and transport the stocks and insurance of stocks is recommended. If finance has to be borrowed to buy the stocks, then this will incur interest charges. Lower stock levels are likely to reduce these costs significantly. 3. Risk of wastage and obsolescence – if stocks are not used or sold as
rapidly as expected, then they probably deteriorate or become out-dated. Goods often become damaged whilst held in storage or being moved. Costs of not holding enough stocks.
This occurs when a business can is not able to operate the JIT system. However there are risks to holding low stock levels, these have financial costs for the firm. These costs are often called ‘stock-out’ costs:
1. Lost sales- if a firm is unable to supply customers form stock, then sales could be lost to other firms, this could lead to future losses too. Also in purchasing contracts between businesses, there may be a penalty- payment if stock is late.
2. Idle production resources – if stocks of resources run out, production will have to stop. This will leave expensive equipment idle and labour with nothing to do.
3. Special orders could be expensive
4. Small order quantities - keeping low stock levels may mean only ordering goods and supplies in small quantities, the firm may lose on bulk
discounts, and transport costs will be higher as more deliveries will have to be made.
Controlling stock levels- a graphical approach
Stock control charts are widely used to monitor firm´s stock position. These charts record
- Levels of stock - Stock deliveries
- Buffer stocks-the minimum stocks that should be held to ensure that production could still take place should a delay in delivery occur or should production rates increase. The greater the degree of uncertainty
about deliveries times or production level, then the higher the buffer stock level will have to be.
- Maximum stock levels over time- this may be limited due to space or
- Reorder quantity- the number of units ordered each time .They will be
influenced by the economic order quantity.
- Lead time- the normal time taken between ordering new stocks and their delivery. The longer the period of time, then the higher will have to be the re-order stock level.
Just in time (JIT) stock control.
JIT: this stock control method aims to avoid holding stocks by requiring supplies to arrive just as they are needed in production and completed products produced to order.
For JIT requirements to be met there are certain very important things that have to be done
- Relationship with suppliers have to be excellent-
- Production staff must be multi skilled and prepared to change jobs at short notice
- Equipment and machinery must be flexible and be there at all times - Accurate demand forecasts will make JIT a much more successful policy - The latest IT equipment will allow JIT to be more successful.
- Excellent employee-employer relationships are essential for JIT to operate smoothly
- Quality must be the priority, as no essential spare stocks to fall back on.
Advantages Disadvantages
Capital invested in inventory is reduced and the opportunity cost of stock holding as well
any failure to receive goods of material or components may lead to expensive production delays
Costs of storage and stock are reduced delivery costs will increase as frequent small deliveries are an essential
feature for JIT much less stock becoming out dated or
processed The multi skilled adaptable staff
required for JIT to work may gain from improved motivation
The reputation of the business depends significantly on outside factors such as the reliability of supplying firms
JIT evaluation
JIT requires a very different organisational culture to that of other stock control systems that are often referred to as JIC- holding stock JUST IN CASE.
JIT may not be suitable for all firms at all times:
- There may be limits to the application of JIT if the costs resulting from the production being halted when supplies do not arrive far exceed the costs of holding buffer stock of key components
- Small firms could argue that the expensive IT system needed for JIT effectively cannot be justified by the potential cost savings.
- Rising global inflation make holding stocks of raw material more beneficial as it may be cheaper the buy a large quantity now than smaller quantities in the future when prices may have risen.
Chapter 24
Introduction to business finance.
No business activity can take place without some finance- or the means of purchasing the materials and assets needed before the production of a good or provision of a service can take place. Finance decisions are some of the most important that managers have to take. The range and choice of finance sources are extensive and skilled managers will be able to match accurately the need of their business for particular types of finance with the sources available.
Why business activity requires finance.
Finance is required for many business activities, like for example: • Setting up a business
• For the day to day finance- for bills and expenses • To expand
• Finance is needed to buy out the owners of the other firm • Special cases- more finance is needed in the recession mode. • Research and development into new products or to invest in new
Start-up Capital- Capital needed by an entrepreneur to set up a business
Working capital- The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. In accounting terms working capital= current assets-current liabilities.
Capital and revenue expenditure.
Capital Expenditure- Involves the purchase of assets that are expected to last for more than one year, such as building and machinery
Capital Revenue- is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock.
Working capital - meaning and significance.
Working capital is often described as the “lifeblood” of a business. Finance is needed by every business to pay for everyday expenses, such as the payment of wages and buying of stock. Without sufficient working capital a business will be illiquid- unable to pay its immediate or short-term debts.
Liquidity- the ability of a firm to be able to pay its short-term debts
Liquidation- when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors.
The simple calculation for working capital is: current assets less current liabilities. Virtually no business could survive without these three assets: Inventories, accounts receivable and cash in the bank.
How much working capital is needed?
Sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts. Too high level of working capital is a disadvantage; the opportunity cost of too much capital tied up in inventories,
accounts receivable and idle cash is the return that money could earn elsewhere is the business
The working capital requirements for any business will depend upon the “length” of this ·working capital cycle”. The longer the time period from buying materials to receiving payment from customers, the greater will be the working capital needs of the business.
As the diagram shows, if credit to customers given by the business will lengthen the time before a sale is turned into cash. Credit received by the business will lengthen the time before stock bought has to be paid for. To give more credit than is received is to increases the need for working capital. To receive more credit than is given is to reduce the need for working capital.
Manager’s working capital efficiently is vital for all businesses. Where does finance come from?
Companies are able to raise finance from a wide range of sources. It is useful to classify these into:
Internal sources of finance Profits retained in the business
If a company is trading profitably, some of these profits will be taken in tax by the government and some is nearly always paid out to the owners or
shareholders (dividends). If any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities.
Sales of assets.
Established companies often find that they have assets that are no longer fully employed. These could be sold to raise cash. In addition, some businesses will sell assets that they still intend to use, but which they do not need to own. In these cases, the assets might be sold to leading specialists and leased back by the company. This will raise capital, but there will be an additional fixed cost in the leading and rental payment.
Reduction in working capital
When businesses increase stock levels or sell goods on credit to customers, they use a source of finance. When companies reduce these assets – by reducing their working capital – capital is released, which acts as a source of finance for other uses.
Internal sources of finance – an evaluation
This type of capital has no direct cost to the business if assets are leased back once sold, there will be leasing charges. Internal finance doesn´t increase the liabilities or debts of the business, and there is no risks of loss of control by the original owners as no share are sold.
External sources of finance Short – term sources
Bank overdrafts
This means that the amount raised can vary from day to day, depending on the particular needs of the business. The bank allows the business to “overdraw” on its account at the bank by writing cheques to a greater value than the balance in the account. This overdrawn amount should always be agreed in advance and always has a limit beyond which the firm should not go. Business may need to
increase the overdraft for short periods of time if customer’s don´t pay as quickly as expected or if a large delivery of stocks has to be paid for.
Trade Credit
This means when suppliers provide goods without receiving immediate payment and this is the same as “lending money”. These process of “lending money” is not free because discounts and supplier confidence is lost.
Debt factoring
This means selling of claims over debtors to a debt factor in exchange for
immediate liquidity – only a proportion of the value of the debts will be received as cash.
Overdraft – bank agrees to a business borrowing up to an agreed limit as and
when required.
Factoring - selling of claims over debtors to a debt factor in exchange for
immediate liquidity – only a proportion of the value of the debts will be received as cash.
Sources of medium – term finance
Hire purchase – an asset is sold to a company that agrees to pay fixed
repayments over an agreed time period – the asset belongs to the company.
Leasing – obtaining the use of equipment or vehicles and paying a rental or
leasing charge over a fixed period. This avoids the need for the business to raise long – term capital to buy the asset. Ownership remains with the leasing
company.
Long – term finance
Long term loans – loans that don´t have to be repaid for at least one year Equity finance – permanent finance raised by companies through the sale of
shares.
Long-term bonds or debentures;
Long-term bonds or debentures: bond issued by companies to raise debt finance, often with a fixed rate of interest.
A company wishing to raise funds will issue or sell such bonds to interested investors. Company agrees to pay a fixed rate of interest each year for the life of the bond, which can be up to 25 years. Long-term loans or debentures are usually not secured on a particular asset to gain repayment, the debentures are known as mortgage debentures.
Sales of shares-equity finance;
All limited companies issue shares when they are first formed. Capital raised will be used to purchase essential assets. Sell shares to the wider public means potential benefits for a business. Also there’s a risk of the loss of control over the business by the stakeholders. This can be done by two ways:
• Obtaining a list on the Alternative Investment Market (AIM), part of the stock exchange concerned with small companies that want to raise limited amounts of additional capital.
• Apply for a full listing on the Stock Exchange by satisfying the criteria of (a) selling at least 50,000€ worth of shares and (b) having a satisfactory trading record to give investors some confidence in the security of their investment.
Public issue by prospectus – advertises the company and its shares sale to
the public and invites them to apply for new shares. This is expensive, as it has to be prepared and issued.
Arranging a placing of shares with institutional investors without the expense of a full public issue- once a company has gained plc. status, it is
still possible for it to raise further capital by selling additional shares.
Rights issue: existing shareholders are given the right to buy additional shares at a discounted price.
Debt or equity capital – an evaluation; Debt finance, advantages:
• No shares sold, ownership of the company does not change.
• Loans will be repaid eventually, there’s no permanent increase in the liabilities of the business
• Interests changed are an expense of the business and are paid out before corporation tax is deducted.
• Gearing of the company increases, this gives shareholders the chance of higher returns in the future.
Equity capital, advantages:
• Never has to be repaid, permanent capital
• Dividends do not have to be paid every year; in contrast, interest on loans must be paid when demanded by lender.
Other sources of long-term finance;
Grants: Many agencies that are prepared under circumstances, to grant fund to
businesses. Two major sources in the most European countries are the central government and the European Union. Grants often have conditions attach to it, such as location and the number of jobs created, if conditions are met, grants do not have to be repaid.
Venture: Small companies that are not listed on the Stock Exchange –
‘unquoted companies’-can gain long- term investment funds from venture capitalist. Special organizations or wealthy individuals, prepared to lend risk capital to or purchase shares in, business start-ups or small to medium-size business that might find it difficult to raise capital from other sources. Venture capital it’s a great risk as they could lose all of their money.
Venture capital: risk capital invested in business start-ups or expanding small business that have good profit potential but do not find it easy to gain finance from other sources.
Finance for unincorporated business;
Unincorporated business: sole trades and partnerships, cannot raise finance from the sale of shares and are most unlikely to be successful in selling debentures as they are likely to be relatively unknown firms. Owners of these businesses will have access to bank overdrafts, loans and credit from suppliers. They can borrow money from family and friend and use the savings and profits made by the
owners.
Any owner of an unincorporated business runs the risk of losing all property owned if the firm fails.
Grants are available to small and newly formed business as part of most government’s assistance of small business
Micro finance
This approach to provide small capital sums to entrepreneurs has grown in importance in recent years. Microfinance is the provision of financial services to low-income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services.
Finance and stakeholders
Providing finance to a business creates a stakeholder relationship with that business. All stakeholders have certain rights, responsibilities and objectives, but these will differ between the various sources of finance.
These are the three main providers of company finance
Shareholders - Part ownership of the company in proportion to the number of shares owned - To attend the AGM and vote - To receive a dividend by the board - Capital investment cannot be claimed back from the company, except when it ceases trading - Receive an annual return on investment in shares - To receive capital growth through an increase in share price Banks - To receive interest payments as laid down in the loan or overdraft agreement - To be repaid before shareholder s if the company is wound up - To check on business viability before loan or overdraft is agreed, this is both a responsibilit y to the banks and the companies’ shareholder s - To make a profit - To receive repayment of capital at the end of the loan term Creditors - To receive payment agreed - To be paid before shareholder s in the event of the business being wound up - To provide regular statements of amount owing and terms of repayment - To provide credit to encourage the business to purchase stock
Raising external finance- the importance of a business plan
Business plan- detailed document giving evidence about a new or existing business, and that aims to convince external lenders and investors to extend finance to the business.
Business plans do not guarantee the success of a business, but they are likely to increase the chances of avoiding failure. This plan does not only provide
- Forces the owners to think long and hard about the proposal, its strengths and potential weaknesses
- Gives the owner and managers a clear plan of action to guide their actions and decisions
Making a financing decision
You need to use the following steps:
Decision making typically follows a six-step process: 1. Identify the problem or opportunity
2. Gather relevant information
3. Develop as many alternatives as possible 4. Evaluate alternatives to decide which is best 5. Decide on and implement the best alternative 6. Follow-up on the decision
Factors influencing finance choice Why significant
Use to which finance is to put. - It is very risky to borrow long term finance to pay for short term needs. Businesses should match the sources of finance to the need for it
- Permanent capital may be needed for long term business expansion
Cost - Obtaining finance is never free
- Loans may become very expensive during a period of rising interest
- A stock exchange flotation can cost millions of dollars
Amount required - Shares issues and sales of debenture, because of the administration and other costs , would generally be used only for large capital sums
- Small bank loans or reducing debtors payment period could be used to raise small sums
Legal structure - Shares issues can only be used by limited companies.
- If the owner want to retain control of the business at all costs, then a sales of shares