Business Assignment On Financial Parameters Of Mediterranean Delights Ltd
Mediterranean Delights Ltd (“MDL”) owns and operates 30 delicatessens throughout the South of England. It also supplies several chains of restaurants with its own range of imported products. The company last year had turnover in excess of £50 million. Two key corporate customers are Delios Ltd and San Pedro Ltd.
The company is managed by Wade, who owns 25% of the shares in the company, while the remaining 75% is split between three other family members. The other shareholders are concerned about the business. Although there seems to be plenty of business coming in and the last year has been reasonably profitable (Operating profit was £5 million last year before interest and tax), the company’s debt has increased to £18 million from £16 million the year before. Wade has started talking about the need for the other shareholders to invest more money to reduce the debt. Towards the end of last year MDL acquired a 40% stake in an Italian company which produces a range of premium pasta. MDL invested £10 million in the company to acquire the shares and has agreed to pay an £8 million advance fee for exclusive supply of the products. The company is owed £1.5 million pounds for a series of large orders placed by Delios last year. There is also an outstanding dispute about a £2 million delivery to San Pedro completed in 2017. This has led to payment being withheld while negotiations continue between lawyers and industry consultants.
There is a further problem that Wade believes the San Pedro issue arose due to the supply of sub-standard materials by a Maltese agricultural group, Valetta Ltd in 2017. He has refused to pay Valetta which is now threatening legal action. In the meantime, a large stock of materials and supplies has built up at the company’s London warehouse. Wade insists that the company needs to have this level of stock for when the dispute is sorted out. He is also reluctant to press his key customers too hard for payment. The other shareholders have approached MDL’s accountants to review the situation.
Prepare a report of up to 1,250 words for the shareholders addressing the following issues.
i. Using the reading list provided on the VLE, explain:
a. what is meant by Profit and Cashflow and how they are different
b. what is meant by Working Capital and, the meanings of Receivables, Inventory and Payables
c. how changes in Working Capital affect Cashflow (25 marks)
ii. Apply the concepts in (i) above to this company to show how the way the company is being managed might affect its financial results. (10 marks)
iii. Analyse and recommend what steps should now be taken to improve this company’s cashflow through better Working Capital management.
Second Sight Plc is an international company which produces prescription glasses and sunglasses for a number of leading international brands. The company has been operating for 25 years and had revenues last year of £250 million. It was listed on the London Stock Exchange 10 years ago and has a market capitalisation of £300 million with debt of £50 million. The founder, Nasser, is the CEO and owns 15% of the shares. The company headquarters is located in Manchester which accommodates 40 staff including management, sales, finance, HR and administration. It has a production centre in the UK and another in France. In these centres it employs 250 staff. The company is planning to open a new facility in the Netherlands and is considering a joint venture project with an Indian company. If the Indian venture goes ahead it would involve setting up a facility in Chennai which is expected to employ 800 staff. The company has always used a traditional budgeting system. The Finance Director, Bridget, joined 3 years ago but is concerned that this approach might not be the most appropriate. However, if a change of budget approach is going to be made, she thinks it should happen in time for next year’s budget process. That way any “bugs” can be ironed out before the company goes through more significant changes in the following years.
Prepare a report of up to 1,250 words for the board addressing the following issues:
i. An understanding of the purposes of preparing a budget; an explanation of a) traditional budgeting approaches and b) the following alternative budget methods: rolling budgets, zero based budgets and activity-based budgets, explain their relative strengths and weaknesses (25 marks)
ii. Demonstrate the application of these methods showing how they might be used to plan future cost management for this specific business. Illustrate your answer with examples of how products and processes for this business would be budgeted for in a traditional approach and using the alternative methods (10 marks)
iii. Analysing whether a traditional or alternative budgetary system is appropriate to all or any parts of the business in its planned future form
The present business assignment deals with the concepts of working capital, cash flows and profits and these concepts are applied to the current situation of the business of Mediterranean Delights Ltd (“MDL”) which operates its business across South of England. The company deals in supplying material to multiple chains of restaurant and through its business it has been able to generate sufficient profits in the last year but due to poor management of working capital the company’s shareholders had concerns over its liquidity state. The company examined in the business assignment has remained inefficient in managing its current assets such as accounts receivables, inventories as well its current liabilities i.e. accounts payables.
Concept of Cash Flow and Profits and their interrelationship
In every business both profits and cash flows are the two key financial parameters to determine its financial state. Both the factors mentioned in the business assignment are equally important for the success of business and in the absence of any of said factors a business is vulnerable to collapse. The term cash flow refers to the total money that is going out of the business and the total money coming in the business. When the money that flows out of the business it is called as outflow of money and when money flows in the business it is termed as inflow of money and the difference of total cash inflow and outflow in a particular period is called as Net Cash Flow of the business. Whenever business makes payment of any expense or incurs a cost the outflows of cash occurs for it and whenever it receives any income or generates any sales cash inflow occurs. The outflow and inflow of cash that takes place in a particular period may or may not be related to the expense or income of such period particularly and therefore net cash flows of the business defines the amount of money that is available with the business at a given point of time whereas profit implies the financial gain of the business (Aktas, Croci & Petmezas, 2015). When all the expenses or costs related to a particular period are deducted from all the incomes or revenues of such period, net profit is derived. However, not every expense recorded in the business involves cash outflow. For example, depreciation or amortization of assets is called as business expenses but in actual there is no such cash flow in such events. Though, it is clear in the business assignment that the terms cash flow and profit are not same but yet are interlinked to each other as it is always possible that a business is profitable but short of cash and vice versa because profits of the business merely reflects the book profit and not necessarily reflects the actual cash flow of business.
What is the role of Working Capital, Receivables, Inventory and Payables in the context of business assignment?
Working capital is the total amount of money that is available in the business to deal with daily operations of business. Net working capital of the business is derived when its total current liabilities are deduced from its total assets. A positive working capital shows that a firm is efficient enough to cover its short term financial obligations out of its current assets (Aktas, Croci & Petmezas, 2015). There are various current assets of the business such as receivables, inventories etc and current liabilities like accounts or trade payables, bank overdraft etc. Receivables are also called as trade receivables which are the current assets which are owed by customers or any third party to the business for their purchase of goods from such business. On the other side, payables which are often termed as trade payables are the money owed by a business to its creditors on account of credit purchases of its inventory related goods or related expenses. It is noted herein business assignment that inventory is again a current asset for any business which is held either for the purpose of sale during the course of business or to produce the final product.
Change in each line item of the working capital results in certain movement of cash either inside the business or outside it. If the balance of any current increases from one period to another, it will result in decrease in the cash flow from operating activities of the business. Whereas on the other hand it is also discussed within this section of business assignment that when a current liability balance increases from one period to another it results in increase in the cash flow for the business for that particular period (Atrill 2014). For instance, if the balance of trade receivable increase in a year as compared to previous period it implies that firm could not collect more cash from its receivables and if a balance of accounts payables reduces in a period as compared to previous period it implies that firm has made paid more cash to its trade payables.
Steps to improve this company’s cash-flow
In the present case of Mediterranean Delights Ltd (“MDL”) explored in the business assignment wherein the company has earned reasonable profits in the last year there are concerns related to its liquidity state due to inefficient management of its working capital. Though the business of the company is being carried successfully and has prospects of its future growth as well it could generate decent revenues out of the business but still it is facing the working capital management issue since the significant amount of its revenue generated in the year has been blocked with its two key corporate customers due to which it is not left with sufficient cash to meet its day to day business expenses. Further, it is also depicted in the business assignment that the company is inefficient to turn up its trade receivables in cash in a reasonable time. Also, the company has stocked excessive inventory in the business which has resulted in unnecessary blockage of business funds (Watson Head, 2016). Moreover, due to excessive reliance on external financing of business requirements the debt proportion of the company has increased which would result in excessive payment of interest expenses which are the type of short term financial obligations for the business of MDL. Due to all these factors the working capital management of the company has remained poor in the last year which has ultimately casted liquidity concerns even in the state of sound profitability of business. The current case of MDL clearly shows that even a profitable business cannot run itself smoothly in the situation of shortage of cash or cash equivalents for the business.
In the current scenario of business assignment wherein MDL is enjoying reasonably sound profitability state of the business but due to poor working capital management it is facing the liquidity crunches in its business which is also concerning the shareholders of the business. Though profits are inevitable for the business of MDL but it is important for the company to understand the importance of cash balances available with it. The shortage of cash funds has been evolved from the inefficient management of its overall working capital (Atrill 2015). Hence, it is highly recommended in regards to the case of business assignment to the company to extend its equal consideration to availability cash balances as given to the profitability aspect of the business. It must understand the due importance of cash availability for the business fund its day to day business activities without which even profits could not be generated in long run. The working capital management of the company must be strengthened enough to allow itself to remain with sufficient cash balances to meet out its current financial obligations. It must maintain an optimum level of inventory in the business which could be sold off in the normal business scenarios and must not block excessive business funds in creating huge piles of inventory. Excessive inventory stocking not only involves purchasing cost but also it involves warehousing costs. In the present case of business assignment, the company has stocked its inventory in the London warehouses which would have resulted in payment of excessive warehousing cost. Also, it must reduce its credit limit that is currently being extended to its customers for the sale of its goods or if must make such arrangements which could help it in speedier collection of cash from its key customers. There shall be a strict trade credit policy framed by MDL so that it can clear its trade receivables well in time and make payments to its trade payables on time. By managing the adequacy of cash balances in the business, MDL can also cut down its excessive reliance on external financing for its business operation which involves high financing costs. With sufficient cash balances in the business it can internally arrange funds for the business as and when required.
This part of business assignment illustrates that every business requires certain amount of planning to be done for a particular period, well before it starts actually performing in such period. Budgeting is a key aspect of planning process of the business. It involves estimation of expenses and costs that would be incurred in the business in the coming period along with the anticipation of revenues and incomes that will be generated in such period. The management of the companies therefore requires businesses to apply proper and advanced approaches of budgeting particularly when their businesses demands accuracy of decisions.
Purposes of preparing a budget and Comparison of Traditional and Modern Budgeting
Budgeting is an important aspect of any business planning as outlined herein business assignment. A budget provides a foundation to a business based on which its finances are managed and controlled in the upcoming period for which it is prepared. For any business, budget is prepared keeping in mind the past business trends (in case of existing business) or the future prospects of growth (in case of both existing and new business). A detailed as well as realistic budget depicted in the business assignment acts as a guide to the company in the entire period for which it is prepared as it gives business insights to the managers of how their business year would look like. Budgets are prepared to set the goals and objectives, business priorities, spending caps and also it enables the business managers to identify the areas from where more revenues could be generated and the areas from where funds could be sourced. Further, the budgets are prepared to analyze the performance of business at the end of business period by comparing the budgeted figures with the actual results so that it could be identified that in which areas there remains the loopholes which could not let the business achieve the expected and desired results.
Budgets can be prepared using both the approaches: Traditional Approach and Modern Approach. The traditional budgeting involves preparation of budgets taking the previous year as the base. The budget for the current year is prepared by making adjustments for various events such as inflation, market situation etc. to the last year’s budget. Though, the readings developed in this aspect of business assignment clarifies that these budgets are easy to be prepared and involve lesser efforts since things are forecasted on the basis of previous budgets yet these budgets have a typical limitation that they become out of date frequently due to rapidly changing conditions on the basis of which such budgets are prepared. Another major limitation of traditional budgets mentioned in the business assignment is that such budgeting activities are quite time consuming. In the today’s scenario where business environments are highly dynamic, traditional budgets remains unresponsive. Traditional budgets also do not meet an acceptable level of accuracy in forecasting. Further, traditional budgets do not foster innovative ideas and works on one common idea.
To deal with the limitations of traditional budgeting approach which is often termed as incremental budgeting technique, the researchers have introduced various modern techniques of budgeting such as rolling budget, zero based budgeting or activity based budgeting. The said budgeting techniques have the potential of improving the overall budgeting processes and serving the true purpose of budgeting.
Unlike incremental budgeting, rolling budgeting technique the keeps on updating the budget when the earlier budgeting tenure expires. The continuous updating of budgets helps the managers to take into account the frequent changes that take place in their business environment. However, it is different from incremental budgets which are altered only once at the end of the budget period. Though, rolling budgets helps the firms to keep themselves and their business updated with the new changes such as challenges, threats and opportunities etc. but it involves significant time to follow this approach of budgeting as such budgets are required to be kept updated frequently.
Zero Based Budgeting is yet another classic example of modern budgeting technique wherein budgets are prepared from the scratch irrespective of any previous period spending or earning pattern. Each line item in the budget is evaluated and justified from ‘zero’ baseline. This approach certainly helps in achieving accuracy of budgeted and actual results and also enhances firm’s efficiency as it focuses on the present needs of business and do not take into account the past trends or results. However, this technique requires intensive training and skills sets to be applied. Also, it consumes huge time to prepare such budgets from scratch all over again every-time.
The other classic approach noted within the business assignment of modern budgeting is activity based budgeting. Under this type of budgeting the total cost is estimated which will be required to undertake all the activities that are important in a business process. ABB undertakes allocation of resources on the basis of past efficiencies of activities. Unlike ZBB, ABB provides accuracy of results and also eliminates the redundancy of non-value-added-activities but it requires large time to prepare such budgets and also require advanced training and skills for the person preparing such budgets.
Application of Modern Budgeting Techniques to Present Case
In the present case of business assignment, Second Sight Plc is operating its business at a large scale and across the world it is required for it to switch to advanced management accounting techniques from Traditional approaches for its budgetary planning to achieve accuracy in the business. With the rolling budget technique it can keep its budget updated with the changing market situations such as change in the foreign exchange rate and inflation rate etc. Since, the company is operating its business on international platform it must take into account all the dynamic changes that takes place in the environment (Drury, 2016). Therefore rolling budget could be used. Further, considering the size of the company’s business, Activity based budgeting technique must be used to allocate the estimated cost based on the activities that drive the major costs of the business. Since, the company is involved in the production of multiple activities it must apply activity based budgeting to estimate the true cost. Zero based budgeting could also be applied to seek accuracy of the results of the company wherein it will start its budgeting process from the scratch without considering the previous budget. The budget of each year will be prepared using the latest economic factors affecting the business and other aspects and not on the basis of past performance wherein the last year’s budget is used to make the adjustments for current year budgeting (Weetman, 2010).
Analysis of whether Traditional Budgeting is better or Modern Techniques
In the planned scenario of business assignment, wherein Second Sight Plc is preparing itself to set up a new facility in Netherland and to enter into Joint Venture with an Indian Company, it is necessary for the company to take into account all the environmental factors whether internal or external while formulating the budgets for a particular period. Also, it is necessary to update the budget on the regular basis for the necessary changes that takes place in the business environment. In traditional approach of budgeting only changes are made in the last period’s budget which does not promote the accuracy of decision making. Therefore, modern approach such as rolling budget as discussed herein business assignment must be adopted in order to reach at the correct decision making at the planning stage. Therefore, for the planned future of the business, it is of utmost importance for the business to use advanced level of management accounting techniques particularly in the area of budgeting in order to reach at the correct decision making (Drury, 2016). The use of traditional budgeting technique i.e. the incremental budget might lead to incorrect decision making which may ultimately cause company heavy losses in the business. With so many activities to be taken up in business of manufacturing the sunglasses and glasses, it is necessary for the company to take into account all the activities which drives the product cost. Therefore, arguments raised on this business assignment for such purpose activity based budgeting would be an appropriate technique in place of traditional budgeting approaches.
Aktas, Croci, Petmeza, 2015. Is Working Capital Management Value-Enhancing. Journal of Corporate Finance 30, pp. 98-113.[pdf] business assignment Available through ARU, VLE: Business finance reading list
Atrill 2014. Financial Management for Decision Makers. 7th ed. London FT Prentice Hall. Chapter 10 - Working Capital.[pdf] Availablethrough ARU,VLE: Business finance reading list.
Atrill, 2015. Management Accounting for Decision Makers. 8th ed. London Pearson. Chapter 6 Budgeting.[pdf] Available through ARUL, VLE: Business finance reading list
Drury, 2016. Management Accounting for Business. 6th ed. London Cengage. Chapter 9 The Budgeting Process. [pdf] Available through ARU, VLE: Business finance reading list
Watson Head, 2016. Corporate Finance. 7th ed. London Pearson. Chapter 3 - Working Capital.[pdf] Available through ARU, VLE: Business finance reading list
Weetman, 2010. Management Accounting. 2nd ed. London FT Prentice Hall. Business assignment Chapter 13 Preparing a budget.[pdf] Available through ARU, VLE: Business finance reading list