Describe a forecast cash flow, a forecast Profit and Loss account and a forecast Balance sheet
Discuss the importance of them to an organisation when financial planning
Describe the importance of analysing budgets to an organisation
Analyse how these documents help organisations to make appropriate decisions
Hi lo ltd a traditional manufacturing company is currently facing some financial difficulties, the aim of the report is to analyse the interests and the importance of different stakeholder groups of the business, and how the business has to focus its resources to satisfy the interests of these stakeholder groups.
The paper highlights the importance of financial planning and budgeting for the long run profitability and the success of the business. The paper also reviews the capital budgeting decision undertaken by the business through the net present value analysis and highlights the importance of the analysis in the financial decision making process.
2. The Stakeholders
A business is a social entity with a large numbers of groups of individuals associated with it; these individuals are referred as the stakeholders of the business. According to Freeman (1984) a stakeholder can be defined an as individual or a group of individuals that are affected and affect the achievement of an organization. The organization should be able to manage the interests of all parties associated with it. It is important that interests of all stakeholder groups are safeguarded by the management of the firm. The stakeholders are an integral part of the decision making process of the company therefore it is important to consider them in the decision making process. Thus based on the analysis the most important stakeholder groups have been identified as
- Local communities
The shareholders are the part owners of the company and therefore demand a share in the profits of the company. They shareholders demand and continuous increase in dividends as a reward for their investment in the business.
- Employees and Management
The employees and management of the company are interested in the prospects of their salaries and job security to be provided to them by the management of the firm. Several studies also argue that there should be employee ownership in the top management of the company, as ensures creation of a free and fair work environment. Several studies have indicated an improvement in the performance of the organization owning to giving employees ownership in the business (Yener, 2002).
It is important that the business safeguards the interests of its customers as the customers are the revenue generators and the main source of profits for the business. A company should understand the needs and the priorities of the customers. The company should ensure effective information exchange between itself and the customers to clearly understand the needs of the customer. An organization should be able to ensure both quality and accountability to their customers (Schwartz, 2006)
The suppliers of the organization provide the organization extremely valuable resources for the firm to undertake efficient business activities. The suppliers have to ensure the sustainability of their contracts and ensure the timely payments for the goods and services provided to the organization. Suppliers should be selected according to their commitment to economic, social and environmental responsibility.
- Local Communities
An issue increasingly gaining importance is the protection of the interests of the local communities. It is believed as the business is using the resources of the society the business is ethically responsible to return those resources back to the society as well. Keeping the interests of stakeholders in mind the CSR concept is gaining increasing importance. The CSR enables the recognition of the social responsibility of the business According to one of the definitions of the CSR, the CSR can be defines as a concept which integrates social and environmental interests in the operations of business and the management of stakeholder interests. Though the CSR is a voluntary concept but has become a vital part of organizational decision making
Keeping the above groups in mind different corporate strategy tools has been developed to understand the stakeholder interest in the business. Strategic tools like Porters five forces, which analyses the bargaining power stakeholder groups on the business. Other strategic tools like the PEST and the SWOT analysis which enable the environment analysis for the stakeholder groups. Various numbers of books and theories have been developed to understand stakeholder interests with the changing business environment.
The Stakeholders may sometimes impose conflicting demands on the business, like the suppliers and employees are concerned their pay and hence the reduction in profits on the other hand the shareholders want increased profits so that they can receive higher dividends. Another issue is of the local communities, which may reject a business proposal as it may not the environment friendly but to the management is a huge profit gaining venture. It is to counter these conflicting demands that effective stakeholder management is essential, the management has to maintain a balance and ensure the satisfaction of all stakeholder groups.
3. Importance of Financial Planning and Budgeting
Planning is an integral part of business. It is on the basis on planning that the businesses are able to understand and analyse their sales, target markets, customers, profit forecasts and a wide variety of parameters critical to the business process. Financial projections are important in the business planning process. Creating budgets enables organizations to plan ahead and hence check their performance (Businesscasestudiesuk 2004).Financial budgets are an integral part of the strategic planning process .All the resources of the business are allocated in the budgets (Dimitris N. Chorafas 2007). Financial planning is done using financial statements of a firm like the profit and loss statement, balance sheets and cash flow statements.
3.1 Importance of Budgeting
1. Firstly, the financial budget planning process enables the management to identify and review the impact on the firm’s cash flows, inventory planning as well as the balance sheet. It also enables the firm to access their financial position and their needs of borrowing from the market.
2. Secondly, Budgeting enables the allocation of financial resources towards a key strategic plan developed by the management. Once the resources are allocated only then can the management take up the task of achieving the specific target identified.
3. Thirdly, Formulation of financial budgets enable the organizational management to respond actively to the market conditions to fast track the goal attainment process; As well as the identify the forthcoming coming. Risk identification would enable organization to adopt measures that would lead to financial risk minimization.
4. Fourthly, Creation of a financial plan enables the management to identify risk and returns. It also helps in the identification of the gap between investment and financing plans. For example: While formulating the financial plan the firm is able allocate resources and inventory to adequately meet the customer demands. These may be both short term as well as long term.
(Fabozzi, et al, 2009)
3.2 Importance of Cash flow
Amongst the financial budgets one of the most important financial statements generated is the projected cash flow statement. Cash flows are generally related to capital costs of a project. As well as determining the savings and the expenses such as tax , depreciation, energy costs , labour costs and other working capital investment(Em- Financial Management).Businesses often underestimate the importance of cash flows and hence end up in trouble example Kingfisher Airlines currently suffering huge losses , because of its inability to maintain sufficient working capital(The Economic Times 2012).
Thus the cash flow projections are made taking into account the market conditions
Fig 1: Different Factors taken in account to project Cash flows in a business (Dimitris N. Chorafas 2007).
Cash flows help in determining the Time value of a project. Based on the cash flow projection the time value of money can be calculated or in other words the feasibility of the project can be analysed. Mathematically it is denoted as
Cash flow also enables the calculation of the rate of return on investment. This value is of key importance to the investors of the business.
Higher ROI indicates a better performing investment.
Cash flows are also able to project the internal rate of return (IRR) or simply the yield on investment. While calculating the internal rate of return the NPV is equivalent to 0.Thus the calculation of the discount rate is based on a method of trial and error making room or creating in accuracy in the calculations.
The discounted cash flow is a better indicator of value of investment as it takes into account both the time value of money as well as considers the cash flows entirely
3.3 Importance Income Statement and Balance Sheet
The objective of financial statements is indicating the financial position of the company and performance of the company.
3.3.1 Importance of Balance Sheet
The balance sheet is a measure of the financial position of the firm. The balance sheet reports the information of the company’s assets and liabilities as well as the solvency position of the company. The objective of the balance sheet is to provide information about the past resources of an organization and predicting their future capability to generate cash. It also provides information about the future financial structure of the organization, and thus enables the successful distribution of cash flows of an organization. The Projected Balance sheet is also an indicator of the solvency and the liquidity position of the corporation at a future date. It enables the firm to ensure the flow of cash at the required future date.
3.3.2 Importance of Income Statement
The information about the company’s financial performance is recorded in the statement of profit and loss or the income statement of the firm. The income statement is a projection of the income and expenses incurred by the firm and its effects on the future profitability of the firm. Information regarding the profitability of the firm is important to analyse the financial performance of the firm as well is an indicator of the financial efficiency and the revenue generation capacity of the firm.
4. The Capital Budgeting Decision
4.1 Net Present Value of Project 1
|Project||Project 1||Discounted Cash Flow|
|Year 1||60000||600000/1.1 = 54545.45|
|Year 3||40000||40000/(1.1)^3 = 30075.18|
|NPV||100,000- 109414.01= 9414.01|
Net Present Value on Project 1 for Hi lo Ltd is $ 9414.01 based on the discounted cash flow method, therefore also calculating the payback period for Project 1
Pay Back Period for the project
The Pay back for the Project is in the 1st year of operation.
Now Considering Project 2
4.2 NPV of Project 2
|Year||Project Return||Discounted Cash flow|
|Year 1||36000||36000/1.1= 32727.27|
|Year 2||16000||16000/1.1^2= 13223.14|
|Year 3||28000||28000/1.1 ^ = 21052.63|
|NPV||60000- 67003.04 = – 7003.04|
Thus the Net Present Value of Project 2 is – $ 7003.04
4.3 Hi lo should Accept Project 1
The capital budgeting decision by Hi-Lo should be undertaken after a careful consideration of the risk- return factors. The NPV of the projects has been calculated and based on which the investment decision should be taken by Hi-lo ltd. The calculation of the NPV allows the corporation to undertake an appropriate risk – return analysis before the project is undertaken. This is especially important in the case of the Hi-Lo because the company has been already been faced with a crisis situation. Thus, the management should undertake the decision with some caution so that the efficiency and the profitability of the corporation can be increased.
Thus the Investment in Project 2 would be considered un-profitable, as the NPV of the project is negative. The negative NPV is an indicator of a high risk and a low return project, Also the project would not be able to recover the costs within the 3 years of Operations. On the other hand investment in Project 1 by Hi Lo Ltd is highly recommended as the project has a NPV of $9414 (approx.) indicating a considerably high return on the project within the 3 years of operation , As well as the project would be able payback and recover all costs within the 1st year of operation.
Therefore hi lo Ltd should invest in Project 1 based on the NPV and discounted cash flow analysis, as the project offers higher return and a considerably lower degree of return.
As Hi- Lo ltd is already faced with a crisis like situation, the management should realise their role and responsibility and undertake activities which increase organizational efficiency. The following recommendations are made to the managers of Hi-Lo ltd.
- Firstly, the management should consider the demands of all the stakeholders of the business and should be able to create a balance between the interests of all the stakeholder groups.
- Secondly, the management should use various strategic tools like the porters five forces .BCG etc. to appropriately realise the bargaining power of each stakeholder, and then make the final decision keeping the interests of the stakeholders in mind.
- Thirdly, the firm should practice a certain degree of caution and avoid undertaking high risk project as the firm is already facing a cash flow constraint. The operations improving the cash flow operations should be undertaken and the high cost operation should be avoided.
- Fourthly, the firm should form budgets and aim to stay within the limits set up by the budgets. Following the budgetary allocation would increase operational efficiency as well as improve the implementation decisions on projects to be taken throughout the organization.
- Fifthly, the budgetary process is also likely to motivate employees and as they would work hard to achieve the targets set by the budget.
- Sixthly, the capital budgeting decision on the consideration of investment in the projects has been undertaken after the NPV and discounted cash flow analysis. Thus the Investment in Project 2 would be considered un-profitable, as the NPV of the project is negative. The negative NPV is an indicator of a high risk and a low return project, Also the project would not be able to recover the costs within the 3 years of Operations. On the other hand investment in Project 1 by Hi Lo Ltd is highly recommended as the project has a NPV of $9414 (approx.) indicating a considerably high return on the project within the 3 years of operation , As well as the project would be able payback and recover all costs within the 1st year of operation.
Therefore hi lo Ltd should invest in Project 1 based on the NPV and discounted cash flow analysis, as the project offers higher return and a considerably lower degree of return
Project 2 should be strictly avoided by the firm as it would further strain the cash flows of the firm. Thus, the firm after considering the above recommendations should be able to realise organizational efficiency and profitability.
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