Financial performance of Horniman Horticulture
Horniman Horticulture (HH) has been growing consistently in revenues, profits, and value. In fact, many key financial indicators point towards sustainable growth. The return on assets (ROA) is greater than the industry benchmark ratio, indicating that the company is utilizing its financial resources for maximum gain. The return on equity (ROE) of 5.4 percent is greater than the benchmark ratio of 4 percent (exhibit 2), which demonstrates that a higher percentage of the net income trickles to shareholders equity, thereby leading to an increased net worth for HH (exhibit 1) (University of Virginia Darden School Foundation 2006).
Increased business for HH has led to a 15 percent increment in revenues. Anticipated opportunities are expected to grow revenues by a record 30 percent in 2006, illustrating that the company is in a rapid growth state. The increase in profit margins could indicate that there have been increases in price levels, or a reduction in related costs. HH has reduced its accounts payables days, from the industry benchmark of 26.9 days to 9.9 days. While this strategy will make the company take advantage of purchase discounts, it also reduces the liquidity of the organization by reducing the cash balances.
However, fixed assets have been increasing at a disproportional rate as compared with liabilities, which could explain why cash balances have been reducing at alarming rates thereby restricting the company from achieving its minimum cash balance amount. HH seemed to be financing most purchases, both on current and non-current assets, on a cash basis. While profitable, the company could experience future solvency problems as it may lack sufficient funds in readiness to pay off creditors.
Delay in paying creditors will come at an increased cost for the company, where HH may experience higher interest rates for borrowing funds due to its reduced credit rating in the money markets. Horniman Horticulture Company, in a bid to increase business has more than doubled debt periods for its customers, 50.9 average receivable days as compared to the industry norm of 21.8. This move has led to decreased cash flows and increased accounts receivables, consequently adding on to the risk of bad debts.
Erosion of cash balance
Factors that lead to the erosion of the cash balance are those that could decrease a company’s liquidity. Inadequate payment terms will affect a company’s cash flows by leaving less money in cash balances. Reducing payment time for creditors and subsequently doubling the cash receiving period will stretch the company’s financial resources. Less money will be available to provide for operational expenses and future urgent cash requirements. Furthermore, extending debt to customers offers a form of interest free loans.
Too much debt may result to higher possibilities of bad debt, and ultimately increasing losses for the company (Brigham & Ehrhardt 2008). Decrease in revenues will reduce cash inflows, and this may put a company in a difficult position if expenses maintain their annual levels. Sudden increases in expenses, such as fuel costs and repairs will have a negative impact on cash flows, and the balance sheet in general. Rapid growth, such as the one experienced by HH, if not properly managed, could lead to an unexpected increase in overhead costs which will affect the financial position of the company especially if revenues are not collected in a timely fashion.
Undercapitalization could be caused by inadequate cash savings or safety nets. Should unexpected demands occur, the company will be forced to use liquid cash meant for operations for other purposes other than those intended for in the first place, such as purchase of fixed assets. Consequently, using cash for long-term financing ties up the cash available, meaning that the company will have to result to leverage for immediate use. Leverage should be used in financing plans that offer higher returns than the rate of interest, but use of too much debt increases the interest burden on a business, leading to increased expenses.
Solving for business cash problems
A business should first restructure its capital structure, where the use of debt is encouraged in operations that offer high returns. A mixture of debt and shareholders equity can be used to finance the acquisition of long term or non-current assets. The company could dispose of unproductive assets to reduce the burden of tax, or increase cash balances. Businesses should set up appropriate payment programs for both account payables and receivables. The average receivable period should be reduced, so as to increase the rate of inflows into the business, while the payment period should be increased so that the company can enjoy free credit, which can subsequently increase the return on equity.
Credit appraisals should be used before extending debt to customers, a procedure that is meant to shield the company from the possibility of bad debt doubling. In case the business is run by the owner, then the owner could reduce the rate of withdrawals, or amount of drawings, so as to leave enough money in the business to sustain its operations. Effective contingency planning and liquidity risk management can reduce the impact of future risks that may cause solvency problems, and prevent the risk of falling into bankruptcy (Berman & Knight 2008).
Berman, K. & Knight, J. (2008). Financial Intelligence for Entrepreneurs: What You Really Need to Know About the Numbers. New York, NY: Harvard Business School Press.
Brigham, E. F. & Ehrhardt, M. C. (2008). Financial Management: theory and practice. New York, NY: Cengage Learning.
University of Virginia Darden School Foundation. (2006). Case Study: Horniman Horticulture (case number UVA-F-1512).