Question

Musical Instruments Business

A group of musicians have established a company selling medieval period musical instruments by mail order and appointed themselves company directors. The musicians have raised £750,000 of the capital required themselves and borrowed a further £500,000 in the form of a long-term bank loan. In order to establish the business, they have undertaken the following transactions.

• Bought premises for £850,000 (paid by cheque).
• Bought furniture and fittings for £100,000 (paid by cheque).
• Bought (on credit) stock of instruments for resale for £300,000.
• Bought a motor van for £20,000 (paid by cheque).

The remaining £280,000 of the total initial funds provided is deposited in the business’s bank account.

During the first year of trading, the following transactions occurred:

• instruments costing £1,400,000 were sold on credit terms for £2,000,000
• more instruments were purchased on credit terms for £1,500,000
• wages and other expenses of £300,000 were paid in cash
• cash totalling £1,250,000 was received from debtors
• cash totalling £1,400,000 was paid to creditors
• interest (paid cash) on the long-term loan was 10%.

At the end of the year, the directors decided to make a provision for bad debts of 5% of the year end debtors’ figure.

Closing stock (valued at cost) was £400,000.

An allowance for depreciation is to be made as follows:

• buildings, 2% of cost = £17,000
• furniture and fittings, 10% of cost = £10,000
• motor van, 20% of cost = £4,000.

Task

Construct a cash flow statement and use the information provided by it. The purpose is to highlight the factors that determine an organisation’s liquidity.

Refer to figures above for the Musical Instruments Business. You will need this information to prepare a cash flow statement for the business.

During the first year of trading, the directors of Musical Instruments Business have frequently experienced serious cash shortages – even though the enterprise has made a profit.

Advise them how to improve the business’s liquidity. To do this. use Table 2 to record your output. You will need, firstly, to prepare a cash flow statement for the business, for the first year of trading, and use the information this provides to make your recommendations.

Not all of the different categories of cash flow given in the text example – Terrestrial Trading Company – will appear in the first year of trading for Musical Instruments Business. The template below (Table 1) provides you with the structure and content of the cash flow statement: all you have to do is fill in the numbers.

Table 1 Cash flow statement for Musical Instruments Business first year of trading

	£
Cash received from customers	-
Cash paid to suppliers-
Cash expenses	—
Cash flows from operations-
Bank interest paid	—
Net cash flow-

Table 2 Advice on improving liquidity for Musical Instruments Business

Problem identification-
Analysis (investigation)-
Conclusion to the analysis (results of the investigation)-
The solution, listed as a set of SMART recommendations-
Strengths and weaknesses of the recommendations-
The implications of the solution, if implemented-

This should illustrate that profit does not equal cash (the profitability of an organisation does not automatically result in its liquidity). The cash flow statement you have prepared should indicate the main source of this organisation’s lack of liquidity. Such information should enable management to take appropriate remedial action, as well as enable other stakeholders (such as the providers of funds) to form an opinion about the financial management of the organisation. You may have noticed, in preparing the cash flow statement, that the net cash outflow for the year exceeded the business’s cash/bank balances at the beginning of the year; how do you think it financed this deficit?

Answer 1

			£
	A	Cash received from customers	1,250,000
	B	Cash paid to suppliers-	1,400,000
	C	Cash expenses	300,000
	D=A-B-C	Cash flows from operations-	(450,000)
	E	Bank interest paid	50,000	(500000*10%)
	F=D-E	Net cash flow-	(500,000)
		Problem identification-
		High accounts receivable outtanding,Collection is less than payment
		Analysis (investigation)-
		Though sales were at profit,collection was poor
		Revenue=2000000,Costs=1400000+300000=1700000
		Profit =2000000-1700000=300000
		Conclusion to the analysis (results of the investigation)-
		Collection should be faster
		The solution, listed as a set of SMART recommendations-
		Some Incentive can be given as discount for early payment
		Strengths and weaknesses of the recommendations-
		This will make faster collection easier. But there will be cost of discount
		The implications of the solution, if implemented-
		LIQUIDITY WILL IMPROVE