Corporate Finance in Decision Making

 

 

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Outline

1.1  Sources of finance available to a business

1.2  The implications of the different sources

1.3  Appropriate sources of finance for a business project

2.1 The costs of different sources of finance

2.2 Importance of financial planning

2.3 The information needs of different decision makers

2.4 The impact of finance on the financial statements

4.1 The main financial statements

4.2 Formats of financial statements for different types of business

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Introduction

The report paper explores corporate finance in decision-making. Several tasks are carried such as identification of the major sources of finance for business, understanding the implication of finance as a business resource, making financial decisions based on available financial information, and evaluating the financial performance of a business.

2.1  Sources of finance available to a business

Before expansion or establishment of a business, business owners consider the source of finance for the company. Thus, both small and large businesses require financing for start-up or expansion. Businesses are classified as sole trader, partnership, private limited company, and public limited company and each require different sources of finance. The major sources of finances are personal savings, bank loans, debt financing and equity financing. Internal sources of finances are revenue/sales income, ploughed back earning, profits, and selling off assets (Hirschey 2009). Among these sources of finances, equity and debt financing are the common sources. Equity financing entails the exchange of capital for ownership. This means that the equity provider is entitled to a share of the business profits. The major sources of equity include funds secured through government-backed community development agencies, investment banking firms, venture capitals, angel investors, friends and family, and bootstrapping (Covas & den Haan, 2005).

According to the Small Business Development Center for Innovation, bootstrapping entails business funding through the use of personal finances such as credit cards, loans and savings (SBDCI 2012). This is used when starting a company. Venture capital provides finances for survival and business survival. This source of finance is provided to companies which have high potential for growth or high growth (CBI 2010). Thus venture capital is used to drive growth for young and promising businesses.

Debt financing is capital acquisition strategy that involves borrowing of finances from a financial institutions based on the understanding that in the future, it shall be repaid with a given interest (Covas & den Haan, 2005). The different sources that are used to secure debt financing are asset-based lenders, government sponsorship, bank loans, and mezzanine financing (Quiry & Vernimmen, 2011).

Asset based lending entails securing of assets such as premises by lending institutions in exchange for financing. Government sponsorship is mostly applied to small business that the government is willing to support as part of enhancing development growth. The most common and traditional way of debt financing is via the use of bank loans. Loans are provided by banks and other financial institutions at a specific interest rate. Therefore, debt financing is usually a form of a business loan that can be short term or long term. Others sources of finances available for businesses in UK are such as self-issued retail bonds, private placements, development grants, leases, retail bonds, corporate venturing, and peer-to-peer venturing (CBI 2010). All these sources of finance are used as working capital or growth capital.

1.4  The implications of the different sources

Despite the various sources of finances identified, the major sources of finances which are usually applicable are debt financing, equity financing, ploughed back earnings, bank loans, revenue/sales income, and personal savings among others. Each of these sources of finance has positive and negative implications. For example, asset selling diminishes the overall value of the business making it vulnerable to external shocks (Megginson, & ‎Smart  2008). With reference to ploughed back earnings, and sales/revenue income, the business experiences a major setback as most of the revenue that could be used for emergencies is reinvested back into the company. This means that the company’s shareholders may not be given dividends as all profits are ploughed back for investment. Banks though appropriate are arranged with conditions for repayment at a given interest rate (Chakraborty 2004). In some cases, lenders such as banks and other financial institutions demand for control and influence over the business decision-making process. This kind of partnership affects the confidentially of the company as well as its decision making process (Vangen & Huxham 2003).

Bootstrapping though popular for business startups, this source of finance may not accumulate the required amount of capital (SBDCI 2012). With respect to debt financing, the acquired finances have to be repaid back in spite of the business being successful or not. In other cases, business assets in additional to personal assets might be used as collateral, which affects the value of the business and that of an individual (Covas & den Haan, 2005). Debt financing may sometimes result to cash flows problems, which affects the ability to repay the loan back. Besides, accumulated debt makes a business to be labeled as high risk, which may hinder future capital sourcing through debt financing. Accumulation of debts results to high costs of loan repayment, which affects the growth of a business (Madura 2008).  In case the loan is not paid, penalties are inclusive of the charged interest rates.

On the other hand, equity financing entails the exchange of the company’s ownership and to some extent the profits generated, thus giving away the control and the process of decision making (Quiry & Vernimmen, 2011). Since control and ownership is transferred to investors, it becomes hard to make decisions without consulting the investors. As such, some decisions that are urgency fail to take place (Razin et al. 1998). If the business and investors are in irreconcilable disagreements, the investors may take over the company and run it as their own (Quiry & Vernimmen, 2011).

1.5  Appropriate sources of finance for a business project

Under business project we consider the expansion of a business to improve its market share and profitability. In this perspective, the major finances sources available for business expansion are debt financing and equity financing. Below is a table that provides the pros of each of the sources of finances.

Sources of finances

Pros

debt financing

§  The ownership of the business is not transferable

§  Lenders have no legal claim over the company’s future profits.

§  Loans can either be long term or short term

§  Interests and principles are well known

§  The interest levied on the loan is usually tax deductible

§  One the loaned amount is paid back, the business relationship is terminated.

equity financing

§  Less risky compared to a loan

§  Enjoy the network and sources of the investors

§  Does not require channeling of profits as part of loan repayment

§  Presence of more cash in hand that can be used for business expansion.

§  In case the business fails, there is no requirement for paying back the investment

§  Does not require monthly payments

§  No collateral is required when securing equity.

 

Based on the pros associated with the two sources of finances, we conclude that both debt financing and equity financing may be adopted for the business project (Glen & Pinto 1994).

2.1 The costs of different sources of finance

Each of the financial sources has related financial costs. For example, loans have interest added to the loaned amount and time constraint required for its payments (Hirschey 2009). Asset selling has constraints on the total assets as their value is diminished. The use of ploughed back earnings and sales/revenue income as source of finance reduces the available cash flow, thus putting pressure of the available budget. Other than repayment in constrained time frame with interests, debt financing puts pressure on the financial cash flow of the company (Hirschey 2009). Debt accumulation accumulates interests, which ought to be paid. The use of equity financing as a source of finance results to loss of business control because the investors demand for business ownership, control, profits, and assets (Hirschey 2009).  Other costs are such as loss of the business in case of irreconcilable disagreements.

2.2 Importance of financial planning

Financial planning is the process through which an organisation is able to calculate the necessary financing required for the continuity of business operations (Groppelli & Nikbakth 2002). As a process, financial planning estimates the necessary resources available and those required to promote successful business continuity. According to Reisdorfer, Koschewska, Sandra, and Salla (2005), financial planning is adopted as a performance management instrument that is used during the decisions making process. For example, through the use of financial planning, a business is able to chart its course of operations towards the achievement of its strategic goals. This is started through review of current operations, and identification of the needs that required improvement (Hill 2013). Thus, small and large businesses require financial planning to provide the required information for making effective decisions on effective ways to allocate resources. Effective use of resources promoted productivity maximization and hinder wastage of resources.

According to Maritz (2005), the major “purpose of a financial strategy is to ensure that an organisation knows what its financial needs are and where it will get the necessary funding to meet those needs” (p. 5). The implication made is that through the use of financial planning strategy, an organization identifies its financial needs and looks for ways to fund the identified needs. In return, the business realizes the short and long term strategic and organizational goals. In this perspective, financial planning “the identification on behalf of the enterprise, of necessities such as the clarifying or  the expansion possibility, the viability of its budget for the market, the evaluation of possibilities in implementing new projects and their costs, and the planning of reserves for future investment” (Reisdorfer et al. 2005, p. 2). This means that the process allows budget viability identification and business possibility evaluation.  As part of ensuring corporate accountability, financial planning assists in the identification of wasted or exaggerated costs, which allows the top management, make effective decisions.

Gitman (1997) contends that financial planning is used to formalize the procedure used to realize financial goals and ways that can be used to integrate financing and investment decisions into the business strategic goals. Lastly, financial planning promotes in developing ‘what if’ scenarios that allows business leaders and managers envisage probable risks factors and design contingency plans to address them.

2.3 The information needs of different decision makers

Effective decision making in any organization is achieved when different parties interested have access to necessary information. Depending on their levels of power interests, decision makers can be divided into the external parties and the internal parties (Porter & Norton 2010). Thus information needs differs based on their levels of their needs. Internal parties ate such as employees, shareholders, and owners, while external parties are lenders, customers, the public, regulatory institutions, the government, and financial institutions.

Owners and shareholders are the major internal parties and decision makers. Their information needs for decision-making are such as company’s profitability, profits attributable to individual shareholders, organizations assets base, and cash available for future business expansion. This kind of information is provided by the business management and auditors.

Employees are the most important assets of any business. The major concern of employees is financial benefits and salaries provided by their employer (Suthaharan 2013). More importantly, they are interested in the business continuity required for their work security. The information needs of employees are related to future business expansion needs and the company’s profitability.

Lenders and financial institutions seek more of financial and accounting information of the company when providing capital or financial support required for business expansion or other operations (Porter & Norton 2010). Lenders and banks look for information related to profitability, company’s liquidity, interests cover, fixed assets base, and the company’s gearing ratio. Therefore, financial statements are important to financiers and creditors as they assist the information in making effective decisions.

Government and regulatory bodies: As required by the law, government agencies and regulatory bodies have information needs (Porter & Norton 2010). For example, the IRS requires information to enable it undertake taxation. In this context, the information related to taxes payable, profits earned by an organization to generate income tax payable, and compliance with different corporate regulatory bodies regulations are required (Suthaharan 2013).

Customers and public as external shareholders of an organization have information needs. They are usually interested in gathering information on the operations and the continuity of the business (Suthaharan 2013). For example, the public is interested on the business strategy towards social and environmental sustainability, while consumers are interested on quality products and services and value for their money.

2.4 The impact of finance on the financial statements

The influx of funds in terms of retained profits, share issue income, grants, and loans among others has effects on the balance sheet and the loss and profit account appearance (Rich, Jones, Mowen, & Hansen 2013). Increase in the retained earnings changes the amount of the net income and will appear in the balance sheet under shareholders' equity portion. Loans are liabilities are could be categorized as short term or long term liabilities, and they are entered as long term liabilities in the balance sheet. The management has to be aware of retained earnings as they are used for appropriations. Increase in finances improves the appearances of the financial statements, thus prompting potential investors to invest (Rich et al. 2013).

4.1 The main financial statements

These are the formal records of the financial activities of a company. The major financial statements are the profit and loss account, the Balance Sheet, and the cash flow statement (Khan  & Jain 2008; Coles 1997). The balance sheet also referred to as Statement of Financial Position provides information related to the financial position of a company. The major elements of a balance sheet are assets, liabilities, equity. The assets show what the company owns and control, liabilities shows what the company owes to creditors or banks, while equity shows what the business as an entity owes to its shareholders (Maritz 2005; Coles 1997). Assets are usually divided into current assets, fixed assets, and other forms of assets such as copyrights, royalties, and patents (Maritz 2005; Coles 1997). On the other hand, liabilities are current liabilities (such as accounts payable and accrued expenses) and long term liabilities such as long term bank loans and mortgages and equipment loans among others. Therefore, a balance sheet provides a snap view of an organisation (Palepu &  Healy 2007).

Income statement is also referred to the profit and loss account/statement. This type of financial statement is used to provide the financial performance of a company in terms of loss or profits over a given period of time (Maritz 2005). The key elements of the profit and loss statement are expenses and income. Expenses entail all the costs accrued by the business for a specific period, while income shows what the business has accumulated in terms of dividend income and sales revenues among others (Palepu & Healy 2007). The cash flow statement is used to present the movement in bank and cash balances over a specified period of time (Khan & Jain 2008). The major classification of cash flows are operating activities, investing activities, and financing activities.

4.2 Formats of financial statements for different types of business

Different types of business such as self-employed, partnership, limited company and public limited company use different formats of financial statements in terms of details, content, and structure. In respect to profit and loss statement, a sole trade/self employed prepares a simple profit and loss statement in comparison to a public limited company that has to prepare its statement based on GAAP or IFRS standards (Izhar & Hontoir 2000; Khan  & Jain 2008). For partnerships, the statement provides the profits and the interests of the company. Moreover, it analyzes the profits and the capital of the company compared to a limited company that has to reflect non-current assets, earning per share, sales profits, liabilities, and the cost of income tax payable.

With respect to balance sheet, small owned business prepare simple balance sheet compared to partnership, limited or public limited company (Khan & Jain 2008).  For small business, the major components are total assets (such as equipment, cash, and investment among others), total liabilities in terms of what is owned to others, and equity, which is the difference accrued from the total assets and total liabilities (Anthony 2013; Bhabotosh 1990). For large companies such as corporations, partnerships, or limited companies, assets are broken down into long term and current assets, and long term liabilities. Public limited company includes shares of the company into its balance sheet which are not included in other forms of businesses (Epstein, Nach & Bragg, 2009)

 

 

 

 

 

 

 

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