Essay: Financial Management Communication - Excellence Electrics Ltd Analysis.

Excellence Electrics Ltd (“EEL”) owns and operates three factories in London, Birmingham and Manchester producing electrical components for household appliances. The company last year had turnover in excess of £35 million.The company is managed by Dieter Braun, the grandson of the founder who established the business in the 1930s making radio parts. Dieter owns 25% of the shares in the company, while the remaining 75% is split between three other grandchildren, Hild, Angela and Ragnar.
Most of EEL’s clients are large manufacturers in the UK and EU. Two key customers are Canterbury Cookers Ltd and Radios Formidables SA.The other shareholders are concerned about the business. Although there seems to be plenty of work coming in and the last year has been reasonably profitable(Operating profit was £5 million last year before interest and tax), the company’s debt has increased to £18 million from £15 million the year before and Dieter hasstarted talking about the need for them to invest more money to reduce the debt. The company is owed £1.5 million pounds for a series of large orders placed by Canterbury last year. There is also an outstanding dispute about a £2 million consignment for Radios Formidables completed in 2015 which has led to payment being withheld while negotiations continue between lawyers and technical specialists. 
There is a further problem that Dieter believes the Radio Formidable issue arose from faulty workmanship by a contractor EEL engaged in 2014. He has refused to pay the contractor who is now threatening legal action. Because this area of work has been suspended a large stock of materials and supplies has built up at the company’s London site. Dieter insists that the company needs to have this level of stock for when the dispute is sorted out He is also reluctant to press his key customers too hard for payment.
The sisters have approached EEL’s accountants to review the situation.

Understanding of Profitability and Cash Flow

The title of the report is communication of financial management to the shareholders of the company. Shareholders of the company are the investors of the company who invest their money in order to have profitable returns. Due to this, the shareholders shall be provided with the details of each and every company about the working of the organization along with the financial statements of the company detailing the profitability and solvency of the company. For analysis, financial situation of Excellence Electrics Limited have been discussed. The main aim of the report is to equip the shareholders of the company with the relevant and sufficient information so as to make them enable to take effective decision. The aim has been followed throughout the study irrespective of the change of the subject under consideration in case of both of the parts.  With this consideration the report has been prepared and the information required by the shareholders has been detailed in two sections.

In the first section, the difference between the profitability and cash position of the company has been described then the working capital management of the company in the current situation has been discussed. After that the steps that shall be taken by the company to improve its working capital conditions have been detailed. In the second section, capital budgeting process has been detailed. Given the two independent proposal for the company namely Leeds and Bristol, capital budgeting methods have been prescribed.  After prescribing the methods, the methods are applied for choosing the best alternative out of the two proposal and the results are analyzed accordingly. The report has been ended up with the conclusion giving the overall findings of the report along with the recommendation giving the suggestion and recommending whether the steps for improving the working capital management of the company and whether the capital budgeting methods so detailed are appropriate according to the nature and size of business.

With this the report has been prepared in proper heading and sub heading to emphasize on each and every matter.     

In the case under study, Excellence Electrics Limited is engaged in the business of making radio parts and has been in business since the early years of 1930’s. The company functions through the three factories and have two major clients namely Canterbury Cookers Limited and Radio Formidable SA. The company major business depends on these two customers only. Various situations have occurred with these two customers along with other situations which have implied that the working capital situation of the company is very weak and is not taking very serious steps to improve the working capital situation of the company otherwise the day will come when the company will be facing the short term as well as term long term solvency. Therefore, in the below paragraphs first the difference between the profit and cash will be discussed, then the company’s current working capital situation will be discussed and after analyzing the same the steps or ways are provided to improve the working capital management of the company.     

Working Capital Management of the Company

As per the common parlance, the profit is termed as the net income of the company earned after deducting all the expenses of the company. But in terms of the accounting it is referred to as the margin that the company charges from the customers and the same may vary from person to person. Company may charge high price to some customers or else sometimes charges low price to the same or different customers. Thus, the term profit is defined as the margin earned in the business from the goods sold after deducting the cash as well as the non cash expenses incurred by the company. Cash expenses are like salary, advertisement, sales promotion, conveyance, etc and non cash expenses are like depreciation, impairment and the like expenditures. There are two terms associated with the profit – one is gross profit and second one is net profit. Gross profit is the margin that the company earns after selling the goods and is net of direct expenses i.e. which can be directly allocated to the product or goods of the company (Ball,Gerakos, Linnainmaa and Nikolaev, 2016). Net profit is the margin that the company after deducting all the indirect expenses including the non cash expenses of the company. The gross profit and net profit are identified for a particular period and are so identified through the preparation of the Statement of Profit and Loss. It will show the financial performance of the company over the period.

Cash is the current asset of the company which can be used to satisfy the daily requirements of the company and can be used to set off the current liability towards the expenses or the sundry creditors or any other current liabilities. Cash flow is defined as the inflow and outflow made by the company in cash and cash equivalents for the particular period (Campbell, 2015). The cash inflow represents the earnings or receipts of the company and outflow represents the expenses or payments of the company. For determining the cash position of the company and how cash has been flowed throughout the reporting period, the cash flow statement has been prepared. Cash Flow statement follows three types of activities which every kind of business has. These three activities are operating, finance and investing. The main purpose of the cash flow statement is to determine at the end of the period that during the period how much increase or decrease has been reported in the cash and cash equivalents over the reporting period.

Therefore, the profitability of the company determines how much margin the company is earning over its revenues over the reporting period and cash flows determines how much cash or cash equivalents has been generated or loosed by the company over the reporting period.     

In the given case, profitability is expressed as Operating profit as £5 million and that too before the Interest and Tax. If both are deducted then net profit will come which will show the profitability of the company. Cash flow is expressed with the increase in financing activities by increase of Loan amount by £ 3 million and with no change in current assets due to litigation over the £2 million from Radio Formidable and non receipt of £1.5 million from Canterbury.

Steps to Improve Working Capital Management

Working capital is defined as the difference between the current assets and current liabilities of the company. In other words, working capital determines whether the company will be able to meet its short term needs or requirements easily or whether there are the chances of getting the risk of short term insolvency in the business. Thus, working capital denotes these two things and that is why the management of the working capital is very necessary for each and every kind of the business (Aktas , Croci  and Petmezas, 2015).

In the current situation of the Excellence Electrics Limited, the working capital management is applied in the following ways:

• Firstly, The long term debt of the company has been increased from £ 15 million in the last year to £18 million in the current year. It signifies that the company has get the additional loans financed from the bank and is planning for reinvesting the same in another product.
• Secondly, Along with the above financing, the company is in position to have the bad debts due to no change in the sundry debtors. The amount receivable from the major customer of the company – Canterbury £1.5 million. The company has still not obtained. Similar thing has been happened in case of other major customer – Radio Formidable for £ 2 million.
• Thirdly, due to the faulty workmanship, the second major customer of the company – Radio Formidable refused to pay to the contractor and which has resulted in additional pilling up of the stock which has created the risk in working capital as the short term funds have been blocked and the company is not able to liquidate the same.
• Fourthly, the company does not have the system of regular follow up for the payment rather is very reluctant in obtaining payment from the major customers.

In this way, the working capital management is applied in the given case under consideration. As per the current situation the working capital of the company is being managed in a very haphazard manner and if the same happens in upcoming future the company will be facing an acute shortage of liquid funds to meet daily needs and will soon have short term insolvency.    

As per the current situation, the working capital management of the company shall be improved so as to avoid any future contingencies. Following are the steps the company should take to improve the working capital management (Mathuva, 2014):

• Defining the Working Capital Cycle – The company shall defined the working capital cycle as to how much time the company shall take to generate payments from the goods sold to their customers. The company shall divide the time in four parts – purchase payment, production of goods, sale of goods and revenue collection. For instance the company shall prescribe 30 days credit from the supplier, 10 days for production of goods, 5 days for sale of goods and 7 days for getting the collection from customers and the remaining 8 days shall be kept as the extra so as to avoid the rush to make payment from own funds in case working capital cycle time increased suddenly.
• Reduce Stock Piling - The Company shall define the minimum order quantity that the company shall have all the time and the excess shall be kept only in case of emergency or in case of the urgent order. Unnecessary piling up of the stock will increase the finance cost of the company and also block the funds of the company.
• Constant Follow up – The Company shall have the system of constant follow up from the customers for the payment and shall not be reluctant in asking for the payment. If it happens then the working capital cycle will get badly damaged as the credit period obtained from the purchaser will depend upon the credit received from the customer.        

Continuing with the working capital difficulty being faced by the company and in the need of investing the extra loan so obtained in some project from where the profits can be generated and which in turn will used for the repayment of the loan amount so obtained, the company has two options of investment. One is Leeds venture and the other one is Bristol Venture. In the first venture the company will have to incur initial cost of £10 million and thereafter the project will function for nine to ten years without any further spending and in the second venture the company will have to spend initially £6 million and will have a useful life for five to six years. In order to choose the projects, the capital budgeting methods shall be used. In the below paragraphs, the capital budgeting process has been described along with the application of such methods to both the projects and describing which one will be the best for taking up the project.  

Capital budgeting is defined as the process by which it is determined that whether the company shall invest in the particular project or not (Bierman and Smidt, 2014). These are correlated with the available funds of the company and whether the project will generate the cash flows which will set off the investment cost at an early stage (Bogsnes, 2016). With this consideration, the capital budgeting is done. Following are the steps for capital budgeting (Juan, Teruel and Martinez, 2007):

• Identifying the Proposals– This steps lies with the top management of the company. The top management shall identify the various investment proposals and shall delegate to the finance managers of the company to know as to whether the company shall invest in the particular project or not keeping in view the policies and procedure of the company along with the working capital management of the company.
• Checking the proposals– The finance manager shall check the proposals and confirm whether the proposal so proposed to be undertaken are in accordance with the objectives of the company
• Evaluating the proposals – The finance manager then evaluates the proposal through the use of the different capital budgeting methods like Net Present value method, internal rate of Return method, Profitability Index and Payback period, etc.  
• Prioritizing-The next step after evaluating the proposal is to prioritize the proposal. It refers to the activity which includes rejection of the non profitable investment proposal and ranking of the remaining proposal in the order of the profit or other benefits offered by them.
• Approval– After prioritizing the proposals, the approval is obtained from the top management so as to confirm in which proposal the company shall invest.
• Implementing – After obtaining the approval from the necessary authority, the next step is to implement the proposal within the organization.
• Reviewing the Performance– The last step is to review the performance of the proposal so undertaken and implemented on the periodical basis and to review whether the results so anticipated from the proposal is coming as actual or not.  

There are four main capital budgeting methods which are generally considered by all the companies. These are Net Present value, Internal Rate of Return, Payback period, Profitability Index (Daunfeldt and Hartwig, 2014). These are explained below:

• Net Present Value- It is represented as the difference between the present value of cash inflows and the present value of cash outflows. If it comes as positive then the project is selected otherwise rejected.
• Internal rate of Return – It is that rate of return at which the present value of cash inflows and the present value of cash outflows are equal. If the cost of capital is lower than the internal rate of return then the project is accepted otherwise rejected.
• Payback period – It is described as the period in which the outflow of the company can be recovered.
• Profitability Index – It is the division of Present value of Cash Inflows by the Present Value of Cash Outflows. The project is accepted when the result is comes in greater than figure one otherwise it is rejected (Mukherjee, Rahahleh and Baker ,2013).

These capital budgeting methods can be applied in the following ways:

1. Net Present Value– Let us assume that the present value of outflows in Leeds Venture and Bristol Venture is £20 million and £12 million respectively.  

NPV for Leeds Venture - £20 million minus £10 million = £10 million.

NPV for Bristol Venture - £12 million minus £6million = £ 6 million.

2. Internal Rate of Return- Let us assume that the cost of capital of the company is 12% p.a. Internal rate of return in Leeds Venture is 10% p.a. and Bristol venture is 14% p.a.

3. Payback period– As per the cash inflows assumed above, the payback period in case of Leeds Venture is 5 years and Bristol Venture is 3 years.

4. Profitability Index– As per the assumed figures, the Leeds Venture will have profitability index of 2 (20/10) and Bristol venture have profitability index of 2 (12/6)

In the current situation, the company is provided with the figure of the cash outflows and the useful life of an asset. No information was there regarding the cash inflows of the different projects, cost of capital which can be treated as the discounting factor and other details. For making the effective comparison the figures have been assumed to apply the capital budgeting methods to both the investment proposals.   

Although all the four methods as calculated above are the important methods but the method of Net Present Value and Payback period is most important and appropriate for making the decision in the given situation.

• The net present value will defined in anticipation whether the project so undertaken will generate profits in the future so as to cover the initial outlay at ease. Because many projects end up without giving the adequate profits to the company and even brings loss to the company.
• To know by how much time the company would be able to recover the initial outlay, the company has to apply payback period method. It is also important because the company is facing the situation of shortage of cash and by knowing it the company would have an idea that it will be receiving the amount so expended till the completion of particular year like 3^rdyear in case of Bristol Venture. 

Conclusion

Excellence Electrics Limited has been facing the acute problem of working capital management. Working capital management is very important for the surviving of any organization whether it is small in the structure or large in the structure. The company shall have sound working capital management infrastructure otherwise the company may run into liquidation. Also the company shall evaluate each and every investment proposal using the capital budgeting methods.

From the analysis of the case study, it is recommended that the company shall improve its working capital management by adopting the steps as laid down in the report. Secondly as per the calculation made, the company shall go for Bristol Venture as the same have less payback period and higher internal rate of return and less initial cost.

References

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

Ball R, Gerakos J, Linnainmaa J T and Nikolaev V, (2016) Accruals, cash flows, and operating profitability in the cross section of stock returns- Journal of Financial Economics, 121(1), pp.28-45

Bierman Jr H and Smidt S, (2014) Advanced capital budgeting: Refinements in the economic analysis of investment projects. Routledge.

Bogsnes B, (2016) Implementing beyond budgeting: unlocking the performance potential-John Wiley & Sons

Campbell J L, (2015) the fair value of cash flow hedges, future profitability, and stock returns - Contemporary Accounting Research, 32(1), pp.243-279.

Daunfeldt S O and Hartwig F, (2014) what determines the use of capital budgeting methods? Evidence from Swedish listed companies- Journal of Finance and Economics, 2(4), pp.101-112

Juan García-Teruel P and Martinez-Solano P, (2007) Effects of working capital management on SME profitability- International Journal of managerial finance, 3(2), pp.164-177.

Mathuva D, (2015) The Influence of working capital management components on corporate profitability, pp 13-17

Mukherjee T K, Rahahleh, N M A and Baker H K, (2013) Capital budgeting techniques in practice: US survey evidence- Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects, pp.151-171