Business Profitability
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Executive Summary
This report is divided into two parts after the introduction. The first part deals with capital management and how it is very important to a business. The segment uses a case study to explain how poor management of working capital can affect the performance of a business. The report further discusses how the business can change management systems and improve performance. The second part discusses the budgeting systems in the organization. The defines the traditional and alternative budgeting systems and gives the advantages and drawbacks of either system. The part also gives illustrations on how the budget can be calculated and how it affects the business. Finally, the part compares the traditional and alternative budgeting systems.
Contents
1.1 Working capital: Receivables, inventory, and payables
1.2 Effects of changes in working capital on cashflow
1.21 Change in the interest rates
1.22 Changes in market demand for the business output
1.3 Effects of working capital on the financial stability of a business
1.4 Management of working capital
2.2 Alternative Budgeting systems
Advantages of zero-based budget
Drawbacks of zero-based budget
2.3 Applications of budgeting systems
Introduction
Working capital management is optimizing output while at the same time reducing the cost of production. Working capital management involves minimizing the operating costs, hiring qualified personnel to audit the business operations, and maximizing the scales of production. When the business does not manage the working capital properly, it risks litigation and possible dissolution. Therefore, the business should use the available resources to ensure that it maximizes production and profitability while minimizing the costs. Budgeting, on the other hand, refers to an approximation of how a business is going to spend and generate income. There are two main budgeting systems, the traditional and alternative budgets. The traditional budget makes the financial position of a business based on past information, while alternative budgeting makes the decisions based on current data.
1.0 BrightLawns Ltd
The success of a company depends on its ability to manage profits and cash flow. Interestingly, some companies make profits but end up closing down due to poor management of cash flows (Aktas, 2015). Notably, most firms ignore cash flow because they do not understand how it works or its impact. Cash flow refers to the amount of money that flows in and out of business. On the other hand, profit refers to subtraction of expenses from the revenue collected. Profitability does not take into account the goods and services purchased using credit, and this adversely affects the cash flow. In the case of BLL, the business cash flow was affected by credit purchases and delayed payments. In order to reduce the cash outflows, BLL reduced the units it was producing annually, and this adversely affected the sales. In order for the profitability of BLL to be viable, it has to reduce the expenses, which consequently will reduce the cash outflows.
1.1 Working capital: Receivables, inventory, and payables
The working capital is very crucial to a business because it influences how the business organizes its operations. Working capital refers to the difference between current assets and current liabilities of a firm. Current assets refer to resources that are used to service the daily activities of a business. The common current assets include inventories, cash in hand or bank, and trade receivables. A business that manages these assets meets all the short-term goals without incurring debts.
1.11 Receivables
Receivable for BLL Company refers to the money that the debtors should have paid. BLL is owed money by BricoFrance SA and C&P DIY Ltd. If the two companies clear the debts they owe BLL, it will settle the receivables.
1.12 Inventory
Inventory refers to the stock at hand in business. The inventories for BLL include work in progress (WIP), finished goods, and raw materials (Gowthorpe, 2011). The WIP refers to activities that consumed resources but were not completed at the end of a financial period. The WIP is calculated as follows:
(Beginning work-in-progress inventory + total WIP costs) –cost of finished goods.
The BLL should have also taken care of both the raw materials and finished goods. When the buyers took a long time to pay for credit purchases, the cost of production became too high, and therefore the inventories decreased in value (Watson and Head, 2016). In order for the company to increase the production of water valves, it should collect the money the clients owe it.
1.13 Payables
Payables refer to the money that a company owes creditors. Payables are liabilities to a business. The payables for BLL include the fines for failing to pay the contractor. Payables affect the working capital negatively and should, therefore, be minimized.
1.2 Effects of changes of working capital on cashflow
The cashflow is affected adversely when the working capital changes negatively. The working capital is affected by the following factors which consequently affect the cashflow.
1.21 Change in the interest rates
The interest rate of interest rate can for, or, against the business. If the company sold the valves on credit at a rate of 7.5%, then the cost of buying materials and manufacturing rose from 6% to 8.5%, the company will have lost 8.5%-7.5% plus the time taken to manufacture the valves. If the company incurs loss, the cashflow is also adversely affected. One the other hand, if the rate of manufacturing drops to 5.5%, the company will have gained 7.5%-5.5%, minus the time taken to manufacture the valves. When the interest rate changes positively, the company gets more profits and consequently the cashflow improves significantly. However, the company should ensure that that all the debts are collected instantly so as not to affect the cashflow.
1.22 Changes in market demand for the business output
When the demand for outputs increases, the cash inflow also grows significantly. On the other hand, if the business demand goes down, the cash inflow also goes down. When the demand for the products goers down, the cost of production goes up and consequently, the cashflow goes down (Atrill, 2014). The demand can change due to changes in purchasing power of the people or availability of more affordable substitutes.
1.23 Changes in the seasons
The change in season causes the demand to go down. For instance, during winter, water freezes and causes the pipes to burst due to the pressure. The demand for valves therefore goes up and consequently more cash flows into the business.
1.3 Effects of working capital on the financial stability of a business
The working capital is delicate to the performance of a business. BLL had a turnover of £50 million last year. On the other hand, the profit was £5 million. Since the company is a partnership, the four shareholders were expected to get £1.25 million before earning and tax (BET). However, the company incurred an increase in loss from £16 million to £18 million.
Percentage increase in loss: (18-16) = 2/16 ×100=12.5%.
If BLL collects the money the debtors owe it, they will collect £3.5 million, which will consequently lower the debts owed. If the four shareholders do not work in harmony and collect the money owed to the creditors, BLL will be overwhelmed by expenses and affect the working capital negatively. Consequently, the company will not be able to increase the level of output and this will affect the profitability which could cause it to be dissolved.
1.4 Management of working capital
BLL can improve the working capital by employing a number of strategies. First, the company should manage all the costs related to the working capital (Melville, 2017). The costs include storage and handling, costs that are related to managing the inventories, opportunity costs and costs of managing pilferage and valves that are obsolete.
The second way through which the company can manage the working capital is through optimization of economies of scale. The company receives large discounts when buying raw materials for the production of valves. Therefore, the company can optimize on the large discounts by producing many valves and use the savings to advertise the products.
Thirdly, BLL can hire financial experts to help it collect debts and reduce production costs. The company can also take advantage of their large production capacity to pay the experts in time who will consequently deliver quality results. Although hiring qualified staff is expensive, it cuts on costs on the long run and enables the company to cut on unnecessary expenses such as hiring external auditors to evaluate the company performance. Therefore, BLL should therefore control the cost of production, optimize the benefits of large scale purchases, and hire experts to manage the business.
2.0 Budgeting
Budgeting is a crucial tool for a business. In order for BoatWorld Inc to perform optimally, it has to come up with a feasible budget plan. The following are the reasons for developing a budget.
Budget makes an estimate on income and expenditure
A budget helps businesses to predict whether it is going to make profits or losses. First, it calculates the total expected expenditure then compares it to the expected returns from the investment. When constructing a budget, the financial planners should weigh on factors that could hinder the business from optimizing on profits and put them on control. In the case of BoatWorld, the budgeting committee should ensure that it weighs both the income and expenditure then decide whether to use that particular budget.
Budgeting is used for monitoring business performance
The approximated budget should be in sync with the expected performance. If the projected income does not match with the actual performance of the business, investigations are carried out to determine the main reason why the business is not performing per the expectations. BoatWorld should therefore carry out an investigation as to find out whether they are performing as per the projections.
Budgeting is a tool for decision making
When drafting a budget, the planners should consider its during decision making. The budget should consider issues such as acquisition of loans to finance the business. The budget determines the amount to be spend on labor, production and marketing in order to break-even and make profits. A business also uses budget to try a new venture. A business budget is also used by courts when issuing verdicts on delayed payments or breach of contract.
2.1 Traditional budget system
Most businesses operate on traditional budget system. The traditional budget uses the previous year as the base year. In order to prepare the current budget, adjustments are done to the base year by considering effects of inflation, consumer demand and the financial situations of the market. If the current year records a high inflation, the expected income is reduced. Traditional budget system is common in national governments.
Advantages of traditional budget system
The budget saves on cost since it focuses on the long term plan.
It is easy to calculate
Drawbacks of traditional budgeting system
The budget is not effective when calculating inflation.
2.2 Alternative Budgeting systems
2.21 Rolling budget
A rolling budget is not fixed and therefore, is updated during the financial year depending on the business performance. If the business records an increase in income during the financial year, the budget estimate on expected income is increased. Rolling budget is prepared on short term basis, in most cases every month
Strengths of a rolling budget
A rolling budget is easy to plan since it is used on short-term basis.
Besides, the budget is flexible and can be adjusted according to the economic condition.
Unlike the traditional budget where the initial year is used as the base year, rolling budget uses the current year as the base year and is therefore more reliable
Drawbacks of a rolling budget
The budget requires constant review and therefore consumes a lot of time.
2.22 Zero-based budget
Zero based budgets do not have a base period. Instead, the planning committe asses the expenditure and income of each department then comes up with an estimate on how much should be expected for a particular period.
Advantages of zero-based budget
The budget keeps a track record on how the expenses are used.
The budget ensures that all the resources are allocated accordingly.
Drawbacks of zero-based budget
The budget can overlook the long term plans and consequently result to economic sabotage.
The budget requires a lot of expenses which he company might be unable to provide.
2.24 Activity based budgeting
Activity based budgets are prepared after calculating the overhead costs of an organization. The activity based budget is therefore carried out based on the daily activities of an organization, rather than the overall functions of the organization.
Advantages of activity based budget
The activity based budget is very crucial especially in cutting unnecessary expenses.
The budgeting team focuses on individual departments and therefore increases profits.
The budget helps the business to avoid bottlenecks which are common in many organizations.
Drawbacks of activity based budget
It is complex to calculate because of the many procedures involved.
The budget is only suitable for short term plans and therefore cannot be used for a long term.
The budget consumes a lot of resources, making it very expensive.
2.3 Applications of budgeting systems
Budgeting systems are very crucial in the future planning of a business. Both the traditional budget and alternative budgets is used in the planning.
Traditional budgeting system
The traditional budgeting system is used to calculate the long term budget for a business.
Here is an illustration of how a traditional budget works:
If the business records an income of £23 million and spends £10 million in year 1, and the next year it makes an income of £34 million and £5 million on expenses, the next budget will use year 1 as the base year and make adjustments depending on the inflation and market conditions.
If the business uses alternative budget system, every financial year will be used as the base year.
Illustration
If BoatWorld records £30 million income and spends £10 million, it will use that data to predict on the future budget. Therefore, the company will not form a base year but instead depend on the current data.
Traditional vs. alternative budgets
There are several differences between traditional budgeting system and alternative budgets. Here is a breakdown of the differences between these budgeting systems:
| Function | Traditional budgets | Alternative budgets |
| Complexity | It is easy to prepare | Complex and requires a lot of keenness |
| Effectiveness | The effectiveness of traditional budget depends on whether the people who prepared the previous budget were experienced | The effectiveness of the budget depends on proficiency of the current top management |
| Orientation | The budget focuses on the concepts of accounting | The budgets revolve around the units mandated to carry out decisions about the organization. |
| Cost effectiveness | The budget is cost intensive and therefore does not save on money. | The main reason why the budgets are preferred is because they are cost effective. |
| Emphasis | It puts more emphasis on the previous year. | Emphasizes on the current year financial information. |
| Meaning | During preparation, the previous year is used as the base year. | There is no base year in alternative forms of budgeting. Instead, the current expenses and income are used to forecast the budget. |
| Approach | The budget is calculated using historical information. | The budget is prepared after estimating current information. |
3.0 Conclusion
From the report, it is evident that the two companies are not sure on the solutions to the management of working capital and budgeting systems respectively. For BrighLawns Ltd, it is hard to collect money owed to creditors. Besides, the partners are not willing to cost share on the cost of debts. In order to avoid getting into financial problems, BLL should hire financial ecperts to audit the business and provide solutions to the problems. On the second hand, BoatWorld Inc if faced with the challenge of getting the best budgeting system. The use of traditional budgeting system is costly and cannot be depended upon for short term solutions. However, the alternative budgets are not depended since each has unique challenges to each other. In order to solve the problems, the company should operate the traditional and alternative budgets parallel in order to optimize on the results. The solution to the challenges facing the two companies is hiring experts.
Bibliography
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Atrill, P. and McLaney, E. (2014). Financial accounting for decision makers. Harlow:
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Gowthorpe, C. (2011). Business accounting and finance. Andover: 3rd ed. South-Western
Cengage Learning, p.chapter 6 and 9 pp. 98-156 and 259-350
Melville, A. (2017). International Financial Reporting : A Practical Guide. Pearson Education
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Watson, D. and Head, A. (2016). Corporate finance. New York, NY: 7th ed. Financial
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