In response to the concern of the shareholders of the EEE firm regarding the management of the firm, I conducted a research around;
Distinction between profitability and cash flow and how they are represented in the company’s financial statements. The report also covers the application of the working capital concept to the company and the way the current situation is reflecting the management efforts. Furthermore, I consider steps necessary to improve the company’s working capital.
The methodology used was majorly secondary data thou supplemented by interviewing the employees of EEE and observing how the operations were undertaken.
Cash flow is the variation between the amount paid out by a company and the amount received. On the other hand, profitability is the difference obtained when expenses are subtracted from the revenues.in the company’s preparation of financial statements both the cash flow and the profitability are covered (DeFond, 2003). Profitability is generally a bookkeeping notion and its measurement is not based on money received or paid. It just come by from the accrued incomes and accrued expenditures that are recorded with no consideration of the accompanied monetary transactions. Some cash flows are not recordable as either revenues or expenses at the period of a transaction on the other hand there are cash flows which are not even part of the operating activities of the firm hence have no relationship with the profits (Wasley, 2006).
Working cash flow
This is any cash activity arising from the operations of the business be it from revenue earned or the expenses incurred. Just to say any advanced payment of cash to a company has the effect of increasing cash flow with no effect on the company’s profitability (Penman, 2006.).
Non-working cash flow
There are cash flow in accompany which has nothing to do with the company’s operating activities such cash flow have no effect on the business profitability (Richardson, 2006). Other than including their working cash flows in the financial statements both the investing cash flows and financing cash flows are covered.
In the company’s report profitability may grow yet its cause is not cash revenues. In such a case the profitability has no influence on the firm’s cash flow. In the company records earned revenues are recorded in line with the accrual basis of accounting. Even if no cash is received at the time of the transaction (Bhattacharya, 2005). When this cash is later collected, there will be an impact on the cash flow but no further effect on the firm’s profitability. Should the company fail to collect this cash a cash shortage may arise in the firm hence limiting its capacity to fund its activities a situation which might later reduce the profitability.
There are some expenses which don’t involve cash. The profitability of the firm might reduce from these expenses yet the firm’s cash flow is not affected at all.in the accounting books expenses are recorded at the time of the transaction via the accrual basis. As the company later makes the payments for the expenses there is reduction in the company’s cash flow yet no effect on the profitability. Now any delay in the company’s settlement of expenses is favourable too its profitability as it means the money is being used to fund other profit generating activities.
Expression in the company’s account
The company is having a turnover of 35 million which is increasing its cashflow.in addition the debt increase is also an added cash flow to the firm. Should the investors put more money to the firm to cover for the debt there will be no effect in the cash flow as the money received will directly go to paying the creditors’ hence leaving the cash flow of the business to its original status (Tervel, 2007).
Canterbury is owing the company 1.5 million on the other hand Radios formidable is owing the firm 2 million. Even though this amount is already reflected in the business profitability based on the accrual principle, the delays in its collection is having a negative effect on the company’s cash flow something which is limiting cash available to fund operating activities. This situation may reduce the Excellence Electrics ltd profitability in the future. if the payment to the contactor is delayed the business can use the cash to fund other operations and increase the profits but the consequences of the legal action should be analysed to avoid future non-operation losses.
Application of the working capital management concept to the Excellence electronics ltd
Working capital is essential for the operations of the company to move on smoothly. Therefore, to maximise profits, it should be critically analysed and proper management strategies put in place. In the case of Excellence Electronics ltd there does not seem to be an effective way to manage the working capital. The manager of the firm has allowed huge inventory to accumulate in the firm’s store to wait for a single client whose future interaction with the firm is in doubt due to a legal task with the EEE ltd. This is withholding a lot of cash which would otherwise be very useful in supporting other operating activities of the firm. The firm debt capital is increasing despite the increase in profits. This indicates that the profitability is resulting from investment of third party’s capital, a clear illustration that the shareholders’ capital has depreciated in value or are being held up in non-profit making activities.
Dieter, the manager, have failed to put in place an effective communication system to identify default in the service offering process. As a result, the company is now engaged in a legal tussle with radios formidable due to pure services offered by one of the contractors he employed.
In addition, the manager’s failure to collect 3.5 million debt in time because he fears pressing his dependable clients is hurting the firm’s future cash flow the main reason why he is requesting the shareholders for more funds.
How the current situation reflects the business management
First the firm have a very poor marketing strategies evident by the over reliance in the 2 clients, Canterbury and Radios formidable. This has resulted in slow movement of stock hence the piling of inventory in the company’s store. In addition, the manager’s policy of favouring his main clients is hurting the business cash flow. Canterbury is reluctant to pay his 1.5 million. It’s upon the manger to put in place effective debt recovery strategies to improve on the cash flow situation of the firm.
Because of employing unqualified personnel the excellence Electronics ltd is now facing challenges recovering a debt of 2 million from Radios formidable while on the other hand the in effective contactor is threatening to sue the firm for payment.
As a show of effective leadership, the manger ought to have sued the contractor for defaulting his responsibilities. Instead he has no proof of the actual negligence of the contractor and is just basing on a belief. This is giving an indication that the business is lacking ineffective communication system to enable the manager to identify the actual problem and decide on the measured to be taken in time.
Steps needed to improve the company’s working capital management
Having realised the importance of working capital management to the success of the company the following steps should be put in place to make it more efficient.
The manager of EEE should base his decisions on the long-term picture, he should adopt the use of technology to monitor and improve the automation of the account payable and receivable. E-invoicing should be adopted. This all increases the efficiency, accuracy and the result is effectiveness in the working capital. Also, the manager should put in place good information system to help him identify issues early enough to offer a solution before more damaged is realised.
To decrease the current liabilities, the manager of EEE should consult his legal team and settle the issue with the contractor threatening legal action soon. Should he require compensation from him form the default work done to Radios formidable then he should sue him for negligence to correct the defaults caused to the EEE’s client.
The large stock being maintained in the company’s store is withholding cash that would otherwise be used to operate the activities of the firm. It’s essential that efficient marketing strategies be put in places as to move the stock without the over reliance on few clients.
Canterbury is owing the firm 1.5 million a debt which now one year old the manager should but more measures to recover this debt or charge a realistic interest in it to cater for the loss of opportunity from its capital being held elsewhere. Furthermore, the situation depicts need for diversification when it comes to customers to stop relying in a few customers who are causing cash flow problems to the firm.
The growth in the company’s debt will in the future generate more liability to the firm should the shareholders be able to invest more funds to cover the liabilities now it will be a cheaper source of capital compared to the debt capital. In case this is not achievable then it’s recommended the firm secure a long-term loan to fund its operations.
The EEE firm need to put in place adequate measures to manage working capital. I recommend the shareholders to press the manager to put more strategies in debt collection and only pump more cash into the firm to increaser their investments and not to settle the debts. The manger should identify ways of securing long term loan to run the firm and market appropriately instead of relying on the expensive short term debts (Amarjeet Gill, 2010)
The shareholders of Excellence Electronics ltd approached my office to request for assistance in the technique to use to evaluate between a project in Leeds and the other one in Bristol. My work was to cater for their need in terms of the identifying the capital budgeting stages, project evaluating techniques, the applicability of the projects to their case and identifying the best method to observe while analysing their investments options.
In my response, I con ducted a research through interviewing of the management as well as used secondary data, business documents and financial reports, to make my decisions.
In the capital budgeting the first step is to identify and evaluate potential opportunities. In this case, we check for the available opportunities. From the varied choices, we manage to compile we thereby consider the most favourable for our case. Financial and the logistics will be considered in the evaluation process. Example is would you repair the truck, buy or hire another one (Zonneveld, 2007).
Afterwards we estimate the cost of the project and implement it. This stage involves the amount of cash we need to invest for the profit to generate the intended profit. There may be need for research to enable the firm to minimise the cost of implementing the project. I.e. should we choose to require a new machinery what will be the cost
Afterwards the firm will estimate the benefits or cash flows associated with the project. The objective here is to find out the cash which will be generated from the project. Examination of similar projects can be a good tool in this case. Suppose they realise that that up grading of available will be costly relative to the revenues it will generate then the manger should opt for other investments (Istvan, 1961).
Another valuable stage will be to assess the risks that will face the projects implementation and its potentiality to generate the expected results. After establishing the risks, we therefore compare it with the cash flow or expected benefits
The final stage now will be implementing it. After assessing all the elements and ascertaining that the project is worth undertaking the management will there after release the necessary resources needed to put it in place. An implementation plan is therefore designed and followed which will involve paying the project cost, designing ways of tracking the costs and process of recording cash flows or benefits. They should also plan on the timelines with primary project milestones.
Capital investment appraisal methods
Payback period. This is a period which a business take before the capital invested in it initially is fully recovered. When there are two projects with similar initial cost, the use of payback period will consider the number of years or months the business will take to return the money (Christy, 1966)
Net present value. Payback period as explained above does not consider the timing of the cash flows. This indicates that since many companies take many years, payback period which goes for less year may not be appropriate. The net present values are given by
r= rate of discount
t= the time
It will illustrate the limitations of payback period. This strategy is different from the payback period in that it considers the present value.
In cases where the net present value of a project is slightly higher in a project with more payback period, the managers may opt to go for the project with less payback period if they are worried about their capital. Payback period is more desirable method whenever the buyer want to borrow most the purchase price and had a desire to pay back loan sooner as a way of saving the interest expense. To maximise shareholders though we are forced to go for long term, to create long term shareholder value. This make us go for project with higher net present value even if it will take long to payback, this will eliminate destruction of shareholders’ value.
Internal rate of return
Though complicated and subjective it accounts for the time value of money. The internal rate of return of a project is the rate of return that make net present value zero. Internal rate of return is the breakdown of interest. It selects the project with internal rate of return greater than the cost of financing. Suppose the cost of capital is 12% then a rate less than 12% will diminish the shareholders’ capital. While any project with internal rate greater than 12% means increaser in the value of shareholder’s capital. Calculation of the internal rate of return is complex and in some cases, might involve trial and error method to generate or a financial calculator.
Profitability index; is obtained by dividing the present value of future returns by the required investment outlay. Suppose the investment value is spread over more than one year, then that too is subject to discounting by the required rate. The profitability index of more than 1 is acceptable. Should we be subjected to competing projects then the one with higher value is preferable.
Discounted cash flow, this is a general name for the net present value, internal rate of return and profitability index. This method leads to the recommendable model for investment appraisal.
Potential application of these methods to the projects under study
In checking the applicability of this methods to our case will consider their simplicity in computation and the shareholders expectation.
First, we are if when undertaking the investment, the manager’s objective will be to maximise the profitability of the firm. I.e. increase the value of the shareholders’ capital (Commonwealth of Australia, 2006 ).
The internal rate of return considers the time value of money, have simple interpretation and independent to hurdle rate. It is in line with the profit maximisation hence recommendable
Considering the payback period method, it’s easy to compute but does not consider the profit maximisation objective. It might not therefore be an applicable method in this case (Pflomn, 1963).
The present value criteria are also easy to compute and interpret. The method considers the time value of money as well hence applicable in this case.
Most appropriate method to the decision making
All the discounted cash flow methods are applicable in this project. The internal rate of return can be calculated for both the project in Leeds and that in Bristol and the one with higher internal rete chosen. In addition, we can also evaluate the net present value for both the project and select the one with the highest net present value (Brealey, n.d.). Finally, we can calculate the profitability index and again choose the higher one in a situation where two or more of the methods are resulting to a conflicting decision choose the project supported by most of the methods (Abdelsamad, 1973).
But to be able to evaluate this project further study is required to determine the probable cash inflows that will be associated with the projects.
Having evaluated the various techniques, I recommend the Excellence Electronics ltd manager to apply the discounted technique to evaluate the best project to undertake between the project in Bristol and Leeds. But he will need to conduct further financial to generate the expected cash inflows associated with the project (New ZealandTreasury, 2005).
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