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WORKINGCAPITALMANAGEMENT 1. Thenature,elementsandimportanceofworkingcapital 2. Managementofinventories,accountsreceivable,accountspayableandcash 3. Determiningworkingcapitalneedsandfundingstrategies

TheNature,ElementsandImportanceofWorkingCapital
WhatisWorkingCapital? Workingcapitalisthenetofcurrentassetsminuscurrentliabilities.Thatisworkingcapitalisequalto thevalueofrawmaterials,workinprogress,finishedgoodsinventoriesandaccountsreceivableless accountspayable. WhatistheaimofWorkingCapitalManagement? Theaimofworkingcapitalmanagementistoachievebalancebetweenhavingsufficientworkingcapital toensurethatthebusinessisliquidbutnottoomuchthatthelevelofworkingcapitalreduced profitability. WhatismeantbythetermLiquidity? Liquiditymeansthatthebusinesshassufficientinventoryandcashsothatitcantradewithoutitscash orinventorydepleting. WhyisWorkingCapitalManagementimportant? Workingcapitalmanagementisessentialforthelongtermsuccessofabusiness.Nobusinesscan surviveifitcannotmeetitsdaytodayobligations.Abusinessmustthereforehaveclearpoliciesforthe managementofeachcomponentofworkingcapital.

ManagementofInventories,AccountsReceivable,AccountsPayable andCash
Canthelevelofworkingcapitalbefixedforallorganisationsandwhy? Differentindustrytypesrequiredifferentlevelsofworkingcapital.Serviceindustriesneedlittle tonoinventorywhereasretailersneedmore.Dependingontheretailersbusinesstheir inventorywillalsovary.Manufacturerswillprobablyrequiremorebecausetheyneedraw materialstocks,workinprogressandfinishedgoods.Retailersmaysellforcashtherefore havingfewreceivablesandproducersmayhavetradecustomersandhavegreaterreceivables.

Ifsupplydeliveriesareuncertainthelevelofinventorywillbegreater. Ifthelevelofactivityincreasesspecificallysalestheninventory,receivableandpayableswill increase. Thecompanysoperatingcyclewillalsodeterminethelevelofworkingcapital

WhatistheOperatingCycle? Theoperatingcycleisthelengthoftimebetweenthecompanysoutflowonrawmaterials,wagesand otherexpendituresandtheinflowofcashfromthesaleofgoods. WhatarethecharacteristicsoftheOperatingCycle? Theoperatingcycleismadeupofthreeelements: Theinventoryturnoverdays Theaveragereceivablecollectiondays Theaveragepayabledays

HowistheOperatingCyclecalculated? Inventorydays+receivabledayspayabledays=operatingcycle Inventorydays=Inventory/Costofsalesx365days Receivabledays=Receivables/Salesx365 Payabledays=Payables/Costofsalesx365

WhatistheimportanceoftheOperatingCycle? Theoperatingcycleisimportantbecauseitdeterminestheamountofworkingcapitalabusinessneeds. Ifyoucanhavetheoperatingcycleyouwillhavetheworkingcapitalrequirementofthebusiness.Ifthe turnoverperiodforinventoriesandaccountsreceivablelengthen,orthepaymentperiodtoaccounts payableshortens,thentheoperatingcyclewilllengthenandtheinvestmentinworkingcapitalwill increase. WhatisOvertrading? Overtradingisthetermappliedtoacompanywhichrapidlyincreaseitsturnoverwithouthaving sufficientcapitalbacking.Overtradingisriskybecauseshorttermfinancecanbewithdrawnrelatively quicklyifcreditorsloseconfidenceinthebusinessorifthereisageneraltightenintheeconomy.The problemwithovertradingisnotthatthecompanyisunprofitableitisthatthecompanyhassimplyrun outofcash. WhataretheCharacteristicsofOvertrading? Moreintensiveutilisationofexistingfixedassets Moreintensiveuseofworkingcapital

Reliancemoreheavilyonshorttermsourcessuchasoverdraftandtradecreditors Increaseindebtorsasstockincreases Decliningliquidity

Howcanaovertradingbemeasured? OvertradingcanbemeasuredusingLiquidityRatios: CurrentRatio=CurrentAssets/CurrentLiabilities Ameasureofhowmuchoftotalcurrentassetsarefinancedbycurrentliabilities.Aratioof2:1 orgreaterisconsideredasafemeasure. QuickRatio=CurrentAssetsInventory/CurrentLiabilities Ameasureofhowwellcurrentliabilitiesarecoveredbyliquidassets.Aratioof1:1meansthat weareabletomeetourexistingliabilitiesiftheyfalldueatonceoutofveryliquidcurrent assets. Thebankbalanceofacompanyisagoodindicationofovertradingifchangesfromasurplustoa deficitandcontinuestorise. Ifpayabledaysaregettinglonger,thatsuggeststhatthecashpositionisworsening. Ifthelevelofactivityrisessharplythenthismaybeanindicationofovertrading.

DeterminingWorkingCapitalneedsandFundingStrategies
WhatisagoodsolutiontoOvertrading? Agoodsolutiontoovertradingwouldbetoconvertshorttermfinancingwithlongtermfinancing. WorkingCapitalcanbefundingeitherbyShorttermFinanceorLongtermFinance,whatarethe advantagesanddisadvantages? Advantagesofshorttermfinance: Cheaper Shorttermfinanceischeaperthanlongtermfinancebecauselenderswoulddemandagreater compensationforhavingtheirmoneytiedupforlongperiods. Flexible Shorttermfinanceismoreflexiblethanlongtermfinancebecausetheamountoffinance neededwillfluctuateovertheoperatingcycle.Abusinesswillonlypayinterestontheamount ofoverdraft(shortterm)utilisedwhereaswithlongtermthebusinesswillpayfixedinterest eventhoughtheloanisnotfullyutilised. Easytoarrange anoverdraftissimpletoarrangeandisnormallyunsecuredagainstthecompanysassets.It doesnotneedanyoftheformalitiesthatgowithsettinguplongtermfinance.

Advantagesoflongtermfinance: Thefundarepermanentandwillrunforthefulltermoftheloanasaposetooverdraftswhichis repayableondemandwhichcouldseriouslydamagethecompany Thereisnoneedtocontinuallyrenewthefinance.Equityforexamplewillnotnormallybe repaid.

WhatarePermanentCurrentAssets? Permanentcurrentassetsarethenormallevelofstockanddebtorsthatthecompanyneedsinorderto keepthebusinessgoing.Thecompanywillalwaysneedacertainamountofstockandhavingsellthese stocktheywillhavethelevelofdebtorsthatresultfromsellingthesestock. WhatareFluctuatingCurrentAssets? Thesearethelevelsofcurrentassetsthatfluctuateupanddownwiththeseasonalnatureofthe business. AggressiveFundingPolicy: Thisiswheretheorganisationusesshorttermfundstofinanceitspermanentworkingcapital.Thisis cheaperbuthighriskbecauseshorttermfundscanberecalledondemand. ConservativeFundingPolicy: Thisiswheretheorganisationuseslongtermfundingforthepermanentworkingcapital. WhataresomeShorttermSourcesofFinance? Factoringthedebtsofthecompanyareeffectivelysoldtoafactor InvoiceDiscountingselectedinvoicesareusedassecurityagainstwhichthecompanymay borrowfunds. TradeCreditthedelayofpaymenttosuppliersoncreditterms,nointerestfunding OverdraftsShorttermborrowingsfromafinancialinstitution BankLoansLoansbetweenoneandthreeyears BillsofExchangeanagreementtopayacertainamountatacertaindateinthefuture

AssetSpecificSourcesofFinance HiredPurchase FinanceLease OperatingLease

Whataretheadvantages/disadvantagestoofferingCredit? Advantages Offeringcreditencouragescustomerstotakeupourgoods

Disadvantages Baddebts Slowpayersthatincreaseworkingcapital Administrationofthesalesledger Debtcollection

CreditManagement Therearethreeaspectstocreditmanagement: Assessingcreditstatus Decidingthetermsonwhichcreditwillbeoffered DaytoDaymanagement

HowtoassesscreditstatusBankreferences,tradereferences,publishedaccounts,creditrating agenciesandcompanysownsalesrecords. Howdowecalculatethecostoffinancingreceivables? Thereceivablebalanceneedstobefinancedanditisimportantthatacompanyknowshowmuchthe receivablesarecostingitinthecourseofayear.Theinterestratetobeappliedtoreceivableswill usuallybetheoverdraftratethatisfinancingtheworkingcapital. Interestcost=ReceivablesbalanceXInterestrate Discounts Discountsencouragecustomerstopayearly.Thecostofthediscountisbalancedagainstthesavingsthe companyreceivedfromalowerreceivablesbalanceandashorteraveragecollectingperiod. Advantages/Disadvantagesofearlysettlementdiscounts: Advantages: Earlypaymentreducesthedebtorbalanceandhencetheinterestcharge Reducesbaddebtsarising

Disadvantages: Ifdiscountsaretoohighitwillcostthecompany

Ifdiscountsaretoolowmanycustomerswillnottakeit Greateruncertaintyastowhowillpayearlyandwhowillnot Maynotreducebaddebts Customermaypayovernormaltermbutsilltakethecashdiscount

Whatisfactoring? Theyarethreemainfactoringservices: DebtcollectionandAdministration Creditinsurancewithrecourseandwithoutrecourse Financing

Whataretheadvantages/disadvantagesoffactoring? Advantages: Improvecashflow Savingsoninternaladministrationcosts Usefulforsmallandfastgrowingorganisationswhocreditdepartmentmaynotbeabletokeep up Reductionintheneedfordaytodaymanagementcontrol Debtcollectionisoutsourcedthereforemanagershavemoretimetoruntheorganisation Thefactorismoreexperienceatenforcingcredittermsleadingtolowerlevelofoutstanding debts

Disadvantages: Itismorecostlythananefficientlyruninternalcreditcontroldepartment Factoringhasabadreputationassociatedwithfailingcompaniesandthismaycausecustomers tobeconcernedthatthecompanyhascashflowproblems/failinghencetheymaynotfeel confidenttocontinuebusiness Customersdonotlikedealingwithafactor. Customersliketothinkthattheirsupplierscanmanagetheirownaffairs Difficulttoreverttoaninternalcreditcontrol Factorsaremoreaggressivetowardsthecompanyscustomersbecausetheirmainconcernis collectionandnotcustomercare

ManagingInventory Thereneedstobebalancebetweenthebenefitsandcostofholdingstock.Thebenefitsofholdingstock arethatitallowsthebusinesstosellarangeofgoodswhichisimmediatelyavailabletocustomers. However,holdingstockincurscosts,inparticular,opportunitycostofmoneytiedupinstock.

Theyarefourtypesofcostassociatedwithstock: 1. 2. 3. 4. Orderingcost Holdingcost Stockoutcost Purchasecost

Orderingcostsarethecostsrelatingtotheplacingoforders.Theseincludeclerical,administrativeand theaccountingcostsofplacinganorderandexcludesthecostsofthematerialsordered. Holdingcostsisthetotalannualcostofholdingorders.Theseincludethewarehousingandcostrelated tostoring/holdingstockandexcludethecostsofthematerialsordered. Stockoutcostsarethecostsrelatingtothelostcontributionthroughlossofsales,thelostfuture contributionthroughlossofcustomers,thecostofemergencyordersofmaterialsandthecostof productionstoppages. Purchasecostsarethecostofwhatisbought. WhatistheEconomicOrderQuantity? Theeconomicorderquantityisthereorderquantitywhichminimisesthetotalcostofholdingand orderingmaterialsoveragiventimeperiod.Thesizeoftheorderplacedwillaffectthetotalholding costsandorderingcostsovertheyear.Ifthecompanyhasapolicyofplacinglargeordersratherthan smallordersthenthetotalannualholdingcostswillincrease.However,iftheordersizeincreasesthe numberofordersneededtosatisfytheyearssaleswilldecreaseandsothetotalannualcostofplacing theorderswillfall. JustInTime Thebasicaimistoeliminateorminimiseinventory.Thetheoryholdsthatstockisonlyneededifthere areinefficienciesintheproductionprocess,thatis,thebusinessneedstockbecausetheycannot scheduletheworkaccurately,qualityproblems,inflexibleworkpractices.TheideabehindJustintimeis thatifyoucaneliminatetheinefficienciesandcanplananddeliverproductionprocesstoafixedtime scheduletheninventoryiseitherunnecessaryoratleastminimised.However,forthistoworkthe suppliersmustalsobeJITsuppliers. ManagingCash: Cashlikeinventoryisanotherbalancingact,thecompanyneedscashtobeabletorunthebusiness whileatthesametimetryingnottokeepidlecashwhichgenerateslittleornoreturnandcostsmoney tofund.

Therearethreemethodsformanagingcash: 1. MillerOrrmodel 2. Baumolmodel 3. Cashbudget TheMillerOrrModel: Thisisamodelthatconsidersthelevelofcashthatshouldbeheldinanenvironmentofuncertainty. Thisinvolvesstudyingthecashmovementoveraperiodoftimetogetagoodideaofhowcash fluctuateswithnocontrolsinplace.Theorganisationwillthensetlowerandupperlimits.Theselimits aresetusingaformula(givenintheexam).Ifthecashexceedstheupperlimit,theexcesscashshould beinvested.Ifthecashfallsbelowthelowerlimit,morecashisneededinordertobeabletooperate. Transactioncostisthecostofinvestingorrealisingcashasthelimitsarereached. Varianceisameasureofuncertaintyordispersion. Interestrateistherateofinterestperday. Theupperlimitissimplythelowerlimitplusthespread Returnpoint=lowerlimit+1/3ofthespread) Themodelisbasedonuncertaintyofcashflows Themodelisdesignedtoofferawayofcontrollingcashbalancesonadaytodaybasis Ifthetransactioncostincreasesthespreadincreasesandviceversa Iftheinterestrateincreasesthespreaddecreasesandviceversa

BaumolModel ThisissimplytheuseoftheEOQmodeltomanagecash. CashBudgets Acashbudgetisastatementofalltheinflowsandoutflowsofcashforagivenperiod.Weareonly concernedwiththeinflowandoutflowsofcash.Noncashflowssuchasdepreciationareignored. THEEND.