Financial Statement Balance Sheet

FINANCIAL STATEMENTS

Notes to the Financial statement

1.1 Retained Earnings. The Academic Analysis brief did not provide the value of the retained earnings, so to calculate retained earnings, the formula below was employed.

Retained earnings = Total Assets – Total liabilities & equity

   2560 – 2390 = 170

1.2 Cost of Goods Sold. The cost of goods sold is equal to the opening inventory plus purchases minus the closing inventory

Based on the Academic Analysis brief;

Administrative Expenses. For this analysis, administrative expenses are made up of wages and interest.

Occupancy costs. These are made up of rent and utilities.

Other Expenses. This is made up of the loss from sale of machinery.

Part 2.

Financing – Risks and Returns

2.1

Below are some feature/characteristics that a business owner can consider when seeking potential sources of funding for their business.

Fees

When considering funding sources, it is important to check out the fees to establish how much the loan will cost. Different lenders charge different fees, and these could include establishment fees, ongoing monthly fees, early repayment fee, exit fee and refinancing fees. (ASIC, 2018)

 Security

A security is a financial instrument, that basically holds monetary value and can be readily traded. Equity or Stock and debts or bonds are the most common types of securities. Equity securities give the holders some rights and control of a firm via voting rights. Debt securities ‘represent money that is borrowed and must be paid back with interest’ (Kenton, 2018). Debt securities can be secured or unsecured (Bragg, 2018; Kenton’ 2018).

Time of maturity

Relevant to debt, Maturity refers to the remain life of a debt instrument. The time of maturity is the point in time when a debt needs to be repaid in full. For bonds and debt securities, the principle is not paid until the maturity date. (Chen, 2018)

Collateral

Collateral is an easy concept. It is a property, or an asset offered by a borrower to secure a lone. This asset can be seized by a lender if the borrower defaults on their debt. Business owners may offer property to a bank when they need to borrow funds to finance their business. (Kagen, 2018)

Default.

Default is when a borrower fails to make debt repayments of interest or principal on a loan when due. ‘if a business issues bonds and it is unable to make coupon payments to its bondholders, the business is in default on its bonds. When deciding whether to issue a loan or invest in a debt security, lenders and investors must carefully consider the chance of default and must manage its risk’ (Chen, 2018).

2.2

Below are three sources of financing suitable of financing for a start-up firm.

Credit cards

Credit cards offer a lot of flexibility and can be an effective way to finance a start-up and get the business off the ground. Most owners of start-up usually do not have collateral and may not qualify for bank loans, credits cards can be used for fast and flexible access to finances for a start-up.

Several credit cards offer 0% interest pa for 12 to 24 months, so this gives start-up owners an opportunity to build a paper trail and show the banks how your business uses money and pays it off. (Treece, 2018; Peavler, 2018)

  Personal Savings

Along side Credit cards, Personal saving can be another great and flexible way to start-up a business. It is likely that a start-up owner will have to use some of their own money to invest in the business. Self-financing is very cost effective in that start-up owners retain full ownership of the business and do not need to payback or rely on outside sources like lenders and investors.

The drawback of using your personal savings to finance a start-up is that it could be strain on your personal and family life, and if managed poorly can not only lead to business failure but could leave start-up owners with no money for day to day living (Oxley, 2017).

Family and Friends

Borrowing money from family and friends is one of the primary sources for funding a start-up in the early stages, and this method will complement using your own personal savings. Here you, and every family member or friend can have shares in your start-up. This also reduces on the strain of using mostly your personal savings.

Funding from friends and family can be in terms of gifts, or in terms of equity. There are lots of ways to structure friends and family agreements and getting a lawyer is highly recommended.

2.3

Here are three sources of financing suitable for a growing –expansion firm.

Debt Finance

A growing firm can apply for a bank loan at this stage. Debt finance is getting money in form of debt like a loan from a bank.  A sound business plan will be required, as well as profitable business projections and some money of your own. Banks will need to see that business owners can still invest their own money in their businesses.

With debt finance, business owners still have full control and still fully own profits from their business. The biggest risk from debt finance is bankruptcy is finances and repayments are poorly managed (Business, 2018)

Funding from Internal sources

A firm can fund its growth and expansion from internal sources, and depending on the nature of the business, these are likely to be retained profits from previous years, sales of machinery and effective use of capital.

Funding through retained earnings/profits for example does not add to your debt and allows business owners to ‘maintain full control of your business rather than complicating the picture with creditors, new partners or outside investors’(Decker, n.d.).

Venture capital and Angel investors

Venture capitalists are investors who invest funds in business that are ‘believed to have long-term growth potential’ (Kenton, 2018). Investments from venture capitalists are not limited to monetary funds. Venture capitalists are high net worth professional individuals – commonly known as angel investors and are already successful in their field of business, so they can also offer technical and managerial expertise for start-up and growing business.

Business owners should keep in mind that with Angel investors, ‘they will own a piece of the business and business owners then have a fiduciary responsibility to act in the best interests of the business and its shareholders’ (Gleeson, 2013)

Part 3.

Cashflow Estimation and Project Evaluation.

3.1

The rate of diminishing value of depreciation is 40%

Diminishing value = 2 x 1/5 = 0.4 = 40%

The straight-line depreciator rate is 1/5 = 0.2=20%

The straight-line depreciator rate is cost (200,000) minus the salvage value (10,000), which is (190,000).  20% x 190,000 = 38,000.

The straight-line depreciator rate is $38,000.

The table below show the dollar amount of depreciation and book value each year.

Based on the brief of this analysis, we see that asset does not depreciate to zero as required, there fore a write-off of the assets value is applied in year 5.

3.2

The table below shows ABC Pty Ltd incremental EBIT in years 1 to 5 and it’s after tax earnings.

EBIT = Revenue – Expenses.

3.3

The table below shows the firm’s incremental free cash flows in years 0 to 6.

3.4

Based on the table above, the Net Present Value of the decision to proceed with this project is calculated below.

The Net Present Value is defined as the sum of the present values of incoming and outgoing cash flows over a period time. If Net Present Value is a postive value, it results in profit. .

Where r = discount factor, and -t = years.

Discounted Cash flow = discount factor x initial outlay.

The NPV of the Project for ABC Pty Ltd results in a profit and based on this the project should be implemented.

NPV is the optimal decision tool for project evaluation.

3.5. Discuss alternative evaluation measures and their pros and cons.

Accounting-based measure, tools and techniques are used by firms to evaluate projects suitable for capital budgeting. The evaluation measures presented below are mainly used because of their simplicity and ease of use and interpretation (Megginson, Lucey, & Smart, 2008)

Payback

Payback period is the amount of time required for a project to repay an initial investment for a project (Law, 2014). Using this project evaluation technique, a firm can determine whether to accept a project or not.

The decision rule to follow when evaluating a project using the payback method is to accept the project if the payback period is shorter than the required time frame projected by of a firm (Kagen, 2018).

Payback Formula:

Payback = $\frac{\mathit{Initial\; investment}}{\mathit{cashflow\; per\; year}}$

The main advantage for the use the payback period is its simplicity. Even though the payback method has been the subject of much criticism (Lefley, 1996; Weingartner, 1969), many financial analysts still use it as ‘supplementary tool supporting the more sophisticated IRR/NPV methods’ (Lefley, 1996. Pg 216).

The Payback period is also easy to use as a comparison tool several projects to determine which project a firm can accept or reject based on the shortest payback period.  (Woodruff, 2018).

The drawback of the Payback period is it does not give any account to the time value of money which is a very important concept in finance (Kagen, 2018). The Payback method also ignores the cash flow after the payback period, thus there is no opportunity to generate additional cash flows. (Bragg, 2018).

Accounting Rate of Return (ARR)

Accounting Rate of Return, is an accounting ratio that expresses the amount of profit of an organisation’s investment before interest and tax. (Law, 2016; Kenton, 2018). The Accounting Rate of return is “not only a central feature of any basic text on financial statement analysis but also figures commonly in the evaluation by investment analysts of the financial performance of firms”(Whittington 1988, 261) as cited in Brief & Lawson, 1992. Pg 411)

Accounting Rate of Return formula:

Accounting Rate of Return =  $\frac{\mathit{Average\; net\; income}}{\mathit{Average\; Investment}}$

Accounting Rate of Return is used to evaluate projects for inclusion in capital budget, and a project is accepted if the Accounting Rate of Return is greater than the target rate. Some analysts use it as an additional point of reference in a capital budgeting decision technique (Penman, 1991).

The Accounting Rate of Return can be useful when a firm decides to compare a new asset’s rate of return against that of an existing assets’ Return on Asset (Ducere, 2018)

The main drawbacks of the Account rate of Return is the lack of consideration of cash flows or Time Value of Money which can be an integral part of maintaining a business (Kenton, 2018).

Profitability Index (PI)

PI is another technique of evaluating whether a project should be included in a capital budget or not.

Profitability Index Is the ratio of the present value of cash inflow to the initial investment outlay.

Profitability Index = $\frac{\mathit{Present\; Value\; of\; future\; cash\; flows}}{\mathit{Initial\; cost}}$

The decision rule to follow when evaluating a project using the Profitability Index method is to accept it if the Profitability Index is greater than 1.0 and reject the project if Profitability Index is less than 1.0. A project is also accepted if the Profitability Index is equal to 1.0 (Megginson et al., 2008)

The Profitability Index method is best used along side Net Present Value measurements. On its own, it does not give an accurate representation of a ‘project with the highest value contribution to a firm’. (Ducere, 2018 slide 34)

Internal Rate of Return (IRR)

The Internal Rate of Return is the rate at which a project breaks even, or ‘the rate that forces the present value of the inflows to equal the cost’ (Ducere, 2018. Slide 35)

The decision rule for Internal Rate of Return is if a project with an Internal Rate of Return greater than the cost of capital, then the project is acceptable.

Just like the Profitability index, the Internal Rate of Return can be misleading when used alone.

Because of its tedious nature, Internal Rate of Return is calculated either through trial and error or using excel, scientific calculators or specific software programmed to calculate it. (Kenton, 2018; Ducere 2018).

REFERENCES

• ASIC. (2018, September 11). Fees. Money Smart. Financial guidance you can trust. Retrieved from https://www.moneysmart.gov.au/borrowing-and-credit/home-loans/fees
• Bragg, S. (2018, December 03). Payback method | Payback period formula. Accounting Tools. Retrieved from https://www.accountingtools.com/articles/2017/5/17/payback-method-payback-period-formula
• Bragg, S. (2018, November 15). Equity security. Accounting Tools. Retrieved from https://www.accountingtools.com/articles/2017/5/6/equity-security
• Brief, R., & Lawson, R. (1992). The Role of the Accounting Rate of Return in Financial Statement Analysis. The Accounting Review, 67(2), 411–426.
• Business, (2018, August 24). Finance for your business. Retrieved from https://www.business.gov.au/new-to-business-essentials/series-four/finance-for-your-business
• Chan, K., Karolyi, G., Longstaff, F., & Sanders, A. (1992). An Empirical Comparison of Alternative Models of the Short‐Term Interest Rate. Journal of Finance, 47(3), 1209–1227. https://doi.org/10.1111/j.1540-6261.1992.tb04011.x
• Chen, J. (2018, February 28). Maturity. Investopedia. Retrieved from https://www.investopedia.com/terms/d/default2.asp
• Chen, J. (2018, February 8). Maturity. Investopedia. Retrieved from https://www.investopedia.com/terms/m/maturitydate.asp
• Decker, Fred. (n.d.). Pros & Cons of Financing Expansion Through Retained Earnings. Small Business – Chron.com. Retrieved from http://smallbusiness.chron.com/pros-cons-financing-expansion-through-retained-earnings-40390.html
• Ducere 2018. 9614 Finance for Managers Slide 25. Retrieved from https://learning.ducere.edu.au/course/view.php?id=1691
• Ducere 2018. 9614 Finance for Managers Slide 30. Retrieved from https://learning.ducere.edu.au/course/view.php?id=1691
• Gleeson, B. (2013, August 29). 4 Realistic Ways To Fund Your Small Business. Forbes. Retrieved from https://www.forbes.com/sites/brentgleeson/2013/08/29/4-realistic-ways-to-fund-your-small-business/#37ac0d3340be
• Kagen, J. (2018, August 4). Collateral. Investopedia. Retrieved from https://www.investopedia.com/terms/c/collateral.asp
• Kagen, J. (Jan 2018). Payback Period. Investopedia. Retrieved from https://www.investopedia.com/terms/p/paybackperiod.asp
• Kenton, W. (2018, June 28). Accounting Rate of Return (ARR). Investopedia. Retrieved from https://www.investopedia.com/terms/a/arr.asp
• Kenton, W. (2018, May 4). Security. Investopedia. Retrieved from https://www.investopedia.com/terms/s/security.asp
• Law, J. (2014). payback period. A Dictionary of Finance and Banking. Oxford University Press. Retrieved from http://www.oxfordreference.com/view/10.1093/acref/9780199664931.001.0001/acref-9780199664931-e-2775
• Law, J. (2016). accounting rate of return. A Dictionary of Accounting. Oxford University Press. Retrieved from http://www.oxfordreference.com/view/10.1093/acref/9780198743514.001.0001/acref-9780198743514-e-60
• Lefley, F. (1996). The payback method of investment appraisal: A review and synthesis. International Journal of Production Economics, 44(3), 207–224. https://doi.org/10.1016/0925-5273(96)00022-9
• Longstaff, F., & Schwartz, E. (1992). Interest Rate Volatility and the Term Structure: A Two‐Factor General Equilibrium Model. Journal of Finance, 47(4), 1259–1282. https://doi.org/10.1111/j.1540-6261.1992.tb04657.x
• Megginson, W. L., Lucey, B. M., & Smart, S. B. (2008). Introduction to Corporate Finance: Cengage Learning.
• N. Berger, A., & F. Udell, G. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of Banking and Finance, 22(6), 613–673. https://doi.org/10.1016/S0378-4266(98)00038-7
• Oxley, B. (2017, July 20). USING PERSONAL FUNDS TO LAUNCH: PROS AND CONS. Dynamic Business. Retrieved from https://www.dynamicbusiness.com.au/small-business-resources/growing/using-personal-funds-to-launch-pros-and-cons.html
• Peavler, R. (2018, March 09). Using a Credit Card Financing to Start a Small Business. Retrieved from https://www.thebalancesmb.com/credit-cards-starting-business-393140
• Penman, S. (1991). An Evaluation of Accounting Rate-of-return. Journal of Accounting, Auditing & Finance, 6(2), 233–255. https://doi.org/10.1177/0148558X9100600204
• Treece, D, D. (2018, June 22). Business Credit Cards, Financing, Starting a Business. Retrieved from https://fitsmallbusiness.com/when-to-use-a-credit-card-to-fund-your-business/#
• Weingartner, H. M. (1969). Some new views on the payback period and capital budgeting decisions. Management Science, 15(12), B-594.
• Woodruff, Jim. (2018, June 29). Advantages & Disadvantages of Payback Capital Budgeting Method. Small Business – Chron.com. Retrieved from http://smallbusiness.chron.com/advantages-disadvantages-payback-capital-budgeting-method-14206.html