For every company, its financial statements like profit and loss account and cash flow statement are very necessary to analyse the expenses, sources of income and liquidity position of the company. It helps shareholders to take important decisions whether to invest in the company or not and to check that the company is financially sound before putting its money into it. The Part A of the report talks about profit, cash flow and the difference among them. Further, the discussion is about Working Capital and its key areas. All these concepts are then applied and analysed for Bright Lawns Ltd.
1. Understanding basic concepts:
a) Meaning of Profit and Cash Flow and their difference
Profit: Profit of the company is determined by calculating all its expenses and then subtracting it from the revenues of the company. Suppose company earns revenues of £20,000 and its expenses are £15000, then its profit will be £5,000. This reflect the actual gain of a business and it is used as a very essential tool to analyse and take strategic decisions (Buck and et. al., 2013).
Cash Flow: Cash flow reflects the actual amount of available cash with the business at a given point of time. Cash flow gives a true picture of the liquidity position of a firm and in which areas of the business the cash is consumed. There are three areas of cash flow, i.e. : Operating activity which shows that cash inflow or outflow from the production area, Investing activity which reflects the buying and selling of assets in the company and financing activity tells about the payments done for interest or issue of dividends (Hofstede, 2012).
Difference: Profit reflects the difference between revenues as well as expenses of the firm while cash flow shows the cash position of the company and the availability of cash for regular operations. When a company generates revenue or incurring any expenses , it does not mean that the cash of the firm will increase ore decrease. Both are necessary for the health of the company.
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b) Meaning of Working Capital, Accounts Receivables, Accounts Payables and Inventory
Working Capital: Working capital is determined by calculating the current assets of the organisation and its current liabilities and then deducting both of them. It reflects the amount needed for the regular operations of an organization. Usually a positive figure is recommended where current assets are higher then current liabilities. A good working capital means the company is doing good on operational aspect (CardoÅŸ, 2014).
Accounts receivables: They are also called debtors of the organization. The company offers its goods and services on credit terms in which the customer can make the payment afterwards. Debtors are the current assets for any organization.
Accounts Payables: They are also called as creditors of the organization. Companies can also buy the goods and services on credit basis and decides to make the payment at some future date. Creditors are the current liabilities of a firm.
Inventory: Company maintains some stock of the goods it sells in the market and that is called as inventory which is the current asset of the firm. It may include raw materials, finished as well as goods which are in process of manufacturing.
c) Explanation of how the change in the working capital of the company affects its cash flows
Cash flow is directly affected by any change in the items of working capital, i.e. current assets as well as current liabilities. So, there are two basic rules for it: i) Any increase in current asset will decrease the cash flow and vice versa and ii) Any increase in current liabilities will increase the cash flow with that amount and vice versa. All this is reflected in the operating part of cash flow as +/- changes in the current assets as well as current liabilities. For example: If Debtors of the firm are increased which reflects that company offered the goods on credit terms and hence no cash is actually entered in the business, so it will be shown by deducting it from the net income of the company (Pais and Gama, 2015).
2. Applying the above mentioned concepts in the situation of Bright Lawns Ltd.
Profit: Bright Lawns Ltd EBIT for the last year was £5 million which is quite good. There has been reasonable demand for the goods as well services of Bright Lawns Ltd. And the turnover was also more than £50 million. So, overall company is doing well in terms profitability and revenues aspect as per the data available for the last year. But the challenge which the company is facing is about the increasing debt i.e. earlier it was £16 million and now it is £18 million. The company must take steps to decide the best capital structure and should put efforts to decrease its liabilities. Simmo thinks that they want more equity to reduce the overall debt but this may be difficult for the company as raising money through equity will be expensive in this case as they will ask for higher returns to invest in a company with increasing debt because of the high risk factor. The higher debt position is dangerous for company as it may affect the profitability of BLL due to increased interest expenses.
Cash Flows: BLL has recently took a 30% stake in an organization that make fountains and related goods. It has also paid £8 million as advance out of £10 million which is the acquisition cost. The company's cash flow will be affected by this transaction as the cash is going out of BLL for the fees paid in advance. But this will only happen if this deal will be a complete cash deal. It is generally observed that no company make acquisitions with too much cash and usually take loans from the bank. This will be a risky for company as already the debt is on increasing level and additional debt will make situations even more difficult. So, it's definitely not wrong to acquire a company and there are several advantages for the same if the acquisition is done after taking into account the synergies between them. Another benefit is that when a company is acquired, the existing cash with the company which is acquired also come along with that acquisition and hence the cash inflow will increase (Hofstede, 2012).
Working Capital: The company has two debtors at present, i.e. C&P and BricoFrance. It has sold good worth of £1.5 million pounds to C&P on credit basis. BLL is also struggling with the dispute with BricoFrance of consignments amounting to £2 million. So, account receivables of BLL is on increasing level and hence no cash is coming in the business which will reduce the cash flow and hence will directly affect the liquidity as well as financial position of the company.
3. Analysis and suggestions of the steps that should be taken by the company to improvise its cash flow with the better management of working capital
The company is facing many issues on the matters of working capital. It need a complete focus on the key areas i.e. debtors, inventory, payables, etc. to improve the liquidity and operations of the business (Faulkender and et. al., 2012). Below mentioned are few recommendations that can be taken by BLL to improvise its cash flow with the better management of working capital:
a) Handling the accounts payables or creditors: BLL can try to manage its creditors effectively as increase in the accounts payables will increase the cash flow as cash can remain in the company for a longer duration. So, they can request their suppliers to give good duration to pay back for the goods taken on credit as this will improve their working capital cycle. But they should also pay to the creditors on time and must not delay a lot (CardoÅŸ, 2014).
b) Managing the inventory: BLL is struggling with a conflict of £1.5 million and due to this it had to close one of its site on temporary basis. After resolution, the company has to maintain the same stock level again and so inventory management must be a focus right now.
c) Stringent policies for Debtors: BLL is already very restrictive in asking for the dues from its debtors but now they have to be little strict and should take actions to get money from C&P and other debtors. Company can give some incentives for early payments. The company should also resolve the conflict with BricoFRance on urgent basis.
d) Evaluation of increasing debt: BLL should try to reduce debt and even should make interest payments fast so that they can avoid the future penalties. This will enhance the working capital of BLL.
The second part of the report focusses upon the different approaches of making a budget for a company, i.e. traditional as well as alternative and their benefits and disadvantages. It also discusses on the purpose of preparing a budget and how BoatWater Plc can make use of different budgets to manage its expenses in future and which method is more appropriate for them.
1. Purpose of Budget Preparation and Different Budgeting Methods
a) Purpose of Budget Preparation:
Companies prepare budgets to estimate and predict for the future expenses and costs for the business. It is an essential part to monitor the different departments in the organization and acts as a benchmark for measuring the performance. Budget supports managers to take strategic decisions and facilitates major objectives of the company.
b) Budgeting Methods: There are two approaches towards budgeting which are discussed below:
- Traditional Budgeting Approach: This budget is prepared by making use of the past budget. To project the future expenses, past figures are used and as per the current market, economic and company's situations, future costs are forecasted by making alterations in those figures itself (Kraemer-Eis and et. al., 2019).
Pros: Traditional method gives a complete framework for future budget and acts as a reference which makes it simpler to predict. It takes less time as only some changes have to be made in the previous budget. It also helps in decentralizing and provides freedom to managers while maintaining certain standards.
Cons: There can be a lot of errors in entering data and inefficiencies can increase and there are higher chances of manipulation so that the picture seems more appealing.
- Alternative Budgeting Approaches
A) Rolling Budgets: It is a kind of budget which is made continuously. Under this the forecasts are done on regular basis in the whole year. So, suppose a company prepares a budget for Jan till Dec, 2019, then as soon as Jan 2019 ends, then Jan 2020 budget can be added (Agha, 2014).
Pros: The main benefit of rolling budget is that it can be changed as per the current situations the business is facing whether economic downturn or recession, lack of sales, etc. and another is that it looks the spending budget just like a guide and not something absolute.
Cons: The budget takes a lot of time and energy as it is prepared continuously and the targets may keep on updating for the employees which may demotivate them.
B) Zero based Budgets: These budgets are prepared in detail and there is no base for this budget. It is prepared from starting and each cost or expense is considered very thoroughly. Every estimation regarding cash flows, revenues and expenses is done again.
Pros: This budget is very accurate and efficient and provides better fund as well as resource allocation and follows a top-down method (Popesko and et. al., 2016).
Cons: It takes highest time and resources and professionals are required to analyse everything from starting. Even training has to be give to some employees for it.
C) Activity-based Budgets: Under activity budgeting, each and every activity is identified and analysed properly and then budget is made as per different activities. This is done to make the process streamline (Hansen, 2011).
Pros: It enhance cost management by taking into account the costs of each activity. It even reduce redundancy as well as improve efficiency.
Cons: Its focus is more upon short term rather than long term and same like ZBB, it requires a lot of expert employees and training.
2. Application of above methods and cost management
Currently, BoatWater Plc is using traditional method to make the budget but as per the current situation, the director of finance is concerned about this traditional method and feel the need to change the method before the company go through some major changes in the operations. So, for this the BoatWater Plc is using the previous budget and is just making some alterations in that to predict expenses as well as revenues for the company. It is mentioned in the case that the company is planning to open some new stores in Netherlands as well as Germany. This is a major operational change for the company and for this purpose it has to issue almost 30 boats for this purpose. Now, the company need to take some actions to change its budgeting methods.
If company keeps on using the traditional method, then according to that:
The previous budget was made according to eight operations, i.e. five in France and three in UK and in total there are 145 employees currently working in the organization. So, expenses and revenues were forecasted as per these 8 operations. But now, the BoatWater Plc is adding three more new outlets. Expenses and revenues both will increase and altered on the basis of 11 operations (8 – Old and 3 – New). The costs will include: increased salary expenses for the employees who will be working in new outlets, rent, transportation, installation charges of 30 boats, marketing, outlet supplies and utilities. There will be increase in all these expenses on the budget which has to be forecasted.
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While, if the company uses any kind of alternative method like rolling, activity-based or ZBB. If BoatWater Plc uses rolling budgeting technique, then it will be beneficial as this budget changes as per the changing business scenario and BoatWater is going through major operational changes. There will be many types of costs which will be unexpected in the expansion process and they can keep on adjusting them on the budget on continuous basis. Example: If BoatWater has estimated the expenses of £100 million in the month of July but the expenses actually incurred was £140 million, then in the next budget it can increase some amount of expenses to make it more accurate. If company goes for ZBB, then it will be able to analyse and identify every kind of cost which are going to incur in future (Zeller and Metzger, 2013). There will be less chances of errors and prediction will be more accurate. Example: With the new outlets, there will be additional costs of payroll, rent and boats, then it can be added to the budget very easily without making any kind of alterations as it was in traditional method.
3. Analysis of most appropriate method (Traditional or Alternative Budgeting) for BoatWater Plc
BoatWater Plc must use alternative budgeting techniques instead of traditional method and there are various reasons behind that:
- Alternative budgeting will help in aligning and linking the budget with the strategy of the BoatWater Plc like in this situation, expansion strategy can be very well linked with the budget. Balance Scorecard can be used in addition to align the review and budget method (Heyns and et. al., 2011).
(Source: trginternational.com, 2019)
- The rolling or continuous kind of budget is much better than the fixed one as it will help to make budget as per the changing situations in the market, economy as well as company. It can be revised as and when the company requires. Companies can focus on short-term goals as well. But under traditional method, company will have no option and scope for any changes (Agha, 2014).
- Under the alternative methods, the company can make use of indicators which are non-financial in nature. For example: Instead of fixing up the targets under traditional method, rolling method enables to set relative targets for the employees which motivate them and also release the tension of achieving the fix numbers. This brings growth options for employees and helps to beat the competition.
- BoatWater Plc can also reduce the details of a budget and make it more concrete and as per the key performance indicators. Traditional budgets are extremely detailed and the focus from KPIs may shift. This will also allow decentralisation in the process of decision making and hence budget will be more clear to everybody in the organization (Hansen, 2011).
Companies must look into each and every aspect to take better decisions like profit, cash flows and working capital. Better working capital helps companies to maintain good liquidity and offers better availability of funds on regular basis. Current Assets and Liabilities should be monitored in a proper manner. Budgets are also necessary for future predictions of expenses as well as revenues. There are traditional and alternative methods which companies can use and as per the current scenario, alternative methods are more beneficial for the companies.
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