Cash Flow Problems - Case Study Example

Topic: Problems in poor cash flow and comments on profitability, liquidity and investment ratios of three companies Introduction: This paper seeks to answer two sets of questions with the first one relating to problems on poor cash flow while the second requires comments on three companies’ profitability, liquidity and investment ratios. 2. Questions and Answers 2.1 Q1) Many businesses fail through poor cash flow, even whilst their published accounts show a profit on trading activities. Explain why this might be the case and explain what managers can do to avoid becoming insolvent through periods of high sales growth. High sales growth could result to insolvency if revenues mostly come from credit sales. Cash flow problems could result if cash are not collected on time. In accounting, revenues could take the form of cash and non cash. Since revenues do not necessarily equate to cash, a profit on trading or selling activities could still produce an insolvent company. To understand this there is a need to explain how profit is computed and how cash is generated. Revenues are the result of business activities in delivering goods or services to customers. Now since not all customers pay cash, it could happen that the company could be making a great part of its revenues by selling goods and services on credit. As far as profitability is concerned, the company may in fact have high revenues from which expenses could be deducted to arrive at profit. Expenses may also take the form of cash or liability hence it could happen also that all expenses are liabilities. Thus net profit could as computed by deducting expenses form total revenues represent a theoretical value which may not be necessarily be cash. Good financial stewardship therefore requires wise management of cash flow. As to how cash flows could be improved, revenues must include both cash and on credit. Revenues on credit must be collected within the company policy which normally should be shorter than its payment period to its suppliers. Failure do this would affect the company’s management of its working capital or cash flow. Incapacity to pay to currently maturing obligation could bring the company problems like bankruptcy. To illustrate, employees and workers salaries must be paid on time since these people work daily and they expect to have money at salary period to defray their family expenses. These salaries are current obligations which require cash or current assets to settle them. Another example is the suppliers of goods or supplies or services who will also demand timely payment, other wise they could affect the daily operation of the company. It may be observed that these liabilities are only short-term which can involve just a day, yet the impact of failure to meeting them could really be a problem. Although accounting periods are normally measured in years, the same are actually broken down into months and which are in turn broken into days. It must be remembered that one cannot have a month without days and a day cannot be had without a minute. Failure therefore in a day could actually ruin the whole business. Short-term decisions are also as important in achieving long term goals. 2.2 Q2) Analyze the financial position of three companies that operate in food retail industry. 2.2.a) Comment on the companies’ profitability. The following data are used for this section. Company A B C Gross profit margin % 0.15 0.22 0.40 Net profit margin% 0.09 0.10 0.12 Return on capital employed % 0.15 0.13 0.16 Return on shareholder funds % 0.20 0.13 0.12 Profitability measures how well a company is earning from is selling goods or rendering of services to customers. It uses revenues and expenses (Bernstein, 1993; Brigham and Houston, 2002; Droms, 1990) to measure the same. Company C is the most profitable among the three companies while company B is more profitable than Company A as confirmed both by the gross profit margin and net profit margin. Gross margin is computed by dividing gross profit by the total revenues. Gross profit is computed by deducting cost of sales from the total revenues. (Meigs and Meigs, 1995). Net profit margin on the other hand is computed by dividing net profit to total revenues. Net profit is a result of further deduction of operating expenses, interest expenses as well as taxes from the gross profit as stated earlier. Another measure of profitability is the return on capital employed under which company C was sustained to the best among the three. However return on shareholder funds did not sustain the leadership of company C in terms of profitability. It is also intriguing to find why company A has higher return on capital employed and return on shareholder funds compared with company B which has a higher net profit margin than company A. This could be explained by a possibility that company A has employed less assets than company B. Since said assets could either come from investment of owners company or its creditors, it is possible that the greater amount of investment in assets for company A is matched with less stockholders’ equity than company B. The same observation may be applied between company A and company C, where it could be inferred that A has less investment from stockholders than company C. It may be observed that each companies has its own business strategy in attaining profitability (Byars, 1991; Cooper, 2000; Porter ,1980; Kotter, J. and Schlesinger, 1991; Johnson, G. and Scholes, K. ,1993). 2.2.b) Comment on the companies’ working capital management The following data are used for this section. Company A B C Stock days 18 25 45 Debtor days 9 32 65 Creditors days 9 42 55 Working capital management deals on how management tries to use its current assets in meeting its currently maturing obligations (Helfert,1994; Kotter, J. and Schlesinger,1991; Meigs and Meigs ;1995). Since the information given does not mention about current assets and current liabilities, there must be a way of determining how the companies meets their currently maturing obligations. In terms of stock days it would seem that company A has the fastest moving stock or inventory compared to other two com companies. Company B is better than company C. For purposes however of knowing deeper which of the companies is managing its collection and payment period, it must be asserted that it belongs to the company that has the capacity to collect faster than the period required to pay. Among the three it would appear that company B is the best since its collection period as expressed in debtor says at 25 days is shorter than its payment period as expressed in creditor days at 32. While company A has the same payment period and collection period it could mean that the company has no allowance in time to pay it current obligations on time. In simple terms, it could mean that company A will have to collect today so that it can pay its obligation today. Company C is the worst among the three because it takes the company to collect in 65 days while it must pay its obligations within 55 days. This means that it would require the company to make a borrowing for the next ten days to finance it currently maturing obligation. If this problem of company C is not addressed the company could become bankrupt. 2.2.c) Comment on the investment ratios. If you were going to buy these companies shares, which one would you choose? Explain your reasons. The following data are used for this section. Company A B C Earning per share in pence 15 20 25 Price earning ratio 16 12 19 Dividend yield % 0.07 0.08 0.04 Investment ratios measure how attractive is the company for purpose of considering the same as an investment option (Ross et. al, 1996; Van Horne, 1992). The first one is the earning per share which is the relationship of net income to the total outstanding shares of the corporation. Under said criteria on earnings per share, Company C is the best company among the three while company B is better than company A. The other measure is the price earning ratio which measures how much investors are willing to pay per dollar of reported profits. This would mean therefore that company C is the best among the three since investors are willing to offer higher price of every earning per share. Although absolute values of numbers are the same, using the price earnings ratio would mean that two companies showing the same profitability in terms of earnings per share may not be necessarily viewed by the investors as the same. What could explain this is that the companies may be belonging to different industries hence they receive different price earnings ratio. It would imply then that for every industry has its own risk, hence although a company may be earning it may not be as attractive as one which is earning the same level under a different industry. As could be observed from the comparison of the ratios of the three companies, company C which has the highest earnings per share and happens to be the one with the highest price earnings ratio. What seems to be intriguing is the fact the company A has a greater price earnings ratio than company B despite the fact that company B has higher earnings per share. What does this imply then? It could mean that company B is belonging to a more risky industry than the industry where company A belongs. Another investment ratio to measure the attractiveness of the stock of corporation is the dividend yield which is computed by dividing dividend per share by price per share. Since the same is expressed as rates, the one with the highest rate must be the most attractive of them all. Applying the formula to compare the three companies, it would appear that company B is the best at 8%, which is followed by company A at 7% and company C at 4%. The results would show again intriguing results when compared with the result of the earlier two investment ratios. Earlier this paper theorized that company B’ industry must riskier than Company A’ industry. How one would now reconcile the fact the company B is now the best using dividend yield? A possible explanation was that that company C is the one which gives the least dividend among the three. Since company C has the highest price earnings ratio, there is basis to infer that company is still the best. The fact that company provides dividend regularly and hence higher dividend yield does not mean that it is the best since a company’s stock price is still controlling since higher stock prices means more wealth for the stockholders. In fact a company which does not declare dividend regularly may have an implied a reinvestment of funds by reinvesting retained earnings into the company’s capitalization. 3. Conclusion This paper was able to establish that high sales growth could result to insolvency if revenues mostly come from credit sales and there is poor collection. It was established that revenues or even profit is not the same as cash. A company could even have plenty of cash yet it is losing in business. As for comparison of the profitability of the three, it was found out that company was the best as far percentage of revenues are concerned but on the basis on the amount of shareholders, it would appear that company is the best because of possibly smaller amount of investment from stockholders as a percentage of total assets compared to the other companies. On the basis of liquidity, company B was the best as its collection period was shorter than payment period hence the risks of bankruptcy would lowest for the company. As far the present investors’ choice is used, it appears the company C is the highly valued, since it has the highest price earnings ratio among the three which is indicative of investors’ willingness to match the earnings per share of each of the companies. From the point view of investment, however it is best to choose company B because of its good management of its working capital although it is not the best in term of profitability. An added advantage for company B is its high dividend yield. Moreover its lowest price earnings ratio may be a sign a sign of undervaluation which may make the company most attractive to invest with for purposes of selling later. 4. References: Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK Byars, L. (1991) Strategic Management, Formulation and Implementation – Concepts and Cases, New York: HarperCollins Cooper, L. (2000) Strategic marketing planning for radically new products, Journal of Marketing, Vol. 64 Issue 1, pp.1-15. Droms (1990) Finance and Accounting for Non Financial Managers, Addison-Wesley Publishing Company, England Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Syndey, Australia Johnson, G. and Scholes, K. (1993) Exploring Corporate Strategy – Text and Cases, Hemel Hempstead: Prentice-Hall. Kotter, J. and Schlesinger, L. (1991) Choosing strategies for change, Harvard Business Review, pp.24-29. Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK Porter (1980) Competitive Strategy, Free Press , London,UK Ross et. al (1996) Essentials of Corporate Finance ,IRWIN, London,UK Van Horne (1992) Financial Management and Policy, Prentice-Hall International, London, UK Read More