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8/20/2019 Impact of Working Capital
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INTRODUCTION:
Working capital management is important part in firm financial management decision.
An optimal working capital management is expected to contribute positively to the
creation of firm value. To reach optimal working capital management firm manager should control the trade off between profitability and liquidity accurately. The purpose of
this study is to investigate the relationship between working capital management and firm
profitability.
The four major components of working capital are:
. !ash
". #arketable $ecurities
%. &nventory
'. Account (eceivables
!ash:
!ash is defined as Demand deposit plus Currency. !ash is probably the least
productive asset you can have. )ot only does it not earn any thing* it actually loses
purchasing power as a consequence of inflation. There are three motives for holding
cash balances:
• Transactional motives++. To conduct day to day business of paying for
purchase* labor etc.
• ,recautionary motives++. To cover unexpected expenditure. &f delivery
truck breaks down* it must be repaired or replaced if you want to stay in
business.
• $peculative motives+++. -nusually good opportunities occasionally arise.
&f you have the money available* you can take advantage of these
opportunities.
#arketable $ecurities:
#arketable securities are financial securities that can be sold on short notice. They are
not cash* but they can be easily converted to cash on very short notice. They are a way of
holding cash but with attribute of earning interest. Thus they are )ear !ash Assets e.g.
-.$ treasury ills* Anticipation )otes* !ommercial ,aper* anker/s Acceptances.
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&nventory:
&nventories 0raw materials* work in process* finished goods1 make up a large portion of
most firm/s current assets* and for many total assets. As such* the extent to which a firm
efficiently manages its inventories can have a large influence on its profitability. Thus*
keeping abreast of inventory policy is critical to the profitability 0and value1 of the firm.
&nventory can be broken down into three major categories*
A. 2rdering cost
a. 3ixed !ost4 stocking* clerical
b. $hipping !ost4 often fixed
c. #issed quantity discounts4an appropriate !ost
. !arrying !ost
a. Time value of money tied up in inventories
b. Warehousing !ost
c. &nsurance
d. 5andling
e. 2bsolescence* breakage* shrinkage
!. $tock 2ut !ost
a. 6ost sales
b. 6oss of 7oodwillc. $pecial shipping !ost
Account receivable:
Accounts receivable are generated when a firm offers credit to its customers. The first
thing that needs to be addressed when establishing a credit policy is to set the standard by
which a firm is judged in determining whether or not credit will be extended. This is what
known as 8 !s of credit.
. !haracter4 the willingness of the borrower to repay the obligation
". !apacity4 the capability of the borrower to earn the money to repay the obligation
%. !apital4 sufficient assets available to support operations 0as opposed to a firm that
under capitali9ed1
Working !apital:
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Working Capital is the money used to make goods and attract sales.
The less Working Capital used to attract sales, the higher is likely to
be the return on investment. Working Capital management is about
the commercial and fnancial aspects o Inventory, credit, purchasing,
marketing, and royalty and investment policy. The higher the proft
margin, the lower is likely to be the level o Working Capital tied up in
creating and selling titles. The aster that we create and sell the books
the higher is likely to be the return on investment.
Working capital is an important issue during financial decision making since its being a
part of investment in asset that requires appropriate financing investment. 5owever*working capital always being disregard in financial decision making since it involve
investment and financing in short term period. 3urther* also act as a restrain in financial
performance* since it does not contribute to return on equity 0$anger* "1. Though* it
should be critical for to a firm to sustain their short term investment since it will ensure
the ability of firm in longer period.
The crucial part in managing working capital is required maintaining its liquidity in day4
to4day operation to ensure it/s smooth running and meets its obligation 0;ljelly* "'1.
<et* this is not a simple task since managers must make sure that business operation is
running in efficient and profitable manner. There are the possibilities of mismatch of
current asset and current liability during this process. &f this happens and firm/s manager
cannot manage it properly then it will affect firm/s growth and profitability. This will
further lead to financial distress and finally firms can go bankrupt.
&n traditional view of relationship between cash conversion cycle 0as measure of working
capital management1 and profitability is ceteris paribus. The shorter firm cash conversion
cycle* the better a firm profitability. This shows that less of time a dollar tied up in current
asset and less external financing. While* the longer cash conversion cycle will hurt firm/s
probability. The reason is that firm having low liquidity that would affect firm/s risk.
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5owever* if firm has higher level of account receivable due to the generous trade credit
policy it would result to longer cash conversion cycle. &n this case* the longer cash
conversion cycle will increase profitability. Thus* the traditional view cannot be applied
to all circumstances.
=ilemma in working capital management is to achieve desired trade off between liquidity
and profitability 0$mith* >?@ (aheman )ast* "B1. (eferring to theory of risk and
return* investment with more risk will result to more return. Thus* firms with high
liquidity of working capital may have low risk then low profitability.
Working Capital Cycle
A useful mechanism for the small4business owner is the working capital cycle. The
working capital cycle can be defined as the period of time which elapses between the
point at which cash begins to be expended on the production or purchase of a product and
the collection of cash from the customer. The working capital cycle analy9es accounts
receivable* inventory* accounts payable* and equity and loans. As shown in the diagram
below* the cash flows in a cycle into* around and out of a business. The faster a small
business grows the more cash it will need for working capital and other investments.
2wners need to understand that the cost of providing credit to customers and holding
inventory can represent a substantial proportion of a business/s total profits.
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To help explain the diagram above* some items need to be covered. The two main
elements in the working capital cycle that absorb cash are inventory and receivables. &n4
stock products or work4in4progress items are examples of inventory. (eceivables are
established when customers owe the business money. 3inally* the main sources of cash
are payables* equity and loans. ,ayables are established when the business owes a
creditor money.
;ach component of the working capital cycle 0inventory* payables* and receivables1* has
a time dimension and a money dimension. When it comes to managing working capital*
most business owners will say that time is money. &f an owner can get money to move
faster around the cycle by collecting money due from customers more quickly or reduce
the amount of money tied up by reducing inventory levels relative to sales* the business
will generate more cash or it will need to borrow less money to fund working capital. As
a consequence* a business owner can reduce the cost of interest or have additional moneyavailable to support additional sales growth or investment.
As a helpful guide to small business owners* below are some Cif D thenE statements.
$ource: ,lanware.org
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If a business owner …… Then ……
collects receivables from customers faster* they can release cash from the cycle.
collects receivables from customers slower* the receivables soak up cash.
can get better credit from suppliers* they can increase their cash resources.
can move inventory faster* they can free up cash.
can move inventory slower* they consume more cash.
Factors Inluencing Working Capital !erormance
3or most !32s* the greatest challenge with respect to working capital management is the
need to understand and influence factors that are out of their direct control* in order to
obtain a complete picture of the companyFs needs. The !32s span of control can be
limited in terms of functional silos* though corporate finance may well have some powers
of influence over operating units.
While organi9ations generally concentrate on the right processes* such as cash* payables
and their supply chain* they are less likely to take into account various internal and
external constraints that can dictate how effectively those processes are executed. 3or
example* the legal and business environments can have a significant impact on
performance. $imilarly* internal considerations as such as organi9ational structure* shared
systems* autonomous business units* multinational operations and even information
technology can impact working capital* creating barriers that can hinder a !32s ability to
truly understand* and therefore manage* the companyFs needs.
The human factor is another important consideration. &f management is focused purely on
top4line growth* insufficient attention may be applied to cash flow management and
forecasting. A hard4line focus on year4end or quarter4end results can produce a flattering*
but inaccurate* picture of working capital performance and lead to counter4productive
behaviour. !onsider the impact on working capital of a year4end sales push* where
production has been building up inventory 0which may not be the appropriate inventory1
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to meet this artificial demand and the quality of receivables deteriorates during the early
part of the following year.
While there is no magical solution for effecting robust working capital management*
there are a number of prerequisites for gaining control of the complex process.
Cas" Flo# Forecasting
,roper cash flow forecasting is essential to successful working capital management. To
do this effectively* organi9ations must take into account internal and external working
capital drivers and consider the sensitivity of those drivers to changes in the business or
market.
Garious questions need to be asked: 5ow will unforeseen events impact working capital
requirementsH What if a sudden market downturn or upturn occursH What if the company
loses a major customerH What happens if a major competitor takes a significant action to
improve its market positionH $ince each of these could have a si9able impact on the
business* organi9ations must assume that the only certainty will be uncertainty* and
prepare accordingly.
&n addition to assessing the cash flow impact of potential events* companies should
consider the possibility of having to make additional working capital investments. ThatFs
because events could affect non4operational cash requirements such as investments* credit
ratings and the ability to service debt* as well as inventory* payables and receivables.
!ompanies must implement contingency plans that take a holistic view of the
organi9ation in the context of a variety of different challenging situations. This will help
minimi9e the adverse effects of unforeseen events and provide financial flexibility in
uncertain times by having working capital as a ready source of cash.
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5ow can you manage uncertaintyH The three fundamental approaches are: control it*
predict it* react to it. The most successful approaches are based around one approach* but
contain elements of all three. #arket4leading companies* perhaps not surprisingly* are in
the best position to manage uncertainty* often enjoying the ability to control supply*
minimi9e inventory and apply payment pressure on customers. !ompanies with less
influence* however* must rely more heavily on a strategy of prediction. To properly
prepare for events and improve or maintain performance during times of uncertainty*
organi9ations must develop an objective* business4driven view of the role of working
capital. Without real insight into true working capital drivers* a company may be able to
produce a reasonably good consolidated forecast* but find that accuracy drops
considerably when it comes to producing divisional* operating unit or even a product4line
forecast.
$eyond $alance %"eets
The Balance heet comprises !ong term "ssets #real estate, motor
vehicles, machinery$ and %et Current "ssets. The word Working
Capital is oten used or Net Current Assets.
Thus our Balance heet appears as ollows&
!ong Term "ssets ',(((
Working Capital )*,(((
Cash in Bank +,(((
Total Capital -,(((
We defned Net Current Assets as Total Current Assets less Total
Current Liabilities
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We subtract current liabilities items from current assets as follows:
&nventory 8*
(eceivables B*
,repayments I*
,ayables 0>*1!ustomer ,repayments 0*1
Working !apital "?*
-sing this format we can state than any reduction in the Working !apital figure* other
than for provisions for write4offs and write4downs* will generate the same amount of
cash. Thus if a customer pays -$J 8 that he owes to the organi9ation* the Working
!apital figure will fall be -$J 8* and the cash figure will be increased by the same
figure. This revised format is useful when designing spreadsheet financial planning
models for business plans or for internal reporting.
Income %tatement Osiris
Turnover *
!ost of $ales 08B*1
(oyalties 0?*1
7ross ,rofit "8*
=istribution costs 08*1
,romotion 0"*1Write4offs 0%*1
Administration costs 0*1
2perating ,rofit 8*
&nalysis
$alance %"eet Osiris Working !apital K$ales L
"?.L
&nventory 8* &nventory in days >I
(eceivables B* (eceivables in days I"
,repayments: authors %* ,repayments in days:authors
I
,repayments : printers %* ,repayments indays : printers
>
,ayables 0>*1 ,ayables 0%I1
!ustomer ,repayments 0*1 !ustomer,repayments
0'1
Working !apital "?* Working !apital >?
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!ycle in days
;xplanation of the calculations
Working Capital igure '(planation
&nventory in days 0&nventory K !ost of $ales1 x %I8 M >I days. #ore correctly the
purchases figure* if available should be used* in this case excluding
royalties. Thus the publisher holds approximately " months of unsold
inventoryAccounts receivable in
days
0(eceivables K Turnover1 x %I8 M I" days. Assuming the turnover is
phased evenly throughout the year* this means the on average
customers take I" days to pay,repayments in days D
authors
0,repayment: authors K (oyalties1 x %I8 M I days. &n practice royalties
will be earned that reduce this figure while new advances are also paidto other authors.
,repayments in days D
printers
0,repayment: printers K !ost of sales1 x %I8 M > days. &n practice part
of the !ost of $ales figure would be new title pre4press costs not
carried out at the printer. This item relates to cases where advance
payments are made to printers as a deposit or for paper. The purchases
figure if available would give a more accurate figure.Accounts ,ayable in
days
0,ayables K0All purchases1 x %I8
0>* K 08B* N ?* N 8* N "* N *1 x %I8 M %I days
The purchases 0investment1 rather than the cost of sales figure should
be used if available. & have assumed that this figure includes money
owed to authors 0see prepayment: authors1!ustomer ,repayments 0!ustomer ,repayments K Turnover1 O %I8 M ' days
Working !apital cycle in
days
>I N I" N I N > 4 %I 4 ' M >?
Working !apital K $ales
L
"?* K * M "?L
'(planation o t"e igures
• 2n average it takes 2siris >? days to turn an investment into cash and profit.
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• )ew tiles will use more Working !apital than reprints
• 2n average Working !apital equates to "?L of turnover
• The percentage of Working !apital to turnover varies according to the type of
publishing
• Trade publishing in developed countries may have a figure of between %84 '8 L
of turnover. Academic publishing is higher. ,rofessional publishing uses a lower
Working !apital L figure
• Working !apital is also a measure of risk
This figure may include new titles* reprints* foreign language coeditions* licence sales.
The figure would be different for each of these. Within the total alance $heet* the
Working !apital figure will vary throughout the year according to the phasing of newtitles and the sales cycle. ,ublishers should know the typical Working !apital cycle and
the level of Working !apital as a L of turnover for each market or distributor* for each
category of book.
T"e relevance o Working Capital to publis"ing in young economies
&n the 3$- Working !apital levels were controlled at government rather than factory
level. &nvoices were settled on standard credit terms. )on or slow payment was not amajor problem for printers and publishers. (isk was a government problem. Authors were
paid standard royalty rates and terms. &nventory levels and print runs were according to a
formula: in textbook publishing* 8L of the textbook requirement would be printed in
year * the remaining 8L would be used for replacement copies in subsequent years.
,ublishers* printers and distributors would negotiate for annual cash budgets but did not
have to concern themselves about Working !apital questions except where budget
moneys were delayed.
,rinting capacity was sufficient to produce local and other agreed requirements. Thus
textbook printing would commence in )ovember for the following $eptember. &n a
competitive open economy printers would have to offer discounts and credit to persuade
publishers to take the risk of early ordering. $chools would demand the latest up4to4date
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editions. ,ublishers would have to borrow money from the bank or shareholders to pay
for the inventory.
3or young economies* the implications are as follows.
. &n young economies the first industries to develop are those with low or negative
Working !apital L to sales. )egative Working !apital is where the organisation
uses supplier credit or customer ,repayments to fund their day to day needs.
;.7. banks and financial services* retailers* distribution* industries with cash sales
or advance payments on signature of contract 0e.g. printers1. 2rganisations with
negative Working !apital use the money from their customers with which to
invest and to pay suppliers.
". !ompetition is fiercest among industries with low or negative Working !apital K
sales L figures. 3inancial entry barriers are lower and these industries are easier
to expand. 5owever profit margins are often lower because of the competition
0but not alwaysP1 and the failure rate among such industries among developed
countries is usually higher.
%. anks are attracted to industries with low or negative Working !apital K sales L
figures as cash and profits are earned more quickly
'. ;ntrepreneurs are attracted to industries with low or negative Working !apital L
figures
8. #ost marketing innovations in book publishing have come about through the
application of the above Working !apital concepts to creating additional sales and
expanding the market. #ost of the innovations introduced at the end of the
previous chapter were created by reduced the level of Working !apital and the
time schedule of creating and selling books.
I. The customers* suppliers and authors of book publishers also want to operate to a
low or negative Working !apital K sales L. Thus printers ask for advance
payments e.g. for paper* distributors will try to withhold payment until they have
received money from their customers.
B. ,rinters are loath to change from their dominant position where they could dictate
prices and schedules according to price scales formulated at state level. These
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price scales were geared to maximum production output* not to satisfying
publishers and their customers under national or international competition. '4
colour printing would cost '4times the cost of single colour printing* despite the
introduction of modern '4colour sheet4fed presses. ,rinters will change their
attitude to pricing and print4runs only in a crisis. &n many young economies
printers have not co4operated with publishers 0partly the fault of the publishers1
and faced near collapse as publishers have purchased printing overseas.
?. &n developed countries publishers have sometimes allowed retail groups extra
credit 0M higher Working !apital for publishers1 in order to encourage them to
expand into new outlets or sell more books. &t is essential to distinguish between
genuine expansion cases and opportunistic entrepreneurs. The more a publisher is
actively engaged in marketing and distribution* the less likely is the publisher to
have to rely on offering credit as an incentive.
>. The concept applies equally to state enterprises and non4profit making
organisations. &f cash and profits are generated more quickly* new titles can be
commissioned sooner* staff and suppliers paid promptly. ank interest is reduced.
. Where producers are dominant* their customers will have to accept higher levels
of Working !apital. Where customers are dominant* the producers have to accept
a greater burden. &n some young economies* the government may have a policy of
holding key organisations in the state sector or as majority owned state enterprises
rather than encouraging a Cfree4for4all enterprise policy. This may affect printers*
publishers and distributors. This policy will affect the evolution of the Working
!apital cycle and may tilt it more in favour of producers.
Working Capital levels in book publis"ing in developed countries
Working !apital is a major problem in book publishing. #ost publishers solve the
question on a temporary basis by negotiating credit with printers and other suppliers.
Their own customers solve the problem by negotiating credit with publishers or
demanding Csale or returnE terms. C$ale or returnE terms make planning and cash
forecasting much more difficult. #ost publishers rightly prefer to offer a slightly higher
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discount for a firm sale. (etailers will argue that they would not purchase many new titles
without their risk being mitigated by a Csale4or4returnE policyE
The central issues* which must be solved* are:
• &nvestment decisions rely too heavily on economies of scale e.g. in printing
prices* by amorti9ing first edition costs against larger print runs
• ,ublishers produce too many titles* which receive too little promotional effort and
thus sell slowly or not at all.
These can be solved only through long term changes in publishing strategy and greater
attention to the Cvalue chainE where suppliers* publishers* wholesalers and retailers co4
operate to mutual benefit and shared risk. 2n demand publishing may reduce inventory
levels but does not solve the marketing aspects.
#any publishers have studied the publishing of music !=/s and cassettes* and of greeting
cards with a view to finding solutions. While lessons can be learned* there are major
differences:
!=/s* cassettes and greeting cards
• Are all high margin projects
• !arry much heavier promotion budgets and commitment to marketing
• Are standardi9ed in format
• ;njoy few economies of scale so short run and on4demand manufacture are the
norm
• $ell to a more wide variety of retailers
• $ell on a less seasonal basis
,aperback publishers have adopted some of these aspects and have fought successfully to
overcome the low price perception of paperbacks. ,aperbacks can now sell in many cases
at the same price as a hardback edition. The creation of Chit4paradesE or CTop E listings
has been adopted for books of different categories and has attracted significant media
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attention thus making books more fashionable. As a result books may sell faster* perhaps
at higher prices and thus reduce Working !apital levels.
)$ook !ackagers*
ook packagers create books under contract to publishers* book clubs or foreign
distributors. They evolve as part of the speciali9ation process especially when publishers
become larger and more bureaucratic. ,ublishers buy the rights for a territory for a period
of years or number of printings 0provided that the title stays in print1. The financial
attraction to publishers is that they can buy smaller print runs at economic cost. #ost
publishers will make advance payments to the packagers but may be able to approve the
content and design. #ost packagers prefer to sell finished books rather than license titles
on a film and royalty basis.
,ackagers buy at low prices from printers because they create only a small number of
titles but each title will have a large print run. ,ackagers often stay loyal to printers who
reward them with long credit and* in many cases* lower printing prices than those paid by
their publisher customers.
&n the TG world many program companies will create programs for several networks
while TG companies concentrate on distributing the programs. The production companies
will retain the rights and earn fees for repeat4shown programs. A similar situation exists
in the multimedia field.
Thus packagers are specialists who are not involved in marketing and distribution.
$ubsequently a small number of them have decided to become publishers and done so
very successfully after re4financing. #ost stay as packagers. !ompared with publishers*
these packagers have little market value in acquisition terms.
Thus packagers are very similar to many private publishers in young economies but with
important differences as the table below shows:
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$ook !ackagers !rivate publis"ers in young
economies
4 3ounders are creatively rather
than market driven@ enjoy
CfreedomE
4 3ounders are creatively rather than
market driven@ enjoy CfreedomE
4 &nternational printers offer
them low prices and credit@
printers have often offered credit
to allow packagers to start up*
sometimes with dire results for
the printer
4 ,rinters tend to give better prices to
established publishers
4
$ome publishers may be closely linked
with a printer. The printer may demand
advance payment
4 ,ackagers usually allow
publishers to approve content
4 ,ublishers will not involve customers
in the book content except in special
cases e.g. textbooks and #inistry of
;ducation* -niversity ,ublishing
5ouses
4 (eceive advance payments
from publishers
4 Are paid after delivery
4 5old no &nventory but reprints
make high profits
4 Will often sell the total print run to a
single or small number of distributors
4 ,urchase rights from authors
and designers* and sell territorial
or other rights to a number of
customers
4 $ell books with no transfer of rights
The Working !apital cycle in both cases is similar in both cases. The reason is perhaps
the same. )either the book packager nor the young private publisher is adequately
financed@ both enjoy the creative aspects but do not want to expand if it means losing
control. There are few potential buyers for book packagers.
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The cost of starting such organi9ations is much lower. Working !apital is lower because
they are involved only in creating the books. They influence distributors* retailers and
consumers only so long as they generate saleable new ideas. While book packagers can of
course sell foreign rights* their potential to sell reprints is lower.
+aking more eicient use o Working Capital
The table below lists items* which influence Working !apital levels favorably and
adversely
Items t"at reduce Working Capital levels orpublis"ers
Items t"at increase WorkingCapital levels or publis"ers
4 &ncreased profit margins 4 6ower profit margins
4 !ustomers who pay promptly
4 Advance payments by customers
4 6ong print runs except where all
the books are required on
publication e.g. $chool and
university textbooks
4 &nventory which is sold and paid for quickly by
customers after publication4 6ower &nventory levels by reducing print
quantities and working with printers who will
deliver quickly and produce low print runs
economically
4 $low authors who deliver late and
whose manuscripts requiresubstantial editing
4 5olding paper stock unless market
conditions demand and the savings
are large
4 $low schedules for the
development of new titles
4 $uccessful promotion that speeds up the rate of
sale
4 #aking advance payments to
printers
4 $easonal sales except where the
publishers prints only for the season
4 6icensing 0but problematic in young economies1
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4 ,aying suppliers on completion with credit
4 Authors who deliver manuscripts on disk ready for
computer make4up
4 &ncentives to staff * authors * suppliers* customers *
sales staff and agents to speed up the rate of sale
and of developing new books* delivering
manuscripts on schedule
The attention of readers is again drawn to the examples at the end of the previous chapter*
which illustrate ways in which publishers have produced affordable books through a
marketing initiative. The concepts of this chapter apply in each example.
T"e danger o averaging Working Capital levels
2siris has a Working !apital to $ales figure of "?L. 5owever the figure will be the
average of the organi9ations different activities. 6et us assume that there are three
divisions that produce different types of books for different markets and use different
methods of distribution. The table below shows how each division generates much )et
!ontribution and also how much Working !apital is used in each division. The cost of
sales* royalty* distribution* promotion costs and write4off figures differ in each case as a
percentage of sales although not all the costs are necessarily variable. The term )et
!ontribution is the amount of money that each division generates towards the central
administration cost of the company and hence to profit. &tems below )et !ontribution is
not relevant to our analysis unless administration cost vary according to each market.
&nterest on bank loans could however be usefully charged against each division to give an
even more meaningful figure. Although a alance $heet item* Working !apital is shown
under )et !ontribution to highlight the relevance of comparing )et !ontribution and
Working !apital levels by division.
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Income %tatement Division & Division $ Division C Total
Turnover I* %* * *
!ost of $ales 0%%*1 0?*1 0I*1 08B*1
(oyalties 0*?1 0I*"1 0*1 0?*1
7ross ,rofit I*" 8*? %* "8*=istribution costs 0%*>1 0*1 01 08*1
,romotion 0*1 0>1 0"*1
Write4offs 0*B1 0*1 0"1 0%*1
)et !ontributionOO >*8 "*? "*B 8*
Working !apital >*" B*? * "?*
OO 7ross ,rofit less distribution* promotion and write4offs. The contribution to
administration costs and profit from publishing activities
The analysis of the above sheds useful light on profitability and use of Working !apital
by division. This is discussed in detail below.
&nalysis o t"e net contribution
The table below shows each cost item included in the )et !ontribution calculation
expressed as a percentage of turnover.
Division & Division $ Division C &verage
!ost of $ales L to Turnover 88.L I.L I.L 8B.L
(oyalty L to turnover ?.L ".BL .L ?.L
7ross profit margin L "B.L >.%L %.L "8.L
=istribution L to turnover I.8L %.%L .L 8.L
,romotion L to turnover .?L %.L .L ".L
Write4off L to turnover ".?L %.BL ".L %.L
)et !ontribution L to turnover 8.?L >.%L "B.L 8.L
Working !apital K Turnover L %".L "I.L .L "?.L
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The most effective programs for both improving working capital performance and
forecasting are those that look beyond the local organi9ation and consider the broader
corporate environment. !orporate investment and financing arrangements* for example*
may provide for cash to be delivered by one location* but utili9ed at others. (estrictions
on the repatriation of cash* internal inefficiencies in moving cash* delays driven by banks
and sometimes4inadequate access to information can make the process problematic.
!ash generated in one country* for example* many not have the same value to the
organi9ation as cash generated in another. As a result* companies must plan global
working capital improvement initiatives in the context of the ultimate use for the cash*
rather than simply managing local balance sheets.
Improving Working Capital +anagement
$uccessfully improving working capital management requires a multi4pronged approach.
!ompanies must seek granular detail to identify the underlying drivers of working
capital. This requires separating perception from reality and pinpointing impediments to
efficient cash flow* such as poor links between production and billing or clumsy treasury
operations.
!ompanies must also adopt an entrepreneurial mindset. They must act quickly to drive
change by combining operational and financial skills* and expand their thinking beyond
the finance organi9ation to gain a more complete view of overall operations. (ather than
wait for the perfect solution* they must identify and implement strategies that result in
quick wins* generating short4term cash to fund longer4term projects.
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5aving the right people in place can also make or break the effort. !ompanies need to
identify individuals who can be responsible for setting targets and performance levels and
be held accountable for delivering. These professionals should be encouraged to
challenge the status quo and drive change* using cross4functional teams.
+easured &pproac"
3inally and this is where many projects fail* companies must remove emotion from the
analysis process. All initiatives must be business4case driven* and projects without
measurable results or those not contributing to overall goals should be abandoned.
!ompanies must agree on success criteria* prioriti9e based on contributions to these
criteria and continuously measure performance.
While working capital forecasting is critical to a companyFs ability to make informed
strategic business decisions* many !32s struggle with the process because of a lack of
control and real insight into the underlying drivers of their working capital needs. y
empowering the entire organi9ation to understand the companyFs true working capital
needs* companies can successfully reduce their financial risk* prepare for uncertainty and
create a ready cash reserve that will provide flexibility and security during difficult times.
,, Ways Companies +ay Improve T"eir Working Capital !osition
With interest rates continuing to rise* oil and commodity costs mounting and ever4
increasing pressures from Wall $treet to increase shareholder value* itFs surprising that
some companies are not taking more measured steps to drive effective cash management
and increase free cash flow.
Working capital is a highly effective barometer of a companyFs operational and financial
efficiency and effectiveness. The better its condition* the better positioned a company is
to focus on developing its core business. y addressing the drivers of working capital* in
fact* a company is sure to reap significant operating cost and customer service
improvement.
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According to an analysis of financial results from the "* largest companies in the -.$.
and ;urope performed in "8 by 5ackett4(;6* -.$. and ;uropean companies have
reduced working capital by " percent and B percent* respectively* over the past three
years. This strongly indicates that awareness of the benefits of working capital and cash
management improvement has been elevated beyond the treasury to the office of the
!;2.
'(cess Cas"
ut while corporate profits may be soaring* corporations are still overlooking billions in
cash a staggering J'I billion in the -.$. and some J8B million 0QRS'I> million1 in
;urope. This enormous sum is literally stuck in transit* a result of inefficient receivables*
payables and inventory practices that could be reclaimed with relatively little investment.
5ackett4(;6* which is part of The 5ackett 7roup* a strategic advisory firm* calculates
that in the -.$. alone* getting this excess under control would reduce total net debt by ">
percent* increase net profit up to percent and improve return on capital employed
0(2!;1 from %.> percent to 8. percent.
6iberating the billions in cash trapped on the balance sheet is easier than one may think.
=ell &nc.* for instance a lauded for overall strong corporate management and working
capital performance builds a computer only when it has received payment for an order*
and doesnFt pay its own suppliers for an agreed4upon period of time thereafter. As a result*
=ell enjoys negative working capital and* the more it grows* the more its suppliers
finance its growth.
)ot all companies can operate like =ell* but most can improve their working capital
position by at least " percent over time if they pay attention to the following list of cash
management doFs and donFts:
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,- .et educated/ There is more to working capital management than simply forcing
debtors to pay as quickly as possible* delay paying suppliers as long as possible and keep
stock levels as lean as possible. A properly conceived and executed improvement
program will certainly focus on optimi9ing each of these components* but also* it will
deliver additional benefits that extend far beyond operational rewards. All this
underscores the need for ambitious executives to integrate working capital management
into their strategic and tactical thinking* rather than view it as an extraneous added bonus.
0- Institute dispute management protocols/ !onsider a case where a companyFs
working capital is deteriorating due to an increase in past4due accounts receivable 0AK(1.
A review of the past4due AK( illustrates a high level of customer disputes* which are
taking on average of % days to resolve and consuming significant amounts of sales*
order4entry and cash collectorsF time.
y tackling the root cause of the disputes in this case* poor adherence to pricing policies
the company can eliminate the disputes* thereby improving customer service. ;stablished
dispute4management protocols free up time for sales* order4entry and cash collectionsF
personnel to be more effective at their designated roles* and they also will increase
productivity* reduce operating costs and potentially boost sales. And finally* days payable
outstanding 0=,21 and working capital will improve* as customers wonFt have reason to
hold payment.
This example illustrates how working capital is one of the best indicators of underlying
inefficiency within an organi9ation and why it is critical that senior executives remain
focused on addressing the primary causes of working capital excesses to control
operating costs and remain competitive.
1- Facilitate collaborative customer management/ 2ne of the most important cash
management and working capital strategies that executives !32s and treasurers* as well
as !;2s can employ is to avoid thinking linearly and concerning themselves solely with
their own companyFs needs. &f it is feasible to collaborate with customers to help them
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plan their inventory requirements more efficiently* it may be possible to match your
production to their consumption* efficiently and cost4effectively* and replicate this
collaboration with your suppliers.
The resulting implications for inventory levels can be massive. y aligning ordering*
production and distribution processes* companies can increase inherent efficiency and
achieve direct cost savings almost instantly. At this point* payment terms can be most
effectively negotiated.
2- 'ducate personnel3 customers and suppliers/ A business imperative should be to
educate staff to consider the trade4offs between various working capital assets when
negotiating with customers and suppliers. =epending on the usage pattern of a raw
material* there may be more to gain from negotiating consignment stock with a supplier
instead of pushing for extended terms 4 particularly in cases of long lead4time items or
those that require high minimum4order quantities.
The same can hold true for customers. Would vendor4managed inventory at a customer
site provide you the insight into true usage to better plan your own productionH &t is
important to remember* however* that this is not the solution for all products* and it
should be evaluated on a case4by4case basis.
4- &gree to ormal terms #it" suppliers and customers and document careully/ This
step cannot be stressed enough. Terms must be kept up to date and communicated to
employees throughout the organi9ation* especially to those involved in the customer4to4
cash and purchase4to4pay processes@ this includes your sales organi9ation.
Avoid prolific new product introductions without first establishing a clear product4range
management strategy. Whether in the consumer products or aluminium extrusions
business* many companies rely heavily on new products to maintain and grow market
share. 5owever* poor product4range management creates inefficiency in the supply chain*
as companies must support old products with inventory and manufacturing capability.
This increases operating costs and exposes the company to obsolete inventory.
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5- Don6t orget to collect your cas"/ This may sound obvious* but many businesses fail
to implement effective ongoing collection procedures to prevent excess overdue funds or
build4up of old debts. !ustomers should be asked if invoices have been received and are
clear to pay and* if not* to identify the problems preventing timely payment. !onfirm and
reconfirm the credit terms. 2ften* credit terms get lost in the translation of general
payment terms and whatFs on the payables ledger in front of the payables clerk.
7- %teer clear o arbitrary top8do#n targets/ Too many companies* for example*
impose a percent reduction in working capital for each division that fails to take into
account the realistic reduction opportunities within each division. This can result in goals
that de4motivate employees by establishing impossible targets* creating severe
unintended consequences. &nstead* try to balance top4down with bottom4up intelligence
when setting objectives.
9- 'stablis" targets t"at oster desired be"aviours/ #any companies will incentives
collections staff to minimi9e AK( over I days outstanding when* in fact* they should
reward those who collect AK( within the agreed4upon time period. After all* what would
stop someone from delaying collections activities until after I days when they can
expect to be rewardedH 6ikewise* a purchasing manager may be driven by the purchase
price and rewarded for buying when prices are low* but this provides no incentive to
manage lot si9es and order frequency to minimi9e inventory.
- Do not assume all ans#ers can be ound e(ternally/ efore approaching existing
customers and suppliers to discuss cash management goals* fully understand your own
process gaps so you can credibly discuss poor payment processes. Approximately B8
percent of the issues that impact cash flow are internally generated.
,;- Treat suppliers as you #ould like customers to treat you/ 3ar greater cash flow
benefits can be reali9ed by strategically leveraging your relationship with suppliers and
customers. A supplier is more likely to support you in the case of emergency if you have
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treated them fairly* and* likewise* a customer will be willing to forgive a mistake if you
have a strong working relationship.
That said@ also reali9e that each customer is unique. -tili9e segmentation tactics to split
your customers and suppliers into similar groups. 3or customers* segmentation may be
based on criteria including* profitability* sales* AK( si9e* past4due debt* average order si9e
and frequency. 2nce segmentation is complete* it is important to define strategies for
each segment based around the segmentation criteria and your strategic goals.
3or example* you should minimi9e the management cost for low4margin customers by
changing service levels* automating interaction* etc. 3inally* allocate your resources
according to the segmentation* with the aim of maximi9ing value.
,,- Celebrate success in "itting targets/ ;mphasi9e the actions that helped you get
there. Ask your people to remember what it felt like when they hit the target so they can
motivate themselves to hit it again.