Background
The case is about George Olieux who is the proprietor of George’s Trains. George is a former mechanic for a farm machines distributor in Ontario. From the case study it is seen that George has taken a conservative approach to expand the model train business that he runs with his son. The business started as a hobby when George was making a train model for the nephew. This led to minor repairs which led to repairs to other hobby shops. People referred one another to George. The area of specialization for the firm is selling, repair and trade-ins of model trains. George initially did not have the entrepreneurial skills and capital to invest in the business. But he had a good relationship with the bank. He got a loan that enabled him purchase another business and inventory. George purchased the building in which his business was located. This had an effect on working capital. He needed to keep inventory at reasonable level.
George’s working capital techniques
George is using the aggressive working capital management. In this case, the level of bank balances, inventory and accounts receivables are maintained at sufficient levels. This can be seen by George maintaining the reorder level for the trains when only one train is remaining meaning that the company does not want to keep a huge inventory of trains. The aggressive working capital management is dependent on short-term credit to finance some of the operations (Sagner, 2010). George has taken advantage of the relationship with his banker to seek for short-term credit to finance operations.
In this strategy, George obtains long-term financing in order to finance fixed assets and a component of the permanent working capital. Short-term financing resources like the ones be obtained from his bank are used to finance temporary working capital and the remaining component of the permanent working capital. Through this strategy, George has managed to realize relatively lower financing cost thereby realizing increased profits from operations. He also keeps low inventory thereby reducing the costs of carrying and handling inventory and this also has a direct effect of increasing profitability.
Pitfalls of this strategy
The first pitfall of this strategy is insolvency risk. This is because the strategy finances permanent assets from short-term finances. The implication of this is that the firm would need repeated renewals and refinancing in order to continue maintaining the permanent assets. The business environment may change and George may find challenge renewing refinancing of the permanent assets. If the business will not be adequately refinance the permanent assets, then this creates a risk of the firm selling the permanent assets. Unfortunately, the firm may not be able to realize profits from the sale of the permanent assets and this may result in liquidation. It is very difficult to liquidate permanent working capital as such comprises of both inventory and accounts receivables (Baños-Caballero, García-Teruel & Solano, 2010).
The second pitfall is that aggressive capital management results in lower stocks within the stores. This may result in customers preferring competitors because of the variety that is offered in competitor shelves. The reduced sales result in reduced returns on assets and may result in unsustainable high operational costs for the company. In George’s stores, cash flow is managed by anticipating demand and ordering inventory accordingly. However, some of the forecasts may not be accurate resulting in the above problem of not satisfying the needs of customers (Sagner, 2010).
The third pitfall is that the strategy results in lost opportunities for the firm. The firm cannot take part in sudden big sales contracts because of the low inventory levels. The low inventory levels also results in shocks in the business operations if the firm delays in acquisition of raw materials or experiences a breakdown in its operations. The buffer within the stores may not be enough to sustain the operations of the company (Talonpoika et al., 2016).
Cash flow statement
When the cash from operating activities is compared to the net income of a firm and the cash from operating activities is higher than the net income, then that firm has sustainable operations because it is profitable. However, this cannot be surely said of George’s firm.
Recommendations
The first recommendation is that George should increase the product offering and venture into other products. This means that the firm needs to have a different strategy of managing inventory (Mathur, 2007). Customers should not come into the premises and fail to find the trains. The new product offerings will attract new customers and increase sales and profitability for the firm.
The other recommendation is that the company should use accounting principles and standards to guide its operations. Accounting standards would help George with efficient ways of managing cash flows so that the firm has a good relationship with all the stakeholders. Accounting principles will also make it easy for George to convince investors to put up capital into the business in case he needs to expand to other geographical regions (Talonpoika et al., 2016).
George needs to engage in capital budgeting in order for the firm to determine the projects that yield the highest benefits and pursue such projects. For instance, when George acquired the business, the firm depended on sales of Lionel trains. However, Lionel trains suffered from reduced sales and George had to change strategy to include new products. He ventured into smaller trains and race cars because of the gaining popularity that these products had.
- Baños-Caballero, S., García-Teruel, P.J., & Solano, P.M. (2010). Working capital management
in SMEs. Accounting and Finance, 50(3), 511-527. doi: 10.1111/j.1467-629X.2009.00331.x - Mathur, S.B. (2007). Working capital management and control: Principles and practice. New
Delhi: New Age International. - Sagner, J. (2010). Essentials of working capital management. New York, NY: John Wiley &
Sons. - Talonpoika, A-M., Kärri, T., Pirttilä, M., & Monto, S. (2016). Defined strategies for financial
working capital management. International Journal of Managerial Finance, 12(3), 277-294. doi: 10.1108/IJMF-11-2014-0178
