Memorandum
TO: Superior Living, CEO
FROM: Lela Keel
DATE: August 23, 2011
SUBJECT: Operational Budget Critical Areas
Introduction
Capital budgeting is one of the most important measures a company can make in relation to their financial investment decisions. Through the capital budgeting process the financial position of a company can be determined before making any investment decisions. This capital budgeting process can be particularly helpful to Superior Living since enormous amounts of funds could be misused if our capital project turns out to be unprofitable (“Importance of Capital,” n.d.). With that being said, this paper will discuss how working capital can impact the finances of the company, and what can be done to handle the short-term debt of the company that is coming due. This paper will also explain the current ratio for the company, its implications for the company, and what a good current ratio is for the company. In addition, it will be briefly described within this paper how the company can make positive capital budgeting decisions that can make an investment a success.
Impact of Working Capital on the Company’s Finances
In order to determine how the working capital of the company will have an effect on our finances it must first be defined what working capital is. Working capital is technically defined as the current assets the company has minus the current liabilities the company has. If the company did not have sufficient working capital then we would have a difficult time running the operations of the business. For instance, if we were in need of raw materials but could not purchase these raw materials due to lack of working capital then this would mean we could not manufacture our products, and as a result no products would be sold. This would impact our finances dramatically since our main goal is to manufacture and sell furniture products to consumers to keep the business up and running (CTU Online, 2011).
How the Company can Handle Short-Term Debt
Working capital is vital to the daily operations of the organization. It will be used to pay for many things including inventory, utilities, and short-term debts that we may incur due to the operations of the business. These short-term debts of the company will typically be required to be paid back within a year or less. In order to ensure that the short-term debts of the company are paid back within sufficient time a business plan for handling these obligations should be put into place. The business plan for the company in handling our short-term debt should include three components which are a list of our current assets and liabilities, a numerical chart of the business in regards to profits and expenditures, and a financial chart should be included to show every transaction in which our disposable income was utilized for. Working capital is technically defined as the current assets the company has minus the current liabilities the company has. If the company did not have sufficient working capital then we would have a difficult time running the operations of the business. For instance, if we were in need of raw materials but could not purchase these raw materials due to lack of working capital then this would mean we could not manufacture our products, and as a result no products would be sold. This would impact our finances dramatically since our main goal is to manufacture and sell furniture products to consumers to keep the business up and running (CTU Online, 2011).
In addition, the in order to pay back the short-term debt obligations of the company we must not take away from our primary business operations, and being late on a repayment schedule will harm our future credit history (Unknown Author, n.d.).
Current Ratio and its Implications for the Company
In order for the company to monitor the position of working capital we have our current ratio must be determined. We can determine this by dividing our current assets by our current liabilities to come up with the current ratio of working capital the company has. The figure related to this will be an indication of the company’s ability to meet our short-term obligations. For instance, if the company has a total of $12,000,000 in current assets and a total of $9,000,000 in current liabilities the current ratio would be 1.3. This is good since a general rule when calculating the current ratio is that anything greater than 1 means that the company has adequate working capital. With that being said, the 1.3 current ratio of the company would mean that we are in good financial standing in regards to paying for our short-term obligations (CTU Online, 2011).
How the Company can Make Positive Capital Budgeting Decisions
The company should examine the capital budgeting project they are considering on the criteria of how much cash will be generated on the project and how much profit the project will bring in. The Net Present Value (NPV) and the Modified Internal Rate of Return (MIRR) is a means for the company to determine whether to accept or reject the project. The NPV is a means of determining how much cash the project will generate and the MIRR is a means for measuring the return on the investment. With that being said, a project that has a positive NPV and a higher MIRR is one that will typically be chosen rather than those that have a lower MIRR (CTU Online, 2011).
Conclusion
The company should implement a plan for managing our short-term obligations so that we are not suddenly overwhelmed with debt. Each project the company is considering will assume different risk levels in regards to financing requirements. However, as long as the project being considered is properly managed and it is ensured that we are not taking on more than we can handle by determining that the current ratio of our assets and liabilities is greater than 1, then we can successfully finance the capital project so that the company can continue to operate and bring in revenue (CTU Online, 2011).
References
CTU Online. (2011). Applied Managerial Finance. Phase 1 course materials [text]. Retrieved from https://campus.ctuonline.edu/pages/MainFrame.aspx?ContentFrame=/Home/Pages/Default.aspx
Importance of Capital Budgeting. (n.d.) Retrieved from http://www.finweb.com/financial-planning/the-importance-of-capital-budgeting.html
Unknown Author. (n.d.). How to handle short-term debt within a corporation. Retrieved from http://www.ehow.co.uk/how_6868924_handle-short_term-debt-within-corporation.html