Budgeting and capital management of an organization

An awareness of how working capital management affects cash flow Working capital is a crucial asset for improving a company’s financial success. Working capital gives insight into how stable the economy will be over the coming 12 months, which lays a solid basis for achieving the company’s goals. As opposed to this, cash provides a summary of income and expenses for each day, month, and year (BaosCaballero, GarcaTeruel, and Martnez Solano 2010, p. 521). Working capital management is , therefore, essential for an organization’s ability to adapt to a bad economy and initiatives to offer stability between liquidity of daily operations and getting most out of short term investments. Efficient management of working capital is essential in the day to day running of a company and is a paramount tenet of the financial matters of businesses. When the need for working capital is less, there is less need for financial aid and reduced capital cost, consequently more funds available for shareholders (Baños‐Caballero, García‐Teruel and Martínez‐Solano 2010, p.521.

Besides, a company can make a profit but have a shortage of cash because profit is calculated using expenditure and revenue which is not the same as the firm’s disbursements and cash receipts, i.e., spending is different from expenses and receipts are not similar to income (Harris 2005 p.52). For example, utilizing the accrual accounting method, if a company provides services worth of $15,000 and the clients agree to pay at end month; the company’s revenue is $15,000 in the first month but received in the second month (Harris 2005 p.52). If this company’s expenses add to $10,000 in the first 30 days, the profit reported is $5,000, but the company will not have received any money from its customers (Harris 2005 p.52). Thus firms strive to manage an optimal amount of working capital to maximize cash flow. Working capital management affects cash flows in the following ways

It is important for scalability

A developing business can be challenging. The management must determine the quantity of stock demanded the optimal number of staffs to ensure customer satisfaction and the business process which needs a transformation to cope with the new demand (Baños‐Caballero, García‐Teruel and Martínez‐Solano 2010, p.522). It is unfortunate that even established enterprises occasionally experience a reduction in sales because of new competition, economic instability, or other unidentified circumstances. When there is a drop, a well-managed working capital will assist avoid liquidation of assets, taking loans or downsizing to meet the operations expenses thus help the company in an upward trajectory (Baños‐Caballero, García‐Teruel and Martínez‐Solano 2010, p.521).

Working capital management determines cash flow resiliency

Resiliency is how fast the company’s cash flow bounces back to its original state after a shock. If a decline occurs, the cash flow can be more robust if the working capital is greater than debts one expects in the next one year (Filbeck and Krueger 2005, p.11).

It shields against bankruptcy for production firms like MeDex

Working capital management is important for a manufacturing company like MeDex because its assets are mainly current assets thus affecting its cash flows if poorly managed. It is risky to a firm if it lacks efficient working capital management frameworks; it can quickly fall bankrupt even if it records real profits and this is dangerous, and MeDex needs to take serious steps to remedy the situation (Filbeck and Krueger 2005, p.12). Further, too much working capital can reduce the valuation of the firm, but its shortage or its mismanagement can lead to inefficient cash flows because of the difficulties in maintaining a company’s daily operations (Filbeck and Krueger 2005, p.12).

Working capital is critical to cash flow patterns of fast growing firms especially medium-sized and small businesses.

These companies where MeDex is inclusive do not have or have limited access to financial markets, and they overcome this challenge by good management of working capital and short-term borrowing (Filbeck and Krueger 2005, p.13). An adequate amount of money allows the firm meet its short-rum objectives efficiently increasing its credit worthiness and reducing the dangers of defaulting. Therefore, it is possible to explicitly say that good management of working capital influences cash flows of a firm both in the short-run and the long run (Filbeck and Krueger 2005, p.13).

ii. Steps MeDex Products limited should take to improve the company’s working capital management

There are key steps which the company leadership especially the finance manager should take to ensure sobriety in working capital management. They include the following:

Evaluation of the current position

This this the first thing the finance department leadership of MeDex Products Limited should take into consideration. It is critical in identifying the flow of incoming and outgoing funds and receivables and align them to acceptable standards (Padachi 2006, p.42). With correct supervision, it will be easier to track origins of trouble like consistent late invoices sitting out for one, two, three or even more months. As the company maps out payables and receivables over a specified duration, it should employ key performance indicators and inventory metrics like cash conversion efficiency, a day’s working capital, a day’s sales and inventory outstanding, etc. Senior-level management especially the chief financial officer and the chief executive office should assist holding staffs accountable to realize desired success (Padachi 2006, p.42).

Tracking of performance

It is important to cultivate management dashboards and reports to monitor and capture compliance across the firm, both horizontally and laterally. Besides, the finance department should consider partnering with an internal audit group that will implement the strategic redemption plan (Filbeck and Krueger 2005, p.13). Besides, MeDex management should analyze the correct level of activity for the company; the entity may consider erecting teams per department, country or region to monitor changes in the business environment in every geographical location closely. Irrespective of the scope or size of responsibilities, the erected teams should form a comprehensive appraisal of operations continuously and from the raw data for an evolution of cash flow optimization. An analysis of business environment data will assist the teams to gather correct information and hence formulation of appropriate remedies Filbeck and Krueger 2005, p.13).

Creation of an action plan

If the approach is designed for implementation in phases, the creation of an action plan is fundamental. Every department of the firm must create measurable and practical programs with the principal accountable personnel and expected dates for results (Filbeck and Krueger 2005, p.14). The measurability of goals is critical for success. Studies by Ernst and young reveal that to effectively increase returns on capital and offer high returns to company shareholders, and firms must run continuous structural and operational improvements targeting the root and branch facets of the working capital, metrics, and policies (Filbeck and Krueger 2005, p.13).

Implementation of the strategic plan

The top leadership of MeDex should spearhead the implementation of the strategic plan. One person from the executive management should monitor the implementation process of active capital management companywide (Harris 2005 p.53). This is a necessary step to show the junior staff the level of commitment the leadership has in turning around cash flows to acceptable levels. Every senior manager should pass the inflow downwards in all units ensuring that every group and leader has complete of knowledge of the scale and scope of the preferred changes and the responsibilities bestowed on them. All employees must be aware of their duties in restoring effective capital management and cash flows (Harris 2005 p.53).

Improvement should be continuous

The adopted transformation policies must be sustainable. Making things simple is key, especially when implementing holistic plans touching every section of the company. Room for improvement is always available and consistent collaboration and analysis is significant for long term management of working capital for optimization of cash flows. I big difference is noticeable when the firm gets the implementation right (Harris 2005 p.53).

iii. Explaining the application of the concept of working capital management to the company and how the current situation is a reflection of how the business is managed.

The current situation is a revelation of inefficiencies in management at MeDex products limited. The effects of the neglect of the credit control department are evident; in one year, the rise of overdraft from £ 1 million to £3 million is worrying. Another evidence of mismanagement is delayed payment of suppliers. This trend can have adverse effects on the company including the following: first, persistent mismanagement will result in a lower rating of the company thus leading to higher rates of interest (Filbeck and Krueger 2005, p.14). A company with poor management of working capital struggle to pay creditors and lacks sufficient cash flows. When a corporation is lowly rated, financial institutions charge higher interest when it seeks credit for expansion (Filbeck and Krueger 2005, p.14). Secondly, a mismanagement of working capital will make the company miss growth opportunities. The reason is the inability to take advantage of some exciting business opportunities. Thirdly, it is hard to attract bankers and investors to invest in the company. Fourthly, the company will lose trade discounts. In case a company is having poor management of working capital, it delays making account payables and thus will not be granted trade discounts given within a specified period. Finally, any company with an ineffective management of working capital will develop a bad financial reputation in the market (Filbeck and Krueger 2005, p.15). Late or non-payments builds poor relationships with suppliers which slowly hampers the company, and at some point, some providers will stop releasing their raw materials on credit to the company hence crippling the company.

Part 2:

i. Stages of capital budgeting process and the primary capital investment appraisal methods

Capital budgeting is a procedural action undertaken by a business to establish the financial benefits of an investment opportunity. The determination of whether to implement or deny investing in a project as part of a company’s expansion policies entails determining the rate of returns of a project. Nevertheless, whether the estimated rate of return is acceptable or otherwise is influenced by several factors peculiar to the firm and the project in question (Alkaraan and Northcott 2006, p.149). The budgeting framework is a feasible methodology of determining the long-term financial and economic viability of an investment venture (Alkaraan and Northcott 2006, p.149). The capital budgeting is significant because it provides a structured process that assists a firm to achieve the following: first, Formulate and establish long-term strategic objectives. Secondly, helps in looking for new investment opportunities. Thirdly, it is key in forecasting and projecting future cash flows. Fourthly, it assists in the transfer of information. Lastly, it helps in control and monitoring of expenditure (Alkaraan and Northcott 2006, p.149).

Steps of capital budgeting

1. Identification and assessment of the investment opportunity

The whole budgeting process starts with an evaluation of the available opportunities. For this occasion, Wombat Gmbh should consider multiple options. For instance, Wombat Gmbh is looking forward to expanding its production. Thus it should take into consideration of acquiring a larger space in a new region or add the production in its current building. In this context, these options have to be scrutinized to establish which is more efficient (Burns and Walker, 2015).

2. Approximate implementation and operations expenditure

This is the next step, and it entails determining how much it will take to erect the project from scratch into completion. Wombat Gmbh should note that this action needs detailed research from both internal and external perspectives (Burns and Walker, 2015). Wombat Gmbh leadership may assign its finance department to establish how much it costs to produce packaged ready meals for supermarkets at the same using an outside source to determine the expenditure then choose the best option (Burns and Walker, 2015).

3. Estimation of benefits and cash flows

At this point, the determination of how much cash flow this project is expected to generate is made. The best way to make this estimation is to look at the data of similar projects in the past which proved successful (Burns and Walker, 2015).

4. Risk assessment

In this step, risks associated with the implementation of the project including the amount of money Wombat Gmbh stands to lose in case the project fails to yield the expected results or if it ultimately fails. After determination of the degree of risk, Wombat Gmbh can examine it against the approximated benefits or cash flow to determine if it is viable to implement the project (Burns and Walker, 2015).

5. Project implementation

Wombat Gmbh needs an implementation plan to see the fruition of this business opportunity. The implementation strategy should take into consideration source of finances to pay for the project, a cost tracking program, and procedure of capturing cash flows. Besides, the implementation process should include the deadline for each step including the final date of project completion (Burns and Walker, 2015).

Primary capital investment appraisal methods

1. The payback method

The method entails the duration/years taken to recoup the amount of money used in the investment. The cumulative cash flow table helps in calculation of the payback period as shown below.

Year (t)

0

1

2

3

4

Net cash flow

-$4000

$2000

$1600

$1200

$400

Cumulative NCF

-4000

-2000

-400

800

1200

Payback period= number of years until break-even point or full recovery of invested money.

The decision rule for payback period: this method operates on the principle that the shorter the recovery period the better (Miller, and O’leary 2007, p. 701). To establish the optimal number of years to recover the principal, the company must determine the model payback period. If it is less than the estimated time, the leadership should adopt the project and reject if otherwise (Miller, and O’leary 2007, p. 701).

Advantages of payback period: it is a good estimator of the project risk and liquidity. Besides, it offers the opportunity for investors to determine the length to recover their money (Miller, and O’leary 2007, p. 701).

Limitations: its main weakness is its negligence on the time value for money. It does not consider income beyond the payback period (Miller, and O’leary 2007, p. 701).

2. Net Present Value (NPV)

The NPV depends on discounted cash flow (DCF) examination. The first point in NPV evaluation is to find out the current value of cash flow discounted by the initial invested capital. The method assumes that the cost of capital has been attuned to risk. All discounted cash flows are summed when calculating NPV (Miller, and O’leary 2007, p. 702). The formula is as follows:

Decision rule for NPV: accept the project as long as the NPV is positive

Advantages of NPV: it is a direct measure of the project benefits to the investors. It is a traditional method and is widely accepted. Also, it takes associated risks into account together with the cost of capital. Additionally, it considers the time value for money. It is the best method as it results to practically correct capital budgeting (Miller, and O’leary 2007, p. 702).

The weakness of NPV: it does not take into account the size of the project but only the size of returns. For instance, the NPV of $200 is greater for a project costing $200 but too little for an investment costing $100,000 (Miller, and O’leary 2007, p. 702).

3. The Accounting Rate of Return (ARR)

This method appraises a project through the division of average profit by average investment. In the computation of ARR, the profit figure utilized is known as the concept of operating profit. Also, the average investment is known as the book value of assets (Miller, and O’leary 2007, p. 703). Besides, the idea of amortization and depreciation is taken into consideration, that is, use of accounting principles. Therefore the profit and asset value used is after factoring in depreciation (Miller, and O’leary 2007, p. 703).

Strengths of ARR: it is easy to calculate and simple to understand

Limitation: it is too simplistic and rarely used by investors.

4. Internal rate of return (IRR)

IRR is closely related to NPV. It is the rate of discount which equates NPV to zero. Besides, it is the rate of growth a project is estimated to initiate. A project with higher IRR is more acceptable than one with a lower one (Miller, and O’leary 2007, p. 703).

Advantages of IRR: first, it takes into consideration the riskiness of the project. Secondly, it depends on cash flow and rate of return to evaluate an investment given the time value of money (Miller, and O’leary 2007, p. 703).

Disadvantages: first, it needs electronic gadgets to calculate. Secondly, the method is difficult to compute as it uses trial and error criteria to get the value down to zero (Miller, and O’leary 2007, p. 703).

ii. Potential of applying project appraisal methods to Wombat Gmbh’s ready meals project

In the first place, Wombat Gmbh used to look at profits alone while considering investment in a new project in the past. But from the business perspective, profit alone is not a sufficient factor to look at when launching a new project (Guilding 2003). For instance, most investments yield negative benefits in the short-run because of associated investment and operations cost. If the company considers only profit, then it will not implement the project because the amount of resources involved (£25 million) is too high that it will be difficult to recover the money in the short run. Therefore, these appraisal methods are fundamental in analyzing the feasibility of the project in both the short-run and long term (Guilding 2003). Therefore, it is prudent to analyze the viability of the project by prospective cash flows, rates of return and the associated risks. To achieve this evaluation, the use of any of the four project appraisal methods is fundamental (Guilding 2003).

iii. Analyzing which of these methods (or a combination) would be most appropriate for the decision-making process in this case

The analysis looks at the four methods individually, and then a decision is made.

1. Payback period

This approach vividly gives the time frame it will take to recover the amount invested in the project. It provides an analysis of the cash flow for every year until recovery of invested capital. Its ability to evaluate risks associated and the expected duration to earn the principal amount makes it a candidate for the application.

2. Net present value (NPV)

The first challenge with this criterion is that it assumes adjustment of risks to costs and is used when evaluating many projects by various institutions, and the risks which come with the plan. Looking at the fact that NPV is the cash flow generated after repaying the invested amount throws the efficiency of NPV into doubt.

3. Accounting rate of return (ARR)

The greatest strength of this approach is factoring in depreciation when calculating profits and cash flows. Therefore, it is more inclusive as it caters for inflation and other arisen costs in each financial year and at the end of 10 years of the project. Besides, its ease of computation makes it easy for the company to apply it to test the feasibility of the project.

4. Internal rate of return

First, it takes into consideration the riskiness of the project. Secondly, it relies on cash flow and rate of return to evaluate an investment given the time value of money. However, the method is difficult to compute as it uses trial and error criteria to get the value down to zero.

Final decision from the company leadership: the company should consider using a combination of payback period, NPV, and ARR. These methods are complementary in appraising a project since they cover the weakness of one another.

References

Alkaraan, F. and Northcott, D., 2006. Strategic capital investment decision-making: A role for emergent analysis tools?: A study of practice in large UK manufacturing companies. The British Accounting Review, 38(2), pp.149-173.

Baños‐Caballero, S., García‐Teruel, P.J. and Martínez‐Solano, P., 2010. Working capital management in SMEs. Accounting & Finance, 50(3), pp.511-527.

Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.

Filbeck, G. and Krueger, T.M., 2005. An analysis of working capital management results across industries. American Journal of Business, 20(2), pp.11-20.

Guilding, C., 2003. Hotel owner/operator structures: implications for capital budgeting process. Management Accounting Research, 14(3), pp.179-199.

Harris, A., 2005. Working capital management: difficult, but rewarding. Financial Executive, 21(4), pp.52-54.

Miller, P. and O’leary, T., 2007. Mediating instruments and making markets: Capital budgeting, science and the economy. Accounting, organizations and society, 32(7), pp.701-734.

Padachi, K., 2006. Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms. International Review of business research papers, 2(2), pp.45-58.