What is working capital? Working capital financing policy Working capital cycle Monitoring working capital cycle

Lecture 6Working Capital Management

6-1

What is working capital• Working capital is the amount of money that a

company has tied up in funding its day to day operations.

• A company has to tie up money to fund its stocks, credit sales and other current assets, but this is offset by its ability to fund this from current liabilities such as purchases on credit. If a company buys on credit it does not have to tie up (as much) money in its stocks. In some businesses (such as grocery retail) working capital can even be negative. A business that buys on credit and sells for cash is being partly funded by its suppliers.

6-2

Working capital terminology• Gross working capital – For financial analysts, the term

working capital means current assets. Sometimes, it is called gross working capital; simply refers to current assets used in the operation.

• Net Working Capital - For accountants, working capital refers to net working capital. It is the dollar difference between current assets and current liabilities.

• Net operating working capital – current assets minus non-interest bearing current liabilities.

• Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets.

• Working capital management – Working capital management involves both setting capital policies and carrying out policy in day to day operation: controlling cash, inventories, and A/R, plus short-term liability management.

• It measures how much in liquid assets a company has available to build its business.

• Different industries have diverse working capital profiles.

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Type of Industries• Hypermarkets : high cash sales, minimal

trade receivables• Car dealers: hold inventory of finished

goods• Manufacturers: maintain stock of raw

materials and WIP• Food with perishable nature: sold within

specific time period• Big companies : bargain for extended

credit term from suppliers• Seasonal business: travel agents / hotel

6-4

Classification of Working CapitalWorking capital as current assets can be classified according to: • Components, such as cash, marketable securities, receivables,

and inventory.• Time, as either permanent or temporaryPermanent Working CapitalIt refers to the amount of current assets required to meet a firm’s long-term

minimum needs. Permanent working capital is different from fixed assets because it is constantly changing. Permanent working capital does not consist of particular current assets staying permanently in place, but is a permanent level of investment in current assets, whose individual’s items are constantly changing over.

 

Temporary Working Capital• It refers to current assets that fluctuate with seasonal or cyclical

variations in a firm’s business. Example, when the company sales increase during the festive season, temporary current assets must likewise increase.

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Objective of Working Capital Management• To ensure sufficient liquid resources• To minimise the risk of insolvency

while maximising the return on assets• To maintain the optimum balance of

each of the working capital components.

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Classification of current assets

Current assets can be classified into:– Permanent current assets – those assets held

to meet the firm’s long-term requirements. For example, a minimum level of cash and stock is required at any time, and a minimum level of debtors will always be outstanding.

– Fluctuating current assets – those current assets that change with seasonal or cyclical variations. For example most retail stores build up considerable stock levels prior to Christmas. Chinese New year, Hari Raya periods and run down to minimum levels following such sales.

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Working capital financing policies• Aggressive – Use short-term financing

to finance permanent current assets.• Conservative – Use permanent capital

for permanent current assets and temporary current assets.

• Moderate – Match the maturity of the assets with the maturity of the financing.

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Aggressive financing policy Uses more short-term financing to finance

current assets. Firm’s risk increases due to the risk of

fluctuating interest rates, but the potential for higher returns increases because of the generally low-cost financing.

Involves the use of short-term debt (current liabilities) to finance at least the firm’s temporary assets, some or all its permanent current assets and possibly some of its long-term fixed assets.

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

S-TLoans

L-T Fin:Stock,Bonds

Aggressive financing policy

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Conservative financing policy Uses long-term borrowing to finance current assets. Long term borrowing is less risky than borrowing

short term because the borrower has a longer time to use the loan proceeds before repayment is due. Furthermore, if interest rates go up during the period of the loan, the borrower has locked in a fixed interest rate and may end up paying less.

Involves the use of long term debt and equity to finance all long term fixed assets and permanent current assets in addition to some part of temporary current assets.

However, long term financing is generally more expensive than short term financing

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Conservative financing policy

$

Years

Perm C.A.

Fixed Assets

Marketable securities Zero S-T

Debt

L-T Fin:Stock,Bonds,Spon. C.L.

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Moderate financing policy The moderate approach is in between the

aggressive and the conservative working capital financing approaches.

Temporary current assets that are only going to be on the balance sheet for a short time should be financed with short term debt. Permanent current assets and long term fixed assets that are going to be on the balance sheet for a long time should be financed from long term debt and equity sources.

This approach balances the same amount of risk by the same amount of expected return.

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Moderate financing policy

Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

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Working Capital Cycle • A.k.a.Operating Cycle / Cash Cycle / Cash

Operating Cycle / Cash Conversion Cycle / Working Capital Cycle

• The average length of time (measured in days) between paying for purchases of materials and eventually receiving payment from customers.

Working Capital Cycle =Raw materials holding period + WIP holding period+ Finished goods holding period+ Receivables collection period- Payables payment period

Is a short working capital cycle good?6-15

Elements of Working Capital Cycle Ratio

1. Average Inventory Turnover Period- Time between buying inventory and using it to

create a sale

2. Receivables Collection Period (Debtor Days)- Time from making a sale to receiving payment from customer

3. Payables Payment Period (Creditor Days)

- Average period of credit taken from suppliers. Reduces the length of the working capital cycle

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Example A company generally pays its suppliers six weeks after receiving an invoice, while its credit customers usually pay within four weeks of invoicing. Raw materials inventory are held for a week before processing, which takes three weeks. Finished goods stay in inventory for an average of two weeks.

How long is the company’s operating cycle?

Answer = 4+1+3+2-6 = 4 weeks

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Importance of Working Capital

• The longer inventory turnover period and /or long debtors period will lengthen the operating cycle. >> increase investment in inventory / receivable >> tied up more cash in working capital.

• To maintain the length of operating cycle at a level where investment in working capital is not excessive and liquidity is sufficient.

• Ratio Analysis can be used to identify working capital areas that require closer management.

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Liquidity (Working Capital) Ratio

Liquidity means having cash or access to cash to meet payment liabilities.

1. Current Ratio- Ratio of current assets to current liabilities- Ability of a business to pay what it owes- “Rule of Thumb”; it should be 2:1

2. Acid Test Ratio (Quick Ratio)- Ratio of liquid asset (ie. Current assets excluding

inventory to the current liabilities.- Inventory is a slow-moving item and so not very liquid.- “Rule of Thumb”; it should be 1.0 or higher

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IllustrationCurrent Ratio = CA / CL

= 260/150 = 1.73 (last year)= 280/204 = 1.37 (this year)

- For every $1 owing as current liabilities, there is $1.37 of cover provided by the current assets.

- It has come down to 1.37 year; liquidity position of the company is getting worse which may indicate cash flow problems.

6-20

IllustrationAcid Test Ratio = CA (exclude stock) / CL

= 190/150 = 1.27 (last year)= 120/204 = 0.59 (this year)

- It indicates poor liquidity this year with ratio of 0.59

- Potential new supplier is likely to limit the amount of an credit or refuse any credit at all.

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Working Capital Cycle Ratio• If business starts taking longer time

to pay its payables, this could be a sign of liquidity problems.

• If a business starts giving its customers a longer time to pay, this could be a sign of inefficient debt collection. If receivables take longer to pay, the cash flow position of the business will deteriorate.

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Receivables collection period (Debtors Days)- The number of days on average that

customers who have purchased goods and services take on credit to pay for them.Averages receivables

Credit sales X 365 days

Payables Payment period(Creditors Days)

- The average time taken to pay payables who have supplied goods and services on credit Average trade payables Purchases

X 365 days

Note: If purchases figure is not given in question, use cost of sales.

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Inventory Turnover Ratio (in times)- How many times the average inventory held has

been sold during the course of the trading year. A low ratio could indicate the presence of slow moving inventory. Cost of Sales

Average inventory held

Inventory Holding period (in days)- A measure of time (on average) that inventory is held before being sold. It is also known as the inventory turnover period. Average inventory held

cost of sales X 365 days

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Activity 1Extracts from the income statement for the year and the balance sheet as the end of the year of ABC Sdn. Bhd.

RMSales 250,000Cost of sales 210,000Purchases 140,000Receivables 31,250Payables 21,000Inventory 92,500

Assumes all sales and purchases are on Credit TermsCalculate the length of working capital or cash operating cycle.

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Solution1. Average Payment Period= (21k/140k)x365

= 55 days

2. Average Collection Period = (31.25k/250k)x365 = 46 days

3. Inventory Turnover = (92.5k/210k)x365 = 161 days

Length of cash operating cycle = 161+46-55=152days

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Monitoring of Working Capital Cycle

• A useful comparison is to look at the length of the cycle in the past, and to assess whether the cycle is getting longer or shorter.

• Longer working capital indicates a larger investment in inventory plus trade receivables less trade payables >> worse cash flows.

• Shorter working capital indicate a smaller investment in inventory plus trade receivables less payables >> improved cash flows

• Managers use both cash budgets and liquidity ratio to manage cash flow and liquidity.

• Liquidity ratio can be calculated easily and quickly, and more useful than cash budgets in identifying improving or worsening trends.

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Over-capitalisation• It happens to a firm if its working capital is

excessive for its needs.• Excessive inventory, receivables and cash

and very few payables will lead to a low return on investment, with long-term funds tied up in non-earning short-term assets.

• Example of over-capitalisation:– Current ratio higher than 2:1– Quick ratio more than 1:1– Inventory and receivables collection periods

being too long– Short period of credit taken from suppliers

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Overtrading• It occurs when a business is conducting its

business operations with inadequate capital. It is also called under-capitalisation.

• It occurs when a business accepts work, and tries to fulfill it at a level that cannot be supported by its working capital or net current assets. It does not have enough cash and cannot obtain enough cash quickly.

• A business can start to overtrade when it is growing, and finds it difficult to obtain long-term finance to pay for its growth. Therefore, it finances its inventory and receivables with short-term credit.

• Overtrading could be profitable. But, it suffers from poor and worsening liquidity. It could be in serious danger of insolvency.

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Symptoms of overtrading• Greatly increased sales• Increase in receivables and longer time to

pay• Taking longer credit from suppliers• Unusual inventory movement. Fall sharply

in response to growing sales demand. Increase significantly as the business buys more to meet demand

• A falling of current ratio and quick ratio• A rising bank overdraft

Businesses that overtrade run a serious risk by over-relying on short-term finance.

6-30

Control of Orders ReceivedOvertrading can cause grave financial problems, so it may be vital to limit the amount of business that is accepted. Each order must be analysed to discover the following:- its effect on factory capacity- the amount of working capital tied up in the order- the length of time for which the company must provide finance- the estimated profit or contribution of the order

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Control of Purchase Commitments

• Payables can put the firm into liquidation if their demands for settlement are not satisfied.

• Purchasing manager should verify that materials to be purchased would be resold or used in production within a reasonable time.

• Should carry greater weight than the savings that can be made by bulk buying.>> seek to negotiate with suppliers in an attempt to obtain bulk discounts by placing larger orders but delivery over a long period > reducing total initial liability.

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Methods of reducing Cash Operating Cycle:

• Reducing the average stock turnover (holding) period by applying carefully planned purchasing procedures.

• Reducing if possible the average length of the production cycle, perhaps by using more efficient equipment, by improving labour efficiency.

• Reducing the average period of credit taken by credit customers.

• Taking more credit from trade suppliers, perhaps by arranging longer credit periods.

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Activity 2Main is a company producing a range of high quality hi-fi product, which it sells to specialist hi-fi shops. Recently, sales have begun to rise rapidly following excellent reviews in consumer magazines and a general increase in consumer confidence. The Chairman is delighted at the firms improved performance but the other directors are concerned that Main may be overtrading as it is getting close to agreed overdraft limit of $50,000. Main accounts for the past two years are summarised below:

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Profit and Loss account for the year ended 31 December

  2006$’000

2007$’000

Revenue 2,400 3,200

Cost of Sales 850 1,200

Gross profit 1,550 2,000

Other Operating costs 640 813

Operating profit 910 1,187

Interest - 3

Profit before Tax 910 1,184

Taxation 200 234

Profit after tax 710 950

Dividends 210 250

Retained Profit 500 7006-35

Balance Sheet 31 December2006 2007

$’000 $’000 $’000 $’000

Non-current assets (net) 1,800 2,400

Current Assets

Inventory of finished good 300 475

Inventory of components 100 150

Receivables 350 600

Cash 300 10

1,050 1,235

Total assets 2,850 3,635

Current Liabilities

Overdraft - 45

Trade Payables 300 400

Other Payables 100 40

400 485

Ordinary Shares ($0.50) 1,000 1,000

Accumulated Profit 1,450 2,150

Total equity and liabilities 2,850 3,6356-36