Edecel Applied Business Unit 11 Finance Task B Essay Example

Edecel Applied Business Unit 11 Finance Task B Essay Example Edecel Applied Business Unit 11 Finance Task B Essay Edecel Applied Business Unit 11 Finance Task B Essay Working Capital is the money used by the business to fund revenue expenditure; this is the day to day expenses. Day to day funds are needed in order to fund a business. The working capital would be used to buy resources such as raw materials, fuel, wages and fees etc. Working capital can also operating liquidity that is available to them. Working capital has two components which are; things owed (current liabilities) and things owned (current assets). They are used when calculating the working capital: WK = CA CL. If companys assets are less then their liabilities then this results in a bad working capital because they will not have enough cash in the business to pay current liabilities; and therefore will owe more then they own. This is why working capital is very important in order to run an efficient business. A business will have many current liabilities that they owe banks, people and other businesses. These can include things such as, bank overdrafts and bank loans which businesses would of borrowed from, these are common methods of borrowing money as it can be fairly easy for businesses to get loans and overdrafts. Credit Card debts are also common in businesses. A businesses liabilitys also includes accruals and these are something that businesses will owe and these are all the extra things such as electricity bills. Hire purchase, dividends proposed and trade credit will also fall within a businesses current liabilities. Businesses current assets are thing that they have or own. These can be general things such as stock, unfinished goods and raw materials for stock. These can be the hardest assets to turn into actual cash. The businesses money in the bank and investments are also current assets as well as any debtors the company has and prepayments which are deposits. Working Capital Management the Problems When looking at working capital is important to analyse where cash is used in the day to day running of Thomas Cook; this can be known as a liquidity cycle. The start of Thomas Cooks cycle would begin with them securing the hotel room and flights needed for their future customers, these would be on credit. They then sell these to the customers and take deposits/receivables. Thomas Cook need to ensure they get the correct balance between the hotels and flights they book and the correct amount of customers. This may be a big problem for their working capital if demands drops, and this will be likely in the current recession. To have a good liquidity Thomas Cook needs to ensure deposits quickly, because the longer it takes them to sell their holidays the more liquidity problems it will create. The next step is for Thomas Cook to pay the suppliers; Thomas Cook will use the customer deposits to pay them however this will not cover the whole of the costs. Therefore Thomas Cook need an injection of cash and this is likely to be an overdraft. By having an overdraft will ease the flow of cash around the business and help liquidity. However banks may not want to give businesses an overdraft or loan if they are worried the company will not pay it back. This is more common recently with the recession as banks are becoming more careful with their money. By resorting to an overdraft does have its advantages, but overall in the long run it will increase costs for Thomas Cook as they will have to pay back extra interest fees. This can therefore reduce the profit for Thomas Cook which they will not want. Banks may also think that the business is not doing well if it needs a loan and this could be a risk for the bank. If Thomas Cook cannot receive any injection of money then they will struggle to pay back suppliers on time and this can result in bad relationships and they may withdraw their trade credit or decrease the credit period. This will have a negative effect on the working capital. The final part for Thomas Cook is to collect the rest of the customers payments so Thomas can pay back the bank their overdraft and likely to make a profit, however it can still create problems for Thomas Cook. Customers may cancel their holidays as it would have been several months since they booked it so many people change their mind. This means that Thomas Cook will only have deposits to pay back banks etc. They will have to sell extra rooms and flights last minute and cheap and they could lose money. One solution to this would be to increase the deposit price therefore customers would feel like they are losing more money and they would be unlikely to cancel. It also means there is a safer barrier for Thomas Cook and they would have more money which will help ease they liquidity. We have suggested that over booking hotel rooms and flights is bad for Thomas Cook as they may not be able to gain enough customers but what about the opposite? Thomas Cook may have customers waiting and not have any rooms or flights available, this would be a missed opportunities for Thomas Cook. This is why it is extremely important for them to get the balance between securing the hotels and flights, and the amount of customers. Ratios Current Acid Test Ratio Ratios can be used to help asses the working capital position of Thomas Cook and look at the management to Thomas Cook. The first ratio will let us directly measure liquidity and this is the current ratio. It will show us how much current assets there are to a Euro of debt. Formula for current ratio: Current assets / current liability = current ratio Looking at the balance sheets of Thomas Cook we can work out the current ratio for 2009 and 2008. 2009: 2008: 2303.2 / 3737.9 = 0.6:1 1386.2 / 2077.8 = 0.7:1 Another ratio that can use is the Acid test ratio this is the same as the current ratio however it takes away the stock as stock is not easily converted to cash. Formula for Acid Test ratio: (Current Assets Stock) / Current liabilities = Acid Test Ratio Looking at the balance sheets of Thomas Cook we can work out the acid test ratio for 2009 and 2008. 2009: 2008: 2303.2 274 / 3737.9 = 0.6:1 1386.2 105 / 2077.8 = 0.7:1 By looking at the current ratio we can see that for every euro of debt/current liabilities it has 60cent of current assets which are stock, cash and debtors. This doesnt appear a situation for Thomas Cook as they cant afford to clear its short term debts with its current assets. For example if their overdraft was reduced and their trade credit stopped Thomas Cook would not be in a liquid position. The suggested standard acceptable ratio is 1:1 which means business have equal assets to liabilities so they can easily pay back short term debts. A 1:1 ratio means the assets and liabilities are equal and surely it would be better to have a 2:1, however for firms such as Thomas Cook it is easy for them to raise finance and thats why it is acceptable. Another factor we can look at is the time period; these figures were taken from a balance sheet in October and there wouldnt have been a lot of current assets coming into the business as October is not their peak month. We have to keep in mind that Thomas Cook are a seasonal business and therefore figures will be very different during periods of the year. In October it would be likely that Thomas Cook are spending money to securing next years holidays and they could also be borrowing money to do this. By taking this into consideration we can judge that the ratio may be acceptable and these figures are likely to be industry wide. We can also compare 2009 to 2008; the position from 2008 has gone down in 2009 and therefore it is a negative trend. This can be seen as bad for the businesses liquidity however by looking at other aspects of the balance sheet this could change the view. Trade and other payables is a lot higher in 2009 and this could indicate they are securing more holidays for the coming year. This looks like a good sign as they will be likely to secure more customers and therefore receive more profit. On the other hand we can look at it as it has created extra liability for Thomas Cook and we have to ask what if Thomas Cook cannot secure the extra customers; this would mean they would lose money. The Acid test ratio has received the same results as the current ratio, this is because Thomas cook are not a production business and therefore do not have many stock as they offer more of a service. Only a tiny portion of their current assets are stock and therefore it will not have much effect on the acid test ratio. The suggested accepted ratio is 0.75:1 for this ratio as it takes the stock into consideration. We can see that Thomas Cook is very close to this ratio and therefore there are virtually no liquidity problems. However by looking at the 2008 ratio we notice the downward trend and this would be a bad trend to continue. Nevertheless we have identified the reasons for it and as a result we can understand the trend. Debtor Collection The debtor collection ratio looks at the management of debts and how well Thomas Cook covers their debts. Thomas Cook mainly receives debts from their customers as they offer holidays on trade credit. Thomas Cook has a policy where their customer has to pay six weeks prior to their departure. This settles any outstanding money that customer owe Thomas Cook. Problems can arise for example if a customer pay late it will be Thomas Cooks duty to chase they money back. If not Thomas Cook may decide to sell they holiday to someone else however this may be costly for them. To work out how many days it takes Thomas Cook to receive back their debts we use the debtor collect ratio and the formula is shown below: Debtors / turnover x 365 = no. of days 2009: 2008: 1240.1 / 9439 X 365 = 48days 600.6 / 7780 X 365 = 28days This shows a negative trend and Thomas Cook has to wait an extra 20days for them to receive their monies in 2009. It is good if Thomas Cook receives money as soon as possible as this can enable them to have cash ready in order to buy more holidays for future customers. On the other hand in 2008, we can see that they are receiving there money well before the six week period; this is good because they can receive cash sooner and therefore have more available for longer. However comparing this too 2009 we can see that it takes just over 6weeks for them to receive their debts back. Although the time period is only just over 6weeks this should not become a constant trend otherwise Thomas Cook will not have cash ready in time. Credit Payment Days The credit payment days looks at how long it takes Thomas Cook to pay back their creditors and this is any money that they owe. This is usually to the hoteliers and for the rooms and flights they have booked in advance. To work out how many days it takes Thomas Cook to pay their creditors we use the credit payment days ratio and the formula is show below: Trade creditors / turnover X 365 = no. of days 2009: 2008: 2046.1 / 9439 X 365 = 80days 1208.7 / 7780 X 365 = 57days These answers also shows us a deteriorated trend between 2008 and 2009, as in 2009 it takes Thomas cook 23 more days to pay back their debts. We can assume that Thomas Cook creditors gives a payment time period of 60days and in 2008 they have made this payment but in 2009 they have gone 20days over. By taking longer to pay back debts can be risky as the hoteliers may reduce their credit period as they may feel like Thomas Cook has taken liberties. They could also choose to take away their credit completely or even stop trading with them and trade with a competitor instead. This is unlikely to happen as Thomas Cook are a large company so they are a valued customer, but if the trend becomes regular then their creditors might decide otherwise. Although Thomas Cook are not paying on time this can work as an advantage for them. The sooner that customers pay Thomas Cook and the later Thomas Cook pays their creditors means that they will have ready cash for a longer period of time. If Thomas Cook can get away with a longer time period to pay back their creditors then it will ease their working capital as they will have more cash in hand for longer to put to use. Evaluation I am going to make a judgement on the working capital of Thomas Cook by looking at all the analysis. The current and acid test ratio demonstrates how liquid Thomas Cook is and how able it is to pay its short-term debts. The ratio revealed that there is declining trend in the figures between 2008 and 2009. It also showed that Thomas Cook do not have equal debts to assets which may mean future problems for Thomas Cook. The Debtors days ratio demonstrates how well Thomas cook gains back their debts in days. This also shows a negative trend as it took them longer in 2009 to receive back there monies. The Creditors day shows how well Thomas Cook pay their creditors and this ratio shows that Thomas Cook were taking longer to pay their creditors in 2009. The main negative trend that the majority of the ratios shows may raise concern for Thomas Cook especially when paying back short term debts as this should be easy for big companies to do. Also the fact that it takes Thomas Cook 80days to pay their creditors may be worrying; do they not have enough cash to pay them, or are the securing the financial inflows and therefore playing it safe? When analysing the financial position of Thomas Cook we always need to take into consideration what time of year the balance sheets are from. This can make a large change to the figures and outcomes of analysis especially because Thomas Cook is a seasonal business. During October Thomas Cook will be out of their peak stage therefore there balance sheets are likely to show some negatives. We can conclude that during this stage Thomas Cook may be waiting to book holidays for next year therefore they are saving up the cash in order to purchase them in the next few months. If we look at the balance sheet s during June or July we would see a big difference as ratios would look better as there would be a greater income into the business. The management of working capital of Thomas Cook is satisfactory from looking at the balance sheets; the business is not booming, however this is due to the seasonal nature of the business. By taking this into account we can believe Thomas Cook has no major financial problems which will affect the business. I feel however they can make improvements in resolving there negative trends shown by the debtors days ratio. They could do this by managing the inflows coming in and also working out a more agreeable period of payback to their creditors. Overall I think that Thomas Cook management of working capital is fairly good with consideration to the time period.