This essay involves report writing. It occurs in two parts whereby part one deals with analyzing the difference between the profit and cash flows, with specific interest on whether the two can change independently without affecting each other. It goes further to describe what working capital, receivables and payables are as well as how they affect cash flows. After the cash flows, analysis of UTL company takes place to show how the issues dealt with in the company relate to the changes in cash flows and working capital in the organization. Recommendations are given for the company to improve on its day to day doings. Part two, on the other hand, deals with the description of various financial ratios, calculating the specific ratios and explain what the ratios denote. The possible reasons for the high or low ratios get explained which give different gestures for the life of the company.
Part 1. Definition and relationships of terminologies and statements
In the corporate world, each organization works with the goal of realizing a gain at the end of the day. This gain is always either positive or negative depending on the effectiveness the management put in the trading affairs more so on the issue of cost. What constitutes profit is the positive form of the gain. Therefore, profit is the positive gain from operations of the said organization. It is the residual figure that results after subtracting the sum of all costs and all expenses from the revenue realized from the sales (Aktas, Croci and Petmezas, 2015).
With the profit as a tool, the management or any other stakeholder can determine the success or the failure of business though this is alongside consideration of other factors. For instance, if one needs to put a given institution’s growth in comparison with another, it is of great import to use a ratio of profits to sales (profit margin). A firm that does well in terms of profitability acquire a good image in the corporate environment; for example, lenders will not shy away from extending loans to such firms. Again the public will find it an excellent place to invest (Aktas, Croci and Petmezas, 2015, P. 99).
Cash flow refers to the amount of money that comes in or leaves the organization during the trading. Thus cash flow can either be cash outflow or cash inflow. The cash flow can result from the sale or purchase of different items of the balance sheet as well as receipt and payment against items that are outside the balance sheet (Melville, 2017).
1.3 Differences between profit and cash flow
Someone may at times confuse the profit for cash flow and vice versa, but in the real sense, the two have a big difference. It should be in every manager’s mind that a firm must generate profits and at the same time realize a positive cash flow for it to thrive in the corporate world; This means the difference between the two is there, and a track of it is crucial for effective operations (Watson, and Head, 2016).
Profits come when the selling executes, but cash flows are recorded only when the money comes or leaves the company. For example, a businessperson may sell an asset at a very high profit that he purchased it but under an agreement that money will exchange hands in a future date; this means that the seller has received gain, but the cash inflow is still pending. The only thing that is logical here is that there has occurred an outflow and the business may struggle to exist (Watson, and Head, 2016, P.69).
A cash flow transaction does not necessarily mean that the firm is profitable. For instance, if company A borrows money to pay a debt, the cost of the debt may show a very high figure such that making the profit from this does not materialize. Hence cash flow and profit are two different things (Watson, and Head, 2016, P. 70).
1.4 Working capital
From the statistical point of view, working capital is the difference that exists between the current assets and current liabilities of a given institution. The main items used in calculating the working capital include the stock, trade payables and trade receivables. From the dynamic point of view, working capital is the equilibrium that occurs between the activities that generate income and activities that help in purchasing the resources in the business entity. Networking capital is an excellent tool to measure the liquidity of the firm (Aktas, Croci and Petmezas, 2015, P.106).
Inventories refer to the goods in their finished form and ready for sale as well as the raw materials that help in coming up with the products for sale. From this definition, most of the current assets fall under the category of inventory. Holding a lot of stocks may deter the business cash inflows (Atrill, and McLaney, 2014).
Receivables are the amounts owed to the institution by the customers it serves. The more the debtors, the high the risk of default. Receivables affect the cash flow, and the management should exercise due care in the customers to give credit (Atrill, and McLaney,2014, P. 409).
By definition, the term payable is the money that pends payment. It is the amount that is owed by the organization to the lenders. Payables are short-term in nature and affect the cash flow positively. If the management can delay the payments, then the figure of the cash flow would remain high (Melville, 2017, P. 362).
1.8 Effects of changes in working capital on the cash flow
Investment in working capital reduces the number of cash inflows because the money goes out to those investments. In this conjunction, the books of the expanding firms portray a huge WC and little cash inflows. Sluggish collection of cash from creditors may lead to fewer cash inflows, and this makes the account receivable to go to drain (Melville, 2017, P. 364).
Although the company has realized high profits, the cash flow is at risk since the more the benefit comes in, the more the debtors demand their pay. Also, the interest paid to the debts carries along huge amounts that could otherwise impair the financial soundness of the entity (Watson, and Head, 2016, P. 71).
The company invested more in WC, and this action reduced the cash flows rendering the company profitable but bankrupt. This bankruptcy mainly was from the fact that more cash went away with less or no inflows.it is from this reason that the manager called for more subscription of shares. Delayed cash flows due to the court order is a very serious cause of alarm for this come. The company is awaiting to pay them for the orders that were placed by D&R. Combination of these delays make the company unattractive (Melville, 2017, P. 365).
The management needs to cut down the numbers of debts and concentrate on capitalizing on what they already have for them to come back to their excellent cash inflows. Reducing the number of debtors means that the payables diminish and the little profit they realize will have a positive increment in the cash flows. The costs associated with the debts reduce with reduced liabilities and therefore no extra charges will go out of the company (Watson, and Head, 2016, P. 78).
The idea of acquiring a license to manufacture a range of chainsaws was a good thing, but since this increased the working capital, it should not have happened. The recommendation is that the management should avoid more investment in the WC for the betterment of the current situation (Watson, and Head, 2016, P. 79).
On the issue of receivables, the company should set rules on collection of the same to avoid too much shortage of cash yet with huge profits. Again to avoid defaulting, the customers need to be assessed well before they are allowed credit. The rate of credit sales should meet reduction by encouraging the customers to pay on delivery if possible and if not then they should have it in mind that a given maximum level of credit sales is applicable (Aktas, Croci and Petmezas, 2015, P.100).
The company should avoid issues to do with court proceeding by assessing people with whom to enter into contracts with so that no or less suit cases can find their way to the organization; This is because as court orders prevail, more costs will come to rein interfering with cash flows (Atrill, and McLaney, 2014, P. 408).
Part two: ratio analysis
A ration is defined as an expression in a mathematical form of one item to another, for example, gross profit over the sales revenue. A ratio can either be a percentage, fraction, translation statement, or even a decimal. Some of these ratios are explained in details in the following paragraphs with calculations and interpretations for each (Watson, and Head, 2016, P. 80).
The volume of sales at any particular time is very crucial. Sales growth ratio is concerned with showing how the sales grow from one year to the other. It’s a good ration in management since it shows how good it is. The investors are in a good position to analyze the viability of the firm by examining how the products of the company are marketable or the level of demand the company has in the business world. If the ration is high, the demand for the products offered by the company is like to increase highly in the years to come (Melville, 2017, P. 368).
sales growth rate= (360-0)/0
A sales growth ratio of zero means that the firm may be new in the corporate world since figures for the previous year are missing. It could also come out of the firm not recording its transactions previously.
Sales growth rate= (396-360)/360
The firm here has realized a growth of 0.1 which shows that the company’s products have increased demand amongst the customers. With more customers, the sales revenue normally increases as the volume of the same increases.
Sales growth rate= (459-396)/396
Compared to last year the firm’s growth rate has hiked by 0.059; This could have resulted from the advertisement practices the firm does. The better the communication to the public, the better the customer loyalty hence more sales realization.
2.2 Gross Profit Margin:
GPM is a ratio that expresses the gross profit of a firm as a percentage of the revenue received from sales. It gives a sense of the rate at which the management effectively manages the costs associated with the firm’s activities (Atrill, and McLaney, 2014, P. 409).
GDP= (230/360) *100
= (252/396) *100
= (272/459) *100
The GDP has declined over the years because of the reduction in the gross profit. The main issue that can have caused this is an increment in the cost of sales. The sales could also have lost value through issues of inflation.
This ratio is quite impressive. The high figure of this ratio is probably due to the organization working hard to minimize the cost of acquiring the sales. It indicates that the managers are competent in managing costs.
Unlike the GPM operating profit margin concentrates in the operating efficiency. It shows how good the management does away with the profits from the daily operations. High operating ; gains usually result in high OPM (Melville, 2017, P. 372).
OPM= (107/360) * 100
This figure tells us that the firm is fairly good at minimizing the expenses involved in the operations. The advice to the managers is that they should work on an increased rate of reducing the expenses involved in operations. This reduction will increase the operating profits in a greater way.
OPM = (101/396) *100
The trend of the OPM is has shown a declining direction. The organization seems to allow some expenses in operations probably advertising expenses. These expenses should diminish if possible.
OPM = (49/459) * 100
The firm needs to do something since the trend is not welcoming. With this trend, we are sorry that the firm may fail in its goals. Also, the cost of sales may be the issue here, and therefore management should take keen note of the same and act.
2.4 Gearing Fraction:
Gearing ratio refers to the ration which determines the rate at which the long-term lenders support the organization with funds. A highly geared firm is hazardous to invest in by the ordinary shareholders; this is because a lot of cash will always find their way away from the firm in terms of interest payment (Melville, 2017, P. 375).
This company has depicted an increment in gearing ratio over the years; This means that the managers have incorporated more debts as years went by. With this trend, the company may turn out unattractive for investment.
2.5 Interest Cover Fraction:
Interest cover fraction is a quotient of operating profit (numerator) and the cost of the finances used in the firm. It shows the number of times the payment of the interest that is payable to the security holders have happened over the stated period. A high ratio denotes that the lenders would not face the danger of losing interest for a considerable decline in profits (Aktas, Croci and Petmezas, 2015, P.105).
The rates of interest cover declined over the years. The rate is facing an accelerating ratio meaning that the number of times the interest can pay the lenders successfully minimizes. This decline denotes that the company is becoming unattractive since the lender has an increased probability of losing interest in case the profits continue to decline.
2.6 Liquidity Ratio:
Liquidity ratio is a ratio that divides the current assets with current liabilities. It measures whether the firm is in a position to meet its obligations that appear in short-term nature as and when they fall due. Though it depends from firm to firm, the standard ratio is 2:1(Melville, 2017, P. 378).
The amount for the ratio in the year 20×9 is right since it surpasses the standard expected. The firm is in an excellent position to meet its short term obligations as and when they come around.
In the year 20×0, Still, the ratio is promising. The high figure is suitable to enhance the company in paying the short term debts.
Short term liabilities have increased more than the current assets making the results for this ration to decline. The management is in a problem of not effectively being able to meet the short term obligations.
2.7 Return on Equity:
Return on equity is a profitability ratio that shows the percentage of the net profits over the funds contributed by the ordinary shareholders. The investors find this kind of ratio very crucial in analyzing the given company with a view of determining the viability of the shares offered. The higher the ration, the better (Atrill, and McLaney, 2014, P. 411).
ROE= (78/304) *100
The percentage is very low for this ratio. Although low, the amount of ROE here is reasonable since no comparison is available from the previous year. This ratio would work well if a figure existed in the year before.
ROE= (72/347) *100
The less amount of ROE is simply from low net profit which draws its cause from the reduced gross profit. Different factors like depreciation contribute to this amount. If measures to curb these factors come to light life will stand out better.
ROE= (26/344) * 100
The return here has gone extra down meaning that some controls over the expenses have to take place to reverse the trend. Reducing costs also is a good idea to deal with this situation. The recommendation is that everyone in the organization needs to have a sense of efficiency in their operations
2.8 Return on Capital Employed:
ROCE is a type of ratio that gives a percentage to express the relationship between the operating profit and the amount of capital employed by the business entity. It is different from the return on equity in that return on equity deals with the net profits and shareholder’s funds only. ROCE considers all the sources of funds without minding where it sourced (Aktas, Croci and Petmezas, 2015, P.110).
ROCE= (107/ (215+ 304)) *100
For a start, the ROCE is reasonable. The company is expected to pull up its socks for the better. If the operating expenses come down, then the figure for this ratio will go up.
ROCE= (101/ (302+347))
The gesture here is that less operating profits have a significant effect on the ROCE. Still, the recommendation in the previous year’s ROCE holds water. The concerns are for the company to improve on reduction of expenses.
ROCE = (49/ (462+344))
The company has realized the lowest operating profits ever. This low figure has reduced the ratio greatly. Such a figure calls for the attention of improvement by the organization. The nagging item here is the expenses which must reduce for improvement.
Aktas, N., Croci, E. and Petmezas, D. (2015). Is working capital management value-enhancing?
Evidence from firm performance and investments. Journal of Corporate Finance, 30, pp.98-113.
Atrill, P. and McLaney, E. (2014). Financial accounting for decision makers. Harlow:
7th Ed. Pearson Education Limited, chapter 3 pp. 70-106, and chapter 10 pp. 408-453
Melville, A. (2017). International Financial Reporting: A Practical Guide. Pearson Education
Canada. Pp. 361-387
Watson, D. and Head, A. (2016). Corporate finance. New York, NY: 7th ed. Financial
Times/Prentice Hall, chapter 2 and 3, pp. 54-110