Free Capital Budgeting Practices Case Study Sample
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Management of Working Capital Case Study: "George's Trains".
George’s Train Shop is a family-owned firm that sells and repairs model trains. Currently, the business is profitable but the owner needs advice on his working capital management strategies. Working capital management involves inventory management, management of debtors and creditors, management of cash, among other elements. The strategies have a direct effect on the current and future profitability. This paper analyzes the working capital management practices of George, his capital budgeting techniques. In addition, it explores the limitations of investment appraisal techniques. Finally, the paper develops a simple cash flow statement for the business and examines measures the owner can take to improve the firm’s cash flow situation.
Description of working capital management practices
George applies the strategy of controlled growth for his business. This implies that he regulates the growth of the firm to avoid problems associated with uncontrolled growth. Rapid growth in sales and growth of the business through capital investments may cause the fall of the firm. This is because the rapid growth may lead to a reduction in inventories and inadequate to finance operating activities (Byrd, Hickman & McPherson, 2013). Controlled growth is, therefore, suitable to ensure continued growth and profitability of the business in future periods.
George uses the conservative approach in managing the working capital of his shop. Under this approach, the firm limits short-term borrowing as a way of reducing risks of having to refinance on maturity of the short-term obligations (Byrd, Hickman & McPherson, 2013). It helps in maintaining a high working capital by reducing the amount of current liabilities. The business focuses on borrowing from long-term sources than short-term sources. At the inception of the enterprise, George borrowed money from the bank to purchase the initial business (Searchcenter.intelecomonline.net, 2015). It is reported that he borrowed a sufficient amount to pay for the business and acquire inventory. This was meant to finance the firm’s working capital needs through long-term borrowing (Searchcenter.intelecomonline.net, 2015). In addition, when the business was under threat of losing established customers due to the termination of the lease agreement, George decided to buy the building through a bank loan. The additional loan put a lot of pressure on the firm’s finances. However, George resorted to measures such as cutting down expenses and keeping inventory level to a low level instead of borrowing short-term funds to maintain the high levels of inventory (Searchcenter.intelecomonline.net, 2015). This strategy helps in ensuring that there is adequate cash to meet daily operation expenses without necessarily borrowing. However, low inventory levels could be disadvantageous for the business. Without a high inventory level, it may be impossible for the shop to exploit opportunities that may result if the demand goes up. In addition, low stock levels may cause shortages thereby leading to the loss of existing customers among other stock out costs.
Before purchasing the business, George studied the financial statements, and he was impressed. The examination of the financial statements enabled George to assess past performances and to predict future performances. The information was then used to generate the future profits associated with the investment. George applied traditional capital budgeting methods such as the accounting rate of return (Byrd, Hickman & McPherson, 2013). He used the expected profits from the business to determine the expected rate of return on his investment.
Potential limitations of the capital budgeting technique
Accounting rate of return does not take into consideration the aspect of risk in purchasing the business. This is because it ignores the time value of money as it does not discount the accounting profit using the firm’s cost of capital. It does not consider the timing of the expected profits. The risk aspect is ignored since investors prefer current to future returns (Arnold, 2013).
It assumes that the accounting profit will be stable during the entire life of the business. This assumption is unrealistic in modern day businesses. It is reported that the demand for model trains is cyclical hence George keeps a low inventory level during the low seasons. The method is also limited by the fact that it is based on accounting profit rather than cash flows. George examined the financial statements of the business before making a decision to buy it. Accounting profit is not suitable since it is subject to a number of accounting treatments and may be manipulated. For instance, just a change in depreciation policy from straight-line to reducing balance methods would change the accounting profit (Arnold, 2013). Cash flows are more suitable since they are not subject to several accounting treatments and are not as prone to manipulation as accounting profit.
Finally, when comparing multiple investments, accounting rate of return will be misleading since it ignores the size of investments (Arnold, 2013). A smaller project may have a higher accounting return than a bigger project despite the bigger one generating more profits. This is because it is relative and not an absolute measure.
Cash flow statement (Direct method)
Measures to improve cash flows
George can improve the cash flow situation by enhancing efficiency on operations. He should organize training arrangements for employees and adopt proper technologies processes in production (Arnold, 2013). In addition, he should reduce the level of inventory and enhance the collection of cash from its accounts receivable.
Arnold, G. (2013). Corporate financial management. Harlow, England: Pearson.
Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial finance. San Diego, CA: Bridgepoint Education.
Searchcenter.intelecomonline.net,. (2015). Intelecom Player. Retrieved 6 February 2015, from http://searchcenter.intelecomonline.net/playClipDirect.aspx?id=4870EEC7664070BB9D6744FDA7325EE44F45E0E47862343D60FAA8E3325D1A83C46D5C6FAB3D01A758FA30144214BB3D
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