possible investment project. On the other hand, payback period does not take into account the cash flows resulting from investment projects. Additionally, net present value considers and takes into the time value of money while calculating the values of different inflows and outflows. By taking into account the time value of money in the process of calculating the inflows, net present value puts more validity on the different items of investment projects. But that is not the case with the payback period. The payback period does not take into account the time value of money while performing the process of calculation. Also, the payback period totally neglects the time value of money. Most of all, net present value uses cash flows to perform the process of calculation on the different element of project which are relevant and have some probable future cash flows. On the other hand, the calculation of payback period is based on average profits, these average profits are expected from the investment. P7 (02.4.01): Examine the published profit & loss account and balance sheet of an organization using ratio analysis. Highlight the strengths and weakness of this form of analysis. Answer: Ratio analysis is used to evaluate and understand the firm’s financial position and financial condition in the previous years. The ratio analysis helps to provide the percentage change in some of the basic elements of the profit & loss account and the balance sheet of the firm. Following are the main ratios which are relevant and they are useful to understand the percentage change experienced by the elements of the balance sheet and the elements of profit & loss account: 2009 2010 1. Profitability Ratio: Gross Profit Margin Ratio = (Gross profit/Turnover)x 100% = (1470/3900)x 100%= 37.69% =(2000/4500)x100%= 44.44% Operating Profit Ratio = (Operating profit/Turnover)x100% = (480/3900)x 100%= 12.31% =(900/4500)x100%= 20.0% Net Profit (after tax) Ratio=(Operating profit/Turnover)x100% = (327.5/3900)x 100%= 8.4% =(760/4500)x100%= 16.9% 2. Liquidity Ratios: Current Ratio= current assets/current liabilities = 2781/1351 = 2.058 Acid test (quick) Ratio= current assets(less current inventories)/current liabilities = 1781/1351 = 1.31 3. Investment and efficiency ratios: Debt to equity ratio= Total debt/ shareholders’ equity = 2930/2930 = 1 Debt to total assets ratio= Total debt/total assets = 1551/4481 = 0.346 Strength and weaknesses of ratio analysis Ratio analysis brings one single figure of any particular activity. With the help of ratios, a company would be in a position to compare its current financial performance with the other factors. For instance, the current year ratios may be compared with the ratios of previous year. Here, the management of the company in a position to clearly understand its current financial position in comparison with the previous year’s financial performance. If the current year’s financial performance suggests that the company has outshined the past year’s financial performance and has shown more strong financial strength than the past year’s financial strength, this would be clearly authenticating that the company’s existing financial policies are going well and they are generating the required level of financial performance. In contrast, if the company’s current financial ratios suggest that the company has underperform this year and it has shown less financial performance, it has increased its, short term and long term liabilities and decreased its long term assets and decreased its revenues as well. This would be a red sign for the company; it must look into its current financial policies and to highlight those factors that have contributed into the financial underperformance of the company. Also, the results of ratio analysis can be used to compare with the ratios of competitors in an industry. This comparison would greatly benefit the company in highlighting and clearly pointing out the current position of the company in the industry. If the comparison suggests that the company is increasing and improving its ranking in the industry, this would again authenticate that the company has sound financial policies, which are heading in the right direction and the management of the company has full and considerable understanding about its current financial policies. Ratios have some weaknesses. When they are viewed and analysed individually, they cannot be helpful and they cannot be used for any purpose of decision making on any investment or financial decisions. Additionally, different companies use different accounting treatments and different accounting policies, in that case any comparison based on the ratio analysis between two companies, using different accounting treatments, would be useless. The comparison with the help of ratios would be of no use. P8 (02.4.02): Propose reasons why it is more advantageous to use the cash flow statement rather than the balance sheet when a company is applying for funds. Answer: Cash flow statement provides a report for the company’s receipts and payments SchweserNotes(2010, p. 12). On the other hand, SchweserNotes(2010, p. 12) maintains that the balance sheet reports the company’s financial position at a point of time. Cash flow statement gives a clear picture of company’s liquidity. On the other hand, the balance sheet does not suggest anything related to it. Balance sheet only gives the one or three major figures relating to the liquidity of the company. In the statement of cash flows, three major cash related operations are maintained and clearly highlighted: operating cash flows, investing cash flows and financing cash flows. Each nature of cash flows is a part of the statement of cash flows. Furthermore, solvency and financial flexibility of the company may be more clear and understandable from the financial information given by the statement of cash flows rather than the financial information given and provided by the balance sheet. Also, the balance sheet is made and prepared under the concept of accrual accounting, but the statement of cash flows is made and prepared on the basis of cash accounting. This distinction is more advantageous and useful for the financial analysts and other fund providers because the cash based accounting treatment has more acceptance and validity than the acceptance and validity of the concept of the accrual based accounting. When a fund provider is approached by a company for the purpose of obtaining funds, which could be used by the company for the purpose of additional or further investment into the business, the fund provider mostly demands the most latest available statement of cash flows instead of demanding the financial information of the balance sheet or income statement. Although the value and significance of the balance sheet and the income statement cannot be underestimated during the process of putting an application for funds, but the statement of cash flows is mostly more relied and more asked by the fund provider. References 1. Berggren, B, Olofsson, C, Silver, L, 2000, ‘Control aversion and the search for external financing in Swedish SMEs’, Small Business Economics, Vol. 15 No.3, pp.233-42. 2. Grossman, S J, Hart, O, (1982), ‘Corporate financial structure and managerial incentives’, in McCall, J. (Eds), The Economics of Information and Uncertainty, University of Chicago press, Chicago, IL,. 3. Modigliani, F, Millier, M. H, 1958, ‘the cost of capital, corporation finance, and the theory of investment’, American Economic Review, Vol.48 No.3, pp.261-97. 4. Gonenc, H, 2005, ‘Comparison of debt financing between international and domestic firms: Evidence from Turkey, Germany and UK’, International Journal of Managerial Finance, Vol. 1, Is. 1. 5. Myers, SC, 2001, ‘Capital structure’, The Journal of Economic Perspectives, Vol. 15 No. 2, pp.81-102. 6. Papadimitriou, S & Mourdoukoutas, P, 2002, ‘Bridging the start-up equity financing gap: three policy models’, European Business Review, Vol. 14, Is.2. 7. Schweser(a), 2010, ‘Financial reporting and analysis’, Kaplan: USA. 8. Schewser(b), 2010, ‘Ethical and professional standards, and quantitative methods’, Kaplan: USA. 9. Schweser(c), 2010, ‘Corporate finance, portfolio management, and equity investments’, Kaplan: USA. 10. (The Business dictionary defining credit control 2011) References: Read More