Financial Management Case Study

Financial Management Case Study

FinancialManagement Case Study

FinancialManagement Case Study

Thisreport contains details of the solutions that the Griffins Hotel andLeisure Group (GHLG) should take in the wake of the increased lossesof two of its hotel outlets: the Auckland and Wellington hotels. Asfinancial statements indicate, the only outlet making profits is theNelson hotel, though the profits are not very impressive and thepotential of the company. Currently, the board intends to get theloss-making outlets back to profitability, but there are somesignificant challenges standing in the way. The first challenge isthat, the company’s working capital is unsustainable to make anynew investments. To solve this challenge, the company must sourcefunds more prudently through ways that will not further bloat thegearing ratio but enable the company to get the much needed workingcapital. The second challenge is that the company has a very highgearing ratio.Regardless of the high gearing ratio, the company hasvery few options of increasing the working capital to sustainablelevels other than increasing debt.Increasing the amount of borrowedmoney in its working capital will also make the planned investmentsmore risky. Finally, the company has a huge asset base that canenable it to mobilize more capital through mortgaging some of theassets and the report points out that the Auckland or Nelson hotelsfreehold buildings are the potential targets for such a step. Thisbrings in the third challenge, which is the best financial controlprocedure the company can initiate so that the funds mobilized end upmaking good returns on the anticipated investments.This consultancyreport contains professional advice on: 1) ways through which thecompany can source and apply funds prudently so that it can returnthe company to profitability through increasing working capital inrejuvenating the Wellington and Auckland hotels. 2) The risk of ahigh gearing ratio and the strategies the company can use to reduceit, 3) the relevant financial control procedures the company can useto ensure that all the funds sourced end up earning the anticipatedreturns on investments.

Sourceand application of funds and the working capital position

Beforedeciding the source of funds and how they will be applied, the boardmust consider the following facts: the company’s overallprofitability is decreasing due to the two loss making outlets. Thus,any sources of funds that will further gear the company areundesirable. In fact, this is the time when the company shouldconsider having low gearing because it has other financialliabilities to deal withregardless of the present circumstances.Thus, the following sources of funds could be the reasonably feasiblefor the company because they can increase the company’s ability togenerate more cash flows from the hotel outlets that wouldsubsequently reduce the level of gearing:

MoreEquity financing from shareholders: When a company is in such a direneed of funds to increase its working capital, shareholders areusually the first people to turn to. The board should convinceexisting shareholders and other prospective investors to buy moreshares to increase their stake in the company. Although this maythreaten the ownership position of some shareholders, it is a betterdecision than leave the company to slip into insolvency. Theadvantages of this step are: 1) more equity financing does not tocome with the financial obligation of having to repay like loans. 2)Some shareholders may end up getting positions on the board. Being onthe management, they will be in touch with all that goes on in thecompany hence, tying them to the agency challenge that themanagement faces. They also become accountable to othershareholders.3) The investors can resale the shares to the company ifthey feel dissatisfied later.

Bankoverdrafts: As everything stands now, the company cannot afford tomake any more losses since they are threatening its position in theindustry and in the eyes of creditors. Furthermore, it needs minimalshort-term debt because it is more flexible and has less gearingeffects than long-term debt. Thus, an overdraft is the onlyshort-term debt financing the company should seek. The company needsan overdraft because: 1) it is the ideal short-term debt that canhelp finance the planned improvements that otherwise could have beenimpossible to finance with current cash flow fluctuations. 2) Therenovations and improvements at the Wellington and Auckland outletsrequire heavy spending. The cash flows from the renovated outlets cangenerate the profits to repay the overdraft. 3) The company does nothave a negative credit past hence, the chances of arepayment-on-demand from the company are slim. 4) It is costeffective because the interest is only repayable on the total amountrequested and is agreeable on at a margin set by the Federal bank.5)The unforeseen events that affect the hotel industry may not pose adanger to repayment.

Loanconversions

Nowthat reducing the current gearing ratio is one way of improving thecompany’s credit-worthiness in future, the board should considerseeking loan swaps with some creditors for some stake in the company.If the some of the creditors agree to take some stakes in thecompany, the money that would have been disbursed as loan repaymentscan be converted to working capital. Furthermore, the creditors willbe more interested in improving the current state of the company’scash flows to make the same amount of returns they would have made onthe loans they disbursed to the company.Furthermore, this step willhave increased the proportion of capital financed by equity, furtheraltering the company’s capital structure that is friendly to thecurrent threat to its solvency.The company must ensure that itsfuture cost of capital is sustainable, its share price is steady, andits credit rating is not threatened because it still needs some levelof short-term debt to finance the planned improvements that will putit back to profitability.

Loanconversions will also help mitigate the risk of reduced creditratings. Now that a bank overdraft is one of the sources of funds forthe company, the funds saved from loan conversions will be depositedon the company’s current account to increase its viability toaccess a bank overdraft.

Gearing

Gearingrefers to the amount of capital that comes from debt rather thanequity(Bevan &ampDanbolt, 2002). When a company has a higherproportion of its capital from debt financing, it is said to be“highly geared”. “Lowly geared” companies have a greaterproportion of capital from equity financing rather than debtfinancing. High gearing has several risks. GHLG, therefore, risksfacing the following risks it increases its overall debt:

  1. Low credit rating- Lenders are the most concerned people about a highly geared company. A high gearing ratio indicates more risky investments. The result is that lenders are likely to have more restrictions on the company such as more cash flows for debt repayment and also more restrictive covenants before advancing a debt to the company. If the company rejects such restrictions creditors and lenders may reject loan applications by the company.

  2. Insolvency if the business is not making profits: The Company is currently making losses in two of its outlets and a small profit from Nelson hotel.Thus, continued gearing will make it impossible to repay debt since the cash flows from are low due to its reduced working capital and low profits.

  3. Increased accounts payable:More gearing means that more creditors provide funds to the company. Although the company’s huge asset base may allow for mortgaging to obtain funds to repay loan, mortgage loans are inflexible and costly. The net effect is an increase in the number of accounts payable.

  4. A falling share price:investors consider a high gearing ratio as a negative sign especially when the company’s working capital is low and it is making losses. The subsequent fall of its share price is because the company cannot make more investments and has a low credit rate on the market.

Stepsto reduce gearing

  1. Loan conversions- The current gearing ratio may send wrong signals to investors who might interpret it as a sign towards the wrong direct of insolvency(Juan García-Teruel&amp Martinez-Solano, 2007). The result of such negative interpretations is a continued fall in the share price of the company. If the company could be making profits even with the current gearing ratio, the share price could not be affected because more gearing means more returns for investors in some instances. However, two hotels making losses make the situation worse for the company hence, seeking a loan conversion is one step forward. A steady share price coupled with increased cash flows from sales attracts investors. If investors buy more shares into the company, it will also increase the much needed working capital as well.

  2. Sell company shares:The board should allow for the purchase of more shares so that the cash could be used to pay debts.However, the board should be careful not increase equity capital to unsustainable levels.

Financialcontrol procedures

Thefinancial controls the company should employ range from prudentinvestment and borrowing decisions to the avoiding wastage. Thesecontrols aim to increase the working capital so that the company cangenerate more cash flows from trading activities. The proceduresinclude:

  1. Managing cash flows

Measuresfor efficient management of cash flows are vital. Collection of debtshould be in tandem with the agreed credit terms(Copeland, Weston,&ampShastri, 2005). Cash should be banked as soon as possible.Banking money from credit facilities such bank overdrafts in goodtime reduces the interest charged while increasing the interestearnings from depositing it in the bank.Credit from suppliers shouldbe utilized to the full and payment should be delayed as much aspossible as long as the actions provide benefits that are higher thanthose derived from discounts offered for early payment.

  1. Expenditure budgets: The strategies to get the company back to profitability need numerous expense or cost budgets for budgetary controls(Greenwood, 2002). An expenditure budget for each functional unit in the company and sub-functional activities should serve as the guide for individual execution of strategies that will get the company back to profitability. An example of a financial procedure of this form is an expenditure budget for the marketing department and another for advertising activities. In such budgets the financial variables will the predominant measure, although other measures of physical activity levels may occasionally supplement the budget expenditures.

  2. Using key ratios as financial control measure to avoid future losses

Thecompany needs to initiate regular reporting and investigation ofdeviations from the budget as the basis of the planning and controlsof financial management(Shumway, 2001). The importance of cashmanagement, assets, profitability, and liabilities should beunderscored in all the decisions. Thus, the company should use keyratio to identify the key indicators or ratios that will act assignals to trigger corrective actions in future. The ratios include:

Profit/totalassets= It is the prime measure of profitability and helps answer thequestion how well the company is doing and would the money be betteroff invested in another venture.

Profit/sales= the final net profit margin helps answer the questions prices inrelation to costs.

Sales/assets= asset turnover and measures whether the total investment in assetsis generating a sufficient level of sales or whether the level ofsales being achieved justifies the amount invested in assets andstock.

Sales/creditors=credit turnover helps answer questions whether any considerations onthe early payments or delayed are good for the company.

Conclusion

Inconclusion, GHLG still has room for adjustment to get back toprofitability. It will largely depend on the decisions the board willmake about the sources of funds. The current state of cash flows andlow profitability demands that the company reduces it gearing ratioin favor of equity. Gearing has the potential to reduce theaccessibility of short-term credit and equity financing frominvestors hence, threatening the company’s solvency. The companyought to take the measures that will reduce gearing as explainedabove. After renovating the Auckland and Wellington outlets using thefunds mobilized, financial controls are the only way to maintainsustainable working capital.

References

Bevan,A. A., &ampDanbolt, J. (2002). Capital structure and itsdeterminants in the UK-a decompositional analysis. AppliedFinancial Economics,12(3), 159-170.

Copeland,T. E., Weston, J. F., &ampShastri, K. (2005).Financial theory andcorporate policy.

Greenwood,R. P. (2002). Handbookof financial planning and control.Aldershot, Hants, England [u.a.: Gower.

JuanGarcía-Teruel, P., &amp Martinez-Solano, P. (2007).Effects ofworking capital management on SME profitability. InternationalJournal of managerial finance,3(2), 164-177.

Shumway,T. (2001). Forecasting bankruptcy more accurately: A simple hazardmodel. TheJournal of Business,74(1), 101-124.