1.0 Introduction.
Effiicent financial management is extremely important for businesses, as it supports and informs the decision making which leads towards the maximisation of the value of a business. Consequently, financial management helps increase the overall profitability of a business, whilist maintaining an efficient cash flow.
This report will highlight and dicuss why a profitable business can still fail due to a shortage of cash, as is the case of Pat simpson. It will also propse which financing option would prove to be most benefical to over come a short term cash flow shortage for Pat.
2.0 Findings
2.1 Explain why a profitable business can fail due to a shortage of cash:
It could be argued that profitability and cash-flow are both financial instruments which are closely related to one another, and may sound like one and the same thing. However, this is the not the case, as both profit, and cash-flows of a business are not directly linked with one another (Kroes, and Manikas, 2014). Profit could simply be explained as the measures of an on-going sustainability of an organisation, whereas cash on the other hand could be explained as the measures of the ability of an organisation to pay its bills and other expenses as they become due (Knight, 2012). For clarity, cash-flow for a specific period could be the closing cash balance arrived at after the deduction of the cash paid (Cash-Out), from the cash which is received by the company (Cash-In). On the other hand the profit for the business is the amount which remains even after the deduction from the overall revenue earned by the business during the period. It also includes the expenses which it incurred in the earning of that revenue.
Therefore, it could be stated that even a profitable business could fail due to shortage of cash. Since, in financial accounting, something could only be expensed once its economic value is completely utilised. However, in a given period the enterprise might have spent far more amount of cash then it actually expensed through the accounting system. A simple illustration of this could be given through an example of a professional who purchased 50 Titleist Trusoft golf balls at £20 per dozen in order to benefit from the discount provided by the supplier. However, the professional only sells 25 dozen during the financial reporting period. Therefore, while the professional outlays the £1000 in case, he only ends up with expenses of £500 during the financial period.
In a similar manner when it comes to the revenue of the professional’s shop, where the professional makes the sales revenue of £1000 in the similar financial reporting period, 50% of the sales were made by the customer who have utilised their shop credit account. Therefore, the company would only end up receiving £500 in cash during the financial reporting period. The remaining £500 would be what the customers would owe to the professional and that amount will be paid in the future reporting period.
Through using a simple example it could clearly be stated that even though a business can be profitable, it could still fail due to negative cash-flows or the shortage of cash. Therefore, the ability of a business to generate positive cash flows throughout the year is extremely essential in order to achieve a viable long-term growth. Secondly, surplus cash also helps a business in promoting its growth and expansion. In turn, this reduces the chances of failure. The key message here is that without a strong and positive cash flow a business will fail to grow and thrive.
3.0 Discuss the following three options for financing a short-term cash-flow shortage as described in the scenario, commenting on the pros and cons of each option:
3.1 An Overdraft:
Overdrafts can simply be explained as the extension of credit from a lending institution such as a bank when the account of an account holder reaches zero (Mills, 2012). Overdrafts enable a business or an individual to continue to withdraw money even if the account is out of funds, or there are not enough funds to cover the withdrawal (Melzer, and Morgan, 2015). Furthermore, overdraft interest rates are only charged over a portion of the overdraft which has been utilised. It is somewhat similar to a credit card, as the more balance is paid by an individual the lesser is the amount of interest.
Advantages of an Overdraft for Pat:
Some of the advantages which Pat could benefit from through utilising the overdraft option include; Flexibly, as Pat will only borrow what he needs at the time. This is the amount required to pay the bills, which are due to suppliers and HMRC. Along with that Pat will only be charged interest when Pat uses the overdraft facility. Generally, bank’s does not charges businesses for paying off the overdraft earlier than expected, and this facility can be reviewed by Pat on regular basis. Bank overdrafts are also far easier and much quicker to set up and usually require significantly less paperwork (eFinance MANAGEMENT, no date).
Disadvantages of an Overdraft for Pat:
There are some major issues which Pat may face if he opts for an overdraft. Pat might be required to extend the overdraft, to which Pat would be liable to pay an arrangement fee. Also, the interest rates on an overdaft are “usually higher than in other sources of borrowing” (eFinance Management, no date). Pat would also be susceptible to much higher penalty charges if he exceeds the limit of the overdraft without any authorisation, an if for instance a customers cheque were to bounce during transaction.
Bank overdrafts may at times also be secured against other policies such as, life insurance etc, and so pat runs the risk of those assets being seized if he fails to meet payment deadlines. Finally, the bank could ask Pat for the repayment of the overdraft amount, at any point of time.
3.2 An Unsecured Business Loans:
Unsecured business loans are loans which do not require any collateral from the business owner, or the one who is taking the loan (National Funding, 2016). It is quite different from a secured loan which is taken from a bank, as bank needs the business owner to put something in collateral. Hence, if the business owner fails to pay the loan, the bank could take over the asset to recover the loan payment (Sba.com, 2016). However, unsecured business loans are not guaranteed by any type of property, therefore, they are a much bigger risk for the lenders.
Advantages of an Unsecured Business Loan:
There are several benefits which Pat could enjoy through an unsecured business loan. Firstly, an unsecured loan can offer Pat higher loan amounts, and do not have any limitations like secured loans. Another major benefit which Pat could enjoy through an unsecured loan, is fasterer accessibility to funding. Unsecured funding can be a lot easier to obtain as compared to secured loan, and also requires less paper work. Unsecured loans can offer Pat additional flexibility in providing Pat with extra cash in hand whenever he needs it. Finally, if pat were to declare himself bankrupt at any stage, a court hearing may discharge the unsecured loan.
Disadvantages of an Unsecured Business Loan:
Like all forms of financial borrowing, there are certain shortcomings associated with unsecured business loans, including the issue of liability. Despite of the fact that the loan is not leveraged against assets, it still is a liability for the business, which means Pat will have to make the payments regularly as per the agreed time. Unsecured loans are given for shorter terms such as; five to ten years. Furthermore, due to an unsecured loan being in a higher risk category for the lender, interest rates tend to reflect that by being much higher. Consequently, for Pat this will typically mean he will pay far more over the life of the loan than if he would have opted for a secured loan.
3.3 A Credit Card:
Finally, a credit card could simply be explained as the form a payment card which is issued by financial institutions such as banks and building societies to be used as a method of payment. A credit card allows the card holder to pay for the products and services based over the promise of the holder to pay for them later on (Manning, 2001). Hence, the credit card issuer usually creates a revolving account, and then grants a line of credit to the credit card holder. The cardholder could then borrow money for payment to the merchant, which in case of Pat would be for the payment of the bills, which are due to suppliers and HMRC.
Advantages of a Credit Card:
There are several benefits to using a credit card, which Pat could avail under the given circumstances. Using a credit card will provide Pat with access to easy straightforward financing As Pat is running a Professional’s shop he often needs access to easily excessable funds, in case of cash flow issues. This is demonstated in the senerio where there is not enough cash available for payment of bills. Hence, in the given scenario a business credit card could prove a viable option. There are also credit cards offering 0% interest rates for a certain period of time. This would mean that as long as Pat pays off his minimum monthly repayment amount and clears his total balance before the 0% offer ends he can “effectively benefit from an interest-free loan” (Shargall, 2016). Alternatively, if Pat is unable to pay back the total amount he owes before the 0% interest rate runs out he can switch his remaining balance onto a 0% balance transfer card. Credit cards can also provide Pat with a financial cushion in cases where the accounts receivables for Pat lag behind and the business is falling short of cash. Furthermore, Pat’s business credit can help him to build and improve the business credit, which could prove to be beneficial for Pat while applying for a bank loan in the future.
Disadvantages of a Credit Card:
Pat will have to think carefully if he selects the credit card option, as credit cards offer low purchase protection. Most business credit cards do not offer, and it could result in causing more problems for Pat. Pat may also face some personal credit issues, as the business credit cards often require personal guarantee. This means that Pat might have to give his previous credit card history, or personal security number, which could raise some serious issues for Pat specifically when the credit companies report Pat’s business activities over his personal credit. Finally, another major issue with credit card financing, is the high price of borrowing. Credit cards can be an expensive method of finance, and Pat may end up paying higher interest rates. In some cases he might end up paying a very high annual or late fee just to continue using the credit card.
4.0 Conclusion:
It can be concluded that no matter how profitable a business is, it is essential that a business possess and maintains a regular cash inflow. In the case of Pat Simpson this could not be emphasized enough. Poor money management and the failure to ensure sufficient funds are ready and excessable in times of hardship, could result in far worse than inncuring interest charges. Ultimately, Pat’s selection of borrowing must only be made after thorough research has been conducted. He may wish to consult the advise of a financial adviser in order to calculate the most favourable options before finally commiting himself.
5.0 Recommendations:
The option which will be the most suitable for Pat will be unsecured loan, in which could take one of the most effective type of unsecured loan, which is the working capital line of credit, through this unsecured loan, Pat will be able to borrow money from a lender in times of need, and he can easily pay it back in big months, when high percentage of people are coming to play golf, and then Pat can borrow the money again in case he needs it. Therefore, using unsecured funding will provide Pat with the high level of flexibility for the life of the loan.
In order to make himself eligible for unsecured loan Pat must improve his credit score, because creditors only grant unsecured loan to the people with credit score higher than 750, along with that Pat must select the lender very smartly because applying for a loan, and getting rejected due to credit have negative impact over the credit score. Along, with that it is also recommended for Pat to pay the loan as per the agreed terms and conditions which will be set forth by the lender, in order to avoid any penalties.