George’s Train Shop is a family owned business that focuses on the sales and repairs of train toys. George is running a profitable business, but as he is aware of my MBA Managerial Finance class, he has asked for advice on his working capital practices. Although George is currently enjoying the benefits of a profitable business, there are opportunities for him to expand his business ventures. This first starts by dissecting degree of aggressiveness in working capital practices, current capital budgeting practices, and areas where he can improve in both arenas. In addition, careful management of the company’s cash flow will allow George’s Train Shop to explore other business opportunities for growth as well as flourish with increased.Alshubiri investigated the relationship between the aggressive/conservative working capital policies and the impact on profitability and risk. The study indicated a negative relationship between the profitability measure of firms and banks and degree of aggressiveness of working capital investment and financing policies (2011).
Aggressive working capital policy is one in which you try to squeeze by with a minimal investment in current assets coupled with an extensive use of short-term credit. Conservative working capital practices are those in which companies assure plenty of cash in the bank, warehouses are full of inventory and payables are all up to date (Bank, n.d.). In an attempt to cut expenses to a minimum, George’s Train Shop owner, George Olieux, manages working capital by keeping few inventory and reordering inventory when only 1 product model is left on shelf (Intelecom, n.d.). According to Bank, as you tighten inventory, your sales and accounts receivable might swoon because you could run short on product.
Inventory shortages might result in lower revenue and collections as competitors with well stocked inventories steal your customers (n.d.). Moreover, you risk default and bankruptcy as you adopt more aggressive working capital policies, as tight inventories can lead to shortages and lost sales. Firms with aggressive working capital policies, such as George’s Trains Shop may not be able to generate more returns on assets by following aggressive approaches towards short term assets and liabilities.
Capital Budgeting refers to the process in which a business determines whether projects are worth pursuing (Byrd, 2012); however, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time (Investopedia, n.d.). When Olieux acquired the business, it was heavily dependent on sales of classic Lionel trains, but when demand dropped, he had to make capital budgeting decision and invest in new product lines (Intelecom, n.d.). George Olieux explored other product opportunities by analysis of trends in the market. Because smaller trains and race cars were gaining popularity, Olieux decided to start selling race cars and smaller train models. The ability to identify which assets are expected to add value to the firm is central to the financial management role (Byrd, 2012).
George’s capital budgeting technique included observation of market trends and pursuing assets, such as race cars and small trains, that were trending at the moment. Since George did not use popular methods of capital budgeting, including net present value (NPV), internal rate of return (IRR), and payback period, George had to take a conservative route by first exploring the success of just one race car product line. A potential pitfall George uses in current capital budgeting practices is the lack of a sophisticated measure of capital budgeting, such as the net present value. Such methods can measure which projects can add value to the business as well as compare various investments to one another. The Net Present Value method measures the dollar added value the investment will bring to the firm. It is calculated by taking the present value of future cash flows minus the initial investment (Byrd, 2012). George has statements from previous years that document cash flows and business cycle trends.
These statements include the timing and magnitude of cash flows, which include increased cash flows in the summer due to tourism, and reduced cash flows during income tax time. Using previous cash flow statements can help anticipate and calculate future cash inflows of a potential investment, such as the purchase of a Race Car or small train line, and can provide George with an accurate picture of the project’s Net Present Value. The lack of a cash cushion is one primary reason small businesses fail; therefore for small businesses, it is important to understand and manage the company’s cash cycle (Byrd, 2012). The cash flow statement records the amounts of cash and cash equivalents entering and leaving a company, and includes three components by which cash enters and leaves a company: core operations, investing, and financing (Heakal, 2010).
The operations section of the Cash Flow statement would include changes made in cash, accounts receivable, depreciation, inventory, and accounts payable (Heakal, 2010). This would include purchases of inventory and the sales of products/services. George keeps inventory levels to a minimum as an attempt to keep cash spending at a minimum, so frequent purchasing and selling of inventory is observed. The investing section of the Cash Flow statement would include George’s investment in acquiring the lease for the building and business, while the financing section includes loans for purchasing the business and interest paid on those loans. A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting (Heakal, 2012); therefore I recommend that George use the business’ cash flow statement in evaluating capital budgeting projects, such as the addition of Race Car and small train product lines, as well as other potential ventures.
Moreover, I recommend George use the statement of cash flow to understand how much cash is generate and how much of that cash stems from core operations, such as the sale of specific product lines or the repair services offered. The management of cash is necessary to start, operate and expand a business. Before George can expand his business, he must prove to potential investors not just the profitability of the business, but the ability to pay short term obligations. By using sophisticated capital budgeting methods, such as the NPV, George can accurately asses the value added from potential investments. Through careful managing of cash flow statements, George has the potential to not just pay off short term obligations, but expand business ventures.
Alshubiri, F. (2011). The Effect of Working Capital Practices on Risk Management: Evidence from Jordan. Global Journal of Business Research, 5(1), 39-54.
Bank, E. (N.D.). Aggressive vs. Conservative Working Capital. Retrieved on
9/5/2013, From website: http://smallbusiness.chron.com/aggressive-vs-conservative-working-capital-65216.html
Byrd, J., Hickman, K., & McPherson, M. (2012). Managerial Finance. San Diego, CA: Bridgepoint
Heakal, R. (2010). What is a Cash Flow Statement? Retrieved on 9/8/2013, from website: http://www.investopedia.com/articles/04/033104.asp
INTELECOM. (Producer). Management of Working Capital Case Study: “George’s Trains”. [Video File]. Retrieved from the Intelecom Video Library.
Investopedia (n.d.). Definition of ‘Capital Budgeting’. Retrieved on 9/6/2013, from website: http://www.investopedia.com/terms/c/capitalbudgeting.asp
Palani, A. A.. & Mohideen, A. (2012). Impact of Aggressive Working Capital Management Policy on Firm’s Profitability. International Journal of Research in Commerce And Management, 3(3), 49-53.