The maintenance of accurate records Essay Example

The maintenance of accurate records Essay Example The maintenance of accurate records Essay The maintenance of accurate records Essay unless there is a change in circumstances when a different approach might be warranted. In this situation full disclosure is made in the accounts. * Prudence concept: provision for doubtful debts and valuation of stock are examples of the prudence concept. The company requires to give a conservative profit figure when there is any doubt, this avoids an over optimistic appearance of the companys annual reports. * Going concern concept: this states that the organisation will continue operating in the foreseeable future. The annual reports are drawn up with no intention to decrease the size of the company; otherwise assets could have different values that will have a huge amplify on its balance sheet. Accounting policies: This policy emphasises on the method each business uses, to demonstrate the effect of transactions, assets and liabilities in its accounts. Referring back to the example in the consistency concept, a business needs to select one appropriate method to depreciate each class of fixed assets e.g. reducing balance method or straight line method. Accounting standard: Accounting standards are a set of rules to frame the accounting of a limited company, which fall under the International Financial Reporting Standards (IFRS) or UK Statements of Standard Accounting Practise (SSAP). The choice of standards will depend on the type of company. A publicly listed company is required by law to produce its financial statements using IFRS. FRS 18 Accounting policies: This policy is an extended version of the consistency concept; it states that a business needs to select the most relevant accounting policies to its business circumstance in order to give a true and fair view. The accounting policies need to be reviewed at regular intervals to make certain that they are still relevant to the business circumstances and are adjusted when required. Enough information is revealed in the financial statements to allow users to understand the accounting policies used and how they have been implemented. SSAP 5 Accounting for Value Added Tax (VAT): VAT is a form of tax that is charged on the supply of goods at a rate up to 17.5%, which is charged at each stage throughout the production and distribution channel. Businesses generating a certain amount of turnover must register for VAT, and generally each quarter makes VAT payments on the total of output tax collected on sales made subtracted the total of input tax collected on purchases to HMRC. If a circumstance where the amount of the input tax is larger than the output tax, the business has got the right to claim the difference of the VAT from HRMC. Besides personal taxation and VAT, the company is liable for corporation taxation as well. Russell Stokes needs to pay out a certain percentage of Corporation Tax calculated from its net profit; all companies in the UK are liable to this tax as stated under various Taxes Acts. Companies that generate taxable profits (being reported profits adjusted for certain items allowed by tax laws) up to à ¯Ã‚ ¿Ã‚ ½300 000 need to make a payment of 19%; companies generating taxable profits over à ¯Ã‚ ¿Ã‚ ½1.5 million are charged 30%. Companies generating taxable profits between à ¯Ã‚ ¿Ã‚ ½300 000 and à ¯Ã‚ ¿Ã‚ ½1.5m are charged Corporation tax on a marginal rate of 32.55 to claw back the benefit of the small companies rate by the time the upper profit limits is reached. The full rate of Corporation tax will decrease to 28% with effect from 1 April 2008. Any internal stakeholder at Kutz ltd, who is classified as an employee is eligible for National Insurance payments to cover state benefits (including medical through the NHS and pensions). Employees with earnings below à ¯Ã‚ ¿Ã‚ ½100 per week make no contribution. Between à ¯Ã‚ ¿Ã‚ ½100-670 per week employees pay 11% over the à ¯Ã‚ ¿Ã‚ ½100 and employers pay 12.8% over the à ¯Ã‚ ¿Ã‚ ½100 floor. An additional 1% is paid by employees and amounts exceeding à ¯Ã‚ ¿Ã‚ ½670 per week and employers pay an additional 12.8% on the wages exceeding à ¯Ã‚ ¿Ã‚ ½670 per week. A new company has specific rules which need to be obtained when deciding under what name the company can trade. The Business Names Act 1985, Company and Business Names Regulation 1981 states that a business cannot register and trade under the name of an existing company e.g. Marks ; Spencer, words such as Royal and Government are not permitted to use and names that origins discrimination or offence are not permitted to use as well. Limited companies have special formalities that must be followed: Public Limited Companies (plc) * The company is required to display on all its paperwork that it is a plc. * A starting up authorised share capital of à ¯Ã‚ ¿Ã‚ ½50 000 distributed to its share holders. * It must have a minimum of two directors and two members, and a secretary to be able to operate. Private Limited Companies (ltd) * The company is required to display on all its paperwork that it is an Ltd. * It must have a minimum of one director and a secretary to be able to operate. Companies trading as a Plc or Ltd must both complete the following forms which needs to be sent to Companies House * An Article of Association * a Memorandum of Association * Form 10 * Form 12 Article of Association: This document states the following: * The companys internal workings * The issue and transfer of shares * The meetings and voting of members Memorandum of Association: * The business objectives * The location of the companies registered office e.g. Wales, England or Scotland. * The companies name Form 10: This form must be completed be signed and completed by a new establishing companies, it states the following: * The details of the first director and secretary * The address of the registered office * Name and address of the company * Date of birth, occupation and details of the board of directors Form 12: This form needs to be signed by a professional legal person e.g. the companies solicitor or secretary, it is a statutory declaration that states that all legal requirements regarding to a limited company has been completed. The legal requirements of partnerships and sole traders are less onerous compared to a limited company. Sole trader and partnerships must also comply with the Business Names Act and Regulations as discussed earlier. Similar to a limited company, partnerships and sole traders are also liable for taxations. A sole trader needs to make a payment of up to 40% on its taxable profit for Corporation tax, whereas in a partnership the rate of tax that is due per partner depends on the ratio distribution of the profits each partner receives and the level of profit. . For example: partnership xyz has a taxable profit of à ¯Ã‚ ¿Ã‚ ½300 000, it will need to pay à ¯Ã‚ ¿Ã‚ ½120 000 tax allocated between the partners based on their share of interest in the partnership. The owners or partners (who are classified as self employed for tax purposes) need to make a contribution towards National Insurance which is a fixed amount of à ¯Ã‚ ¿Ã‚ ½2.20 per employee weekly. If annual generated profit is less than à ¯Ã‚ ¿Ã‚ ½4635, then the partner or sole trader is not charged for National Insurance. Even though a sole trader and a partnership have lots in common due to its similar structure of ownership, there are some differences as a partnership has a statutory framework to follow. The Partnership Act 1890 shows the details of the statutory framework, which include the following: * The partnership is shaped to make a profit and there must be a sharing distribution for the profits * The partners must have common actions, to enable them to have an equal say in the management * The partners must be carrying on a business, I.e. they must be operating a trade (for example, accountancy partnerships carry on the business of providing accounting, tax and audit services) Layout/Template As technology is advancing it enables businesses to use computerised accounting systems instead of manual book keeping, which helps in the production of accurate and efficient decision making. Small businesses such as a sole trader could use spread sheet for forecasting and financial modelling. The use of spreadsheet ensures the accounts are more accurate due to the automatic calculations and formulas. As everything is linked to each other due to the formula, when something is adjusted everything will be automatically updated. Computers set up properly tend to make fewer mistakes than humans! As Kutz ltd is a Limited company it can make use of accounting packages such as SAGE to record its book keeping and to produce annual statements. The key advantage of using accounting softwares is that it can produce automatic reports , which will helps with the control and monitor of the business as the reports can be used as statistics to analyse trends occurring, which will be an important factor to rely on when analysing ratios. Furthermore it decreases the chance of mistakes occurring as entry is made only once for each transaction. Nevertheless, the main drawbacks of a computerised system include capital cost of the installation, the cost of training employees to be familiar with the system, health problems occurring and the danger of system crashing. Even though the introduction of the computerised accounting system could cause short term difficulties it will have long-term benefits; it will have a clear view of its debtors, which will enable quicker debt collection that will increase the inflow of money. For this reason I think it is a very useful tool to use. It also tends to be more accurate, reliable, quicker and able to deal with large volumes. The key reasons to use templates or to follow a specific layout when preparing annual statements (e.g. trading, profit and loss statement (P/L) and balance sheet), it allows the business to make comparison between companies and firms operating in a similar industry worldwide. It is more accessible to external stakeholders such as shareholders, who are interested if investment is worthwhile. The layouts of the annual statements of a sole trader are slightly different compared to the annual accounts of a limited company because of the different industry the business is operating in. Referring to appendix 1A, the P/L template of a sole trader has a clearer structure as it is separated into three columns; it represents an understandable view of its income and expenses. While the P/L template of a limited company has got two columns, especially a public limited company because as they need to publish their accounts to the public they would want to represent the company positive as possible, (Referring to Appendix 1B). The trading account, which is the top section on the P/L of a sole trader and limited company are done in the same way; the way gross profit is calculated. The major difference is in the profit and loss account, the bottom section. In a sole trader P/L, after adding any income and deducting any expenses from the gross profit it will have a net profit figure. Wh ile the P/L of a limited company will have an appropriation section at the bottom, which will show the distribution of net profit. Corporation tax is deducted from profit before tax to give an after tax number. Tax is another expense of the business. The appropriation section is divided into the following sections: * Interim and final dividends * Retained profit Interim dividends paid This is dividends that are paid half way through the year to shareholders. They come in two forms depending upon the capital structure of the group, ordinary shares and preference shares: Preference shares: the shareholders that get paid off first e.g. employees Ordinary shares: the shareholders that get paid off after preference shares. Dividends proposed A share of the profits paid to share holders after dividends have been paid; this again comes in two forms preference shares and ordinary shares. Referring to appendix 2a/b, the balance sheet of a sole trader and limited company have similar headings; fixed assets, current assets, current liabilities and long term liabilities. However, the bottom section represents the equity in the business owned by the shareholders. The financed by section of a sole traders balance sheet will be funded with the owners equity; opening capital, net profit and drawings. While the financed by section of a limited company will be funded by; authorised share capital, issued share capital, capital reserves and revenue reserves. * Authorised share capital: is the value and number of the shares the company is permitted to issue. * Issued share capital: is the value and the number of shares the company has issued. * Capital reserves: represent other reserves generally established by law. This might include the share premium account representing the amount received upon the issue of shares in excess of the shares nominal value (if a company receives à ¯Ã‚ ¿Ã‚ ½10 per share for a share that has a nominal value of à ¯Ã‚ ¿Ã‚ ½1, a share is issued at a premium of à ¯Ã‚ ¿Ã‚ ½9 and this is taken to the share premium account that can be used only for certain purposes prescribed by law). * Revenue reserves: retained profit from the Profit and loss account Task F Ratio After drawing up final accounts, a business would want to assess the businesss strengths and weaknesses. This can be done through calculating ratios, which enables management to draw up conclusions on the profitability, solvency and performance of the business. The ratios enable Russell to analyse current years performance, identify trends occurring through comparing the ratio with previous years and to compare its result to a business operating in the similar industry as a bench mark. Unfortunately I could not have access to the annual accounts of a business operating in the similar industry as Kutz ltd as the information is kept confidential; therefore I was not able to measure Kutz ltd ratios to a bench mark The table below represents Kutz ltd ratio figure and its calculations are on the workings page see appendix. year 2006 year 2007 Profitability Ratios Profitability Ratios Gross margin 62.04% Gross margin 61.94% Net margin 0.74% Net margin 10.89% ROCE 2.22% ROCE 41.00% Liquidity ratio Liquidity ratio acid test ratio 10:1 acid test ratio 2.68:1 current ratio 22:1 current ratio 6.49:1 Performance ratio Performance ratio debtor collection period 34 days debtor collection period 73 days creditor collection period 15 days creditor collection period 55 days stock turnover 183 days stock turnover 242 days * Profitability ratios It shows the relationship between profit, sales turnover, assets and capital employed. Basically how much profit the business makes weighting it against its size. Gross profit margin This represent the gross profit figure, it shows the link between the revenue generated (sales) and cost of sales. It indicates how much profit the business has made on every à ¯Ã‚ ¿Ã‚ ½100 of sale before subtracting any expenses. The higher the gross profit margin is the better. A successful business needs to have a sufficient figure for gross profit margin to be able to cover its expenses and to maintain an up to standard return on capital. If there is a huge decrease in the gross profit margin compared to the previous years, the business should start making investigations into the selling price and purchasing. The table above demonstrates that for every à ¯Ã‚ ¿Ã‚ ½100 of sale, the gross profit earned was à ¯Ã‚ ¿Ã‚ ½62.04 in 2006. The following year it dropped to à ¯Ã‚ ¿Ã‚ ½ 61.94. There is a minor decrease of 0.1% in the gross profit margin that is not a big issue; this could have occurred due to the increase in the prices of raw materials while the same selling price is retained or a decrease in the volume of sales. To prevent the decrease over the long term to happen in the years following, Kutz ltd should take action to avoid bigger decreases through looking for suppliers with lower prices or to persuade the salons with offering discounts, to increase the volume of sales. Net profit margin This represents the net profit figure; it shows the link between the revenue generated and the total expenses of the business. It indicates how much profit the business has made on every à ¯Ã‚ ¿Ã‚ ½100 of sale after subtracting all expenses. The net profit margin figure should increase each year if possible, which shows that the business is keeping its expenditure under control. As with gross profit, net profit should be investigated when a huge decrease occurs. The table shows that in the year 2006 for every à ¯Ã‚ ¿Ã‚ ½100 of sales the business earned à ¯Ã‚ ¿Ã‚ ½0.74 after all operating costs and cost of sales had been covered. The following year it increased to à ¯Ã‚ ¿Ã‚ ½10.89, this is a positive aspect as Kutz ltd will receive a higher return on capital; huge increase in net profit. Bearing in mind that net profit and gross profit are strongly linked together, this is not always necessarily true as you can see Kutz ltd has increased it net profit by 10.15% whereas it has decreased its gross profit. It could have happened due to a huge decrease in expenditure. Kutz ltd should try to maintain the reduction of expenditure through building up good relationships with its creditors and try to negotiate lower prices or making use of economies of scale. ROCE Return on capital employed is the most significant ratio; it shows the link between the capital and net profit earned. The best way to measure the ROCE is to compare it to other investments, for example would I receive greater return on my capital if I put the capital in a savings account? The table shows that in the year 2006 for every à ¯Ã‚ ¿Ã‚ ½100 invested into the business, the profits were à ¯Ã‚ ¿Ã‚ ½ 2.22. The following year for every à ¯Ã‚ ¿Ã‚ ½100 invested into the business, the profits were à ¯Ã‚ ¿Ã‚ ½41.00; this shows an increase of 38.78% a better result. This has been occurred due to the huge increase in the net profit margin. The current interest rates are 5.5%, so if I was putting à ¯Ã‚ ¿Ã‚ ½100 into a savings account I would be receiving a return of à ¯Ã‚ ¿Ã‚ ½ 5.5 for every à ¯Ã‚ ¿Ã‚ ½100. However, as an investor I would be investing my money into Kutz ltd because I would be receiving a greater return on my capital with à ¯Ã‚ ¿Ã‚ ½41. In conclusion the overall profitability is positive, Russell should try to maintain on this level of performance if not try to increasing the profitability would be better * Solvency ratios: This shows the financial stability of the business, how quickly the business can cover its current liabilities with its current assets. (How quickly it can pay off its debts) Current ratio This shows the link between current assets and current liabilities. An ideal figure would be 2:1, which means the business will have assets worth à ¯Ã‚ ¿Ã‚ ½2 to cover every liability worth à ¯Ã‚ ¿Ã‚ ½1. You need to consider that this ideal figure is not applicable to a business operating in a retail industry because immediate payments are made for sales; this decreases the number of debtors. This will result in a lower current ratio figure e.g. 1.5:1 or even less. The table shows that in the year 2006 the current ratio was 22:1. In the year 2007 the current ratio was 6.49:1, it decreased nearly 3 times it has improved. Kutz ltd had tied up assets in unproductive resources in 2006, which was more under control in 2007. It is currently still a huge figure compared to the ideal figure, therefore the Kutz ltd isnt in its best state of liquidity it should have been. Furthermore Kutz ltd has got an enormous amount of cash tied up in working capital of stock of à ¯Ã‚ ¿Ã‚ ½150000 and debtors of à ¯Ã‚ ¿Ã‚ ½104000 outstanding. Acid test ratio This ratio works in the similar way to the current ratio; the only difference is that stock has been omitted. Stock has been omitted as it is the least liquid asset; it takes long to convert it into cash. The ideal figure is 1:1; the business will have for every à ¯Ã‚ ¿Ã‚ ½1 of liability à ¯Ã‚ ¿Ã‚ ½1 of assets to cover it. The table shows that in the year 2006 the acid test ratio was 10:1. In the year 2007 the acid test ratio was 2.68:1, a decrease of 7.32 a positive aspect. Even though the figure of the acid test ratio has decreased, it is quite high currently compared to the ideal figure. Comparing the current ratio to the acid test ratio, it decreased nearly 3 times. This shows that Kutz ltd relies mainly on its stock of à ¯Ã‚ ¿Ã‚ ½150000, which is why it has not got enough cash flowing in. Russell should use its assets more efficiently through selling off its stock using discounts and making use of just in time production in the future rather than having too much stock piled up, this will enable him to expand in the current product range as he suggested because then he will have enough fund that will support his suggestion. In conclusion, overall the solvency of Kutz is lacking and the suggested improvements should be made, which were discussed earlier on. Performance ratios This shows how effectively management controls the current aspects of the firm, whether assets and liabilities are being utilised properly. Creditor collection period This ratio shows on average, how long the business takes to pay its creditors. This figure should be higher than the debtor collection period; if its shorter the business might face cash flow problems. The table shows that in the year 2006, it took Kutz ltd15 days to pay its creditors. In the following year it took him 55 days, an increase of 40 days which is a good thing although too long, might impact relationships with suppliers. Russell could use this as a useful temporary source of finance; however payments over 60 days can cause problems. Russell should try to prevent an increase in the years following as this will establish poor relationships with its suppliers, which will have a negative impact on Kutz ltds reputations. Debtor collection period This ratio shows on average, how long it takes a business to collect it debts the ideal figure is 30 days. The quicker it can collect it debts the better. If the number of days is rising from year to year, the firm might be facing difficulties in collecting money it is owed to. The table shows that in the year 2006, it took Kutz ltd 34 days to collect it debts, which is an acceptable figure. However in the year 2007, it took him 73 days. This is nearly increased twice, which is a bad result. The huge increase could make Kutz ltd end up in cash flow problems as he does not have enough inflows to pay of his outflows e.g. creditors, instalments and interest of his loan. When comparing the debtor and creditor, the creditors are being paid much quicker than cash is being received from the debtors. The situation should be the other way around. Kutz ltd could prevent this through offering discounts for early payments or charge the creditors for late payments. I predict that if Russell doesnt take any action based on the debtors collection period, it should increase the provision for doubt full debts. Even though this will decrease gross profit but it will prevent him from overspending and getting trapped into current liabilities he cannot afford. Stock turnover: This ratio measures how many times a business turns its stock around in an accounting period. The table shows that in the year 2006, Kutz ltd turned its stock over every 183 days. In the year 2007, it took Kutz ltd 242 days to turn it stock over, it has increase by 59 days, this has worsened the situation. This shows that the stock has either increased or the trading has slowed down, increased investment in stock means that the stock is piled up in the warehouse. As part of my secondary research, we went to Price Waterhouse Coopers. I received feedback from my mentor on my work; he suggested to me that Russell should stop purchasing more stock and perhaps invest into a new product range that might result in a quicker stock turnover. In conclusion, overall the performance of this business is lacking as well, it should try to make improvements for the future. Limitation of ratios: Bearing in mind that ratio is a useful business tool to use to analyse; performance, solvency and the profitability of the business, however it has got its draw backs as well: * Different companies use different accounting policies, which makes comparison difficult. * It does not necessarily show future performance as the data is based on numbers only, it should bear in mind the external factors it could affect; economical influences. * It needs to be compared with the businesss past performance, in Kutz ltd case it only had one previous years to compare the data with, which didnt enable me to identify trends occurring as the data was very narrow. Task G Cost of the business having too much cash, including loss of interest and opportunity costs. It is a superior aspect to have a positive bank balance, because this prevents Russell to suffer from cash flow problems; a good state of liquidation. Nevertheless if Russells bank balance is too huge this might mean that he is using his cash ineffectively. Even though he will be earning interest on his cash at the bank account but as shown in the example of ROCE, it could be earning a greater return if he invested the money in other more profitable operating activities. He could also make use of the business tool; opportunity cost in this situation, as he can only spend his money once he would need to consider his most relevant option. For example, If Russell had a huge bank balance and he chooses to expand through investing in new machinery or diversification through buying new beauty products. The danger he would be facing is that if he suddenly needs his money to support the financial state of the business, he would need to sell the machine or his stock most likely at a lower pri ce, which will result in a loss. Costs of the business holding too little cash, such as inability to meet creditors demand and need to borrow at expensive rates It is a negative aspect to have too little cash, because this could make Kutz ltd suffer from cash flow problems as he would not have the funds to cover his current liabilities. If the business is facing problems to cover its current liabilities, during the short term Russell could obtain an external or internal source of finance. It could get an arranged bank overdraft, which is an effective way to cover the cash flow shortage. Nevertheless, overdrafts are very expensive due to the high interest rate charged. It could also try to pay off his creditors as late as possible to use the cash somewhere else for the time being, however late payments could cause problems with Kutz ltd creditor. Furthermore creditors could also charge interest on the debt as a penalty for late payments or they could start to lose confidence in Kutz and stop trading with them. In addition, this will have an effect on the profitability and solvency of the business. Russells current ratio suggests that he has excess cash stored in his business, which is not a good aspect as discussed earlier. Whereas when comparing the current ratio with the acid test ratio, a conclusion can be drawn up that he has not got excess liquid cash (once stock had been taking out). Based on the analysis of the ratios it shows that the business has a huge amount of stock piled up in its warehouse; 242 days. In addition the business has got too much assets, which is not being use effectively. Kutz ltd could be converting the huge amount of stock into liquid cash through selling off his stock in bulks and offering discounts to its customers, as a result this will improve the cash flow of the business He should also send out reminding letter to his debtors that are overdue as his debtor collection period has increased enormously compared to the previous year. As stated earlier, otherwise in view of his large amount of debtors, his provision for doubtful debts could increase in the future and he would not be able to meet his liabilities. To prevent the decrease in Kutz ltd cash flow in the future, it should try to decrease the number of stock purchased through applying the business term just-in-time to its stock as discussed earlier. Kutz ltd doesnt have a huge problem in its state of cash but he is using it ineffectively, which results in a poor cash flow management. The huge decrease in its stock turnover shows that Kutz is having lower volumes of sales; there is not enough demand compared to the supply he is offering, he could improve this through introducing a new product range related to hairdressing e.g. beauty products. My advice to Russell is to use the cash available for expansion through purchasing a new range of beauty products; using diversification as he mentioned as one of his aims. I suggest that he purchases a small amount of beauty products at the beginning and see how profitability, performance and solvent his new investment is, particularly if the stock turns over has increased. If it is very successful he should continue operating with the new product range, as he will be able to utilise his cash quicker because he will make higher profits than the current product range. However, if the product range is not successful it can try to invest in a new resource and it would not have a big impact upon the business as he has only invested in a small amount of beauty products. Methods of improving cash flow It is a significant factor to monitor the business cash flow as it enables Russell to have a better understanding regarding its income and expenses; if it is able to meet his current liabilities. The cash flow forecast will also help him to predict when an internal source of finance needs to be obtained. Furthermore this will help him to avoid problems rising, like overspending or being unable to get the external finance when needed. As discussed earlier it can send out warning letters to its debtors that will increase the inflow of the business, basically a method shortening the length of time taking to collect the debts. My advice to Russell is to take immediate action based on its debtors because if he remains paying off his creditors before he receives any debts that is owed to him, Kutz ltd will be financial unstable that obviously will have an enormous impact on the cash flow of the business. Bearing in mind that his loan repayment is due soon he needs to have sufficient cash flow in order to pay off the loan on time, without affecting the relationship it has with the bank currently. He therefore needs to increase his provision for doubtful debts, to get a picture of the financial stability of the business in the future and try to look for different alternatives for the problems he will be facing. A credit payment can be up to 60 days; Russell should try to negotiate his credit payment period from 55 days to an extended period of 60 days. He should be able to exceed the creditor payments as he is a medium to large size business, he will have some influence upon its suppliers as he most probably buys in bulk. Cash versus profit Profit does not necessarily mean the business has a got efficient cash flow. Profit is the money the business makes when all expenses have been subtracted from revenue, it takes into account the non monetary values such as depreciation and provision for doubtful debts. Cash is the money that enables a business to operate that doesnt take into account the monetary values, for example paying off his loan, dividends to its shareholders, water and gas bills. The non monetary values will have an effect on the profit of the business as they are deducted from the net profit the business generates, however this will not have an impact on the out flow of the business as it is not deducted on the cash flow. Another difference is that on the profit and loss statement outstanding payments to be received will still be included in the turnover when net profit is calculated, but as the business has not received the actual money it will not have an inflow on the cash flow statement. This has the sam e affect on purchases that are outstanding. The profit and loss statement will include the figure of purchases that are still outstanding; this will result in a lower gross profit. While it will not be included in the business outflow as it has not been paid off yet, therefore it will not have an effect on the cash flow of the business. As touched onto earlier, Kutz ltd is in its poor state of solvency. As profitability and solvency ratios are linked to each other, I suggest he should improve its net profit through introducing the new product range, which I assume will increase the volume of sales. To prevent a decrease in the gross profit due to the new expenses, it should try to switch to a cheaper supplier. As the volume of sales are increasing the rate of stock turnover will automatically increase; stock is sold quicker at the same time, which means more cash is available to the business. In conclusion this will solve both problems at the same time as Kutz ltd will have a better cash flow, which will not affect the profit of the business. The business changing its aim due to such things as expansion, diversification, downsizing, and its impact on financial planning. In my opinion Kutz ltd should develop and expand, as it is a limited company it should take the advantage of the limited liabilities it will have, it is easier for him to get access to external finance. The main reasons I think Kutz ltd should expand is to use make use of economies of scale, as the firm is growing it can produce at lower average costs compared to smaller businesses. For this reason they can give consumers lower selling prices which will help them increase their sales and profits. It should diversify its product range (beauty products) as it can sell into different markets, therefore it can reduce the risks that a decrease in sales of one product will have a negative impact on the business; there is less threat to their profit. In my opinion to solve the current cash flow problems Kutz ltd faces, he should also take on the request of the national hairdressing business as he is not using the first floor at the moment; the income he will be receiving from renting out the space could be used to fund the repayment of the loan. Kutz ltd should invest its capital in a delivery service to get ahead of competitors, as this will also help to increase the customer base and the volume of sales. Conclusion The most significant aspect to Kutz ltd at the moment is improving its state of liquidity; a suggestion to recover this problem is through cutting stock. I will be prioritising the significance of the steps Russell could take to become solvent. Reduce level of stock Russells first priority should be reducing the number of stock he purchases as I have discussed previously, he has got excess amount of stock piled up in Kutz ltd warehouse, which could be used to improve his state of liquidation. First of all, I have suggested that he has a 50% cut in his stock (therefore purchases will drop from 238384 to 117374.5) I assume this will deduct his revenue by 10% only (therefore sales will drop from 500000 to 450000) as he turns his stock over at an enormous slow rate. After he implements the changes, Kutz ltd will have a negative net profit (as demonstrated in appendix). From my secondary research at PWC, my mentor emphasised on the fact that cash is king and profit does not equal cash (source Partner at PWC; Simon Friend). Russell is legally insolvent as he has the sufficient assets that could be used to fund his financial obligations but converts them with insufficient time into cash. Furthermore he faces a cash flow shortage through using his assets ineffectively as I have explained earlier. Referring to the words of Simon Friend, lower profits do not indicate the business is not successful; the most important aspect is that the business is solvent. I advice Russell to implement the changes as this will improve the cash flow management of Kutz ltd and at the moment he needs a good cash flow to fund the repayment of his loan, otherwise he will be creating poor relationships with his external shareholders e.g. bank. year 2007 stock turnover: average stock=(100000+150000) = 125000 2 125000 à ¯Ã‚ ¿Ã‚ ½ 365 = 242 368468.5 After the reduction of stock stock turnover average stock=(100000+150000) = 125000 2 125000 à ¯Ã‚ ¿Ã‚ ½ 365 = 124 368468.5 Based on the analysis of the ROCE Ratio, the time taking to turn over stock has increased nearly twice from year 2006 to the year 2007. As demonstrated above after implementing the changes, the time taking to convert stock into cash has decreased nearly by 50%. This shows that even though Russell has got a negative net profit the overall performance of the business has increased by 50%, which is an excellent aspect. Collect debts quicker/ extend creditor payment periods Russells second priority should be taking action on the period of time he receives his debtor payments. I believe he should send out warning letters and stop offering credit payments to its debtors, he should insist on direct cash payments as 80% of his sales are on credit. Through this Russell will receive immediate cash from its sales and could decrease the amount of provision for doubtful debts. Furthermore if sales increase rapidly, I assume Kutz ltd would end up with a positive net profit while having a healthy cash flow. Russell should also try to negotiate a longer credit payment period. If he succeeds to collect his debts quicker and get longer credit payment period offer, he will have more liquid cash around that can be used to fund the repayment of the loan or to invest in the new product range. In conclusion, this will enable Russell to finance the business with its short term liabilities that will be beneficial to Kutz ltd as it does not increase the business cost with in terest payments if he had to take an external source of finance to fund the business. Take request Russells next best option would be renting out the first floor to the National Hairdressing business. The reason behind this is that this form of internal finance, besides being used for the repayment of the loan and investment of a new product range as discussed earlier. It could be used as reserves for the future, instead of risking making repayments including huge amounts of interest on bank loans for investment in other operating activities; it could use the reserves to fund the business objectives without the business facing financial difficulties. Diversify, expand and develop The internal sources of finance that has been collected from reducing the level of stock, taking on the request, collecting debts quicker and extending the creditor payment periods can now be invested into the purchase of a delivery van that will help to increase the customer base and increase volume of sales. It could also be used to diversify into beauty products, which will with anticipation to result in an increasing volume of sales. This means that Russell will still end up with a positive net profit figure and a healthy cash flow, even though I discussed earlier that profit is not important compared to cash but external stake holders might have a different view towards it. So to prevent the loose of stake holders and creating a bad public image, Russell should expand and diversify Kutz ltd. Appendix Trading, profit and loss account of Kutz Ltd for the year ended 31 may 2007 after the reduction of stock *Workings Sales 450000 less sales returns -1923 net sales 448077 opening stock 100000 purchases 121009.5 less purchase returns 3635 117374.5 carriage inwards 1094 less closing stock -150000 cost of sales 368468.5 Gross profit 79608.5 Add other income: bank interest received 42 discount received 14887 94537.5 less expenses rent and rates 2 66000 motor vehicle expenses 7720 advertising expenses 14500 sundry expenses 2 34977 light and heat 3 16460 wages 76251 discount allowed 11238 Depreciation 1 10050 doubtful debts 4 (5200+2080 7280 loan interest 3 22500 266976 operating profit -172439 less directors dividends 12000 retained profit -184439 add retained profit at the beginning of year 2000 balance of retained profit at the end of the year -182439 *The workings are found in appendix