Financial Strategy of Breeze House - Assignment Example

1) Profit and Loss Account 2) Cash Budget February March April May Beginning cash balance 000 (9,500) (41,750) (127,750) Add: Cash Inflows 36,000 (Nov) 18,000 (Nov) 36,000(Dec) 48,000(Dec) 24,000 (Dec) 27,000(Jan) 36,000(Jan) 18,000(Jan) 33,000(Feb) 44,000(Feb) 48,000(Mar) Total Cash Inflows 72,000 93,000 93,000 110,000 Total available cash 73,000 83,500 51,250 (17,750) Less: Cash Outflows Purchases 75,000 101,250 150,000 210,000 Expenses 2,000 4,000 6,000 10,000 Labor 5,500 8,000 12,000 16,000 Equipment 12,000 Dividend 11,000 Total Cash Outflows 82,500 125,250 179,000 236,000 Ending cash balance (9,500) (41,750) (127,750) (253,750) Purchase Outflows Month Actual Sales Actual Purchases When Stocked When Paid For January 90,000 67,500 33,750 41,250 75,000 February 110,000 82,500 41,250 60,000 101,250 75,000 March 160,000 120,000 60,000 90,000 150,000 101,250 April 240,000 180,000 90,000 120,000 210,000 150,000 May 320,000 240,000 120,000 210,000 3) Profit and Loss Account with the Proposed Brewery Sale Cash Budget with the Proposed Brewery Sale February March April May Beginning cash balance 1,000 (9,500) (41,750) (220,188) Add: Cash Inflows 36,000 (Nov) 18,000 (Nov) 36,000(Dec) 48,000(Dec) 24,000 (Dec) 27,000(Jan) 36,000(Jan) 18,000(Jan) 33,000(Feb) 44,000(Feb) 48,000(Mar) Total Cash Inflows 72,000 93,000 93,000 110,000 Total available cash 73,000 83,500 51,250 (110,188) Less: Cash Outflows Purchases 75,000 101,250 231,563 290,563 Expenses 2,000 4,000 6,000 10,000 Labor 5,500 8,000 22,875 16,000 Equipment 12,000 Dividend 11,000 Total Cash Outflows 82,500 125,250 271,438 316,563 Ending cash balance (9,500) (41,750) (220,188) (426,750) Month Actual Sales Actual Purchases When Stocked When Paid For January 90,000 67,500 33,750 41,250 75,000 February 110,000 82,500 41,250 60,000 101,250 75,000 March 160,000 120,000 60,000 171,563 231,563 101,250 April 457,500 343,125 171,563 120,000 290,563 231,563 May 320,000 240,000 120,000 290,563 4) Breeze House is faced with an acute financial crisis due to shortage of cash despite the fact that there sales are increasing. Currently, the company needs to incur a debt of £290,563 at a cost of 15% interest rate in order to manage its operating activities. It is evident from the calculation of cash budget that Breeze house is facing grave problems in managing cash flows. Cash disbursements are outweighing cash receipts thus creating an imbalance in cash flow. Breeze House needs to focus on efficient management of working capital and it needs to deploy proper techniques for cash flow management. The organization needs to stress on reducing working capital requirements since too much money tied up in working capital has caused a shortage of cash. We know that as the organization runs out of cash, it cannot pay wages to its workers and even sometimes it may be unable to provide a service because a vital resource could be missing since the organization cannot pay for it. Efficient management of working capital can improve liquidity by deferring payments, speeding up payments from debtors and reducing stock turnover times. Breeze house should aim to shorten the cash cycle as short as possible but only if the length of cash cycle achieved can be sustained in the future without affecting the operational efficiency. If the cash cycle is shortened at the cost of lost sales or strained relationships with the suppliers, then the cycle will have to lengthen eventually and all the benefits of positive cash flow will vanish. To manage this critical situation, Breeze house first needs to assess whether it has an adequate amount of working capital in place. They first need to calculate some important liquidity ratios such as current ratio or Acid Test Ratio. Current Ratio = Current Assets / Current Liabilities Current Assets = Cash + Account Receivable + Inventory Current Liabilities = Accounts Payable We will calculate the current ratio for the month of May to get an overall status of the scenario for Breeze House. Since we have a negative balance of cash therefore that balance needs to be financed through overdraft facility thus the balance of cash will become Accounts Payable. The balance of cash will remain at zero. Accounts receivable can be calculated by adding the previous balances which have not been paid except for the bad debts. Finally, we know that the ending inventory as per the policy will always remain half of the next month’s budgeted sales. Current Assets: Cash = £0 Account Receivable = 240,000 +320,000 + (160,000 x 0.6) + (110,000 x 0.2) = £678,000 Inventory = 460,000 x 0.5 = £230,000 Accounts Payable = £426,750 (Negative Cash Balance) Current Ratio (May) = (678,000 + 230,000) / 426,750 = 2.13 The current ratio is standing at 2.13 which seem to be good for a service organization but as we know that for Breeze House, none of the portion of current assets comprises of cash as all the money is being tied up in Accounts Receivable and Inventory. Hence, Breeze house needs to reduce both these accounts and improve its cash balance to sustain its business. To maintain liquidity, a company needs to have enough cash available in order to meet payments when they fall due. Generally, organizations aim to maintain sufficient liquidity through their properly managed day-to-day operations. However, in the case of Breeze house they have not properly managed their cash activities and there is a huge imbalance in outflows and inflows of cash. In the case if a company has not sufficient cash to make due payments, it is imperative to have borrowing facilities in place. Breeze House has borrowing facilities available with Lloyds TSB Bank but it is charging an interest rate of 15% for its overdraft facilities. Breeze House need to reconsider its policies as they can create financial risks for the company. Breeze house need to specifically focus on these areas for better cash flow management: Stock Control Debtor Control Creditor Control Stock Control Breeze house needs to properly control the flow of their inventory. At the moment, they are holding too much stock in inventory which is creating cash flow problems. Too much money is being tied up in inventory, which could have been better utilized at other places. This excess inventory is also increasing the total cost of inventory since higher inventory implies higher storage and theft costs. To counter this issue of excess inventory, Breeze house first needs to accurately forecast their income. Accurate income forecasts allow to predict the demand properly thus a clear idea of how much stock will be needed to fulfill that demand. At the next stage, Breeze house need to determine the stock level at which a new order could be placed. This requires a clear understanding of lead time which is the time taken from ordering to receiving the product. The cost of stock holding is essential in the whole analysis and operation mangers need to have reasonable estimates of purchasing, holding and ordering costs. They can deploy inventory control models such as Economic Order Quantity (EOQ) to optimize the control of inventory. They can also adopt Just in time (JIT) inventory systems if it is feasible for the organization. JIT is a technique used in production which allows you to reduce inventory level thus achieving considerable cost advantages (Brian, 2000). Debtor Control Organizations often provide credit sales to their customers in order to spur the sales process. But these increased credit sales have a tradeoff since they create serious cash flow problems. Breeze House major concern in this has been their inability to manage account receivables in a proper manner. Day Sales Receivable has been on a very higher side as the accounts receivables of the company are out of control with 10% of sales incurred as bad debts and almost 74% of the outstanding debts have been due for 90 days or more. They need to take proper actions as the money recovered from here can be used for other purposes which will help in accomplishing organizational goals. Their loose credit policy has created liquidity problems and deteriorated their financial condition since costs are increasing rapidly due to higher interest costs. Breeze house needs to implement a proper debtor control program which should aim to: Identify who owes how much and when there payment is due Send invoices promptly and get consistent feedback from the debtor Handle queries from the customer as quick as possible Chase up late payments Debt levels can be significantly reduced by employing a number of tactics. Breeze House should offer discounts to its clients in order to drive up cash flows. For instance, it can offer a 2% discount to its clients if they pay within 15 days of the service completed. Secondly, it can open a merchant account so that they can accept online orders thus expediting the cash flow process. Finally, the organization should particularly focus on its bad debts since they account for 10% of the receivables. A staff should be dedicated for monitoring the aged debts by introducing an account control system that generates a list of aged debtors at monthly levels. As a proactive measure, customers that have low creditworthiness shall be blacklisted from any transactions from the company until they have settled their debts. Also, authorized personnel should investigate the current financial performance of customers especially for newly acquired customers in order to assess its creditworthiness (Muckain, 1998). The organization should also tighten its credit policy since giving a four month time can trigger serious issues. They can take an initial deposit amounting to 20% of the order while delivering the service. This will boost the cash receipts thus making the cash balance figure look attractive. Creditor Control Breeze House also needs to get acquainted with its creditors. The goal of creditor control is to manage relationships with the partners to whom the business owes money. This also constitutes as a major part of working capital management. As we can see from the case, Breeze House is paying its suppliers too early without gaining from any discount offers. They need to negotiate with their suppliers to extend the period of payment. In addition to that, the organization should focus on paying by the due date; not before the due date as the money could be used for other purposes. The commercial consequences of delaying payments to the suppliers should be realized since sometimes this can exacerbate funding problems for the suppliers and can result in supplier going bankrupt. Breeze house needs to first analyze the commercial importance and financial situation of its suppliers before delaying any payment as it can sour their relationships with important suppliers. They should also avail any discount opportunities from their suppliers if the return on discount is greater than the cost of funds. Another method of improving the cash flow will be to cut back on the space that the company occupies. Since the company operates on two sites, renting one site will be very helpful in generating added income for the company. The store warehouse has a rent value of £5,000, renting this space can acquire added revenues which would imply increased cash for the company. Brewery Sale With the brewery sale, the company can generate additional revenues. However, some policies currently practiced by the company should be changed in order to improve the cash flow. First, the company must require a deposit for the services that the company has offered. With regards to the brewery sale, a deposit of 20% would elevate the cash flow of the business. An initial deposit must be required in order to acquire cash needed for operating activities. Even if the brewery sale will have a 4 months credit, the deposit would be helpful in maintaining the solvency of the company (Higgins, 1995). Conclusion Even if the cash flow and of Breeze House is at critical level, the company has several alternatives and options to be considered in order for it to be put back on track. It is important that the management implement the programs effectively in order to assure sustainability for the business. A company without a steady and stable source of cash is a company that does not do business for profit. References Brian, C. 2000. Cash Flow Control. London: Glenlake Publishing Company Limited Higgins, R. 1995. Analysis for Financial Management (4th ed.). Chicago: Irwin, Inc. Muckain, M. 1998. Finance and Accounting. New York: Alpha Books. Read More