Impact of Working Capital on Cash Flow in Business Finance

This report discusses the difference between profit and cash flow, the meaning of working capital, receivables, inventory, and payables, and the effect of change in working capital on cash flow. It also explores how company management can affect financial results and provides steps to improve cash flow through effective working capital management. Additionally, it analyzes different budgeting methods and their application to Second Sight Plc for future planning.

Business Finance

TABLE OF CONTENTS
PART 1.........................................................................................................................................................3
a. Difference between profit and cash flow.............................................................................................3
b. Meaning of working capital, receivables, inventory and payables......................................................3
c. Effect of change in working capital on cash flow of the business........................................................4
How company is managed that might affect its financial results............................................................4
Steps that can be taken to improve the cash flow by effective management of working capital............4
PART 2.........................................................................................................................................................7
Different methods of preparing budget..................................................................................................7
Application of budgeting methods on Second Sight Plc for future plan..................................................8
Analysing the appropriate method of budgeting.....................................................................................9
REFERENCES..............................................................................................................................................11

EXECUTIVE SUMMARY
In this report, the basic financial are discussed with respect the scenario of MDL Ltd. It presents
the impact of change in working capital on the cash flow of the business and also what are the
steps that can eb taken to improve the cash flow position of the business. Based on the various
strategies were identified which should be used by MDL Ltd.

PART 1
i.
a. Difference between profit and cash flow
Profit: It refers to the amount realized when revenue from the business activity exceeds the
total expenses and cost incurred in operating the business. Earning profit the sole objective of
any business (Kenton, 2019). There are three types of profits- gross profit, operating profit
and net profit which can be found using income statement business. Business can be
profitable but then too there can be a situation that business is not having adequate cash.
Cash flow: It refers to the net value or amount of cash being transferred from the business.
The cash flow comes from three sources which are- operating, investing and financing
activities (What is Cash Flow? 2020). Cash flow from operating activities is the cash that is
generated by the main business activity.
Profit Cashflow
It refers to the net income which is derived after
subtracting all the expenses from the sales.
It is the actual money that is flowing in and out
of the business.
It is calculated by subtracting expenses from the
revenue during a specific period.
It is calculated by deducting cash outflow from
the total cash inflow of the business for a
specific period.
Profit is calculated based on accrual basis of
accounting.
Cash flow is derived based on cash basis of
accounting.
b. Meaning of working capital, receivables, inventory and payables
Working capital: It refers to the difference between current asset and current liabilities of
the business for a specific period (What Is Working Capital? 2020). It helps in determining the
financial health of the business. It measures liquidity position and the operational efficiency of
the business. It can be both positive and negative but it is preferred to have a positive working
capital.
Receivables: It refers to the amount of debt that is owed to the companies by selling
goods and services to its customers on credit. Receivables are recorded when the sale takes place
and not when amount is received (Definition of 'Accounts Receivable'. 2020). It is shown on the
Asset side off the balance sheet as accounts receivable under current assets. Any amount that is
estimated to be uncollectible then it is recorded as bad debts or provision is created for it.
Inventory: It refers to the goods and raw material that are used by the company to
produce goods and sell it to the customers (Inventory. 2019). It is one of the most important
assets to a business because it is the primary source of revenue. It is shown as current assets in
the balance sheet. It is valued using different methods like FIFO, LIFO and weighted average
method.

Payables: It is the reverse of receivables. It presents the company’s obligation to pay the debt to
it’s creditors and other vendors from whom materials are purchased on credit. In big
organizations, there is a separate department for it for making payment to the creditors as and
when due date comes (Accounts Payable. 2020). It appears in the balance sheet as accounts
payable under current liabilities. It is very essential to manage accounts payable which will result
effective management of cash.
c. Effect of change in working capital on cash flow of the business
There is a direct impact of change in working capital on the cashflow of the business. A
positive change in working capital means that there is a cash inflow for that period. On the other
hand, a negative change in working capital will mean that the company has spend more cash.
The increase in working capital shows that management is investing its resources in the short
term which results in decrease in cash flow (Afrifa and Tingbani, 2018). On the contrast,
negative change in working capital will show that it business has heavily relied on short term
borrowings in order to finance its business which resulted in increase in cashflow. For example,
purchase of inventory with cash would have no impact on the working capital as both cash and
inventory are current assets but the cashflow for the business will be reduced by the amount of
inventory purchased. Thus, analyzing working capital is very important.
ii.
How company is managed that might affect its financial results
MDL Ltd is currently having reasonable amount of profits from its business but on the
other hand it has increased its debt to £18 million. Also, it has acquired 40% stake in Italian
company and has further invested £10 million for acquiring shares of it. MDL Ltd has an dispute
of about £2 million. There are chances that another legal dispute may arise as it has refused to
pay Valetta for providing poor quality of materials. It also has large stock of materials and other
supplies which things will be required after resolving the disputes. MDL is also very lenient in
terms of collecting money from the customers. After considering the current situation of the
company it can be said that if the company does not take any initiative then it will have negative
impact on its financial position. For example, it should be hard enough to recover money blocked
by customers and look for other investors for paying back its debt. Another important thing it can
do is to stop making any further investment. Otherwise, it will be left with no cash and negative
working capital.
iii.
Steps that can be taken to improve the cash flow by effective management of working capital
Working capital is very important for the daily operation of the business. It becomes very
crucial for businesses to effectively manage it’s working capital and maintaining the balance
(Singhania and Mehta, 2017). Below are the few essential steps that can be taken by the
company in order to improve its working capital which will further lead to positive cash flow
management.
 MDL Ltd can implement an automated system which will help the company in effective
management of account receivables by reminding the customers to pay on time.

 The company motivate and encourage its customers to pay before due date by offering
them incentives. Also, it should motivate its collection team by offering them incentives
by collecting outstanding invoices on time.
 MDL Ltd should review different suppliers and negotiate for better pricing and if if the
supplier is not willing to come to a favorable term Then it should look for other suppliers.
 The company should look for better payment terms with suppliers and other vendors
which will help in effective management of payment process. Also, balance should be
maintained in the payment terms for both accounts payable and accounts receivable.
 It should use electronic payment system which will help in in ensuring that timely
payments are done and also helps in avoiding the situation of delay payments which will
attract penalty.
 MDL should examine the amount of interest on the loans taken and also if possible can
any modification in interest rate and installment payment can be done or not. This will
help in reducing the cost of paying principal amount which can be termed as savings and
added to working capital.
 It should avoid the situation of overstocking of inventory and it should make sure that
finished products are sold as soon as possible. It helps in further minimizing the cost
associated with inventory in terms of handling and carrying cost.
 The company should work on maintaining good relationship with its customers and
suppliers which can help it at the time of crisis. At the same time, it can also help in
avoiding any disputes.
 MDL Ltd is also required to establish a good relationship with its major customers and
not doing the same is the very serious concern for the company.

EXECUTIVE SUMMARY
In this report, the different budgetary methods that can be used by the organization are analyzed
based on their strengths and weaknesses. After conducting proper evaluation, the best and
appropriate method for Second Sight Plc is determined which is activity-based budgeting method
for its new business plan.

PART 2
i.
Different methods of preparing budget
Budget refers to the statement in which revenue and expenditure for a specific period is
forecasted. Basically, an incremental budget is prepared which is based on the previous year’s
budget and actual performance. The incremental amount is added to the new budget. The
different types of budgets are stated below.
Traditional budgeting approach
In this method, budget is prepared by taking previous year’s budget as the base and only
changes are made in terms of expenses with respect to inflation, market situation etc. It is exactly
dependent on the previous year’s budget (Weigel and Hiebl, 2018). This method cannot be used
for the newly established businesses as it requires last year’s data.
Strengths
 Solid framework as it is based on the reference point which helps in easy management of
the business activities.
 It encourages decentralization as everyone can look into the budget.
 It helps in better decision making as problems can be identified easily.
Weaknesses
 It may lead to budget slack as changes can be done by anyone as per the need.
 It is a time-consuming process as it requires a lot of time in sorting out the things with the
expected expenditure.
 This budget is completely relied on previous year’s budget which can get wrong.
Other alternative budgeting methods
Rolling budgets
This budget is a continuous budget which is updated in a regular period of time as and
when the earlier budget expires (Shum, 2019). It can be said as an extension of earlier budget.
Using this approach, a business always has budget for one year in the future. It is also known as
budget rollover.
Strengths
 It does not involve much time as it is an extension of earlier budget.
 In this method, budget is very flexible so that changes can be made because of any
unexpected events.
 It also helps in identifying the strength and weaknesses of the business.
Weaknesses

 It requires highly skilled personnel.
 It is very costly.
 This method can be used by the businesses where conditions keeps on changing
frequently.
Zero based budgets
In this method, budget is prepared from the initial stage or in other words from the
scratch. In this, all the expenditures are justified for the new period. Nothing is taken from the
previous period. Each and every function of the organization is analysed with respect to the
needs and costs (Dokulil, 2016). Based on the analysis, budget is prepared and resources are
allocated to the departments for implementing their activities. Implementing it requires to follow
certain steps such as identifying the organizational goals, formulating ways for achieving those
goals, identifying the sources of funds and prioritizing it.
Strengths
 It provides clear picture of the resources available.
 It also helps in eliminating unnecessary activities.
 This method helps in establishing effective communication and coordination among the
departments.
Weaknesses
 It is a time-consuming process as everything starts from the scratch.
 It requires highly skilled and experience team.
 This method is very costly.
Activity-based budgets
Under this method, budget is prepared after taking into account overhead cost.in this
method, previous year’s data s not used but a complete cost analysis is carried out. Based on this,
resources are allocated to different activities (Amirkhani, Aghaz and Sheikh, 2019). This method
is used in order to bring efficiency in the activities and also it prepared after justifying the cost
with the cost drivers. Thus, it is an activity-oriented budgeting method.
Strengths
 It helps in saving cost by eliminating unnecessary activities which helps in saving costs.
 This method helps in exercising more control over the activities.
 It has the scope of making changes in the business as per the situation.
Weaknesses
 It is very lengthy process and it requires a lot of time.
 This method requires very talented team for analysing different activities.
 This process is very expensive.
ii.
Application of budgeting methods on Second Sight Plc for future plan
The application of different budgeting methods to the Second Sight Plc is stated below.
Traditional budgeting approach
This method of budgeting is currently used by the Second Sight Plc. This method uses
previous year’s budget for preparing the current year’s budget (Karpenko, Voronzhak and
Sapron, 2017). This method is most suitable for businesses having no major changes in the
working conditions. For example, if there is any error in the actual performance then it can be

easily figured out from the budget as only necessary changes are done. It has other benefits as
well which the Second Sight Plc is taking advantage of it like better decision-making process.
Rolling budgets
If this method is implemented by the Second Sight Plc. it will be very beneficial as it a
continuous budget which can be revised from time to time as per the requirement or changing
conditions. For example, if Second Sight Plc. Adopted a 12 month planning budget which starts
from January to December. As the January month completes, the budget will add another budget
for the following January. So, the budget still remains the same 12 month but now it has
extended from current year’s February to January of the next year. This method is very helpful as
it helps in identifying the strength and weaknesses of eth business and also changes can be made
easily.
Zero based budgets
If Second Sight Plc uses this method of budgeting then it requires to start its budgeting
process from the zero base and the respective manager of the process has to justify each and
every expense (Miller, 2018). The major aim of the businesses for using this method is to
optimize the cost and then revenue. For example, Second Sight Plc manufactures special type of
glasses which requires special parts. the company will analyse the cost of certain parts which are
outsourced to another increases the cost by 5%. After analysis, company is of the view that it can
manufacture it itself which will help in controlling and reducing the cost. Thus, this method is
very useful.
Activity-based budgets
In this method of budgeting, budget is prepared on the basis of the different cost such as
direct material and labour and overhead expenses (Oyadomari and et.al, 2018). It helps in
analysing the cost pertaining to different activities involved. For example, the company Second
Sight Plc estimated the sales for the next year of 100,000 units, each unit cost £5 for processing.
Therefore, the total budget for the expenses will be £500,000. Thus, this method of budgeting
can be used by Second Sight Plc.
iii.
Analysing the appropriate method of budgeting
The Second Sight Plc should switch from traditional method of budgeting to the
alternative methods because traditional method is just an adjustment to the past year’s budget
and that too on the part of inflation or increase in revenue. On the other hand, in order to
overcome such challenges, it should help use activity-based budgeting method. It will Second
Sight Plc in identifying the cost associated with the different activities carried out by it. Since,
Second Sight Plc is looking for expanding its business in other nations as well so it is best
method as it will help in evaluating the performance based on the activities and cost involved. It
will also help it identifying the unnecessary activities which can be eliminated which will
consequently lead to reduction in cost. Also, it will help in establishing an effective control over
the activities in order to improve the efficiency level. Another important point is that it will very

flexible which is beneficial as changes can be made very easily as per changing business
conditions and situations. Thus, this method is appropriate for the Second Sight Plc for
implementing it in its business.

REFERENCES
Books and Journals
Afrifa, G. and Tingbani, I., 2018. Working capital management, cash flow and SMEs’
performance. Int. J. Banking, Accounting and Finance. 9(1).
Amirkhani, T., Aghaz, A. and Sheikh, A., 2019. An implementation model of performance-based
budgeting. International Journal of Productivity and Performance Management.
Dokulil, J., 2016. Budgeting Process in the Business Environment. In Conference Proceedings
DOKBAT (p. 111).
Karpenko, L. M., Voronzhak, P. V. and Sapron, N. O., 2017. FEATURES OF THE
ORGANIZATION AND ESTABLISHMENT OF THE BUDGETING
MANAGEMENT AT THE ENTERPRISE IN GLOBALIZATION CHANGES
CONDITIONS. Science and practice: an innovative approach. p.110.
Miller, G., 2018. Performance based budgeting. Routledge.
Oyadomari, J. C. T. and et.al, 2018. Flexible budgeting influence on organizational inertia and
flexibility. International Journal of Productivity and Performance Management.
Shum, D., 2019. Effective Budgeting for Businesses Today. Partridge Publishing Singapore.
Singhania, M. and Mehta, P., 2017. Working capital management and firms’ profitability:
evidence from emerging Asian countries. South Asian Journal of Business Studies.
Weigel, C. and Hiebl, M. R., 2018. Beyond budgeting: review and research agenda. Journal of
Accounting & Organizational Change.
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https://www.investopedia.com/terms/p/profit.asp >.
What is Cash Flow? 2020. [Online]. Available Through:<
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What Is Working Capital? 2020. [Online]. Available Through:<
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