Analysis of Financial Statement and Ratios
The firm has a low quick acid test ratio. This indicates that the firm cannot pay its debts from the most liquid assets when they fall due (Saleem, Q., & Rehman, R. U., 2011). From the computation, the ratio is much lower than required. Also, the company’s operating profit margin is quite low. Even though the business records a retained earnings, the operating profits are meager. However, the firm can still cover all the operating profits. The return to the lenders of this firm is low. The firm can only manage to return up to the rate of 24.64% from the calculation.
The firm’s debt to equity ratio is more because of the extensive borrowing. The 1.52 ratio indicates that the total liabilities are more than the owner’s funds by that ratio. Basing on this, one can tell that the business is not doing well. It relies on borrowing. On the other hand, the interest coverage ratio provides a clear picture of how many times the operating income covers the interest expense. From the computation, the figure is lower. This indicates a staggering firm.
Some of the strategies that can be utilized to save the firm would be to lower the rate of borrowing, increase sales through aggressive advertising or raising prices, and lowering the operating expenses. Also, the firm should over discounts to attract more customers and lower the closing inventory. Finally, the firm should reduce gearing.
Factors that a business should consider regarding sources of finance
Additional capital to the business is essential as it enables the company to expand and undertake crucial projects. However, this added capital’s origins should be evaluated before the industry resolves to take them. There are various factors to consider before a firm borrows money. These factors relate to the potential finance sources.
The availability of the security
Security refers to the firm’s assets used as collateral while taking the loan. For the business to resolve the source of finance, there must be a security to pledge against the loan. Some companies require that an asset be pledged to act as a security if the borrowing firm fails to honor its promise. Assets such as land and buildings are preferred as good quality for safety. Development expenditure and capitalized research usually are not preferred since they are intangible.
The cost of financing the loan
Another factor that a firm should consider before adopting a given finance source is financing such a loan. Different sources of finance have additional costs. Typically, debt financing is regarded as the cheapest source of finance (Gibson, C. H., & Boyer, P. A., 2013). For a company, debt finance would be less expensive compared to equity. Interest paid on the debt is not taxed. This because it is tax-deductible. In this case, the tax shield effect would favor the company by reducing its tax expense. Thus a business needs to evaluate all the finance sources in terms of their costs before deciding which is cheaper and affordable.
The risk being faced by the business
Another factor that a firm should consider before deciding on which finance source to venture into is its business risk. This is the operating profit volatility (Khan, S., 2015). A company should first evaluate itself to see if tits are either positively or lowly volatile regarding the operating profits. Business with high operating profit volatility is generally at increased risk if the operating profits decline. This is because the decreased profits may inhibit the payment of interests on finance sources. Thus, it is an essential measure for any firm to consider before deciding.
The company’s level of operating gearing
The concept simply implies the firm’s proportion of fixed operating costs to variable costs. When the fixed price balance is more, the operational gearing is said to be high. The high operating gearing is typically associated with operating profit volatility (Garba, A. S., 2011, p.39). This explanation is that fixed costs do not change with the sales revenues. Thus, the overall profits would be high when the sales revenue increases. When the revenues decrease, the operating profits would also decline. Companies with a high level of operational gearing should try to minimize their borrowing. Financial gearing is much incompatible with operational gearing. This is because the company may fail to pay its debt when the sales revenues decrease and the operating profits drop.
The period for loan payment
Finally, the company should consider the loan payment period for each finance source before resolving to borrow. Most companies offer different finances at different duration. Usually, capitals with longer payment terms have lower periodic payments, which may accumulate to a large amount of interest (Khan, S., 2015). This means that offering a short payment period typically requires a sizeable regular price that the company may not afford. Also, the firm should consider the allocation of the agreed charges to its principal and the interest to lower the overall cost of the loan.
From the discussion, a firm must evaluate all the available finance sources before making a final decision on what finance to take. Since some sources are cheaper than others, a rational business would adopt the affordable one. The firm should also look at the payment period offered by each loan. The risks associated with a company and the relevant security availability are also significant.
Financing start-ups in the business context
Business start-ups require financing just like the already existing businesses. The decision on which financing source is the best for the company is crucial. Not all finance sources apply to start-ps. They have specific capital requirements which unique characteristics. The three familiar finance sources for such businesses include personal investment, love money, and venture capital. The uniqueness of these sources gives them an upper hand over the others. The following discussion draws this uniqueness.
The personal investment
Most start-up businesses require that the owner commits themselves to their course by investing in their business savings (Liudmila, B., 2017). Personal investment can be in many forms. You can put some or all of their savings in the business. Additionally, one can sell their land and personal property and generate the sales proceeds into the start-ups. Private land and buildings can also be used as starting assets for the business. Given that most companies require land and buildings to commence, one can use own available assets to steer the operations.
The appropriateness of the personal investment
Personal investment is essential when starting a business as it will enable you to get funds outside. Most lenders would look at the portion of capital that is associated with personal savings before giving out loans. Personal savings acts as a stimulator for those who would like to invest in your business. Start-ups with a large proportion of personal savings give investors some security regarding loan financing. Thus, it is good to note that the more the owners’ contribution to the business, the better they can acquire external funds. Additionally, personal financing attracts more resources from even friends and family since it will be a severe undertaking.
They love money
Sometimes investing personal savings and resources may not be enough to get the business started. It is the owner’s responsibility to look for other financing sources for their businesses. Such finance sources should meet the minimum criteria required for funding startups. One of the best options usually helps from the family, friends, and couple. Love money is the funds family members, willing friends, relatives, and your wife or husband (Rossi, M., 2015 p.51). The source is referred to as the love of money because it revolves around people who have some personal connection with you. This type of finance is another important source for starting businesses. To work out properly, one has to notify these people promptly to avoid failure. Also, one should note that family funds result in them having a share in the business in equity.
Additionally, it is worth noting that most families do not have enough capital to lend out. Besides, business with family members may be complicated, and one should take many precautions before resolving it. Thus, one should consider such factors.
The appropriateness of love money as a financing source for start-ups
One of the reasons why love money is a good deal for starting a business is that family and friends maybe more understanding than anyone else since they are part of your network and they have a good knowledge of you (Montresor, S., & Vezzani, A., 2015, p93). In this case, any news from the business may be treated differently, unlike venture capitalists. When one communicates well about the expectations and risks involved in the industry, the family and friends may understand. Additionally, if the company becomes successful, it is always a nice feeling from those who trusted you with their money. Besides, borrowing money from friends and family is less complicated because they are willing to listen to you.
Another important aspect of financing for start-ups is the angels. These are wealthy people who are no longer in the job markets (Tarq, T., 2013). Most of these individuals are retired managers from known companies but are willing to employ their new starting business expertise to ensure their success. These people look for startups and generate their savings in them in addition to their expertise. Such a source of funds can be a relief to individuals who may not have assets to pledge as securities when sourcing for loans with some companies who may require collateral. This is because angels do not require collateral. One requirement for one to obtain assistance from angels is that they have the right to supervise the business to ensure transparency.
The appropriateness of angels as a financing source for startups
One may prefer angels because they do not require any assets for collateral. In this case, the funds come as a relief for those in such situations. Moreover, financing your business in this way is crucial as it comes with some lenders’ level of expertise. For a starting business to be successful, both finances and useful skills for operating are required. Angel financing comes as a complete pack.
Growing and expanding of the business
There are different stages a business goes through in its lifetime. Each location has its requirement regarding financing. The owners of such firms must recognize this vital point. For instance, the firm would require different finance sources at the startup stage. The same firm would require other funding sources for its expansion or growth. The familiar sources of finance for expanding a business are retained earnings, equity capital, and debt capital.
The retained earnings
Most firms do not use up all their net profits to pay dividends or other allocations. When a business makes a certain amount of net profits, a given portion is customarily set aside for growing the firm, research and development, and some significant projects that the firm sees relevant. Retained earnings are the part of net profits that the company does not allocate to dividends (Reeves, E. & Palcic, D., 2017, p.400). This is the final amount of profits after deducting all the expenses of any firm obligations. Such funds are essential for business growth. Most firms do not have retained earnings because of the high level of expenditures and dividends paid off. When sales revenue is less, it is hard for a company to record retained earnings since all the operating profits are allocated to either interests, taxes, and dividends.
The suitability of retained earnings as a finance source for business expansion
Retained earnings are suitable for expanding a firm because it is generated from within. It is less costly than other sources such as equity and debt capital that require some financing costs. A firm that has retained earnings has some advantages over those that do not appear due to the cost of financing saved in the process (Asero, R., 2011, p.129). Also, retained earnings can be guided by the firm. Given that retained earnings are the final item on the income statement, firms can manage their amount by re-evaluating their expenses and sales revenue. When the total expenses are less, and the sales revenue is more, the retained earnings would be high. In this case, the firm would have enough capital for its growth and expansion.
The equity capital for a firm’s expansion and growth
Apart from retained earnings, equity capital can also be employed to grow or expand a business. This is done by the firm selling some of its ownership stakes to investors after they assume the firm’s ownership as stockholders (Cotei, C., & Farhat, J., 2017, p.4). The stakes are sold as shares with equal amounts of weight. Equity funding does not require payment of interest to the lenders of money. In this case, the method can be a relief to the firms with no profits. However, it is good to note that equity funding dilutes the ownership. Since the firm sells off some of its shares to get funds for expansion and growth, the sold shares dilute the overall request, and the new owners assume the voting rights. The final profits are allocated to all the shareholders of the firm.
Suitability of equity capital as a finance source for business expansion
Equity funding is essential for growing a firm, especially when it has not made any money yet. This is because no interest payment is required on the net profits. However, the final profits are allocated as dividends to all shareholders.
Another source of funds that a company can adopt for its growth and expansion is borrowing from the outside, commonly known as debt capital. This can either be in the form of a bank loan or a debt issue. A bank loan is regarded as private borrowing. The debt capital is categorized as the corporate bond. In this case, many people can lend to the business (Sanyal, P. & Mann, C. L., 2010, p.16). Debt funding, unlike equity, requires interest to be paid annually and the principal at the end of the maturity period.
Suitability of debt capital in funding business growth
Borrowing in the form of a corporate bond is important for firms because they are cheaper than equity. This is because the interest on the debt capital is not taxable. The tax shield provided by the loan reduces tax expense for the firm (Ahmed, I. E., 2013, P.79)
NO, I would not continue with the project based on the NPV because the net present value is negative.
Payback (5.94 years)
NO, I would not continue with the project because the payback period is longer than the project’s economic life.
No, the firm’s minimum return rate is more than the ARR.
No, the project’s profitability index is less than one, and NPV is negative.
NO, the internal rate of return is less than the firm’s minimum rate of return.
Net Present Value (NPV)
NPV is one of the measures used to evaluate projects before purchasing. Net Present Value evaluates the projects by getting the difference between all the inflows’ present values and the outflows of a project (Boliari, N, 2016, p.40).
The pros of NPV
The Net Present Value method enables the firms to make a better decision as it considers the time value of money in evaluating a project.
The cons of NPV
The Net Present Value technique ignores some hidden costs such as such costs. Additionally, the method cannot be adopted when comparing projects with variable sizes.
The payback technique
This technique evaluates the projects by considering the time that would elapse before the initial investment is recovered. It tries to determine the project’s break-even point between the profits and the initial cost (Sarway, Z., 2020, p.57).
The merits of the payback technique
This method is preferred because it is easy for individuals to understand and apply. The method is not complicated to use. Additionally, the method is useful when comparing different projects.
The demerits of the payback method
The payback method does not consider the time value of money while evaluating the projects. Also, the technique does not consider the risks and opportunity costs.
The Accounting Rate of Return
ARR is easy to compute and understand. Also, unlike other methods, a project’s profitability is well pictured while using this measure of evaluation. The Accounting Rate of Return is vital for evaluating the firm’s current performance value. Also, the technique is favored by the owners since it considers the net earnings while appraising the projects (Beke, J., 2010, P.36)
Demerits of the ARR
The computations of ARR and ROI result in different values. This complicates decisions on whether to accept or reject the project. Additionally, the method ignores the external factors which may impact on project’s profitability. The measure does not consider the time value concept when evaluating a project (Caglayan, M., & Demir, F., 2014).
The profitability index evaluates the projects by dividing the cash flows by the given period (Saik, P. B., 2013, p107).
One of the merits of this technique is that it considers the time value of money. Additionally, the methods recognize the risks that affect the projects’ future cash flows. Accounting for risks helps predict how future cash flows would behave. Moreover, the PI is easy to compute and understand.
However, the technique also has some demerits that one needs to consider before its adoption. Profitability is challenging to use when it comes to estimating the opportunity cost. The method does not consider the already incurred cost –the sunk cost. The technique ignores such costs even though they are outflows.
Internal Rate of Return
Another common technique of appraising projects is the IRR. The method has the following merits: compute and understand the Internal Rate of Return as an appraisal technique. Besides, one does not need the hurdle rate when using this method. Also, the way considers the timing of all the future cash flows from the projects.
However, future costs usually are ignored when employing IRR. The project’s size is also ignored, especially when the comparison is required.