Impact of Working Capital Changes on Cash Flow

Part 1

i. Explanation of key terminologies:

a. Meaning and difference of two terms include Profit and Cashflow

Profit is defined as revenue as fewer expenses. It also considers as a net income of a firm which is accumulated by deducting all expenditure from profit figures. It presents the overall picture of an organisation along with the efficiency of business operations (Shapiro and Hanouna, 2019). On the other hand, the cash flow is termed as the inflow and outflow of money from different business operations like business operations, financial management, and investment.

The main difference between the profit and cash flow is that the profit figure determines the amount of money left after the payment of all business expenditure. It provides immediate information on business profit (Madura, 2020). However, the cash flow determines the unavailability and requirements of cash that have been incorporated in different corporate practices.

b. Meaning of Working Capital, Receivables, Inventory and Payables

Working capital is also termed as net working capital (NWC) that would be emerged due to the difference in the current assets and current liabilities. It is mainly considered to measure the liquidity position as well as operational efficiency. The approach of working capital has a great potential to determine the requirement of cash or liquid funds to manage the payment of all current liabilities (Banerjee, 2015).

The accounts payable is also termed as current liabilities of the company that is useful to track the money or dues that an organisation owes to any third party. It may include suppliers, banks, and other business partners (Watson Head, 2016).

The account receivables include a variety of current assets such as debtors, consumers, and others. This money keeps as account receivables that third parties owe to a firm. It could include banks, suppliers, sellers, and others (Brigham and Daves, 2014).

The value of inventory involves the monetary value of all types of unavailable stocks like raw material, work-in-progress and finished stocks that would be available for the next accounting period.

c. Impact of changes in Working Capital on Cashflow

If a transaction increases the current assets and current liabilities at the same rate, then there would be no change that emerged in the working capital and cash flow.

If an organisation’s working capital would be reduced due to a reduction in the cash proportion of current assets with affecting the current liabilities, then the value of cash flow would be reduced (Panigrahi, 2014).

If a firm sells its current assets without increasing current liabilities, then both values include working capital and cash flow would be improved.

When an organisation purchases additional inventory in cash, then there would not any change identified in the value of working capital, but the amount of cash flow will be reduced.

ii. Application of the concept of the question (i) in the present case of Fitt Ltd to manage the financial results

In the context of the present case of Fitt Ltd, the operating profit margin was £55 million last, but the net profit will be calculated by deducting interest-related expenses and taxes. As per the case, the company has recorded the turnover in excess of £250 million that could be emerged as an important cause of positive cash flow. Furthermore, the assessment of the case has found that the debt of the company has increased to £90 million from £65 million that may have a significant impact on the liquidity position of an organisation (Samiloglu and Akgün, 2016). In addition to that, Fitt Ltd could face the negative cash flow because the business entity has acquired the 30% of stakes of an organisation so as the total value of cash outflow would be reached near to £10 million in which organisation has to manage the payment of an £8 million advance fee.

In the context of the contemporary business environment, trade receivables and payables are playing an important role in influencing the liquidity position as well as the requirements of working capital. In the context of trade receivables, the company owes 12.5 million pounds for a series of different orders that were being placed by Mike last year. In addition to that, the company also has an outstanding dispute with the Sadidas, and the total value of the dispute is near to £12 million. Apart from that, the high volume of inventory could lead to a negative impact on the cash inflow along with the corporate liquidity (Gharaibeh, 2014).

As per the case, an owner of the company has proposed to manage the additional investment of equity capital to maintain an appropriate balance between the debt and equity capital. This is because only four individuals have owned the shareholding of the business entity, so the reduction in the amount of debt would reduce the interest related expenditures of the business entity (Weetman, 2010). It would increase the profitability of the business entity and also supports management to generate better cash flow by lowering the dependence on the debt capital (Ponsian and et al., 2014). By developing an appropriate relationship with the business partners and corporate buyers, the organisation can control the trade payable and receivable to reduce the payment period, and it may have significant on the overall business liquidity along with cash flow.

iii. Analysing and recommending steps to improve cash flow through better working capital management

In the context of the present case, the business entity should pay extra attention to the optimum utilisation of resources that could reduce the business expenditure and increase business profitability. It would support Fitt Ltd in lowering the inventory level and increasing the number of liquid sources of finance that would help manage the attainment of the requirements of working capital (Banerjee, 2015). Therefore, the management of Fitt Ltd could improve the cash flow in the company.

As per the case, Fitt Ltd has an outstanding of £12 million and the delivery to Sadidas was completed in 2017 so as the management should establish appropriate negotiation between lawyers and industry consultants to identify different techniques and approaches to recover the old outstanding that would play a critical role in the recovery of all dues and establishing the positive cash flow.

The present case has determined that Fitt Ltd has maintained a large stock of materials and supplies in its London warehouse. This stock comprises a large volume of liquidity or cash, so the company should reduce the number of stocks and inventories through cash (Brigham and Daves, 2014). It may not leave any kind of significant impact on the working capital but improves the cash inflow. Therefore, the alternations in stock levels play a key role in improving the cash flow within an organisation.

In the context of the contemporary business environment, trade payables and receivables have identified two important variables of the working capital that may have a significant impact on the stock levels along with the cash or liquidity position of a firm. By lowering the receivables period and increasing the payable periods, the management of Fitt Ltd would be able to establish an appropriate balance between the cash inflow and outflow (Drury, 2016). This is because if an organisation gets a higher payable period as compared to the receivable period, then the management would require less working capital to manage the early payments of all dues that could influence the inflow of cash within a business entity in a positive manner (Panigrahi, 2014). Therefore, appropriate management of cash inflow and outflow improves the unavailability of liquid cash in different corporate practices.

Part 2

i. Purpose of preparing a different type of budget with an explanation

a. Traditional budgeting approaches

In the context of the contemporary business environment, the importance of budgeting has been enhanced significantly to ensure the optimum allocation of resources. As per the case of Phonus Plc, the company has considered the traditional budgeting approach. It is identified as one of the most common methods that are used by an organisation in order to prepare a budget for a specific period with reference to the budget of previous years (Cardoş, 2014). By comparing the actual outcomes with reference to predetermined budget objectives, a firm would be able to evaluate the overall organisational efficiency.

b. Alternative budgeting approaches

For the attainment of organisational efficiency, companies consider different types of alternative budgeting approaches to handle different business scenarios. In this context, some most popular methods are listed below:

Rolling budget: A rolling budget is regularly improved with a new budget for a new duration which is linked with the previous budget period. It involves the incremental extension of the exiting budget model. The rolling budget takes extra attention to the management of different companies because it offers a significant benefit through regular modifications in the budget model by revising the budget assumptions of the last incremental period of budget (Réka and et al., 2014). Therefore, it is termed as a continuous budgeting approach because it needs regular modifications in a regular manner with reference to old budgets. In the context of the contemporary business environment, this type of budgeting involves sales budget, production budget, overhead budget, financial budget, and others.

Zero-based budgeting: This type of budgeting process starts from a base of zero without making any reference to the prior period’s budget or actual performance. This type of budget is mainly applied to manage resources efficiently. The approach of Zero-based budgeting offers great support to companies to achieve optimum allocations for different business procedures and operations. It considers the bottom-up approach in budgeting (Mutanov, 2015). The key benefit of the zero-based budgeting is that all proposed expenditures can be judged optimally, and different business operations can consistently and closely be scrutinised. In the context of different business operations, an organisation should have to take significant management efforts to evaluate different cost centres and causes of business expenditure (Aktas and et.al., 2015). The required level of data and number crunching can mean that the effort can obscure the purpose. In addition to that, some companies consider the zero-based budgeting for a wide range of cost centres and profit centres through which an organisation can separate cost reduction exercise and maintaining regular financial control with reference to traditional budgeting methods that could maximise the efficiency of business operations (Bogsnes, 2016).

Activity-based budgeting: It is an important part of modern budgeting methods in which an organisation evaluates business expenditures and efforts of management at each level of production to predict costs. This system is mainly applied to record, research, and analyse different activities that could incorporate the costs for the firm. The primary objective of activity-based costing is to minimise the cost of production. The activity-based budgeting is applied after considering the overhead costs (Jones and Smith, 2014). This type of budgeting system is not aligned with the budget of the previous year. In addition to that, different activities that are involved in the budgeting process play a critical role in the assessment of the production cost and corporate overseas in different cost centres. It is mainly adopted to improve the efficiency of different activities of an organisation (Atrill 2014). This system evaluates the requirements of a variety of resources in each activity of the production process. It is mainly prepared to justify different cost drivers. By assessing the usefulness of different corporate activities, the management would be able to eliminate unwanted activities and business processes. This system supports managers in the selection of the most suitable activities that could reduce the overhead expenditure on each activity of the production process (Marseille and et al., 2014). Moreover, it helps the manager in the removal of bottlenecks.

ii. The application of different methods of future cost management in the context of Phonus Plc

In the context of the present case of Phonus Plc, the management is looking to expand business operations with the help of its new production facility. In this context, the traditional budgeting approach could be considered by the management in sales planning. This is because the traditional budgeting process is linked with the budget of previous years. Therefore, the organisation would be able to determine the new sales targets with reference to the historical performance of the company (Dudin and et al., 2015). As per the case, the company is looking to initiate its new production facility so as traditional budgeting approach would assist management in the estimation of future sales results with reference to increased capabilities of the production facility. In addition to that, traditional budgeting can be involved in human resource planning and staff management (Atrill, 2015).

On the other hand, alternative budgeting method like zero-based budgeting and activity-based budgeting could be applied in the present case of the new production facility. For example, the management of Phonus Plc is establishing the partnership or joint venture with a Swedish company so as zero-based budgeting can be applied to evaluate all expenditures and cost drivers of new production facility without consideration of past data (Cardoş, 2014). Therefore, the zero-based budgeting has been found very effective in order to conduct cost planning and resource management for new projects. Apart from that, the activity-based budgeting would support the business entity in the identification of different cost centre and activities in production planning. For example, the assessment of resource requirements on each activity of the production process of the new unit with reference to the production process of the old production unit. This new system will help the production manager in the removal of unwanted activities in the production process that could be acted as a cost centre (Réka and et al., 2014). It may assist the manager in lowering business expenditures.

iii. Analysing whether a traditional or alternative budgeting system to all or any part of business

The present case of Phonus Plc has determined that the company is looking to establish a new joint venture to set-up a new production facility. However, the management has identified some issues in existing traditional budgeting system of old product unit. These drawbacks could adversely affect the cost planning process. The key drawbacks of traditional budgeting system include increased the chances of human errors and time-consuming (Mutanov, 2015). However, the traditional budgeting approaches are failed to business spending with reference to the corporate strategy of an organisation. Furthermore, the inaccurate predictions of the different data point in different cost centre are being emerged as a key driver that has hampered the reliability of traditional budgeting process. In the context of small firms, traditional budgeting system would be found very effective in the cost planning and resource management, but it is not suitable in managing the production plan in the large companies (Bogsnes, 2016).

However, alternative budgeting methods like activity-based budgeting would be identified very useful in performing the production and cost planning for new production unit of Phonus Plc. In this context, activity-based budgeting has found very effective in the assessment of different associated costs in each operational activity. This system would support the management in breaking down different activities and cost drivers that may have a significant impact on the profitability of the firm (Jones and Smith, 2014). This system determines the balance between the production quantity and input of resources that may have a significant impact on cost assessment process in the new production process.

Reference

Aktas, Croci, Petmeza, 2015. Is Working Capital Management Value-Enhancing. Journal of Corporate Finance 30, pp. 98-113

Atrill 2014. Financial Management for Decision Makers. 7th ed. London FT Prentice Hall. Chapter 10 - Working Capital

Atrill, 2015. Management Accounting for Decision Makers. 8th ed. London Pearson. Chapter 6 Budgeting

Banerjee, B. (2015). Fundamentals of financial management. PHI Learning Pvt. Ltd..

Bogsnes, B. (2016). Implementing beyond budgeting: Unlocking the performance potential. John Wiley and Sons.

Brigham, E. F., and Daves, P. R. (2014). Intermediate financial management. Cengage Learning.

Cardoş, I. R. (2014). New trends in budgeting–a literature review. SEA–Practical Application of Science, 2(04), 483-489.

Drury, 2016. Management Accounting for Business. 6th ed. London Cengage. Chapter 9 The Budgeting Process

Dudin, M., Kucuri, G., Fedorova, I., Dzusova, S., and Namitulina, A. (2015). The innovative business model canvas in the system of effective budgeting. Asian Social Science, 11(7), 290-296.

Gharaibeh, A. (2014). Capital structure, Liquidity, and Stock returns. European Scientific Journal, 10(25).

Jones, M., and Smith, M. (2014). Traditional and alternative methods of measuring the understandability of accounting narratives. Accounting, Auditing and Accountability Journal.

Madura, J. (2020). International financial management. Cengage Learning.

Marseille, E., Larson, B., Kazi, D. S., Kahn, J. G., and Rosen, S. (2014). Thresholds for the cost–effectiveness of interventions: alternative approaches. Bulletin of the World Health Organization, 93, 118-124.

Mutanov, G. (2015). Mathematical Methods and Models in Economic Planning, Management and Budgeting (p. 364). Springer Berlin Heidelberg.

Panigrahi, C. M. A. (2014). Relationship of working capital with liquidity, profitability and solvency: a case study of ACC Limited. Asian Journal of Management Research, 4(2), 308-322.

Ponsian, N., Chrispina, K., Tago, G., and Mkiibi, H. (2014). The effect of working capital management on profitability. International Journal of Economics, Finance and Management Sciences, 2(6), 347-355.

Réka, C. I., Ştefan, P., and Daniel, C. V. (2014). TRADITIONAL BUDGETING VERSUS BEYOND BUDGETING: A LITERATURE REVIEW. Annals of the University of Oradea, Economic Science Series, 23(1).

Samiloglu, F., and Akgün, A. İ. (2016). The relationship between working capital management and profitability: Evidence from Turkey. Business and Economics Research Journal, 7(2), 1.

Shapiro, A. C., and Hanouna, P. (2019). Multinational financial management. John Wiley and Sons.

Watson Head, 2016. Corporate Finance. 7th ed. London Pearson. Chapter 3 - Working Capital

Weetman, 2010. Management Accounting. 2nd ed. London FT Prentice Hall. Chapter 13 Preparing a budget