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Academic Year 2018/19

Semester 2
Module Title: Business Finance
Module Code MOD003319
Level 4
Module Leader: Tim Price
Assessment Interim – Report
Assessment No. 010
Word Count: 2583 words

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Executive summary

Management of cash and financial ratio analysis are an essential part of assessing a company’s
performance. This is due to the reason that it helps in understanding the amount of cash a
company has to meet its daily expenses as well as meet its current liabilities. On the other hand
financial ratio helps in comparing current and past year’s performance of a firm. In this study a
theoretical approach to understand the difference between profit and cash flow has been taken.
Working capital, receivables, inventories and payables have also been described. In relation to
the case study of UberTools ltd all these aspects have been considered. Effect of working capital
on cash flow of the company has also been studied and recommendation has been provided.

Financial ratio of the firm Madagascar Industries ltd has been calculated and explained moreover
the reasons for changes in ratios over a period of three years have also been provided.
Recommendation to the board in order to assess the financial performance has also been stated in
the study.

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Table of Contents
Part 1: .............................................................................................................................................. 4

(i) a. Profit and cash flow and the difference between them ..................................................... 4

b. Meaning of working capital, receivables, inventory and payables ......................................... 5

c. Effect of working capital on cash flow.................................................................................... 5

(ii) Management of company and its effect on financial results ............................................... 6

(iii) Analysis and recommendation on steps that should be taken by the company to improve
cash flow position........................................................................................................................ 6

Part 2: .............................................................................................................................................. 8

I. a. Explanation of elements depicted as per financial performance ........................................ 8

b. Calculation of ratio ................................................................................................................ 9

c. Reasons for change in ratios over the year ............................................................................ 11

II. Analysis and recommendation on the way Board should assess the financial performance
................................................................................................................................................... 13

Reference list ................................................................................................................................ 14

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Part 1:

(i) a. Profit and cash flow and the difference between them
Profit is the amount of income that is left after payments of expenditures attributable to the
businesses such as taxes interests and others as well as payment made as dividends. As opined by
Lyngstadaas and Berg (2016), there are different types of profits that a business takes into
consideration. These are operating profit, gross profit and earnings after payment of interest and
taxes. For example in case of UberTools the operating profit has been reported to be £ 36
million.

On the contrary Cash flow is the amount of liquid cash that a company maintains for running
businesses on a daily basis. It is indicative of the amount of cash is that are both coming as
inflow and moving out of an organisation. Cash inflow and outflow results due to mainly three
activities carried on by companies such as operating activities, investing and financing activities
(Foerster, Tsagarelis and Wang, 2017).

There are many differences between profit and cash flow of a company and this has been
discussed below;

● Profit is mainly a type of inflow that is generated with the help of revenue or sales. On
the other cash flow indicates both inflow of income and outflow of expenditures that
are shown under various activities

● It might happen that in spite of high profit earnings a company can face shortage of cash.
This is because it might have to pay large amount of loans from the available funds or
from the reserves created out of profit (Diamond and Kashyap, 2016). Moreover another
reason for such circumstance is that a company might have invested lump sum amount in
other projects or has paid out dividends or interests. For example in case of UberTools
Ltd in spite of a high profitability and operating profit at £ 36 million made last year, the
shareholders are not confident about its business. The main reason behind its increase in
loan from £ 250 million to £ 350 million. On the other hand it has invested in design
company to acquire 30% of stake has resulted in payment of advance fee. All these have
resulted in decrease of cash flow.

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b. Meaning of working capital, receivables, inventory and payables

Working capital

Working capital refers to the amount of money required to meet daily business expenses. It is
generally considered as the difference between current assets and current liabilities.

Receivables

It is the amount of money that is due to be received by a company from its large number of
customers, or debtors (Collier, 2015). It is thus considered as a current asset by an organisation.
In case of UberTools ltd it has been identified that the company owes £ 12 million from D&R as
well as there is an outstanding amount of £ 35 million due from BricoFrance.

Inventory

Inventories are referred to as the stock of raw materials that company kept in order to fulfil, the
demands of its customers. It has been seen that UberTools Ltd has large number of inventory
kept idle for a long time since the production site work is suspended.

Payables

Payables are the amounts due to be paid by an organisation to its suppliers. It is this considered
to be part of the liability or current liability precisely (Mayer, 2017). In case of UberTools ltd it
has been seen to be the amount that is being charged by the contractor however it can be
considered to be contingent as it is dependable on the legal dispute with contractor.

c. Effect of working capital on cash flow

Cash flow is heavily impacted the changes made in working capital for particular period of time.
As per the opinion of Afrifa and Tingbani (2017), working capital is the difference between
current assets and current liabilities. Hence if there is many changes in these two elements of
accounting them the cash flow either decrease or increases. If current assets such as debtors
increases then it means that there has been no inflow of cash in the business therefore cash flow
is impacted negatively. Moreover if liabilities such as payables amount decrease then also cash

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flow is impacted. This is because decrease in liability results in payment of due mounts that
reduces cash simultaneously. For example increase in debts from £ 250 million to £ 350 million
has increased the cash flow as the total debts also holds a part of current liabilities. However the
amount due form the two customers that are £ 12 million and £ 35 million has reduced the cash
flow. Payments of £ 18 million as advance fee have also further reduced cash position.

(ii) Management of company and its effect on financial results

As identified from the case of UberTools ltd, profitability position of the organisation is good
and it seems to rise every year. However the inefficient debt management has led to an increase
in debts by £ 100 million over one year period. This has affected the cash flow from financing
activities as cash inflow would increase. This has resulted in financial risk as there is not enough
liquid cash available to pay off the debt (Reid, 2018). Hence the firm has asked shareholders to
help in paying off the debts. Moreover the inability to collect due money from customers such as
D&R and BricoFrance has resulted in reduction of cash flow. The stock turnover is also not
good as large number of stock is still idle and in addition to this payment of advance fee to the
design company has also resulted in outflow of cash from investment activities. On the other
hand it has been identified that decision to acquire 3 year license has resulted in payment of
considerable amount of 18 million that has resulted in outflow. Therefore on an overall basis it
can be said that ineffective management of the company has affected financial results negatively.

(iii) Analysis and recommendation on steps that should be taken by the company to
improve cash flow position
The working capital management of the firm UberTools is not appropriate as it has led to a
negative impact on the cash flow position. Since the management of debts and receivable is not
efficient hence company has faced problem related to high amount of cash outflow. This has
affected the cash flow from financing as well as investing activities and it has led to an increase
of cash flow position. Moreover its decision making in respect to investments have also been
found out to be ineffective especially during the time when it is running out of funds. All these
problems have led to shareholders being less confident about their returns. In order to improve
the cash flow position of UberTools Ltd, following methods and steps have been recommended;

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● It should match its receivables with that of payables so that working capital is not
affected. This can be done by holding the payment of £ 2 million due to the design
company.

● Moreover its strategy to ask shareholders to pay off debts is also good as it would not
result in inflow of cash from the company's accounts (Aktas, Croci and Petmezas, 2015).

● UberTools ltd should introduce credit management policy that should involve payment of
half of money in the month service product is sold and half in the next month.

● In regards to managing working capital effectively it should take the help of ratio analysis
so that effectiveness can be tested as and when required (Collier, 2015).

● Furthermore UberTools ltd can also apply Just in time inventory so that large amount of
stock is not kept idle for long and this would also improve cash position.

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Part 2:

I. a. Explanation of elements depicted as per financial performance

i. Sales growth

Sales growth as defined by Penman (2016), is an increase in sales over the period one or two
year. It indicates the ability of a firm to increase the turnover rate with the help of efficient
management of assets as well as control on expenses.

ii. Gross profit margin

Gross profit margin is the amount of gross income earned from the sales (Ismail, 2016). It
signifies the ability of a firm to control its direct expenses such as purchases, wages and others.
If the gross profit of any company is high then it signifies that the firm is able to control its direct
expenses effectively. It is represented as a percentage amount of revenue.

iii. Operating profit margin

Operating profit margin is the amount of profit that a company earns after payments of all
operating expenses from the gross profit it has earned in a particular year (Robinson et al. 2015).
In case of operating margin is low then it is understood that operating expenses such as selling,
advertising, administration, depreciation and others have been high. Moreover these are not
controlled properly. It is generally calculated as a percentage amount of sales.

iv. Gearing

Gearing ratio signifies the amount of debt a company has taken and is liable to pay off out of the
total capital employed in a business (Jordan and Kelly, 2015). If the gearing ratio is too high then
it is understood that the company is using high amount of debts.

v. Interest cover

Interest cover signifies the ability of the firm to understand the ability of the firm to pay off
interest expense due on debt amounts. Higher rate of interest coverage means that the firm is
able to meet its obligations and pay off interest on them within time.

vi. Liquidity ratio

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Liquidity ratio is usually measured with the help of two types of ratio that are current and quick
ratio. It helps in understanding the amount of liquid funds available to meet immediate liabilities
due to short term creditors and also an ability to meet working capital requirement (Diamond and
Kashyap, 2016). If the liquidity of a firm is high then it does not face any form of financial risk.

vii. Return on equity

Return on equity is the amount of return generated from effective use of investments made by the
shareholders. If return on equity is high then it means that the investment has been used in the
most efficient way (Ismail, 2016).

viii. Return on capital employed

Return on capital employed, is the amount of return generated from capital employed by the
company. If the return on capital employed is good then it signifies that an organisation has the
ability to use capital employed in the most profitable way.

b. Calculation of ratio

Figure 1: Calculation of ratios

(Source: learner)

i. Sales growth

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Sales growth ratio for Madagascar Industries ltd has been calculated to be 10% for the year 2010
and 16% for the year 2011. Sales growth has not been calculated for year 2009 as it has been
considered as the base year hence it has been indicated as Nil.

ii. Gross profit margin

Gross profit margin for the year 2009 is 63.89%, for 2010 it has been calculated to be 63.64%
and for 2011 it is 59.26%.

iii. Operating profit margin

Operating profit margin has been determined to be 30% in the year 2009. In 2010, it has been
calculated to be 25.51% and for the year 2011 it is seen to be only 10.68%.

iv. Gearing ratio

Gearing ratio has arrived at 37.96% for the financial year of 2009. In case of year 2010, it has
been found out to be 42.07% and for year 2011 it has been calculated to be 51.14%.

v. Interest cover

Interest coverage ratio has been calculated to be 12 times for the year 2009 and for the financial
period of 2010 it has been 8.42 times. In relation to the year 2011 interest cover is calculated to
be 3.06 times.

vi. Liquidity ratio

Liquidity ratio has been found out to be 2.24 times in relation to financial period of 2009. In case
of 2010 liquidity ratio has been calculated to be 2.38 times and for 2011 it is 0.922 times.

vii. Return on equity

Return on equity has been calculated to be 25.99% or 26% approx for year 2009 and for year
2010 it has been 20.75%. In addition to this for year 2011 return on equity has been 7.56%.

viii. Return on capital employed

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Return on capital employed has been 22.04% in case of year 2009. Madagascar Industries ltd has
been calculated to be 16.86% for year 2010 and 2011 has reported a return on capital employed
of 6.96%.

c. Reasons for change in ratios over the year

Figure 2: Changes in ratios

(Source: learner)

i. Sales growth

As depicted in the financial statement of Madagascar Industries Ltd the sales have increased over
the period of three years from £ 360 to £ 459. There has been an upward rise in sales for the
company and this has been mainly due to the fact that company has been able to sell high
number of Jewellery. This increase in sales has been due to the good reputation among customers
and the ability to retain loyal customers.

ii. Gross profit margin

Gross profit margin has decreased over the period of three years and it means that the cost of
sales has increased from £ 130 to £ 187. This has also been due to the ineffectiveness of
organization to achieve economies of scale (Reid, 2018).

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iii. Operating profit margin

Operating profit margin also shows decreasing trend over the years and reduction in operating
profit margin has been sharp. This has been due to the reason that operating expenses and
amount of depreciation have increased by large amounts (Mayer, 2017).

iv. Gearing ratio

Gearing ratio shows an increasing trend over a period of three years which implies that
Madagascar Industries Ltd has started sourcing funds from long term debts to finance its
business.

v. Interest cover

Interest cover has decreased over the years showing that the firm’s ability to meet interest
expenses from operating profit reduced. It has been due to rise in finance expenses every year
and a simultaneous decrease in operating profit.

vi. Liquidity ratio

Liquidity ratio has also declined mainly due to rise in current liabilities over the years and a
fluctuating trend observed in current assets (Afrifa and Tingbani, 2017).

vii. Return on equity

Return on equity has a declining trend that has been due to rise in shareholders fund considerably
and a simultaneous decrease in net profit attributable to the shareholders.

viii. Return on capital employed

Return on capital employed has reduced from 22% to 6.96% approximately. This has been
mainly due to the fact that investments from shareholders increased however there was a
decrease in operating profit.

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II. Analysis and recommendation on the way Board should assess the financial
performance
Financial performance of Madagascar Industries ltd has not been that effective as main element
of financial statements such as operating profit, net profit, current ratio and others have declined.
This means that it is unable to control its cost of sales as well as operating and non operating
expenses. Therefore the Board of Directors of Madagascar Industries ltd should take certain steps
to improve its financial performances. The following steps would help in assessing the financial
performance;

● It should reduce the cost of producing Jewellery so that economies of scale can be
achieved

● It should control the operating expenses such as depreciation by converting the method of
depreciation to straight line basis.

● Current liabilities should be reduced so that liquidity position can be enhanced.

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Reference list
Afrifa, G., and Tingbani, I. (2017). Working capital management, cash flow and SMEs’
performance. 17(3), pp.85-113.

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.

Collier, P. M. (2015). Accounting for managers: Interpreting accounting information for

decision making. New Jersey: John Wiley & Sons.

Diamond, D. W., and Kashyap, A. K. (2016). Liquidity requirements, liquidity choice, and

financial stability. In Handbook of macroeconomics 2(3), pp. 2263-2303.

Foerster, S., Tsagarelis, J., and Wang, G. (2017). Are Cash Flows Better Stock Return Predictors
Than Profits?. Financial Analysts Journal, 73(1), pp.73-99.

Ismail, L. A. L. L. O. O. (2016). Impact of working capital management on financial

performance of SMEs across industries. 9(3), pp.121-136.

Jordan, J.,and Kelly, R. (2015). Companies with a Formal Sales Process Generate More
Revenue. Harv. Bus. Rev. 11(6), pp.56-85.

Lyngstadaas, H.,and Berg, T. (2016). Cash Flow and the Consistency Principle in Working
Capital Management Calculations. Journal of Applied Management Accounting Research, 14(2),
pp.65-76.

Mayer, T. (2017). Austrian Economics, Money and Finance. Abingdon: Routledge.

Penman, S. H. (2016). The design of financial statements. 15(3), pp.147-151.

Reid, W. (2018). The meaning of company accounts. Abingdon: Routledge.

Robinson, T. R., Henry, E., Pirie, W. L., and Broihahn, M. A. (2015). International financial
statement analysis. New Jersey: John Wiley & Sons.

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