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Managing Resources: Week 2, Discussion Question 2 Team Case Study: XYZ

By Yves BELEBENIE & Abdulrahman SAID

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Table of contents
Executive Summary ........................................................................................................................... 21

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1.

Literature review ........................................................................................................................... 2

2.

Finding and Analysis .................................................................................................................... 3

3.

Recommendations and Conclusions: ............................................................................... 54

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4.

Appendices (see attached excel reports) ......................................................................... 85

References .......................................................................................................................................... 85 Executive Summary ............................................................................................................................. 1 1. 2. 3. Literature review ........................................................................................................................... 1 Finding and Analysis .................................................................................................................... 3 Recommendations and Conclusions: ........................................................................................ 4

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............................................................................................................................................ Appendices ( ................................................................................................................................................................. 5 4. see attached excel reports) ......................................................................................................... 5

References ............................................................................................................................................ 5

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By Yves BELEBENIE & Abdulrahman SAID Executive Summary One main reason of why businesses fail is insufficiency of cash flow. Cash flow is one of the three mains financial statements. Cash flow is so important that many studies raises its importance by arguing that it is lifeblood of business (Hasenfuss (2008), Hay (1995), Rujoub, Cook & Hay (1995)). Determine and analyze cash flow can be useful to predict future of business related to success or failure. Two methods exist to elaborate cash flow: direct method or indirect method (Laureate Online Education, 2010, p.121). Direct method is using all payments and receipts records of company for a period to draw the cash flow. Cash flow done through indirect method is based on other financial statements: income statement or balance sheet. Indirect method of determination of cash flow is also called accrual method of accounting. This document is developing a case study proposed to build a cash flow from a balance sheet based on accrual method. This case study focuses on the XYZ Company whose accrual information of balance sheet has been provided at 31 December 2010. The first part of this paper discusses literature review on cash flow elaboration, the second part presents finding and analysis of our work and the last section focuses on recommendations and conclusions that we drawn from this case study.

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1.

Literature review

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Cash flow statement is divided in three parts (Laureate Online Education, 2010, p.118): Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Net increase/decrease in cash and cash equivalents over the period

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Cash flows from operating activities isare related to the cash receipt from the sale of products or services. It also includes profit before taxation, depreciation of fixed assets, interest and dividend received from equity accounted entities (ASB, 1996), taxation from authorities and in or out flow movement of receivables, payables and inventories. Whatever the method used to elaborate the cash flow, the purpose of a cash flow is to determine how much money at bank a company had at the beginning of an accounting period and at its end. Which form money is taken, own cash or overdraft? Cash Flow statement based on accrual is also useful to determine whether a company manages to have debt collection, also negotiate better payment terms, and better manage its inventories. Cash flow statement determination through the indirect method is therefore a good tool to evaluate cash flow management. Grill Jr. (2005) identify some cash flow boosters derived from the cash flow analysis which respond primarily to the following questions: do the company manage well inventories, is the company have set better payment terms, or is the company able to collect faster its receivables. Grill Jr. (2005) then proposed some booster to better manage Cash Flow and therefore establish a better cash flow budget for the next year. When elaborating cash flow forecast, management should set expectations from start; customers and account 2

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receivables debtors must be aware of the estimated payment period, the rates used, and incentives to quickly clear AR debts in order to better follow cash collection (Grill Jr. (2005) & Rojas (2003)). Technology is also one booster of cash flow, as the management of aAccount rReceivables aging help to determine whether the time limits came to fund raising. Cash from investing activities show the investing sources and uses of cash. Investing uses of cash encompasses the payment to the acquisition of fixed tangible or intangible assets. Investing sources asset also includes receipt on disposal of fixed assets. Cash from financing activities includes receipt or repayment of principal. Such include issuing of share, receipt or repayment of loans notes, they are also called acquisition or disposal or movement in liquid resources (ASB, 1996). The use of accrual information to build a cash flow statement is the more popular method of determining cash flow statement. Accrual accounting is the accounting system that asserts that profit is the excess of revenue over the expense and not the excess of cash receipt over cash payments (Laureate Online Education, 2010, p.602). Cash flow can be elaborate from accrual but earnings and cash flow can be different. The difference rely in the fact that accounting convention in regard to the timing of incomes and expenses are not necessarily lead to cash movement into cash flow (Chan, Chan, Jegadeesh & Lakonishok, 2006). Revenue included in income statement or balance sheet may not have been cashed and will be account in trade receivables. Some expenses accounted in income statement or balance sheet for the acquisition of asset or stock may have not been rely paid and are included in trade payable and not as part of cash outflows. Earnings are the result of trades over a period and cash flow is necessary to keep operations running by paying expenses. Of course large positive accrual indicate that the company is healthy but do not necessary means that company is able to generate sufficient free cash flow to invest in its growth or restructuring, or to repay loans, shareholder account. Investors are generally focusing in bottom line of income statement to appreciate the health of the company, the main used indicators is the earnings before Interests, taxes, depreciation and amortization (EBITDA). The accrual information is therefore a driver of stock returns (Chan, Chan, Jegadeesh & Lakonishok, 2006). When Accrual components are combined with cash flow, they improved the quality of prediction of future cash flow (Barth, Cram & Nelson, 2001). There are some evidences of closely cross dependencies between accrual and cash flow. Barth, Cram & Nelson (2001) suggested that accruals can be used to predict historic and future cash flow. Following the above brief research and insight on the usefulness of cash flows, we have looked at how the same can be applied to the company such that to help identify information that we were not able to observe by looking at the balance sheet and income statements only.

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2.

Finding and Analysis

Referring to Appendix 1 which contains the cash flow statement of company XYZ for financial period 2010 we can make the following observations.

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We can see from the cash flow statement that the net cash flow generated from operating activities that it is a much stronger figure than that of profit after deducting dividend and taxation. This can be clearly seen from the cash flow as the company was able convert a good portion of its current assets into cash. If additional inventories were acquired in 2010, then all of this together with what was carried over from 2009 was sold. The company was also able to get the debtors to pay the outstanding balance from 2009 and we can see that 10m was received from the debtors in the current year. We can also see from the cash flow statement that the team was able to negotiate an extended payback period with its creditors and also acquire more goods on credit in 2010. All of this shows a strong working capital management as more cash has been released in the financial period that was previously tied up in the inventories, debtors and early creditor payments. In addition to this, eventhougheven though dividends totaling 12m were declared in 2010, the management was able to negotiate with the shareholders and defer the payments to the next financial period. This is another reason why we are seeing strong cash inflow from operations. During this financial period, the management was able to get rid of 20 old machines which had already depreciated over its life time by almost 60%. The sales proceeds from the machines were reinvested back into the business where the management decided to top up and acquire new machines with the aim of improving productivity. As a result of strong cash flow from operations, the company was also able to make additional investment investments by purchasing additional buildings. In this financial period, the management decided to issue additional shares of which 40m was raised through this exercise. The company decided to use these funds to redeem a huge portion of the long-term loan. This is a change of financing strategy as it involves a change in capital mix. This seems to be a good move by the company as it has been able to reduce interest expenses that were previously incurred from the long-term loans. We can also say that this was a good decision by the management because the dividends due to the existing and new shareholders were deferred during the financial period allowing the cash to be used for other business and investment purposes. If the loan was not paid then the resultant interest expenses would have had to be paid in 2010 and hence reducing the cash strength of the business. Taking the assumption that inventories cannot be converted into cash quickly, we can further examine and justify if the liquidity position of the company has improved by looking at Acid Test Ratios for 2009 and 2010.

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Acid Test Ratio 2009: 40/43 = 0.93 Acid Test Ratio 2010: 59/52 = 1.135

From the above calculaionscalculations, we can see that the liquid assets held by the company in 2010 (current assets excluding inventories) can clearly cover the current liabilities. Compared to 2009, it can be observed that the liquid assets held by the company

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during the period could not quite cover the current liabilities. This proves that the business has shown a strong improvement in its liquidity position in 2010 compared to 2009.

3.

Recommendations and Conclusions:

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Looking at the 2010 balance sheet for the business, we can see that the company ended with a positive cash balance in the account. However, after drawing the cash flow statement we did clearly see how this positive cash balance came about which also cleared the overdraft that the company had with the bank in 2009. Putting together the cash flow statement was very useful as it helped us further to understand the change in fixed assets between the two financial periods and cash movement from the investment and sale proceeds. It is our opinion that this move was good for the business as profit was generated from old assets which had already depreciated over 50% of its cost value. Bringing new machines and buildings would also help the company improve and increase productivity. Even though the company was able save on interest on the loan by changing the capital financing mix between the two financial periods, we would like to propose that the management to further analyze the return on the capital employed as a result of this change, It will be important for the business to see if the this change has also lead to an improved return on the capital. All in all, the business has had a good year, both in-terms of liquidity and profitability.Theprofitability. The beginning of financial period 2010 the business had an overdraft but was able to close the facility completely and still maintain a positive cash balance. Despite the positive analysis of the cash flow, we would strongly recommend that the management should not look this in isolation but also to further analyze the balance sheet and income statements for the periods. A thorough analysis of financial ratios for 2010 and comparing them with the previous years and industry standard should also help to give the management a better picture of the companys performance.

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Appendicxes ( a-XYZ Cash flow statement at 31 deccember 2012

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b-XYZ Balance sheet accrual information

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4.

see attached excel reports)

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References
Chan, K., Chan, L. K. C., Jegadeesh, N. & Lakonishok, J. (2006) Earnings Quality and Stock Returns, The Journal of Business, 79 (3), pp.1041-1082, [Online]. Available from: http://www.jstor.org/stable/10.1086/500669 (Accessed: 15 April 2012) Grill Jr., N. G. (2005) Six cash-flow boosters for your business, Fairfield County Business Journal, 44 (25), p p.17-19, [Online]. Available from: http://ehis.ebscohost.com.libproxy1.liv.ac.uk/eds/pdfviewer/pdfviewer?sid=70cf7b9d-8bf6-4113-8da052e43170fc78%40sessionmgr15&vid=1&hid=20 (Accessed: 13 April 2012). Laureate Online Education (2010) Managing Resources. 3rd ed. Harlow: Pearson Custom Publishing. Hasenfuss, M. (2008) Cash flow a business's lifeblood, Finweek, n.d., pp.67-71, [Online]. Available from: http://ehis.ebscohost.com.libproxy1.liv.ac.uk/eds/detail?sid=7cc2923d-0305-4c3d-b281bbc6412fd57e%40sessionmgr13&vid=2&hid=20&bdata=JnNpdGU9ZWRzLWxpdmUmc2NvcGU9c2l0ZQ%3d%3d#db=buh&A N=34737040 (Accessed: 12 April 2012). Rojas, C. (2003) Managing successful turnaround. Even in tight capital markets, Financial Executives, 19 (6), pp.26-28, [Online]. Available from: http://connection.ebscohost.com/c/articles/10817666/managing-successful-turnaround-eventight-capital-markets (Accessed: 14 April 2012). Rujoub, M. A., Cook, D. M. & Hay, L. E. (1995) Using cash flow ratios to predict business failures , Journal of Managerial Issues, 7 (1), pp.75-96, [Online]. Available from: http://www.jstor.org/stable/40604051 (Accessed: 15 April 2012)

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