Importance of Strong Cash Flow - Assignment Example

Question Importance of strong cash flow Many businesses fail simply because of lack of liquid resources. Liquidity is extremely important for any business which wants to stay in market. Liquidity refers to anything that can be turned into cold or hard cash. Every business needs need sufficient cash to carry on its business. Many companies have a high trading activity but still can not survive in business. Cash is a liquid or quick moving asset which is used by the business to continue its existing operations. Items like inventory or real estate property can be converted into cash but they cannot be used to pay suppliers, rent or employees. Profit growth does not always mean you have sufficient cash in hand. Profit is literally the amount of money earned over a period of time while cash is that liquid asset which you need to have to keep your business running. Even if a company has good profits it does not necessarily mean that it can pay off its everyday expenses. How to avoid insolvency in high sales growth Chasing Bad debts Never let late payments go unnoticed. It is highly essential to keep a close eye on credit customers and to critically scrutinize late paying customers. Avoid overtrading Don’t try to bog yourself down by buying excessive inventory and fulfill more orders than you have the resources and cash to cope with it. Selling unused assets You can sell unused and under performing assets and get good cash flow in return which will be pivotal for your business. Trim your inventory Excessive stock can be a big source of dampening future profits and they tie up sufficient cash which can affect existing operations. By following these important guidelines, investors can avoid insolvency and cash flow problems. Question #2 a) Profitability of Companies Almost all the profitability ratios are in favor of company C. Company A and B have struggled to make any significant profit and haven’t performed satisfactorily. Profitability ratios are an indicator of a company’s performance over the year. Profitability ratios include operating profit margin; net profit margin, return on Capital employed, and return on shareholders fund. Gross profit margin Company A has achieved a formidable gross profit margin of 15%. It is significantly low however when compared to company B (22%) and C (40%). Company C in particular has achieved a very healthy Gross profit margin of 40% which indicates the profitability prospects of the company. Net profit margin Net profit margin is somewhat similar for all three companies. A, B and C have achieved Net profit margins of 9%, 10% and 12% respectively which are not ideal but still satisfactory specially for the food industry sector. Return on Capital employed Return on Capital employed is a very significant ratio especially in investing and profitability terms. C again leads the pack with a 16% return on investment while A and B are not to behind with 15% and 13% respectively. Return on Shareholders fund Shareholders are also interested in return on assets and equity. Their decisions are influenced by these ratios therefore; it is essential that a company projects better return on the asset it employs and the equity it takes. Company A has achieved an impressive 20% return on shareholders fund. Company B and C on the other hand had a torrid time and have achieved mediocre returns of 12% and 13% respectively. b) Working capital Management of companies A company can have massive problems if its assets cannot be readily be converted into cash. To perform well and to perform with consistency a business needs to have a strong and pragmatic working capital policy. Working capital basically includes managing inventories, accounts payable and accounts receivable. Working capital is a key concept in business and its primary aim is to ensure that a company is able to continue its operations and it has sufficient cash flow to satisfy short term debt as well as regular operational expenses. Inefficient and slow movement in working capital can create problems for the company. Money that customers still owe to the business and money which is tied up as inventory cannot be used for further investment or to pay off the company’s obligations. Let’s analyze the working capital management of the 3 companies: Stock Days Stock days measure how well a company converts its stock into revenues. It measures how well a company is making use of the part of its working capital that has been invested in stock. Managing inventory is a cumbersome task. Excessive stuff can decrease the liquidity of a business while insufficient stocks can hinder the progress of a potentially thriving business. The key thing for any business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels and minimizing the cash tied up in stocks. Factors which can be considered include: What are the budgeted sales of each product? How commonly are raw materials available? How much time do suppliers take to deliver? Unnecessary stock levels can tie up cash and cost more in insurance, accommodation costs and interest charges. Company A In our analysis, Company A has been most efficient when it comes to stock days and has achieved a satisfactory result of 18 days. This can be primarily due to the company buying relevant amount of inventory or the company may not want a high turnover which may also result in high amount of bad debts because most of the sales are on credit. Overall it’s a very decent ratio. Company B Company B has done well enough although not perform with perfection but still has achieved a decent figure of 25 days. This means that there is minimal investment tied up in the inventory. Still efforts need to be made to increase its turnover rate as investment in inventory yields zero return and a company would always refrain from having its capital tied up in such an investment. Company C Company C has not achieved a good inventory turnover ratio. It takes 45 days for its inventory turnover which is dismal as compared to the other companies in the industry One thing to remember is that stock tied up for a long time ties up money which can not bring productivity to the business. Company C really needs to review its inventory management system. Points to note The following points should be analyzed by a company when formulating an inventory management system  Review the effectiveness of existing purchasing and inventory systems.  Inventory which is outdated or obsolete should be immediately sold off.  consider having part of their product outsourced to another manufacturer rather than make it them self. Debtor days Slow payment will have a critical impact on a business and particularly for small businesses that may not be able to afford it. If you cant control you debtors than you will soon be in a big trouble. Late payments can erode profits and can result in bad or irrecoverable debts. By maintaining debtors, companies are indirectly giving away interest free loans to their customers. The lower the turnover days, the faster a business is collecting its receivables and more cash the company has on hand. Company A Again company A has achieved a good turnover ratio of 9 days. A has been impressive in its receivables management. However an unusually high turnover compared to your competitors could mean that your credit terms are tighter than your competitors and you run the risk of losing customers to them. Company A may have adapted a rigid receivable strategy which results in an unusual debtor day turnover as compared to its customers. Company B Company B has achieved a moderate turnover of 32 days as compared to its competitors. It is not an enviable performance when compared to Company A but still its good enough when compared to the company C. The ideal ratio in food industries is usually around 35 to 40 days and B is almost there. Company C C has not been efficient enough in its strategy to formulate a productive receivables policy which can dampen its future revenues. A debtor day ratio of 65 days is never good enough. It has to be analyzed that the longer someone owes you, the greater the chance you will never get paid. If the average age of your debtors is getting longer, or is already very long, your business may get into a serious trouble. It could be primarily due to the following reasons: Points to note The following points should always be noted when analyzing debtor days weak credit judgment poor collection procedures lax enforcement of credit terms slow issue of invoices or statements errors in invoices or statements Customer dissatisfaction. Creditor days Management of your creditors and suppliers is as crucial as the management of your debtors. Creditors are a vital part for any business and it is extremely important that you look after your creditors. If you maintain a good credit rating than you can perform well in your business fraternity. Company A Again Company A has performed well and has achieved a comparatively superior performance as compared to its creditors. Because of its superior inventory and receivables turnover, it has been able to pay off its creditors promptly and is able to perform well against its industry rivals. But it doesn’t give a vivid picture. By maintaining a low creditor payable period it may not expand its business. It may be playing safe and just want to achieve better than mediocre profits. It is still good enough in the short term but Company A may have to review and scrutinize its overall performance in the working capital policy in the near future if its competitors are able to achieve higher profits in the near future. Company B Company B has utilized its creditor payable period and because of that has achieved better profitability ratios than Company A who has struggled to get better profit margins. Because it has allowed its debtor longer credit terms and also because of a high stock days, B has taken a considerable longer period than Company A and has achieved better profits also. Company C Yet again Company C has taken more than usual time in another area of its working capital policy. It has offered generous credit terms to its debtors which results in taking more than usual time in paying off its creditors. This could result in a considerably high turnover and potentially better future profits but its still a risky strategy as many of its customers may not be able to pay off promptly which can result in high bad debts amount and as a result it will affect its creditor days as it already has. Points to note Are purchase quantities geared to demand forecasts? Do you use order quantities which take account of stock-holding and purchasing costs? Do you know the cost to the company of carrying stock? How many of your suppliers have a returns policy? Are you in a position to pass on cost increases quickly through price increases to your customers? If a supplier of goods or services lets you down can you charge back the cost of the delay? Can you arrange to have delivery of supplies staggered Investment ratios Investors always want healthy returns on their investment. Stock investment allows third parties to obtain ownership of a company without having direct control and influence in the operations of a company. The investment ratios are discussed further: Earnings per share EPS in common language is the amount of money that a unit of share is able to earn in a particular session. EPS tells us how a company is performing in relation to the number of shares it has issued. There are a few things that affect the EPS figures such as issue of new shares, rights issue etc. EPS is one of the most important ratios from every investor perspective. It is helpful in determining a share’s price. Company A Company A has achieved a modest EPS of 15c per share. It is still a satisfactory amount but comparing with industrial rivals it is still a mediocre performance. A low EPS does not necessarily indicate the company’s true picture but it however can help to determine the investors whether they want to invest in the company or not Company B Company B has achieved an EPS of 20c, which is still not bad, but again comparing with company C is still a bit low. Its not surprising that its EPS is better than average and it does show an earning potential but still there is some room for improvement. Company C Company C has achieved the highest EPS of all the companies involved. An EPS of 25c is good enough and does show companies earning capacity. A high EPS doesnt necessarily make for a solid prospect and other contrasting ratios and scenarios should be thoroughly scrutinized. Price Earning Ratio The Price earning ratio is another key concept in investment analysis. The PE ratio is one of the best known performance and investment valuation indicators. The PE ratio is the most widely used and reported valuation method used by business analysts and investors. The PE ratio is a very crucial indicator for management in many companies and industries. The primary reason for this is that management is paid in order to improve the company’s performance and to increase its stock price. Company A and B Surprisingly Enough Company A has achieved a higher PE ratio than Company B. Company B had a higher gross and net profit margin. This could primarily be due to investors relying on Company A more rather than company B. Company C Yet again company C leads the race and has a higher P/E ratio than company A and B. Company C had a very strong EPS which helped it gain a much higher P/E ratio than its rivals. PE ratio and EPS are related to a certain extent but this is not true in every scenario as it can be seen in Company A and B comparison. Dividend Yield The dividend yield is used to calculate the earning on investment considered only the returns in the form of total dividends declared by the company during the year. Investors logically prefer a higher dividend yield on their investment. A higher dividend yield may suggest that that a stock is under priced or the company is experiencing hard times to cope up with and possibly future dividend may not be as high as in previous years. A low dividend yield may suggest that stock is overpriced or future dividends might be higher. Comparing A, B and C dividend yield comparison A has achieved a dividend yield of 7% whereas B has achieved the highest yield of 8%. C on the other hand has quite a low dividend yield of only 4%. This is interesting because Company C had a very good EPS and PE ratio figure but has quite a dismal Dividend yield % which can make many potential investors think again. However Company C has a much higher earning capacity than A and B which cant be denied and it will be crucial when investors decide in which company to invest because dividends alone are not the core reason for investment. Reasons for Which Company to invest in from an investor perspective, company C would be chosen for the following reasons: Healthy EPS A high EPS is quite important for investors when investing in a company. The higher is the EPS, the more the earning potential of the company. PE ratio It has achieved a very healthy PE ratio of 19. Although not very high, it is still good enough. Potential The Company has a high earning potential primarily because of its healthy EPS, PE ratio, ROCE and a good gross profit margin. These are the core reasons I would like to invest in Company C. Company A B C Gross profit margin % 15 22 40 Net profit margin % 9 10 12 Return on capital employed % 15 13 16 Return on shareholders’ funds % 20 13 12 Stock days 18 25 45 Debtor days 9 32 65 Creditor days 9 42 55 Earnings per share 15p 20p 25p Price earnings ratio 16 12 19 Dividend Yield % 7 8 4 Conclusion All 3 have been tough Competitors in the industry and will continue to do so in the future. Company B has relatively been on the weaker side in terms of profitability but has edged in efficiency of its operations. On the other hand, Company C looks to be the strongest of the 3 competitors primarily because of its strong profitability and comparatively better earning potential whereas only Company A looks to be the company which can compete effectively with company C. References BESLEY, Scott and Eugene F. BRIGHAM. 2008. Principles of Finance. Cengage Learning. BRAGG, Steven M. 2007. Financial analysis: a controllers guide. John Wiley and Sons. BRIGHAM, Eugene F. and Michael C. EHRHARDT. 2010. Financial Management Theory and Practice. Cengage Learning. BUREAU OF LABOR STATISTICS. 2010. Consumer Price Index Detailed Report, Tables Annual Averages 2010. BUREAU OF LABOR STATISTICS. 2010. Consumer Price Index Detailed Report, Tables Annual Averages 2010. Bureau of Labor Statistics. CLAUSS, Francis J. 2009. Corporate Financial Analysis with Microsoft Excel. McGraw-Hill Prof Med/Tech. DOMINOS PIZZA INC. 2010. A new Dominos: Annual Report 2010. Dominos Pizza Inc. FABOZZI, Frank J., Pamela P. PETERSON, and Pamela Peterson DRAKE. 2003. Financial Management and Analysis. John Wiley and Sons. HORNE, James C. Van and John M. WACHOWICZ. 2008. Fundamentals of financial management. Prentice Hall. KROGER CO. 2010. Kroger Co. Annual Report. PUXTY, Anthony G., J. Colin DODDS, and Richard M. S. WILSON. 1988. Financial management: Method and Meaning. Taylor & Francis. SHIM, Jae K. and Joel G. SIEGEL. 2008. Financial Management. Barrons Educational Series. http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1074407631&r.l1=1073858790&r.l2=1074453392&r.l3=1074407360&r.s=sc&type=RESOURCES http://www.investopedia.com/university/ratios/investment-valuation/ratio4.asp http://www.kewdstockanalytics.com/knowledge-center/investment-ratios.html Read More