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Prepare a report of no more than 1,250 words addressing the following issues.

i.Using the reading list provided on the VLE, explain:

a.what is meant by Profit and Cashflow and how they are different

b.what is meant by Working Capital and in particular, the meanings of Receivables, Inventory and Payables

c.how changes in Working Capital affect Cashflow

ii.Apply the concepts in (i) above to this company to show how the way the company is being managed might affect its financial results.   You can use additional hypothetical numbers (ie ones that you make up yourself) to illustrate your answer.

iii.Analyse and recommend what steps should now be taken to improve this company’s cashflow through better Working Capital management.

What is meant by Profit and Cashflow and how they are different

  • The positive figure left after paying all the expenses from the total revenue earned is known as profit. The company makes profit when there is an increase in sales and decrease in debt (Periasamy, 2009).

The movement of cash in the business is known as cash flow. It refers to the in and out movement of cash in the firm. As and when the cash increase, it shows inflow of cash and when the same decreases, it reflects outflow of cash (Knight, 2012).

Profit

Cash flow

It is referred as net income derived from total sales.

It is referred as the money that flow in and out of the business.

It is very important for the growth of the business.

It is needed in the day to day activities of the business.

The statement is prepare on accrual basis.

Cash flow is prepared on cash basis.

It measures the potential of the company to generate profits.

It determines the liquidity and solvency position of the company.

Calculated by subtracting total expenses from total revenue made during a fiscal year.  

Derived from businesses’ operating, investing and financing activities.

  • Working capitalis basically the difference between firm’s current assets and current liabilities. The components of current assets include debtors, stock and cash. On the other hand, current liabilities include creditors and bank overdraft. It is that amount which required for conducting day to day operations of the business. Working capital’s size and composition can vary as per the type of industry. It generally represents the net investments made in short term assets (Watson and Head, 2010).

Receivables are also called as debtors of the company. They are those people to whom company sells its goods and services on credit and make them oblige to pay the required amount within a given time period (Jury, 2012).

Payables are company’s creditors. The people from whom company buys goods and services on credit and provide them the relevant amount in return within the given time period (Muller, 2011). 

Inventory is a component of current assets that includes the items, which an organization holds for the purpose of resale. The stock which is to be converted into cash within a year is known as inventory. It has three parts named as raw materials, WIP and finished goods (Gilbertson, Lehman and Harmon, 2013).

  • Changes in the working capital are basically reported in the cash flow statement while calculating the cash flow from operating activities. It is very obvious that as and when the capital changes, it will directly affect the cash flow. It rises when there is an increase in the value of current assets. This implies that company has invested its resources or cash which makes the outflow of cash. Similarly, the capital decreases when liabilities increases. This means that company has borrowed funds from outside which makes the inflow of cash. So, it can be said that changes in working capital stimulates the inflow and outflow of cash. Therefore, it is very necessary to critically analyse these changes as they affect the cash flow and overall position of the company (Faulkender, et al., 2012).

From the scenario provided about Rook & Cook Ltd., it is seen that though company has made an operating profit of £18 million last year and had a revenue of £220 million, it still lack cash in its business. The debt has been raised and RCL does not have enough cash to reduce the same. Moreover, the company fails to recover the amount of £20 million from the consignment of BricoFrance, due to a legal dispute. The position of its cash can be shown from a hypothetical cash flow statement:

Root & Cook Ltd

Cash Flow Statement

Amount (£m)

A

Cash flow from Operating activities

Cash collected from customers

100

Cash payment made

-80

Increase/Decrease in Working Capital

Increase in Creditors

45

Increase in Debtors

-9

Cash flow from Operating activities

56

B

Cash flow from Investing activities

Sale of an asset

20

Asset purchase

-50

Investment

-10

Cash used in investing activities

-40

C

Cash flow from Financing activities

Loan repayment

-80

Borrowings

37

Cash used in Financing activities

-43

Net decrease in cash

-27

Note: The cash flow statement is prepared as per the scenario given and some hypothetical figures are also taken.

The above cash flow of RCL shows a decrease in the amount of cash worth £27 million. This implies that even after making profits, company’s cash position is not good. It does not have the enough cash to meet its financial obligations. Though rise in creditors represents cash inflow but rise in the value of debtors reflects the cash outflow. Also the company has borrowings of £37 million and at the same time it has invested £10 million in the shares of RoboCut. Moreover, it has purchased an asset worth £50 million which again makes an outflow of cash. All such activities and the legal dispute affects the cash position of RCL and its overall performance. Hence, it is very necessary for the company to take correct measures regarding the same.

What is meant by Working Capital and in particular, the meanings of Receivables, Inventory and Payables

RCL can improve its liquidity position through working capital management. If the company manages its capital in a better way, it can enhance its cash position and can be able to pay off its debt. Certain steps can be taken by the company in order to improve its working capital management:

  • Managing trade receivables: RCL’s cash flow statement shows that debtors of the company are not properly handled. In order to improve its cash flow, company should timely collect its receivables so that more cash will flow into the business, which will be used for making payments.
  • Trade payables management: It is also very important for RCL to maintain good relations with its suppliers and creditors. By paying them timely, company can easily manage its payables and can be able to establish a trust among them. This will benefit RCL in long run when a need of raising funds arises (Damodaran, 2010).
  • Inventory management: It includes the items kept for the purpose of resale. RCL should properly categorize its inventory as raw materials, work-in –progress and finished goods. This is important because most of the times, a huge amount of money got tied up in the inventory which has become obsolete and is not as per the customer’s requirement. So it is very essential for the company to manage its inventories.
  • Forecast: RCL can critically review the past and current position of cash flow in the business and can make future plans regarding the same. Forecasting about future cash flow will help the company to make suitable and relevant decision regarding inflow and outflow of cash.
  • Managing the risk: A systematic and organised process of risk management must be followed by the company in order to measure and deal with the risk associated with the future operations. This help the company to face the uncertainties and contingencies in a very effective and efficient manner. The applied procedure should be according to the role of working capital (Aktas, Croci and Petmezas, 2015).

The above steps clearly define that, by following them company can improve its management of working capital, which eventually lead to the improvement in the position of RCL’s cash flow. The proper management of debtors, creditors and inventory will improve the working capital on a whole and also steps like forecasting and risk management leads to the improvement in overall liquidity position of the Rook & Cook Ltd.

  • Capital budgeting is basically a process followed by the organizations, for the purpose of making best investment decision. It is a tool used by the managers for selecting the best investment proposal among the available alternatives. Making a decision regarding investment is considered to be very critical as it involves the distribution of funds to the most suitable, profitable and appropriate project. So it is very important for the company properly evaluate each and every project for the purpose of achieving set goals (Morris and Daley, 2017).

Following are the reason why companies opt for capital budgeting techniques:

  • To determine the capital expenditure which is most profitable.
  • To measure the returns derived from replacing existing fixed asset.
  • To choose the best proposal among the alternatives.
  • To estimate the amount of funds require for making investments.
  • To find out the sources from where, money can be raised.
  • To select a particular project (Parrino, Kidwell and Bates, 2011).

Some steps are been included in the process such as identifying, analysing, reviewing and selecting the best investment proposal. The process is performed by the top management of the company and is considered as a dynamic function. Reason being, the changes in the environment of the organization can affect the decision regarding a particular project or proposal (Abor, 2016).  The capital budgeting process involves following stages:

  • Identification: It is the first step which deals with the preliminary screening of all the available options. Projects are identified by the managers and are kept for further evaluation and approval.
  • Estimation: In this stage, a capital budget is prepared for the projects which are selected. Estimates regarding the cash flow is made and the amount of funds required for the proposals is determined by the management.
  • Approval: After the proper identification and estimation, the proposal is sent for the approval to the desired authorities. Generally, projects which involve small expenditure are approved quickly than the ones in which huge expenditure is incurred. Such investment proposals has to go through the whole process of authorization and approval.
  • Evaluation: Once the project is approved, it is evaluated on the basis of incremental cash flows generated by it. The profitability of a proposal is evaluated by the management in this stage (Agarwal, 2013).
  • Implementation: This is the stage, where the project is ready to work upon. After proper evaluation it is implemented in the business.
  • Tracking: Project implementation comes along with the project tracking. All the implemented proposals are tracked timely and reports containing details about expenses and revenue earned by the proposal, are prepared.
  • Audit: A post completion audit is conducted in which actual cash flows are compare with the budgeted ones. Any variances or discrepancies are identified and the decision regarding continuity of the project
  • Methods of investment appraisal
  • Payback period: It is the simplest method used for evaluating an investment proposal. It shows the time taken by a project for recovering the initial cash outlay of that project. Management calculate this period, just to know about the viability of the project and to decide whether it is suitable to invest in particular option or not. It is calculated by dividing initial investment with annual cash inflow.  
  • Net Present Value: This method is mostly used and is taken as a basis for taking any investment decision. It is simply calculated by subtracting the PV of cash outflow from the total PV of cash inflow. NPV shows that whether a project is profitable or not. If it is positive then the project is accepted. If it is negative, project is rejected and if it is equal to zero, then the proposal can be either selected or rejected (DRURY, 2013).
  • Internal rate of return: It is that discount rate where PV of cash inflow is equal to the PV of cash outflow. A project having high IRR is considered to be more suitable for the investment purposes (Atrill and McLaney, 2009).

Methods

Merits

Demerits

Payback period

· A very popular and simplest method.

· Commonly used by the management.

· Does not consider the time value of money.

· More focused on determination of liquidity rather than profitability.

Net Present Value.

· Used for increasing firm value.

· Measures risk associated with a proposal along with the profitability.

· Difficult to find appropriate discount rate.

· Cannot be used for the proposals which have unequal investments.

Internal Rate of Return.

· True profitability is determined.

· Advance determination of cost of capital is not required.

· Involve repetitive calculations.  

· Assumption made can be wrong.

RCL has two options in which it can invest its funds. In order to know about the best option, the manager has applied capital budgeting techniques to both the options. Following are the options available with the company:

  • Investing the money in a reading venture which includes a construction on a site that will cost around £20 million. The operating life is estimated for 10 years.
  • Another option is Bristol venture which involves taking over an existing out dated plant amounted to £16 million. The life of the plant is 6 years.

Years

Cash flow (£ million)

0

-20

1

5

2

5

3

5

4

5

5

5

6

5

7

5

8

5

9

5

10

5

Calculation of Payback period

Years

Present values

Cumulative PV

0

-20

1

4.545454545

-15.45454545

2

4.132231405

-11.32231405

3

3.756574005

-7.565740045

4

3.415067277

-4.150672768

5

3.104606615

-1.046066153

6

2.82236965

1.776303497

7

2.565790591

4.342094088

8

2.332536901

6.67463099

9

2.120488092

8.795119081

10

1.927716447

10.72283553

PBP

4.63

Calculation of NPV

Years

Cash flow (£ million)

pvf@10%

Present values

0

-20

1

-20

1

5

0.909091

4.545454545

2

5

0.826446

4.132231405

3

5

0.751315

3.756574005

4

5

0.683013

3.415067277

5

5

0.620921

3.104606615

6

5

0.564474

2.82236965

7

5

0.513158

2.565790591

8

5

0.466507

2.332536901

9

5

0.424098

2.120488092

10

5

0.385543

1.927716447

NPV

10.72

Calculation of IRR

Years

Cash flow (£ million)

0

-20

1

5

2

5

3

5

4

5

5

5

6

5

7

5

8

5

9

5

10

5

IRR

21%

Years

Cash Flow (£ million)

0

-16

1

4

2

4

3

4

4

4

5

4

6

4

Calculation of Payback period

Years

Present values

Cumulative PV

0

-16

1

3.636363636

-12.36363636

2

3.305785124

-9.05785124

3

3.005259204

-6.052592036

4

2.732053821

-3.320538215

5

2.483685292

-0.836852922

6

2.25789572

1.421042798

PBP

                      4.63

Calculation of NPV

Years

Cash Flow (£ million)

pvf@10%

Present values

0

-16

1

-16

1

4

0.909091

3.636363636

2

4

0.826446

3.305785124

3

4

0.751315

3.005259204

4

4

0.683013

2.732053821

5

4

0.620921

2.483685292

6

4

0.564474

2.25789572

NPV

                       1.42

Calculation of IRR

Years

Cash Flow (£ million)

0

-16

1

4

2

4

3

4

4

4

5

4

6

4

IRR

13%

From the above evaluation, it can be said that the project which has high NPV and IRR along with low payback period is considered to be more desirable for investment, from investor’s point of view. Among the available options with RCL, first option is suitable as it has NPV of 10.72 and IRR of 21%, which is more than that of second option. The payback period of both the alternatives is same so by looking at the NPV and IRR, it is recommended to RCL that, it should invest its funds in reading venture for commencing the construction on a derelict site. This option is more profitable because of high NPV and IRR (Gotze, Northcott and Schuster, 2016). 

Conclusion 

The above report concludes that it is very important for the organizations to properly manage their working capital and maintain a better cash position to ensure effective and efficient. Along with the cash management, company should also critically evaluate its investment proposals by applying suitable investment appraisal methods. These techniques or methods form a basis for many of the investment decisions and also helps in increasing the profitability of the company.

References 

Abor, J.Y., (2016). Entrepreneurial Finance for MSMEs: A Managerial Approach for Developing Markets. Switzerland: Springer.

Agarwal, V., (2013). Managerial Economics. New Delhi: Pearson Education India.

Aktas, N., Croci, E. and Petmezas, D. (2015). Is working capital management value-enhancing? Evidence from firm performance and investments. Journal of Corporate Finance, 30, pp.98-113.

Atrill, P. and McLaney, E. (2009). Management accounting for decision makers. 4th ed. England: Pearson Education.

Damodaran, A. (2010). Applied corporate finance. 3rd ed. USA: John Wiley & Sons.

DRURY, C.M. (2013). Management and cost accounting. 3rd ed. New York: Springer.

Faulkender, M., Flannery, M.J., Hankins, K.W. and Smith, J.M., (2012). Cash flows and leverage adjustments. Journal of Financial Economics, 103(3), pp.632-646.

Gilbertson, C., Lehman, M.W. and Harmon-Gentene, D., (2013). Fundamentals of Accounting: Course 1. 10th ed. USA: Cengage Learning.

Gotze, U., Northcott, D. and Schuster, P., (2016). INVESTMENT APPRAISAL. 2nd ed. London: SPRINGER-VERLAG BERLIN AN.

Jury, T., (2012). Cash flow analysis and forecasting: the definitive guide to understanding and using published cash flow data (Vol. 653). USA: John Wiley & Sons.

Morris, J.R. and Daley, J.P. (2017). Introduction to financial models for management and planning. 2nd ed. Florida: CRC press.

Muller, M., (2011). Essentials of inventory management. 2nd ed. New York: AMACOM.

Parrino, R., Kidwell, D.S. and Bates, T. (2011). Fundamentals of corporate finance. USA: John Wiley & Sons.

Periasamy, P. (2009). Financial Management. 2nd ed. New Delhi: Tata McGraw-Hill Education Pvt. Ltd

Watson, D. and Head, A. (2010). Corporate finance: principles and practice. 5th ed. Pearson Education.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., (2009). Managerial accounting: tools for business decision making. 5th ed. USA: John Wiley & Sons.

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