Understanding Profit, Cash Flow, and Working Capital for Better Financial Management

This document provides a comprehensive understanding of profit, cash flow, and working capital. It explains the difference between profit and cash flow, defines working capital and its components, and discusses how changes in working capital affect cash flow. The document also analyzes the current management of Trend Ltd and provides recommendations for improving cash flow through better working capital management. Additionally, it includes a cash budget for Thorne Estates and recommendations based on the analysis.

Project

TABLE OF CONTENTS
Executive Summary.........................................................................................................................3
TASK 1............................................................................................................................................4
I. ......................................................................................................................................................4
a. Defining profit and cash flow and difference between the two..............................................4
b. Defining working capital, receivables, inventory and payables..............................................4
c. Changes in working capital affecting the cash flow................................................................5
ii.......................................................................................................................................................6
Current management of the company might affect its financial results......................................6
iii......................................................................................................................................................6
Improving cash flow by way of better working capital management..........................................6
Executive Summary.........................................................................................................................8
TASK 2............................................................................................................................................9
1. Monthly cash budget (4 months).............................................................................................9
2. Recommendations for management of Thorne Estates based on analysis............................10
REFERENCES..............................................................................................................................13

Executive Summary
The Task 1 is addressed to the shareholders which defines the key financial terms
important for understanding performance of the company. It also incorporates the effect of
change in working capital over the cash flow and the steps that can be taken for improving the
company's cash flow.

TASK 1
I.
a. Defining profit and cash flow and difference between the two
Profit
The profit refers to the amount which is being derived after meeting with all the
expenditure pertaining to the month or year. It is the balance amount which is being left after
reducing all the expenditure from the revenue for a specific period (Boyd, 2020). For calculating
it, profit and loss statement is prepared which involves both cash and non-cash expenditure as
well, for example, depreciation is deducted from the revenue which lead to reduction in profits.
Cash flow
The cash flow basically refers to the amount which is being transferred in and out of the
business. It can be positive or negative. Positive when company adds money to the business and
negative when money is withdrawn from the business. It involves the usage of income statement
and balance sheet and includes only cash transactions. For example, depreciation and credit sales
and purchase are not accounted for.
Difference between profit and cash flow
Profit Cash flow
It accounts for the money which is being left
after deducting all the costs from the sales
figure.
It basically represents cash flow from the
various sources such as the investing, financing
and operational activities.
Profit is determined even before the money is
received.
Cash flow is calculated after the cash is
received.
It is not critical for the survival of the firm. This is important for the survival of the entity.
It follows accrual basis of accounting principle. It follows cash basis of accounting principle.
b. Defining working capital, receivables, inventory and payables
Working capital
The working capital basically refers to the difference between the current assets and
current liability and is also a measuring tool for determining the short term liquidity of the entity

which is crucial for carrying out the financial analysis along with managing cash flow (Altaf and
Ahmad, 2019). It helps in determining whether the company is having sufficient current assets
for meeting its short term business requirements.
Receivables
It is the amount which is being owed to the company in respect to the products and
services provided to the customers on credit. It is termed as the trade receivables and is placed
under the heading current assets (The difference between accounts receivable and accounts
payable. 2020). For instance, a manufacturer sells goods on credit to customer on 1 June and the
customers is allowed to pay the due amount in 30 days. Thus, from June 1 till the company
receives the amount, the company will be having an account receivable.
Inventory
Inventory is the items, goods and merchandise which is procured and held by the entity
for the purpose of selling it in the market and earning profits. For instance, a newspaper seller
uses a vehicle for delivering newspaper to the customers, the newspaper will be considered
inventory and the vehicle is treated as an asset.
Payables
The accounts payable is created when the business entity purchased goods on credit from
the suppliers. It is the short term liability called as trade payables and put under the head current
liabilities (SUZAN, SUDRAJAT and DAUD, 2020). For example, a manufacturer purchases raw
material from supplier on 1 June and is payable within 30 days, thus, from June 1 to till company
pays the amount, it will be shown as account payable in the books of accounts.
c. Changes in working capital affecting the cash flow
Working capital and the cash flow are the important concept pertaining to the concept of
financial analysis. The change in the working capital can be seen in the organization's cash flow
statement (Sensini, 2020). For example, a transaction resulted into rise in the current assets as
well as current liabilities by the same amount then there won't be any change in the working
capital. This can be explained with the help of an example, like if the cash received for the short
term debt which is required to be paid within 60 days, then this will result into increase in the
cash flow but in contrast there won't be any change in the working capital as the proceed from
the debt is cash which is a current asset. Another example is if the company purchased fixed

asset, it will lead to decrease in cash flow and working capital will also decrease as cash which is
current assets is decreased.
ii.
Current management of the company might affect its financial results
By looking at the current situation of the company Trend Ltd (TL), last year company
had reasonable profits and also, the debt of the firm is also increased from £60 million to £95
million and in order to reduce the debt it is looking for investors. Irrespective of the fact, that the
financial position of the company is not good it, Trend Ltd has acquired stake in a company and
invested nearly £20 million for acquiring the same and paid an advance amount of £5 million for
the exclusive supply of the goods. The company is having a dispute amounting to £12.58 million
for the delivery made in 2019. Also, the poor quality material provided by supplier and over
which the payment is not made is now threatening the legal action. In addition to this, the
company is having the unwanted large stock of materials and supplies which has been built up at
the warehouse of the company which might be useful after sorting the dispute (Zimon, 2020).
The company is owed £10 million on the order placed by customer Tkechers last year which the
company Trend Ltd is not able to recover because of its ineffective collection team. Thus, if the
company continuous its business activities in such as way, as it will result into affecting the
survival of the company along with huge debt. It is recommended to stop making further
investment in acquisition until its financial capability is stable.
iii.
Improving cash flow by way of better working capital management
There are various ways through the company Trend Ltd can effectively manage its cash
flow leading to better working capital. Some ways are stated below:
 The company can provide incentives to its customers for paying on time. In addition, by
identifying the delinquency early and undertaking the corrective steps will assist in
preventing the accounts from aging soon. Also, Trend Ltd should avoid having business
with the customers having history of defaulting.
 The company can implement an automatic payment system which will help in ensuring
that the timely payment for the debt obligation is made and overcoming the situation of
delay payment and attracting penalty for the same (Romero, 2019).

 Through the way of maintaining a good relationship with the vendors and offering
discounts to the suppliers supports in cost saving and enhancing the finances. Under the
situation, when the entity comes across the cash crunch situation, this relationship will
help in long way pertaining to getting some leniency.
 Trend Ltd can also examine the interest on loans and other debts in regard to whether it is
eligible for any sort of modification in the interest payment or rates which will help in
lowering the fixed cost burden every month. Along, early clearing of debt will support in
minimizing the cost of paying in future instalments. This will result into saving adding to
working capital.
 The company needs to avoid the situation of overstocking and requires making sure that
the finished goods are sold as soon as possible and can also implement steps of cutting
the production till the old stock is sold out. It will reduce the cost of holding the
inventory.
 It also needs to make sure its collection team is effective to chase the delinquent
customers and rewarding them for collecting effectively.

Executive Summary
The task 2 of the report provides an insight into the preparation of the cash budget and
then analysing the outcome derived from it from the perspective of the company Thorne Estates
Limited. On analysis, certain recommendations is made to the company for improving the cash
management of the company.

TASK 2
1. Monthly cash budget (4 months)
Month Jan Feb March April
Units Sold 10 15 25 30
Price per unit 1,80,000 1,80,000 1,80,000 1,80,000
Total value of
properties sold 1800000 2700000 4500000 5400000
Cash Inflows
Sales commission
1% in current month 18,000 27,000 45,000 54,000
2% past month 36,000 36,000 54,000 90,000
Sale of vehicles 20,000
Total Cash Inflow 54,000 63,000 99,000 1,64,000
Cash Outflow
Variable Expenses 9,000 13,500 22,500 27,000
Salary 26250 26250 26250 26250
Bonus 6300 12600
Fixed overheads 4300 4300 4300 4300
Loan Interest 3000
Outstanding tax
liability 95800

Total Cash Outflows 39,550 44,050 62,350 1,65,950
Cash surplus/ (deficit) 14,450 18,950 36,650 -1,950
Opening Cash Flow -40000 -25,550 -6,600 30,050
Closing cash flows -25,550 -6,600 30,050 28,100
Working note:
Monthly salary cost = (35,000 × 9)/12 = $26,250
Bonus for March = (25 - 20) × 140 × 9 = $6,300 Bonus for April = (30 - 20) × 140 × 9 =
$12,600.
2. Recommendations for management of Thorne Estates based on analysis
The cash budget of the company indicates the rise in the sales over a period of time
which also suggests higher sales as the spring approaches. The large number of residential
property is being sold every month which depicts that the Thorne Estates is experiencing
seasonal trends. A proportion of any excess cash flow is likely to be short term in nature as it will
be needed when the sales is at the lower level. Even if the net cash flow forecasted is positive in
the month of January, but it has the lowest level of property sales and in addition to this, the
negative opening cash balance might be the result of even more lower sales in December and
prior months (Shash and Qarra, 2018). The short terms excess cash should be invested into no or
very less risk of capital loss as these can be called upon any time of need. It mainly includes the
banks deposits, term bills, gilts etc. In regard to selecting between these investment options,
Thorne Estates is required to take into consideration the size of the surplus and the time interval
for which it is available in addition to the yield offered and the related risk of each instrument. A
small organization such as Thorne Estates having a yearly turnover of nearly £1 million would
find bank deposit as the most convenient approach for investing excess funds.
Apart from short term investment, the firm can also consider long term surplus
investment as the company is small so it will likely to invest the excess cash in expanding the

business and would be able to find only limited sources for procuring funds apart from bank debt
and accumulated profits. Thus, there is a need to protect the surplus in order to fund the business
expansion in the future. As the residential property market is very competitive, investment
related opportunities required to selected with care and accumulated should be invested on only
short to medium term basis until right opportunity comes across.
It can be seen that out of four months budget, the company is having 2 months with
closing cash balance be deficit with the high opening cash balance of £40000. In addition, this
deficit occurred when the company was having the loan of £200,000 which is expected to be
financed by bank overdraft facility (Dwiastanti, 2017). The main benefit of this overdraft facility
is that amount can be used as and when needed, until it is within the limit but the firm is required
to pay interest which is being charged at the variable rate. In contrast to interest is to be paid in
full on entire £200,000 irrespective of whether amount is used or not, therefore, interest on
overdraft is lower than long term debt as it helps in meeting with the urgent business needs.
The current situation of Thorne Estates can be further analysed and observed with the
help of “The Baumol model” which is applicable under the situation where the demand of the
cash is constant. This model accounts for the annual demand of cash and cost of every cash
related transfers and difference in the interest rate. This model supports in minimizing the
opportunity cost pertaining to holding of cash and henceforth, decreasing the cost of managing
cash. But, this model is unlikely to be of much support to Thorne Estates as one of its assumption
is constant demand of cash while in case of Thorne Estates, the cash budget highlights the
varying needs of cash. There are various other models which can be implemented as the cash
management tool which helps in determining the optimum amount of cash which the firm should
hold on with. Apart from the assumption of the Baumol model, there are other ways in which
this model is helpful like it helps in deciding the optimum amount should be transferred on a
regular basis to current a/c from the investments.
Also, the company is having a huge amount of tax liability which amounted to £95800
which is due to be paid in the month of April. The company dispose off its fixed asset, a vehicle,
having a net book value of £15000 for sales value of £20000, having again of £5000. The entity
is also needed to effectively evaluate its fixed and variable cost and implement strategies for
reducing the same which will help in increasing the cash surplus. In respect to the fixed cost, the
company is paying fixed overhead every month which amounted to £4300 every month. The

variable expenses also increases as the sales value of the property sold increases as it is 0.05% of
the sales value (Eton, Fabian and Benard, 2018). In addition to this, it is recommended to the
company that it should implement strategies for the purpose of decreasing the variable cost like
reduction the salary or the bonuses being offered to the employees. In regard to the cash inflow,
the percentage commission which the company Thorne Estates charges for selling the residential
property is just 3% and thus, can further increase it for gaining higher cash inflow and
overcoming the situation of cash deficit. Consequently, this will result into making quick
payment of the debt it has taken and reducing the financial burden pertaining to the interest
payment on the company. The company can also create target in regard to the minimum balance
of cash which is required to be maintained under any situation which will lead to effective and
optimum utilization of the available cash and thus, avoiding any the situation of cash crunch and
insufficient balance. The rent amounting to £42,000 which is due in May month is also high,
having the potential to affect the cash surplus to a great extent. Therefore, initiative should be
taken for reducing the rental amount in future dealings after May.
Thorne Estates is needed to make sure that proper balance is being made between the
short term and long term investment of the surplus funds which will support in effectively
meeting with the sudden and future requirements. Inability to do so might result into loss of
money or the opportunity for which the funds were accumulated by the organization. Thus, these
are the key observations which are being made from the above cash budget and based upon
which certain recommendation is being given to management for handling cash which will
support in improving the cash position of the company and assists in effectively meeting with the
future business dealings.

REFERENCES
Books and Journals
Altaf, N. and Ahmad, F., 2019. Working capital financing, firm performance and financial
constraints. International Journal of Managerial Finance.
Dwiastanti, A., 2017. Analysis of financial knowledge and financial attitude on locus of control
and financial management behavior. MBR (Management and Business Review). 1(1).
pp.1-8.
Eton, M., Fabian, M. and Benard, P. O., 2018. Cash Budgeting and Organizational Performance
of Private Firms in Uganda: A Case of Kabale District, Western Uganda.
Sensini, L., 2020. Working capital management and performance: evidence from Italian
SME’s. International Journal of Business Management and Economic Research
(IJBMER). 11(2). pp.1749-1755.
Shash, A. A. and Qarra, A. A., 2018. Cash flow management of construction projects in Saudi
Arabia. Project Management Journal. 49(5). pp.48-63.
SUZAN, L., SUDRAJAT, J. and DAUD, Z. M., 2020. Accounting information systems as a
critical success factor for increased quality of accounting information. Revista
ESPACIOS, 41(15).
Zimon, G. R. Z. E. G. O. R. Z., 2020. Management strategies of working capital in polish
services providing companies. WSEAS Transactions on Business and Economics. 17.
pp.225-230.
Online
Boyd, K., 2020. The critical differences between revenue, profit, and cash flow. [Online].
Available Through:<https://quickbooks.intuit.com/r/cash-flow/critical-difference-profit-
cash-flow/>.
Romero, B., 2019. 6 HACKS TO IMPROVE YOUR WORKING CAPITAL MANAGEMENT.
[Online]. Available Through:<https://blog.apruve.com/6-hacks-to-improve-your-
working-capital-management>.
The difference between accounts receivable and accounts payable. 2020. [Online]. Available
Through:<https://www.accountingtools.com/articles/the-difference-between-accounts-
receivable-and-accounts-paya.html>.