Chapter 4 Working capital. Syllabus Guide Detailed Outcomes Describe the nature of working capital and identify its elements. Identify the objectives

Chapter 4

Working capital

Syllabus Guide Detailed Outcomes

Overview – working capital

Maximisation of

shareholder wealth

Maximisation of

shareholder wealth

Investment decisionInvestment decision Financing decisionFinancing decision Dividend decisionDividend decision

Working capital

can boost profits

Working capital

can boost profits

Working capital can

cause liquidity problems

Working capital can

cause liquidity problems

Definition

Current assets

cash, stock of raw materials, work in progress, finished goods, amounts receivable from debtors, marketable securities

Current liabilities

trade creditors, taxation payable, dividend payments due, short-term loans, long-term loans maturing within one year

Net working capital

=current assets - current liabilities

Working capital

Working capital

Every business needs adequate liquid resources to maintain day-to-day cash flow. It needs enough to pay wages, salaries and accounts payable if it is to keep its workforce and ensure its supplies.

On the other hand, an excessively conservative approach to working capital management resulting in high levels of cash holdings will harm profits because the opportunity to make a return on the assets tied up as cash will have been missed.

Working capital

These two objectives will often conflict as liquid assets give the lowest returns.

Working capital

23/4/19 Slide7

Working capital

The cash operating cycle

– the period of time which elapse between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser.

– raw material in stock time – credit period + production time + debtor collection period

Working capital ratios

current assets

current liabilities (current assets-inventories)

current liabilities(trade receivables

credit sales turnover)

×365 days

– in excess of 1 is expected

– at least 1 for slow inventory turnover– less than 1 with a fast inventory turnover

– for trade accounts receivable only

cost of sales

average inventory (average trade payables

purchases or cost of sales)

×365 days

Working capital ratios

The sales revenue

net working capital ratio

(sales revenue

current assets

– current liabilities)

– lengthening inventory turnover indicates a slow down in trading or a build-up in stock level

– an increase is a sign of lack of long-term finance or poor management of current assets

– working capital must increase in line with sales to avoid problems and this ratio can be used to forecast the level of working capital needed for a projected level of sales.

Working capital needs

Different optimum working capital

cash sales credit sales

trading manufacturing

large small companies

Over-capitalisation and working capital


Indicators of over-capitalisation

Sales/working capital Compare with previous years or similar companies

Liquidity ratios Compare with previous years or similar companies

Turnover periods Long turnover periods or inventory and accounts receivable or short credit period from suppliers may be unnecessary


Over capitalisation – too slowly – long turnover periods for stock and debtors or short credit

periods

– liquidity ratio increase

Over trading – too quickly – rapid increase in turnover

– rapid increase in current assets

– increase in creditor/overdraft

– small increase in equity, more increase in current

liabilities

– liquidity ratios fall, even liquid deficit

– repay a loan without replacing it, with less capital

– in periods of inflation, retained profits be insufficient to

pay for replacement fixed assets and stocks

Chapter summary

Topic Summary

1 Working capital

Working capital is the value of current assets less the value of current liabilities.

2 Objectives The two main objectives of working capital management are to increase the profits of a business and to provide sufficient liquidity to meet short term obligations as they fall due. These two objectives conflict.

3 Overview This is given by the cash operating cycle.

4 Forecasting The cash operating cycle can be used to determine the amount of cash needed at any sales level, and

to identify the possibility of a cash shortfall if sales rise too rapidly.

Chapter 5 Managing working capital


Discuss, apply and evaluate the use of relevant techniques in managing inventory, including the Economic Order Quantity model and Just-in-Time techniques.

Discuss and evaluate the use of relevant techniques in managing accounts receivable, including:

(i) assessing creditworthiness

(ii) managing accounts receivable

(iii) collecting amounts owing

(iv) offering early settlement discounts

(v) using factoring and invoice discounting

(vi) managing foreign accounts receivable


(i) using credit effectively

(ii) evaluating the benefits of discounts for early settlement and bulk discounts

(iii) managing foreign accounts payable

Discuss and apply the use of relevant techniques in managing accounts payable, including:

Overview – managing working capital

Maximisation of

shareholder wealth

Maximisation of

shareholder wealth


Managing

working capital

Managing

working capital

Contents

11

22

33

Management of inventories

Managing accounts receivable

Managing accounts payable

Management of inventory

Benefits of holding stocks


Economic order quantity model

Basic EOQ formula:

EOQ = SQRT(2C0D/CH)

– no discount and ignore stock-outs cost

– Reorder level = maximum usage×maximum

lead time

– Maximum stock level = reorder level + reorder

quantity –(minimum usage×minimum lead time)


Management of inventory‘Lead-time’ is the interval between placing an order with a supplier and that order arriving. It is unlikely that this could be reduced to zero.Constant demand, fixed finite lead-timeThe assumption of constant demand is consistent with the assumptions underlying the EOQ formula. If suppliers take some time to provide goods, orders need to be placed in advance of running out. Figure 4 illustrates the problem and its solution.


Constant demand, fixed finite lead-time – If the lead-time is, say, 5 days, an order has to be placed before stocks have been exhausted. Specifically, the order should be placed when there is still sufficient stock to last 5 days, i.e: – Re-order level (ROL) = Demand in lead-time – So, if lead-time for a particular stock item is 5 days and daily demand is 30 units, the re-order level would be 5 days at 30 units per day, 150 unitsVariable demand in the lead-time – It is therefore advisable to increase the re-order level by an amount of ‘buffer stock’ (safety stock).


Buffer stock – Buffer stock is simply the amount by which ROL exceeds

average demand in lead-time. It is needed when there is

uncertainty in lead-time demand to reduce the chance of

running out of stock and reduce the cost of such shortages.Basic EOQ formula

– Minimum stock level or buffer safety stock

= reorder level – average usage×average lead time

– Average stock = minimum stock + reorder amount/ 2


Possibility of stock-outs

– example The effect of discounts

– minimise: total purchasing costs + ordering costs

+ stockholding costs

Example

The annual demand for an item of stock is 45 units. The

item costs £200 a unit to purchase, the holding cost for 1 unit

for 1 year is 15% of the unit cost and ordering costs are £300

an order. The supplier offers a 3% discount for order of 60

units or more, and a discount of 5% for orders of 90 units or

more. What is the cost-minimising order size?

Answer

Management of inventoryJust-in-time procurement – No stock – Benefits:

– Not suitable for all the cases


Stock ratios

– vary by industry and for different lines by the same firm

– low stock turnover

☆prudent in stockholding policies

☆obsolete or slow-moving stock

– high turnover

☆supply difficulty and lose sales

Offering credit

Offering credit

Five questions about credit management

Managing accounts receivableFactors for credit control


Establishment of credit policy

– The period of credit extend will be set by reference to:


Implementation of credit policy – assessing creditworthiness, sources of information are: 1. trade references. 2. bank references. 3. credit agencies and credit associations. 4. reports from salesmen. 5. information from competitors. 6. financial statements analysis. 7. credit scoring. – monitoring the credit system 1. age analysis 2. ratios 3. statistical data

Managing accounts receivableAssessing credit worthiness


Extension of credit

The

extra

sales stimulated

the

profitability

of the

extra

sales

the extra

length of

the average

debt

collection

period

the required

rate of return

On the

investment

in additional

debtors

Example(1)

Answer(1)


Four possibilities to minimize the investment in trade debtors – more effective credit management – offering cash or prompt payment discounts – factoring – invoice discounting Early settlement discounts – benefit: shorten average credit periods, reduced investment in debtors and therefore interest costs – cost: the discounts allowed


A Case: A business is buying $1,000 worth of goods per

moth and can take 2.5% discount if it settles accounts within

one month. It will lose that source of supply if it delays

payment for more than three months. An alternative supply of goods will be difficult to obtain in the event of the business

getting a bad name.


To work out the cost to the business of taking the extra two months’ credit and losing the discount, carry out the following steps:

Step2: effective interesting cost of not taking the discount is:Discount available/Discounted amount due= $25/$975 =0.0256Effective annual interesting rate= (1+0.0256)6-1 =16.4%


Credit insuranceFactoring

– factoring is an arrangement to have debts collected by a

Factor company, which advance a proportion of the money it is due to collect.Main aspects of factoring

– administration of the client’s invoicing, sales accounting

and debt collection service

– credit protection for client’s debts

– making payments to the client in advance


Factoring the sales ledger –The factor takes over the control of the sales ledger. –The company sends a copy of the sales invoice to the factor . –The factor advances (usually) 80% of the face value of approved invoices. –When the client pays the factor advances the balanceless fees and interest charges. –If the client does not pay i.e. the debtor goes bad the factor does not reclaim the 80% advanced (non-recoursefactoring). –The factor does not pay the balance of the 20% of the bad debt. The effect is that factoring provides 80% insurance against bad debts. –The factor will impose a service charge of (usually) approximately 2% of turnover together with interest on any funds advanced.


Comparison of the costs between existing policy and factoring offer

– cost of factoring offer probably includes:

☆service charge

☆interest of advance

payment

– in general, cost of existing policy at least includes:

☆funding cost for debtor

☆administrative cost

☆bad debts loss


Benefits of factoring


Problems with factoring

– endanger trading relationship and damage goodwill.

– when non-recourse factoring offer is selected, the firms

lose control over decisions about granting favorable credit

to its customers for the sake of other considerations.

– firms will possibly be questioned the financial stability.


A case: A company has monthly credit sales of $200,000, and it gives customers 60 days credit. All customers take the full credit allowed. It has bad debts each year amounting to about 2.5% of sales turnover. It operates with a bank overdraft and pays interest at 8% on its overdraft balance. The company s management is considering whether to use a factor to collect is debts, under a non-recourse factoring arrangement. A factor has indicated that it will take over the administration of the sales ledger and debt collection for a fee of 2% of annual credit sales turnover. This would save the company internal operating costs of $30,000 each year. The factor would also charge 1.5% of turnover for credit insurance. The factor will advance 80% of the value of invoices as soon as they are sent out, and charge interest at 7.75%. If the services of the factor are used, it is anticipated that there will be no change in annual sales turnover and no change in the collection period of 60 days.

Example


Step1 Cost of existing policy Funding cost= 12 ｘ $200,000 ｘ (2/12) ｘ 8% =$32,000 Bad debts loss= 12 ｘ $200,000 ｘ 2.5%=$60,000 Administrative cost=$30,000 Total cost of existing policy=$122,000

Step3 Make comparison Net benefit= Cost of existing policy - Cost of factoring offering=$122,000-$ 115,200=$6,800

Step2 Cost of factoring offering Service charge= 12 ｘ $200,000 ｘ 2%= $48,000 Advance payment charge= 12 ｘ $200,000 ｘ 80% ｘ(2/12) ｘ 7.75%= $24,800 Residual funding cost=12 ｘ $200,000 ｘ 20% ｘ (2/12) ｘ 8%=$6,400 Credit insurance charge= 12 ｘ $200,000 ｘ1.5%=$36,000 Total cost of factoring offering=$ 115,200


Invoice discounting – is the purchase (by the provider of the discounting service) of trade debts at a discount. Invoice discounting enables the company from which the debts are purchased to raise working capital.


Invoice discounting

Managing foreign accounts receivable

Foreign debts risk

– delay

– bad debts

Measures to overcome foreign debtors

– reduce the investment in foreign debtors

– reduce the bad debt risk

– export factoring

– documentary credits

– export credit insurance

– overseas debtors’ general policies

Managing accounts payable

Effective management of trade creditors involves seeking

satisfactory credit terms from supplier, getting credit

extended during periods of cash shortage, and maintaining

good relations with suppliers.

Cost of trade creditor – early payment discounts – loss suppliers’ goodwill – potential damage to the company’s credit rating

Management of trade credit – attempting to obtain satisfactory credit from suppliers – attempting to extend credit during cash shortage – maintaining good relations with regular and important suppliers

Chapter summary

Topic Summary

1 Inventory The economic order quantity model attempts to manage inventory costs. This model ignores the hidden costs of stock. JIT suggests that inventory should be driven down to as close to zero as possible.

2 Receivables Requires a 4 step approach:

(a)A receivables policy

(b)A credit analysis system

(c)A credit control system

(d)A debt collection system

3 Payables Effective payables management involves controlling the timing of the payment of invoices to exploit attractive early payment discounts, and the credit period offered by suppliers; but ensuring that invoices are not paid so late as to endanger long-term supplier relationships.

Chapter 6

Working capital finance

Contents

11

22

33

44

55

66

The management of cash

Cash flow forecasts

Treasury management

Investing surplus cash

Working capital funding strategies

Cash management models


Explain the various reasons for holding cash and discuss and apply the use of relevant techniques in managing cash, including:

(i) preparing cash flow forecasts to determine future cash flows and cash balances

(ii) assessing the benefits of centralised treasury management and cash control

(iii) cash management models such as the Baumol model and the Miller-Orr model

(iv) short-term investments

Calculate the level of working capital investment in current assets and discuss the key factors determining this level, including:

(i) the length of the working capital cycle and the terms of trade

(ii) an organisation’s policy on the level of investment in current assets

(iii) the industry in which the organisation operates

Syllabus Guide Detailed Outcomes – cont’d

Describe and discuss the key factors determining working capital funding strategies, including: (i) the distinction between permanent and fluctuating current assets

(ii) the relative cost and risk of short-and long-term finance

(iii) the matching principle

(iv) the relative costs and benefits of aggressive, conservative and matching funding policies

(v) management attitudes to risk, previous funding decisions and organisation size

Overview – working capital finance

Maximisation of

shareholder wealth

Maximisation of

shareholder wealth


Finance to fund

investments

in working capital

Finance to fund

investments

in working capital

Management of cash

Determining the optimum cash balance – There is no convincing theoretical analysis, the best we can do is to make some practical observations:

Management of cash

Management of cash

Management of cashMethods of easing cash shortages

☆longer credit from supplier: further supplies refused

☆loan repayment rescheduled with bank

☆deferral of paying corporation tax: interest will be charged

☆dividend payments reduction

Treasury management

Advantages of a centralised treasury department

Treasury management

Advantages of a decnetralised treasury function


Baumol model

– Fixed cost: issue cost of shares

– Variable cost: keeping the cash, interest

– EOQ formula: SQRT(2CS/i)

– Drawbacks of the Baumol model

☆in reality, it is unlikely to be possible to predict amounts

required with certainty.

☆no buffer stock of cash is allowed for.

☆there may be other normal costs of holding cash which

increase with the average amount held.


1

33 cos var3

4 int

transaction t iance of cashflowsspread

erest rate

Miller-Orr model

– return point = lower limit + 1/3×spread

–

– drawbacks: cash inflows and outflows are unlikely to be entirely unpredictable

– advantages: save management time

Miller - Orr Model

Time

£

Return Point

Lower Limit

Upper Limit

Invest cashInvest cash

Borrow cashBorrow cash<--

--S

prea

d---

->


Reasons for cash surplus


Short-term investment objectives

– liquidity – safety – profitability

Short-term investment

– deposit – debt instrument – shares of listed companies

No investment – return to shareholders

– increase dividends level

– special dividend payment

– buy back its own shares, rise EPS


The working capital requirement The level of working capital

– a conservative approach

– an aggressive approach

– a moderate approach Permanent and fluctuating current assets

– non-current (fixed) assets

– permanent current assets

– fluctuating current assets


An aggressive approach

A moderate approach

A conservative approach

A conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels of working capital.

An aggressive working capital management policy aims to reduce this financing cost and increase profitability by cutting inventories, speeding up collections from customers, and delaying payments to suppliers.

A moderate working capital management policy is a middle way between the aggressive and conservative approaches.


Other factors

– industry norms

– products

– management issues

☆ the size of the organization

☆ the degree of centralisation

☆ management attitudes to risk

☆ previous funding decisions

Chapter summary

Section Topic Summary

1 Management of cash

Working capital movements have cash flow implications that need to be carefully managed.

2 & 3 Forecasting Cash flow forecasts will be prepared continuously during the year and will allow a business to plan how to deal with expected cash flow surpluses or shortages.

Chapter summary – cont’d

Section Topic Summary

4 Mathematical models

models There are two mathematical models that you need to be aware of:

(a) Baumol’s model

(b) Miller-Orr’s model

5 Managing cash flow surpluses

Desirable investments would generally be low risk and liquid

6 Managing cash flow shortages

A matching policy which uses short-term finance to fund fluctuating current assets and long term finance to fund permanent current assets and non-current assets.

Documents

Chapter 4 Working capital. Syllabus Guide Detailed Outcomes Describe the nature of working capital and identify its elements. Identify the objectives