Importance of Cash Flows and Working Capital Management
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Added on  2023/01/18
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This article discusses the importance of cash flows and working capital management in improving the financial health of a company. It explains the difference between profits and cash flows, and how working capital affects cash flows. It also provides steps to improve cash flows through effective working capital management.
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TABLE OF CONTENTS TABLE OF CONTENTS................................................................................................................2 PART 1............................................................................................................................................1 Executive summary.....................................................................................................................1 I) Explanations.............................................................................................................................1 II) Analysis of Cash Flow statements..........................................................................................3 III) Steps to be taken for improving the cash flows by working capital management................4 PART 2............................................................................................................................................5 Executive Summary.....................................................................................................................5 I)Purposeofpreparingbudgetandunderstandingtraditionalbudgetingapproachand alternative budget methods..........................................................................................................5 II Describing the application of these methods for future...........................................................7 III) Analysing whether alternativebudgetary system or traditionalbudgetary system is appropriate...................................................................................................................................8 REFERENCES..............................................................................................................................10
PART 1 Executive summary This part reveals the importance of cash flows and the profits. They help in determining how cash flows could be negative even when the company is showing profits. There are various cases where the profitability is shown.Working capital of the company could be used for managing the cash flows and how they impact the cash flows. It will also recommend steps that could be used for improving the cash flows. Report to the shareholders I) Explanations a) Profit and Cash Flows and how they are different Profits Profits of a company describes financial benefits realized when revenues generated from business activities exceeds costs, expenses and taxes that are involved in sustaining activity. Profits earned by the business funnel back to its owners , who have the choice of using this profit for their own benefits or to reinvest back into business. Profits are calculated as total revenues less total expense. Profits refers to the money pulled by the business after all the expenses have been accounted. Be it a sole proprietary business or a multinational company primary goal of every business is of earning money, therefore performance of the business is measured based on its profitability. Profits are of three types gross profits, operating profits and net profits and all of these are shown in income statement of company (Williams and Dobelman, J.A., 2017). Every profit gives different type of information that are used by the analysts according to their needs. Cash Flow Cash flow refers to the amount of net cash & cash equivalent that are being transferred in and out of business. At basic fundamental level, cash flows determine the ability of company to generate positive cash flows and create values for its shareholders. It is also aimed at maximising the long term cash flows. Assessing amounts, timings and uncertainty in cash flows is also the objective of financial reporting. For assessing the flexibility, liquidity and financial performance of the company it is essential to have an understanding of the cash flows(Miao,Teoh and Zhu, 2016). Cash flows are important for recognising whether the company is utilising the cash funds in an efficient manner or not. 1
Difference in Cash flows and the profits Profit and cash flows are separate financial parameters, and both are to be considered when running business for keeping the track record. Companies are required to report over both profits and cash holdings. Profit is accounting that is not measurable in cash inflow or outflow. Operating Cash Flows It is outcome of cash activities in business operation regardless, whether cash transactions are generating earned revenues or incurred expenses at time of transaction. For instance when when advance payments are received from customers it will increase the cash holdings of the company but no effect would be seen on its reported profit (Sri, 2017). Non Operating Cash Flows Few cash flows may not be the outcome of operating activities of the company and may not be related to the profitability. Along with operating activities cash flow from financing and investing activities are also reported by the company. When investments are sold or funds are obtained from financing , cash positions are increased, but they are not added to the revenues. Similarly purchase of fixed assets will decrease the cash positions but the profits will not be harmed. Heavy purchases can result in negative cash flows even when the company is showing good profits (Gordon and et.al., 2017). Non Cash Revenues Non Cash revenues are the profit arising on sale of fixed assets, or the company recording accrued profits this will increase the profits but no change in the cash holdings. Non Cash Expenses They decrease the profitability of the company but no impact is seen in cash holdings as they do not result in any cash outflows like depreciation. There are situation where company may show profits but do not have enough cash for meeting the daily expenses. This may result in the break down of company operations. This sometimes cause the company to liquidate due to non availability of cash. b)Working Capital Working Capital refers to difference between current asset like accounts receivables, cash and inventories and the current liabilities like accounts payable. Working capital measures operational efficiency, liquidity and short term financials health of the organisation. Company 2
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having positive working capital have the potential of investing and growing. If the current assets are not exceeding current liabilities, company might face trouble in paying back to creditors or growing it may even go bankrupt (Kopita, Charitou and Karamanou, 2017). Receivables-It refers to the amount due from customers to whom goods have been sold on credit. Inventory-It refers to the stock of goods manufactured or traded by company. Inventory could be of raw materials or the finished goods. Inventory of the company are current assets of company. Trade Payable-Like receivables, payables are the amount due to the supplier of the raw materials from whom company have taken goods on credit. These are shown under head current liabilities. c) Effects of working capital on cash flows Increases in working capital shows that more amount of cash is being invested in the working capital, thereby reducing the cash flows. Those companies having significant requirements of working capital finds that the working capital also grows and this would be reducing the cash flows of company. There is a relationship between cash flows and the working capital, companies that efficiently manage their working capital have high value as compared with firms having high working capital requirements (Girish and Desai, 2017). II) Analysis of Cash Flow statements Analysing the cash flow statement of the company it could be said that the company is not efficiently managing its cash flows. The operating profit of the company is just 5 million that is 10% of the total turnover. The debts of the company have increased by 2 million that will increase inflow in financing activities. Cash flows of 10 million will be considered in investing activities where the 8 millions of advance will be increase the working capital. Company is having current liability of 1.5 million, but this will not affect the cash flows of company. Cash flows of the company will show positive results. The contingent liability of 2 million will affect the cash flows. But the increase in cash flows will not be increasing the profitability of company. 3
Therefore it is essential to effectively manage the cash flows and working capital of the company (Ketz, 2016). III) Steps to be taken for improving the cash flows by working capital management. Working capital means amount through which current asset of company exceeds the current liabilities. Cash flows of the company could be improved by effectively managing the working capital of company. Here the company is growing at constant pace with sufficient profits than also the company may face negative cash flows. Therefore it is essential for company to manage properly its cash flows. Cash flows could be improved by managing the working capital. Improving the Inventory VLE should conduct inventory checks over short periods so that goods that are not moving at same pace like other goods are identified. Company should offer more discounts for selling the products that will increase the turnover and cash inflow to the company. It should not store inventory that is unnecessary occupying space (Mathuva, 2015). Trade Receivables VLE should check the credibility of customers before selling goods to customer on credit. Charge interest on delay over the specified limit in credit days. Reduce the credit days for rotation of the cash flows. Trade Payables For the suppliers VLE should maintain friendly relations with them. This will help in bargaining better trading terms. Ask for discounts from suppliers on early payments for the purchases. Raising long term loans Company for carrying out the working capital requirements should go for long term loans instead of short term loans this will decrease the current liabilities of company (Aktas,Croci. and Petmezas, 2015). 4
PART 2 Executive Summary Budgeting techniques are an important part in determining what are the various expenditures and sources of income for a business and in this part various budgeting techniques have been evaluated to identify the best one for BoatWorld Plc. I) Purpose of preparing budget and understanding traditional budgeting approach and alternative budget methods Abudgetis prepared by the organisations in order to predict initially what are the future income and expenditure sources for the company and further it helps in determining what would be the adequate number o f resources that need to be allocated amongst various activities that an organisationneeds to prefer (Opgenoord and Willcox, 2016). Further, it acts a s a decision making tools for the company where they are able to determine how much expenditure will be there and which tools or either assets are too be brought and which are not within the buying range etc. are highlighted. In this budget reports, it also acts as a method and means to monitor and evaluate the performance of the organization so that it can be ascertained whether the standards that have been set up are being met or not and whether the work done is appropriate or not. The Traditional Budgeting Process is indeed a traditional and redundant process where the budget that was prepared last year is taken as a base for the preparation of current year’s budget. The figures and heads that were formulated in the budget of last year is kept same and only the amount is incremented to the one that was allotted in the last year, i.e. there is no writing off of the budget and it keeps on being carried forward in the organisation. Although it is an extremely easy and quick method of budget preparation yet, in today’s context, it can be said that this is not an adequate method since it does not highlight what was the individual years performance and further, fails to take into purview various new factors that have emerged in the market (Popesko and Šocová, 2016). At BoatWorld Plc as well, the recently appointed finance director recognised that the current budgeting method that was being used in the company, i.e. thetraditionalbudgetingsystemisextremelyredundantandwasnotdepictingthetrue performance of the company. He intends to change it and replace with other more efficient budgeting technique. The alternative budgeting techniques that can be used are: 5
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II Describing the application of these methods for future Rolling budget method also used in future planning such that it involves the incremental extension of the existing budget model in which company may set the standards and analyse whether they are attain in future or not. Through this method, a company may extends it through one year into a future, so that company may response to the unexpected changes as well. On the other side, zero based budgeting is another good budget method in which a company may set expenses for the future and quoted firm may easily analyse whether the set criteria are match or not (O'Shea, 2018). For example, when a company hire a new employee, it is fore sure that there is a need to increase a budget with new wages and payroll expenses. Therefore, using this budget method into the working area will help to align firm spending with the defined strategic goals in order to verify that all the element of annual budgets are cost effective and helps to improves saving as well. On the other side, using activity based budgeting also helps to evaluate single cost driver used in annual budgeting. Therefore, in future, while using activity based budgeting, company allocate budget and also eliminate all sort of unnecessary activities that affect the business in opposite way (Ibrahim, 2019). As a result, in order to gain future competitive edge, company uses this activity based budgeting that helps to sustain the brand image as well. Moreover, this method is used in marge companies where business have more than one unit so that company view the business as a single unit. That is why, most of the companies also uses this method for forecasting the budget in order to get best results. 7
III)Analysingwhetheralternativebudgetarysystemortraditionalbudgetarysystemis appropriate. Traditional budgeting refer to process of making projections for revenues & expenses of the business for upcoming year reviewing the previous budgets. It involves projecting the sales and revenues, estimation of expenses & predicting profits. They do not cover cover rate of inflations in their budget. Traditional budget follows previous year's data for making the budget The modern budgetingtechniques are standing on the same foundation but with modification with the time. They take into account all the adjustments required formaking the budget. Modern budgets are more flexible and could be modified according to the requirements of company and specific activities. Modern budgeting technique provide for different budgets that for different activities of different industry (Gordon and et.al., 2017). Company should go for modern budgeting techniques as it includes more than one budgeting technique that could be used by the Boat World Plc. Company has the business of renting boats. Every year there are some or the other changes the that affect the tourism industry in different countries. Budgets of previous year cannot be used by company for the current year as the errors f previous year might occur in present year. Budgeting techniques like zero based 8
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budgeting and rolling budgets could be used. Company could use zero based budgeting that requires the budgets to be prepared from the beginning taking base as zero. It will help company in preparing budgets based for the every year that are not based on previous budgets. 9