Capital budgeting and alternative investment options. Working capital management

The example of GardenRite Ltd


Essay, 2017

10 Pages, Grade: 5.50


Excerpt

Table of contents

Part I
I. Profit, cash flow and how changes in the working capital affect it
II. GardenRite Ltd management in terms of receivables, payables and working capital
III. Analysis and recommendations
References

Part II
I. Capital budgeting process purpose and key stages. Investment appraisal methods
II. Comparison of the alternative investment options
III. Analysis and recommendations
References

Executive summary

Part I

This report addresses a paradox: high profit and at the same time significant debts for the company. Seen from this perspective, the profit regarded as the difference between the total revenue and the total costs and the cash flow seen as the incomings and outgoing of cash of a particular company, are somehow different. One of the reasons for that is the usage of the accounting conventions of the accruals; however the issues relating to the working capital management are also of importance. In this field of development the way changes in the working capital affect cash flow will be analyzed and important recommendations will be made.

I. Profit, cash flow and how changes in the working capital affect it

What most companies meant by profit is the so-called surplus, or said in short what is remaining after total costs are deducted from total revenue. On the other hand, when companies refer to cash flow they often relate it to the incomings and outgoings of cash, representing in this way the operating activities of an organization (Gowthorpe, 2011). Therefore, any investigation into the difference between profit and cash flow of any company would have as its results the following outcomes:

- In the short term the profits of one company are not identical to positive cash flows (Gowthorpe, 2011).
- The previous fact is due to the usage of the accounting conventions of the accruals, as well as to the concept in which the accounting revenue is not proportionate to the cash received, as well as vice versa (Gowthorpe, 2011).
- The impact of one transaction is not one and the same on the cash of the company, as well as on its profit (Gowthorpe, 2011).

However, talking about both categories of profit and cash flow we need to illustrate how in reality they are different. For example, if there is a sale for cash - the impact on the cash and profit is identical, however if there is a sale on credit there is a mismatch between cash and profit (Gowthorpe, 2011). Moreover, if there is a purchase of a new car and its relevant depreciation for the period of over 4 years and the assumption of no residual value, then the cash will be reduced, while there will no immediate impact on profits; each year for the 4 year period there will be a depreciation charge according to the straight-line method but all this will have no impact on the company's cash resources (Gowthorpe, 2011).

The working capital of the company is yet another important category to be considered. According to Atrill and McLaney (2015) is serious investment for many businesses and simply put it represents the amount that is left after the deduction of the current liabilities from the current assets. Its three main components are the receivables, inventory and payables of the company. For the different industries, is observed different size and composition of the working capital. The manufacturing business normally possesses high level of trade receivables (the latter being regarded as the amount of money the company has to obtain from its customers, that buy products on credit). On the other hand the retailers possess low level of trade receivables as they mostly sell goods for cash, not on credit (Atrill and McLaney, 2015). In general, the service business hold no inventories (finished goods), as the nature of their businesses is different. The payables, usually regarded as a form of free-interest financing, are observed in the periods when businesses are short of cash and as a consequence they postpone payments to suppliers. However, that type of payment delays might seriously lessen credibility on part of the suppliers.

The changes in the working capital always affect the company's cash flow. In case we have an increase in the figure of the working capital, then as a consequence we will have more cash tied up in it, so the cash flow at the present moment will be diminished. On the contrary, when the company's management decides to lessen the amount of the working capital, then the result will be more cash available that can be used for other projects (Brealey and Myers, 2016).

II. GardenRite Ltd management in terms of receivables, payables and working capital

Despite the amazing turnover in excess of £ 50 million, as well as the reasonably profitable figure of the operating profit of last year, GardenRite Ltd company's debt has increased with the significant £ 2 million pounds. However, the greatest issue in the management of GardenRite Ltd is the high figure of its trade receivables - £ 1.5 million pounds. In this regard the company should assess the effectiveness of its receivables collection processes. On the contrary, the figure of the trade payables estimated at £ 2 million pounds is a significant source of finance for the business that will increase with the level of activity achieved by the business. Despite the fact that the year seems profitable, the working capital of the company is improperly managed, leading to problems with the cash flow.

III. Analysis and recommendations

As we have seen the major issue in the improvement of GardenRite Ltd cash flow is the assessment of the effectiveness of its receivables collection processes. The steps that need to be taken in this regard comprise in the establishment of clear policies, concerning:

- which customers of the company should receive credit. The company must make a thorough assessment of its credit ability, based on the five Cs of credit (Atrill and McLaney, 2015).
- how much credit and credit facilities should be offered. Unfortunately, there is no adequate theory established so far that will help the business decide on the appropriate credit limits, so at present it is a matter of judgement.
- what is the maximum period of the credit that the company is prepared to offer. The length of the credit should be influenced by factors such as: the typical credit terms operating within the relevant industry, the level of competition, the bargaining power of the customers, the risk of non-payment and the marketing strategy of the particular company.
- are there any discounts offered for timely payment. For example, the size of the discount will make an important difference to the customer and will determine whether or not he will pay instantly.
- what collection policies should be adopted and
- how the non-payment risk could be reduced (Atrill and McLaney, 2015)

Moreover, the development of suitable to the needs of any business collection policies requires cultivation of the relationship with the staff responsible for the payment of the invoices. What is more, the credit terms of the business should be made public; the latter means that in the earlier stages of the development of the business relationship those terms namely should be openly discussed and an agreement should be reached. The invoices should be promptly sent, as well as the system installed should coordinate the sending of reminders.

Talking about the level of the trade payables of the company it should be noted that after the resolution of the dispute with BricoFrance, the significant amount of £ 2 million will be payable, or least part of it. In that case GardenRite Ltd should take advantage of the cash discount, offered by the supplier for prompt payment. In addition, the management of the company should start to monitor the level of the credit taken.

As a whole the management of the company should adopt several policies for better working capital management; the closer partnership with customers and suppliers is a prerequisite for that. The basic outcome from the working capital management policies is that managers should avoid keeping up too much cash, being unnecessarily tied up into the working capital of the company. In addition, the management of the company must decide how much of each element (receivables, inventory or payables) should be held. This is done is order to weight potential benefits against likely costs, so at the end of the day an optimum investment should be achieved (Aktas et all, 2015).

References:

Business Accounting & Finance Gowthorpe, 3rd Ed (2011) Chapters 6 & 19

Corporate Finance Principles and Practice Watson, Head, 7th Ed (2013) Chapter 3

Management Accounting for Decision Makers Atrill, McLaney, 8th Ed (2015) Chapter 11

Principles of Corporate Finance Brealey, Myers 12th Ed (2016) Chapter 30

Is working capital management value-enhancing? Evidence from firm performance and investments Aktas, Nihat, Petmezas Journal of Corporate Finance, February 2015, Vol.30, pp.98-113

[...]

Excerpt out of 10 pages

Details

Title
Capital budgeting and alternative investment options. Working capital management
Subtitle
The example of GardenRite Ltd
College
Anglia Ruskin University
Grade
5.50
Author
Year
2017
Pages
10
Catalog Number
V427075
ISBN (eBook)
9783668713093
ISBN (Book)
9783668713109
File size
515 KB
Language
English
Tags
capital, budgeting, alternative, investment, options, cash flow, profit
Quote paper
Bachelor Silvia Stamenova (Author), 2017, Capital budgeting and alternative investment options. Working capital management, Munich, GRIN Verlag, https://www.grin.com/document/427075

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