CHAPTER 7

WORKING CAPITAL

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 Contents
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1. What is "working capital”

2. Balancing liquidity and profitability

3. Assessing the liquidity position via ratios

4. The cash operating cycle

5. Managing inventory

6. Managing trade payables

7. Managing trade receivables

8. Treasury management

9. Cash budgets
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1. What is working capital

WC: The total of the current assets of a business less its current liabilities
Aim: Management of liquidity position

Cash

Working
Debtors capital Creditors
cycle

Inventory
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2. Balancing liquidity and profitability

 Cash: by ensuring that business has sufficient liquid assets (cash), it is
reducing its chance of owning more profitable assets
 Receivables: not provide credit to customer may improve liquidity
position but customers would be driven away, revenue would fall
 Inventory: finished goods and raw materials need to be maintained in
store to satisfy customer demand → money tied up in inventories
 Payables: to improve cash position a business might not pay suppliers
until after 2 or 3 months → risk of alienating its suppliers

Business must weigh up profitability vs liquidity

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Balancing short-term and long term finance for WC

• Financing current asset Assets

Short term
finance
Short term
Fluctuating current assets Fluctuating current assets
finance

Long term
Permanent current Long term Permanent current
finance
assets finance assets
Non-current assets Non-current assets

Time
Time

Some permanent current assets All permanent and some fluctuating current

are financed by short-term credit assets arc financed out of long term sources

More profitable but riskier Less profitable but less risky

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3. Assessing the liquidity position

via ratios

Assessing the liquidity

position

via the cash operating

cycle
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Assessing the liquidity positions via ratios

The ratios be compared with:
 the same company in previous periods
 other companies in the same industry

Ratios

Receivables Payables
Inventory Liquidity
collection payment
turnover ratios
period period
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Inventory turnover
• Inventory turnover period is a calculation of the number of days
inventory is held for

Inventory
Inventory turnover period = x 365 days
Cost of sales

• Rate of Inventory turnover is a measure of how many times inventory

turns over during the trading period
Cost of sales
Rate of Inventory turnover =
Avg. inventory
 Receivables collection period
This monitors how long on average it takes to collect debts.

Avg. Receivables
Receivables collect period
x 365 days
= Annual sales revenue

Increase in A/R collection period indicates that credit control

function is poorly managed or changes in credit term

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Payable payment period

• This monitors how long on average the company waits before

paying its suppliers.

Avg. Payables
Payables payment period = X 365 days
Annual purchases

this period should be as high as possible

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Liquidity Ratio Current assets

Current ratio =
Current liabilities
Current Cash
Ratio Ratio

Current assets - inventories

Acid-test Ratio
Quick ratio =
Current liabilities
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Assessing the liquidity position

Worked example: Manipulating working capital ratios 1
Right Ltd currently has inventory and payables of £15,000 and receivables
of £30,000. It pays its suppliers one month after receiving goods from them
but allows its customers two months' credit.
Right Ltd does not expected any change to its level of business, but it now
proposes to reduce its receivables credit period to one month to bring it in
line with its payables payment period. It also proposes an increase in its
inventory levels, such that its inventory turnover period will increase from
30 days to 60 days.
Required:
What will be the effect of these decisions on Right Ltd’s ratios?
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4. Cash operating cycle

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Calculating the length of the cash operating cycle
Avg. Inventory of raw materials
Raw materials holding period = X 365 days
Annual usage

Avg. Trade payables

Average payables payment period = X 365 days
Annual purchases

Avg. Inventory of work in progress

Average production period = X 365 days
Annual cost of sales

Avg. Inventory of finish goods

Average inventory-holding period = X 365 days
Annual purchases

Avg. Receivables
Average receivables collection period = X 365 days
Annual sales revenue
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Investment in working capital

Investment

Finished Receivables
WIP (work in
Raw materials progress) goods

Payables

Purchase Manufacture Sell

Investment influenced by:

✓ Growth
✓Inflation
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Variations between businesses

A large national A civil engineering firm Manufacturer of toys
supermarket chain with many large projects artificial Christmas trees
High investment in Low investment in raw WC fluctuate significantly
inventory material inventory as each due to seasonal nature
job is unique
Low investment in Long WIP and receivables Receivables increase as
receivables days retailers stock up
Long credit terms from Spread production process
suppliers over the year to smooth
production
Cash operating cycle Cash operating cycle vary
relatively stable significantly
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Limitations of Working Capital

 Balance sheet values at a particular point in time may not

be typical

 Balances used for a seasonal business will not represent

average levels

 Concern the past not future

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Over trading
When the business is growing:
✓ The cash cycle gets longer
✓ Sales increase
At the introduction stage, the business:
✓ No trading record, so a very short credit from supplier
✓ No reputation, a long credit period is likely to be extended to customers
If the business has found a 'niche market', rapid sales expansion may occur
This can lead to the cycle being 'out of balance', so short-term financing may be
necessary.
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Solutions to liquidity problems

• Reducing the inventory-holding period

• Reducing the production period

• Reducing customers' credit

• Extending the period of credit taken from suppliers

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5. Managing inventory
Reasons for holding inventory
 to meet demand
 to ensure continuity of production
 to take advantage of quantity discounts or special promotions
 to buy in ahead of a shortage or ahead of a price rise
 for technical reasons, such as maturing whisky or keeping oil in pipelines
 to reduce ordering costs
 suppliers insist on minimum order quantities
 Cost associated with holding Inventory
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 Purchase price
 Holding costs
✓ Opportunity cost of capital tied up
✓ Cost of Insurance
✓ Risk of deterioration, obsolescence and pilferage
✓Store administration
 Re - order cost
✓ Transport cost
✓ Clerical and administrative cost
✓ Batch set-up costs
» Shortage costs
✓ Production stoppages
✓ Stock out costs for finished goods
✓ Emergency re-order costs
 Inventory control systems 23

• Re-order level system: a fixed quantity will be ordered

whenever inventory falls to a pre-determined level

• Periodic review system: inventory levels are reviewed at mixed

time intervals to fit in with production schedules, variable
quantities are ordered as appropriate

• ABC system: inventory is classified into classes A (most control

effort), B (less) and C (less still)
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Inventory control systems

• Economic order quantity (EOQ): EOQ=
D: demand during the period
C0: cost/order
Ch: holding cost per unit of inventory per time period

Worked example: Material X costs £100 per kg. 2,000 kgs are to be used
per year, and holding costs per kg per year are £5. Each order placed costs
£200 in administration time.
EOQ for material = = 400kg
Annual usage is 2,000 kg, so 2,000/400 = 5 orders per year will be placed
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Total
Annual cost
cost Holding costs

Ordering cost

EOQ Re-Order Quantity

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Inventory control systems

• Just-in-time (JIT): production and purchasing are linked closely to
sales demand negligible inventories need to be held

• Perpetual inventory methods: where perpetual inventory records

are kept

• Other ways to manage inventory:

✓Sub-contract (outsource) non-core processes

✓Obtain progress payments from customers

✓ Reduce the number of product line

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6. Managing trade payables

Trade credit is generally a cheap source of finance.

- Credit status may be lost so the supplier gives low priority to the buyer's future
orders, with consequent disruption of activities.

- The supplier may raise prices in order to compensate for the finance which they
are involuntarily supplying.

- The buyer will lose any cash discount for prompt payment; the cost of the lost
discount should be compared with other short-term sources of finance.
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Managing trade payables

Advantages of trade credit:
- Convenient and informal
- Not qualify for credit from a financial institution.
- Not prevent advantage being taken of settlement discounts
- Virtual subsidy or sales promotion device offered by the seller
- Can be used on a very short-term basis to overcome unexpected cash
flow crises in short term
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Managing trade payables

A business should:

- Consider switching suppliers if better credit terms are available

- Negotiate better terms for buying large quantities

- Reconcile statements

- Pay only on completion of correct delivery

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7. Managing trade receivables

Ideal level of trade receivables requires trade-off between:

✓ The cost of extending credit to customers: financing costs,

irrecoverable debts and admin cost

✓ The benefits of granting credit: sales increase

Receivable management includes:

✓ Credit control and collection policies

✓ Financing trade receivables

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Credit control and collection policies

• Credit control and collection policies should be set at board level
• Credit terms and settlement discounts: depend on external factors, such
as, competition, industry norms, customer size, etc
• Credit rating: indicates risk of bad debts and based on:
✓Assessment of ability of the customer to meet the liabilities
✓Assessment of financial statements
✓Use of credit rating agencies
✓Analysis of on going trading experience
✓Exchange information from credit managers with other businesses
✓Credit limits set on a particular customer
✓Trace an bank references
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Worked example: Settlement discount

Left Ltd has monthly sales of £20,000. 25% of receivables are paid within one
month of a sale, and 70% are paid within two months, but 5% of receivables are
never paid. Left Ltd proposes offering a 3% discount to receivables settling
invoices within one month of the invoice date. As a result, monthly sales are
predicted to rise to £25,000 and 500 trade receivables will pay within one
month. 44% will pay within two months but irrecoverable debts will rise to 6%.
All sales are invoiced at the end of each month. The discount will be offered for
all invoices issued from Month 1.
By how much will total cash inflows from trade receivables in Months 1 and 2
change as a result, and what will be the effect on profit?
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Cash received
Sales Month 1 Month 2 Irrecoverable debts Discount allowed

£ £ £ £ £
Current policy 25% 70% 5%
Sales M1 20,000 5,000 14,000 1,000 0
Sales M2 20,000 0 5,000 0 0
Total cash 5,000 19,000 1,000 0
Proposed policy 50% × 97% 44% 6% 50% × 3%
Sales M1 25,000 12,125 11,000 1,500 375
Sales M2 25,000 0 12,125 0 0
Total cash 12,125 23,125 1,500 375

There is a large cash flow benefit of £7,125 in Month 1, and a benefit of £4,125 per month once the
normal pattern is established. The reduction in monthly profits caused by increased irrecoverable
debts is £500, while profits are further reduced by £375 with respect to the discount allowed.
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Financing trade receivables

Invoice
discounting

Receivables
Sale
Factoring
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Financing trade receivables

Invoice discounting

✓Involving selling the invoices to a discounting company for a cash sum,

then repaying the discounter when the debtor pays the invoice

✓The company retains full responsibility for sales ledger, credit control and
collection functions.
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Financing trade receivables

Accounting and
collection

Recourse factoring
Receivable
Credit control
factoring
Non-recourse
factoring

Financing
against sales
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Good practice in receivable management

Look after key

Manage time scales
accounts

Reduce the time between the

20% of customers placement of the order and receipt
represent 80% debts of cash

Eliminate any causes of disputes

or non-payments
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Trade credit insurance

• Trade credit insurance insures a business against the possible default and
insolvency of its credit custorners and political risk.

• Credit insurance means a business can:

 insure all or part of its receivables ledger against default by a customer

 include a 'first loss' (or excess) on its accounts to be insured

 be insured only up to a ceiling ('credit limit')

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Managing trade receivables

Worked example: Total receivables ageing

November of % of December 20X1 % of

20X1 out standing total out standing total
0 - 30 days 10,000 86.21 12,000 80.5
31-60 days 1,000 8.6 2,000 13.4
61-90 days 500 4.3 750 5.0
90+ days 100 0.9 150 1.1
11,600 100.0 14,900 100.0
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8. Treasury management

Treasury
management

• Aim of good
• Short-term • Investing
• Trade-off cash
finance surplus funds
management
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Trade-off

The basic trade-off: cost of holding cash vs. cost of running out of cash
• Cost of holding cash: opportunity cost
• Cost of running out of cash:
• Loss of settlement discounts
• Loss of supplier goodwill
• Poor industry relation if wage payments are delayed
• Creditors petitioning for winding up the business = Bankrupt risk
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Aim of good cash management

• Aim of good cash management is to have the right amount of cash

available at the right time
• Accurate cash budgeting/ forecasting
• Planning short-term finance
• Planning investment of surpluses
• Cost-efficient cash transmission
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Short-term finance

• Receivable factoring and invoice discounting

• Bank overdrafts

• Short-term bank loans

• Operating leases
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Investing surplus funds

• Surplus funds can be in short-term or long-term

• Financial products to invest:

• Treasury bills
• Deposits
• Gilts: Long-term government debt
• Bonds: company bond
• Equities: in the stock exchange
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Investing surplus funds

• Factors to be considered:
• Amount of funds
• Length of time
• Withdrawal time, and penalties
• Risk and return of investment
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9. Cash budgets

• A cash budget is a statement in which estimated future cash

receipts and payments are tabulated in such a way as to show
the forecast cash balance of a business at defined intervals.
• Usefulness of cash budget
• enable management to make any forward planning decisions
• can give management an indication of potential problems.
 Potential cash positions
Cash position Appropriate' management action
Short-term surplus - Pay suppliers early n return for settlement discount
- Increase receivables and inventories
- Invest short term
Short-term deficit - Increase payables by delaying payments to suppliers
- Reduce receivables and inventories
- Arrange overdraft
Long-term surplus - Invest long term
- Expand
- Diversify
- Replace non-current assets
- Increase dividends
- Buy back shares
Long-term deficit - Raise long term finance
- Consider divestment
47 - Consider selling non-current assets
- Plan a controlled shutdown
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Worked example: Preparing a cash budget

Penny operates a retail business. Purchases are sold at cost plus 33 1/3%.
(a)
Budgeted Labour cost in Expenses
sales in month month incurred in
month
£ £ £
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 160,000 5,000 7,000
April 120,000 4,000 7,000
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Worked example: Preparing a cash budget

(b) It is management policy to have sufficient inventory in hand at the end of
each month to meet half of next month's sales demand.
(c) Suppliers for materials and expenses are paid in the month after the
purchases are made/expenses incurred. Labour is paid in full by the end of
each month.
(d) Expenses include a monthly depreciation charge of £2,000.
(e) (1) 75% of sales are for cash.
(2) 25% of sales are on one month's credit.
(f) The company will buy equipment costing £18,000 for cash in February and
will pay a dividend of £20,000 in March. The opening cash balance at 1
February is £1,000.
Requirement: Prepare a cash budget for February and March.