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.
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.
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:
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):
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):
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:
These capital budgeting methods can be applied in the following ways:
NPV for Leeds Venture – £20 million minus £10 million = £10 million.
NPV for Bristol Venture – £12 million minus £6million = £ 6 million.
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.
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
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