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FACULTY OF BUSINESS AND LAW

PROGRAM: BA [HONS] ACCOUNTING & FINANCIAL MANAGEMENT

MODULE: STRATEGIC MANAGEMENT ACCOUNTING MODULE CODE: APC309 MODULE TUTOR: MR MIKE BAKER SUBMISSION DATE: 22ND MAY, 2009

MANAGEMENT REPORT ON MANAGING BUDGETING SYSTEM & MANAGING WORKING CAPITAL

PREPARED BY 089003624 AUSTIN SAMS UDEH

Life changing changing
Word counts 3450

TABLE OF CONTENT 1.0 GENERAL INTRODUCTION 1.1 Budgeting, strategy and Organizational control system 1.2 Behavioural Aspect of budgeting BUDGETING PART I: TRADITIONAL BUDGETING SYSTEM 2.1 2.2
2.3

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2.0

Argument infavour of traditional budgeting Argument against traditional budgeting
ALTERNATIVES APPROACHES TO TRADITIONAL BUDGETING

2.3.1 Better budgeting approach 2.3.1.1 Zero-Based Budgeting 2.3.1.2 Rolling Budget & forecasts 2.3.1.3 Activity-based budgeting 2.3.1.4 Balanced Scorecard 2.3.2 Beyond budgeting approach
2.4 BUDGETING SYSTEMS & BUSINESS ENVIRONMENT

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2.4.1 Budgeting system and Stable environment 2.4.2 Budgeting system and Dynamic environment 3.0 MANAGEM ANAGEMT PART II: WORKING CAPITAL MANAGEMT 3.1 Objectives and Components of Working capital 3.2 3.3 Working Capital cycle of a manufacturing firm Improving the working capital cycle 3.3.1 Management of inventory 3.3.2 Management of debtors 3.3.3 Management of cash 3.3.4 Management of payables 4.0 5.0
CONCLUSION REFERENCES REFERENCES

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[1990]. Figure [1] Phases of management control system [University of Sunderland. [1981. Accounting theorists have long recognized that traditional accounting information provides critical decision-influencing and decision-facilitating information for organizational control [ e. [1996]. Bromwich. 1988. 1983].0 GENERAL INTRODUCTION I t is an established dictum that. The quest to overcome the weakness in traditional management accounting system gave birth to “Strategic Management accounting2”. at the heart of the managerial control functions is budgeting and budgetary control [as depicted in fig.1. [1995]. 3 . Wilson. Tiessen and Waterhouse. [1987]. Cooper and Kaplan [1988]. Shank & Govindarajan. 2007]. Dixon. that traditional management accounting systems is incompatible with modern production systems. The end is to facilitate business strategy towards achieving success. 2 The notion of “strategic management accounting” centre’s around linking business strategy & budgeting. Lord. Simmonds. [1987].g Baiman [1982]. Umble and Srikanth. [1990]. [1998]. Philip Sadler. Unfortunately.[ 2003]. Johnson and Scholes.g Goldratt [1983]. Jayson. Snow & Hambrick. Tim Blumerntritt. [1980]. Birnberg et al. cited in Drury. and increasing competitive advantage with strategic accounting information see. shares similar views. 2008 p. [1998:55]. useful and timely information for planning and control in the rapidly changing and highly competitive business environment. [1998]. [2006]. 1 below]. Lying critically. 1985a. critics1 of management accounting argued that management accounting has failed to provide relevant. accounting is not an end in itself. 14 1 Critics of management accounting e. but a means to an end. Merchant. Kaplan and Johnson.

sales budget. 1992:85]. Both operational budget4 and financial budget5 are usually transformed into what is known as the “master budget” as an overall financial plan for the fiscal year ahead. 2000. quantitatively expressed. et al. where are we going? And how do we get there? 4 The operational budget has components such as. Merchant and Van der Stede. organizational strategy help provides answers to questions such as “where are we now?. 2003] has received an overwhelming popularity in recent times.1. 1994:171] are operational and financial budgets. Administrative expense budgets etc 5 Financial budget comprises of the cash budget. production budget. showing where an organization is heading and how to get there. Terry Lucey. The two basic categories of budgets [Cohen. Budget has been defined as a “predictive model” of organizational activity. (See figure 3 below). budgetary control is a technique whereby actual results are compared with budgets and corrective actions are taken should there arise any variance. 1975. and budgeted balance sheets 3 4 . regarding it strategic role in organizational control system. 2006. Fredrick. 2001. While budget can simply be likened to a ‘financial road-map3. R&D budget. while budget is been likened to a financial road map. F Figure [2] components of Master’s budget Budgeting and organizational strategy.1 Budgeting. Strategy and Organizational control system Budgeting as a conventional tool for management control system [Ekholm and Walin. budgeted profit and loss. for a set time period “or simply a plan that is measurable and timely [Bruns & Waterhouse. Proctor.

7 Researches on the behavioural effects of budget e.2 Behavioural aspect of budgeting The effectiveness of budgeting and budgetary control depends largely on the behavior and attitudes of managers6 and possibly other employees [CIMA. [1952]. [1968]. Horngren etal.1. human factor in budgeting process has a negative effect. Figure [2] the effect of level of budget difficulty on motivation and performance Budget is positive and good for the organization when used as a motivating factor. 2007]. Researches7 on the behavioural effects of budget concludes that improperly administered budget is capable of generating conflicts in an organization (see fig. 2 below). concludes that improperly administered budget is capable of generating conflicts in an organization 6 5 . [2005: 491]. Hofstede. Hopwood. Ironically.[1960]. [1974]. Vroom.g Argyris. The lesson here for managers is that care should be exercise in budget design and implementation.

Their argument concludes that by implication. [1972]. Kral.2005). At the forefront of anti-budgeting crusade with several titles9. a typical manufacturing organization. [1977]. took an entirely different view by questioning the relevance of budgeting in recent times. Atrill and Mclaney. see Bruns & Waterhouse [1975].Researches on the purpose of budgeting and budgetary control concludes that budget serves a multiple of roles8 in an organization [Emmanuel etal. 6 . Horngren etal. The report is in two main parts: while part one critically analyses argument infavour and against the “traditional budgeting and budgetary control” in the light of its suitability to stable and dynamic business environment. [2006].. Khalladwalla. planning versus motivation) equally well. [1984]. a means of motivating organizational participants and a vehicles for performance evaluation and control. Churchill. [2005]. The central purpose of budget as summarized by CIMA. Although authors such as Barrett and Fraser. different purposes of budgetary control systems cannot be the same if they are in conflict. Fibirova etal. Ronald Hilton. Fraser & Hope [2005]. part two extensively discusses managing working capital cycle of xyz limited. [2001:242] have claimed that a given budgetary control system cannot serve multiple purposes (e. planning versus performance evaluation. [2000]. Epstein and Manzoni. [2008]. Merchant. Drury. [2008]. [2007]. Anthony & Govindarajan.(ed. Merchant and Manzoni. canvassing for “dismantling” the budgeting system”is BBRT. “Time to Replace traditional budgeting”.g. Drury. [2002]. 8 9 The multiple roles of the budget e. [1989]. McWatters. a means of authorizing actions. Morse and Zimmerman. 1990 cited in Bhimani. [1984]. The crucial role of the budget as an organizational control tool has long been recognized. focus for forecasting and compel planning a channel of communication and enhance coordination. [2008]. [2007] includes. [2008: 348]. Unfortunately. g “The End of traditional Budgeting”. “Traditional Budgeting time is Up” etc].

[p. 2. 13 10 The name given to ‘Better budgeting’ and ‘Beyond Budgeting’ techniques 7 .0 TRADITIONAL BUDGETING SYSTEM TRADITIONAL Research conducted by Kennedy and Dugdale. and the top-down approach12. helps in promoting a coalition of interest and increase motivation and saves managerial time an attention directed to areas of greatest concern by the exception principle at the heart of budgetary control. cited in better budgeting forum report. it must be properly designed and administered. for benefits and problems. based next year’s budget on the current year’s results plus an amount for estimated growth or inflation [CIMA. Traditionally. more controllable. See [appendix 4]. this type of budgeting system can be performed in several ways. Traditional budgeting system basically. a budget is agreed.an initial estimate is prepared by the centre. 2004]. Terry Lucey. 12 In top-down approach . 2004:2] claimed that today. has claimed that benefit from traditional budgeting system does not accrue automatically.unit managers prepare their own budgets and these are reviewed and consolidated by a central department. [1999. the two extremes are. It simply assumes that the activities will continue in the same fashion in an approach described as incremental budgeting system. 99% of European and US companies are still using traditional budgeting system10 and have no intention of abandoning it. has argue that traditional budgeting is simpler.2] of the same report stated that up to 60% of those companies still claim that they are not wholly satisfied with the traditional budgeting system but are working assiduously to improving the system. Changes are then suggested from the centre and eventually. Paradoxically.1 Argument in favour of traditional budgeting It seems reasonable to describe traditional budgeting as a historic bag containing both benefits and problems within it. [2003: 204. coordination. 11 In bottom-up approach. an important medium for communication. This is then expanded by unit managers to form a detailed budget. Lucey further explains. flexible than advanced budgeting techniques13 and more likely to be the appropriate budgeting system for a firm operating in a stable market. after some negotiation.2. that its a major formal way of translating organizational objectives into plans. with targets for each unit. Wildavsky et al. are the bottom-up11. easier. [2001:147].

1992:99. and are often a barrier to change. Business process: budgets are time consuming and costly to put together.2 Argument against traditional budgeting Traditional budgeting has for long been criticized for its inadequacy as a means of management control. classify weaknesses in traditional budgeting practices under three principal headings. and budgets encourage gaming and vicious behavior. 2007] is that. (1987) seminal book titled “Relevance Lost. Terry Lucey. Competitive Strategy: budgets are rarely strategically focused and are often contradictory. Criticisms of its inadequacy in the fast-changing business world dates back to mid 1980’s with the emergence of Johnson & Kaplan. Horngren et al 2005. Adams et al [2003: 23]. 2005. [1997]. budgets do not reflect the emerging network structures that organizations are adopting. [1999]. and budgets make people feel undervalued. Hope and Fraser.” The classical weaknesses inherent in traditional budgeting system as commonly examined by authors [ e. budgets constrain responsiveness and flexibility. Drury. For a better understanding. from research conducted by Cranfield School of management as. budgets are based on unsupported assumptions and guesswork. view traditional budgeting process as bureaucratic and protracted. Bunce and Fraser. Organizational capability: budgets strengthen vertical command and control. full of inefficiencies and ineffectiveness. and budgets add little value.g Alan Upchurch 2002:495.usually annually. Fraser and Hope. budgets reinforce departmental barriers rather than encourage knowledge sharing. Fanning. past will dominate the future. 8 . budgets concentrate on cost reduction and not on value creation.they turn to be bureaucratic and discourage creative thinking. with past inefficiencies being carried forward to future periods. [1997]. budgets are developed and updated too infrequently.2.

a. better budgeting report.com/index. Better budgeting group led by CIMA and ICAEW16 The approach advocates17 improvement to traditional budgeting system [Fanning. to infer that flaws14 in traditional budgeting system collectively results in business underperformance and an alternative system is needed.3. 9 . 15 16 17 Source:www. more adaptive. The current debate on the appropriate alternatives to traditional budgeting system has two approaches namely. Now.1 Zero-based budgeting In an attempt to overcome the weaknesses in traditional budgeting system. Better budgeting report. Zero-based approach was born to help find answers to two basic questions: “Are current activities efficient and effective?” and should current activities be eliminated or reduced to fund higher-priority?” ZBB is an approach that tries to find answers to these questions by using a decision-package ranking 14 The implications of flaws in traditional system tend towards promoting inward-looking. 2004:2] b.3 Alternative approaches to traditional system It is quite interesting to know that no other innovations in management accounting research have ever triggered such an overwhelming.com Improving the traditional budgeting system with tools such as rolling forecasts. [1997]. a decentralized and participative model. 1999.Drawing from the foregoing. focuses on achieving a budget figure.[ 2007:196]. 2. rather than on implementing business strategy and shareholder value creation over a long-term. balance scorecard etc to make budget forward-looking. flexible and dynamic to cope with the fast-changing environment rather than abandoning it. its seems logical. Atrill & Mclaney. Hope and Fraser. 18 Better Budgeting Reports available at http://www. highly divergence views and yet-unresolved debate than that of alternative to traditional budgeting system15.bbrt.icaew. what is the appropriate alternative to replace the traditional budgeting system? Is the question begging for an answer. [2004:2]. Movement of alternative to traditional budgeting system as initiated by practitioners in Europe and U. 2. that the whole budgeting system be abolished and be replaced with a more pragmatic.S. See. Beyond budgeting group led by BBRT18 The “beyond budgeting” approach advocates19 a radical changes to budgeting process.cfm/route/117649/icaew_ga/pdf 19 It’s of the philosophy.

Firms operating in a rapidly changing industry have adopted a rolling budgets and forecasts. What seems difficult is that of integrating the effects of innovations into traditional budgeting system.2 Rolling Budgets and forecasts The struggle for survival in highly competitive business environment was long recognized by Herbert Spencer as early as 1851. at all times. 10 . This process provides management with an operational tool to evaluate and allocate its resources efficiently and effectively. when he coined a phrase “survival of the fittest”21. evaluating and communicating his activities and alternatives to higher levels of management 21 In 1851. 2007. The major benefits includes. Herbert Spencer coin the phrase “Survival of the fittest” to explain competition in free market economies. 1977]. Atrill and Mclaney. Business must be flexible and innovative. 22 20 Rolling budget is often called “budget for life” by many. consume managerial time and involves high volumes of paper work. Rolling budget is simply a quantitative plans that is continually updated or simply “budget for life22”. high degree of skill in it construction. thereby ensuring that.3. This approach basically involves preparing one budget for each centre from a zero base and that each cost element be specifically justified to be included in the next year’s budget. A rolling budget [Drury. in an effort trying to overcome the rigidity in traditional systems and to cope with uncertainties [Hayes. 2002:116]. providing individual manager a system for identifying. efficient allocation of resources. and there will be a budget for a full planning period. removal of inefficiencies and obsolete operations. 2007:173] will add a new month to replace the month that has just passed.process 20 [Pyhrr. Figure [3 below] compare four-quarter rolling with traditional calendar-based budget. Weaknesses on the other hand includes. is where fixed annual budget is in use. 2. to worsen the case.

rolling forecasts are used side-by-side with a budget but not to replace the budget. Rolling budget & forecasts Benefits and problems of rolling budgets and forecasts The classical benefits of continuous budgets as noted in Horngren. In practice23. up-to-date budget. managers and employees must forecast responsibly every month or quarter instead of annually under traditional budgeting which increases work and cost related to budgeting. Foster. its encourage business managers to think of planning as an ongoing process rather than as a one–off events. highly expensive24. 23 In practice. but rather triggered by important events and changes. Datar. 24 Expensive to run because. 11 . One may ask “does rolling budget have weaknesses?” Yes. the approach consume reasonable time. 2003:196 Figure 3. [2000:182]. Often. [2007:270] is that.CALENDAR YEARS 2008 2009 Source: Axson. real time response to rapidly changing environment is another pronounced benefits of rolling budgets and forecasts and planning is not dictated by the calendar. Fixed traditional budget vs. it usually result in a more accurate. a number of budgets must be produced during the year. managers and employees must forecast responsibly every month or quarterly instead of annually. incorporating the most current information available. it play significant role in organization planning. Drury.

products consume activities and activities in turns consume costs” [Proctor.3 Activity-Based Budgeting The problems of inaccurate cost information25 for decision-making gave birth to activity-based costing with philosophy based on causation links clearly worded by proctor below. Figure [4 ] Activity-Based Budgeting is Activity-Based Costing reversed The traditional approach to costing was discovered to be misleading in terms of cost information and as a result. He called this chain of causations …. activities cause costs to be incurred.[1991].3. 243] Activity Based Budgeting model is new technique that link budgeting with organizational strategy which derives its philosophy from above causation link but in reverse. state that26: “Organization consume products. [2006] Causation link. products cause activities. Proctor. leads to suboptimal managerial decision-making.a causation link.2.Organization cause products to be produced. referred to activity-based budgeting as activity based costing in reverse [see figure 4 below]. Cooper and Kaplan [1998] & Brimson. 25 12 . Precisely. An efforts to address the problem gave birth to ABC 26 Proctor. 2006 p.

Atrill and Mclaney. improved pricing and outsourcing decisions is more reasonable and real[CIMA. its compatibility with other costing systems is a major weakness. 2007 27 The Managers of innovative firms employ balanced scorecard to manage their long term strategy as this is more than a tactical or operational measurement mechanism. ABB equally has its own weaknesses. Its basically help managers27 to see clearly whether the objectives set have actually been achieved.The benefits and weakness of ABB A critical analysis reveals that benefits of ABB outweigh it associated problems. accurate product costing. 2. 2005]. 13 . The central idea of balanced scorecard is translating organizational mission.3. 2007:314]. The information about costs is more scientific and relevant.4 The balanced Scorecard The constant search for appropriate alternative to traditional performance measurement and management led to the development of balanced scorecard by Kaplan and Norton of Harvard Business School.1999: 373. 1996. aims and strategy into a comprehensive set of performance measures that provides the framework for a strategy measurement and management [Kaplan and Norton. Otley. The balanced scorecard measures organizational performance across four main areas as depicted in figure 5 below [Atrill and Mclaney. its increases links between budgeting and strategic planning.

Translating Vision and Strategy Figure [5] Balance scorecard Benefits and problems of balanced scorecard The most significant benefit of BSC ones is translating of strategy into measurable parameters. The superiority of BSc over traditional budgeting system is obvious but it lacks a well-defined strategy and the use of generic metrics are some of it major pitfalls [Mohan. 14 . communication of strategy and aligning individual goals with the firm’s strategic objectives. increase creativity. 2007:196]. 2004] The Beyond budgeting model The “beyond budgeting” movement advocates a radical changes to budgeting process. The central theme of beyond budgeting model is that the whole budgeting system be replaced with a more pragmatic and adaptive model [Atrill & Mclaney.

Beyond Budgeting Round Table 15 .The BBRT28 maintains that “better budgeting” is not the answer to problems of traditional planning and budgeting caused by fast-changing business world [Better budgeting report. 2004:8]. Adding that the only radical way is by “dismantling budgeting system and move towards” a more adaptive planning model as depicted in figure [5] below. Figure 5 Tradtional versus Beyond budgeting model Benefits and problems of beyond budgeting 28 BBRT.denote.

Unfortunately. A snapshot of how various techniques discussed above has been able to attack a specific weakness of traditional budgeting is diagrammatically represented in Figure [6] below. Figure [6] A snapshot of attach launched to address weaknesses in traditional budgeting system In reality. ABM or rolling forecasts. beyond budgeting is only a set of best practices which requires a combination of management tools to be customized29 to firm’s budgeting system for the model to work. its eradicate the traditional mentality of performance measurement and in the fast-changing business environment.One of the fundamental benefits of the model as opined by Fraser & Hope is that. the “adaptive” model enables quick response to changing circumstances. should be ideal candidates for the Beyond Budgeting model. only companies that operates in a highly competitive market and have successfully implement various management tools such as BSC. 29 16 .

Apart from been the most compatible budgeting system with other costing approaches and less expensive. Traditional budgeting is simpler. in such environment.2 Dynamic environment Dynamism in today’s business environment renders a rigid approach to budgeting and budgetary control obsolete [ Adams et al 2003. drawing from critical evaluation of various budgeting approaches.4. say’s that an unpredictable corporate environment makes it difficult to prepare plans in advance. industry and general business environment of operations. 2. 2. and flexible than advanced budgeting techniques30 and the most appropriate for a firm operating in a stable market. [1993]. Hope and Fraser.1 The Stable environment For the purpose of this report. more controllable.4. 17 . 30 31 The name given to ‘Better budgeting’ and ‘Beyond Budgeting’ techniques Zero-based. flexible budgeting. It seems reasonable. Budgeting system must be aligned with organization’s strategic planning on a continuous basis towards responding to the ever-changing needs of customers and compete successfully. 1997]. Therefore. and in terms of either its products or demand on a year to year basis. There is no doubt of the suitability of rolling budget/ forecasts in the presence of other approaches31.4 BUDGETING SYSTEM & BUSINESS ENVIRONMENT An appropriate budgeting system for an Organization largely depends on the nature. rolling budgeting proves effective as it increases the frequency of feedback as well as budget revisions by shortening the budget period. to recommend traditional budgeting for a firm in a stable environment. rolling budget is recommended for firm operating in a dynamic market. Kaizen budgeting. a business is said to operate in a relatively stable environment when there is little changes in method of operations.BUSINESS 2. see figure [3] above. This report makes recommendations of appropriate budgeting system for business operating in a stable and dynamic market below. Tanaka. probabilistic budgeting etc. easier. Activity based.

The term “Working capital” as used by authors e. The concept of “working capital33”is a fundamental concept in finance literature. first to the monumental work of Karl Max’s. working capital management will direct impact on corporate profitability and liquidity [Shin & Soenen. Ross & Westerfield. Proctor. 18 . 2006). [2004]. Both may be right. [1999]. that while “gross working capital” is the total investment in current assets. Most likely. The accountant major concern is arithmetical accuracy of the two sides of the balance sheet while the analyst concerns is to find fund for each items of current assets at such costs and risks that the evolving financial structure remains balanced between the two.3.Vice President. “net working capital” is the term used to describe net investment in short-term assets. 2006]. there is virtually no other “sensitive” aspect of business organization that boosts performance when efficiently managed and drag an organization prematurely into bankruptcy when inefficiently managed than working capital. Hence. Arnold. Naughton . A clear specification of 32 Todd R. [2007]. because concerns of the accountant differ from that of the financial analyst. [2004]. pike & Neale. discussions of this nature should start clearly with the meaning of working capital. [2006]. Watson & Head.”Das Kapital” (1867.0 PART II: WORKING CAPITAL MANAGEMENT Fundamentally. objectives and policies are required to help achieve success. though has been a source of controversy34 on the true meaning of working capital as the concept is easily misunderstood even among board members and professionals managers [Bhattacharya.g Atrill and Mclaney. [2003]. 1993]. cited in Bhattacharya. Karl Max constracts in his word “constant capital” vs “variable capital” and the working capital as we understand today was originally embedded in his “variable capital”. Managing working capital simply denotes the administration of the firm’s current assets and the financing needed to support current assets. Studies have shown that 85% of bankrupt companies around the world have been traced to poor working capital management. The quote of Naughton32 that “a well-managed working capital can be a competitive advantage to a firm” is a confirmation of the importance of working capital management to the firm. They added further. 34 33 While an accountant will regard working capital as the excess of current assets over current liabilities and call this “net working capital” a financial analyst will consider gross current assets as working capital. Finance Zebra Technologies Corporation The concept was traceable. is simply current assets less current liabilities.

For meeting day-to-day cash flow needs. argued that while liquidity is needed for a firm to operate. debtors. 1936]. Interest and Money available at http://www. inventory of raw materials.M Keynes (1936). 37 There is a trade-off between the two primary objectives of liquidity and profitability in practice. [2004]. 2004].org/reference/subject/economics/keynes/general-theory/ 19 . liquidity and profitability objectives37 are not easily achieved at the same time as both often conflicts in practice. 2008). pay wages and salaries when they fall due. are the main objectives of working capital management. Arnold. 2004. In addition. overdrafts and short-term loans. Watson & Head. 1984. Proctor. The General Theory of Employment. Watson and Head. work-in-progress. 2007. a firm may choose to hold more cash than is needed for transactional motive38 [ Keynes. Finance managers should strive for a balance between liquidity and profitability. University of Sunderland. 2004.1 THE OBJECTIVE AND COMPONENTS OF WORKING CAPITAL In a typical manufacturing firm like xyz ltd. On this ground. Unfortunately.e sources of finance] may includes. minimization of risk and maximizing returns on assets from current assets still fall under the objective [Arnold. pay creditors. pay taxes and providers of capital and ensure the long term survival of the business entity 36 Adequate liquidity & profitability [Pass and pike. 35 38 J. The two main objectives of working capital management are. trade creditors. to maintain sufficient liquidity35 for effective and efficient functioning and to improve the profitability of the business36 [Watson and Head.marxists. 2006.3. Atrill and Mclaney. [2004]. short-term investments and cash while current liabilities [i. finished goods. This report emphasis on the concept of time value of money and that Cash kept in safe generate no returns which otherwise should have earned should it be deposited in a bank for a time period. the basic elements of investment in current asset may includes.

2004]. Figure 2 [a] Principles of working capital management [b] working capital policies The principle holds that the inability of a firm to meet its short term obligations. 39 20 . 2007]. Management who prefers to minimize risk by maintaining a higher level of current assets or working capital end up making low returns. equity position. Stressing further. 2006. that the higher the risk the lower is the cost and lowers the risk. Management should always strike to achieve a proper balance between these two.Working capital Policies and Principles Experience has shown that firms only achieve these objectives with clear working capital policy and principles [i. in terms of risk and returns [Proctor. The level of investment in working capital is directly dependent on the firms policies regarding the level of current assets considered sufficiently and reasonably safe. higher is the cost of capital. as they fall due breeds risk and stresses the inverse relationship between the degree of risk and return(profitability). 41 The Principles of equity position is concerned with planning the total investment in Current Asset in such that every pounds invested in the current assets should contribute to the net worth of the firm. 40 The principle of cost of capital indicated the existence of a strong correlation between risks and cost of capital. Pike & Neale. 42 This principle holds the need for adequate planning for sources of finance for working capital and that firms should make every effort to relate maturities of payment to its flow of internally generated funds. cost of capital40 . 2003.e Principle of Risk variation39 .41 and maturity of payment42] regarding the quantum of various components of working capital required as depicted in figure 1 below [Kavitha. Watson & Head.

which simply matches’ assets and liabilities ie long term sources to finance fixed assets and permanent current assets and short term financing for temporary current assets. 44 Firms may decide to adopt approach called matching [moderate] policy. 3. each of the boxes can be seen as tanks through which funds constantly flow into and out of them resulting from daily activities Figure 3 Source: adapted from [Arnold. Firms may decide to adopt approach called matching policy. it takes high-risk where short term funds are used to a very high degree to finance all current and even part of fixed assets and the returns are usually high. While the upper part of the diagram in blue boxes shows a simplified chain of events in xyz. which simply matches’ assets and liabilities ie long term sources to finance fixed assets and permanent current assets and short term financing for temporary current assets. 43 21 .2 Working capital cycle of a XYZ ltd Working capital cycle is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer46 [Watson & Head. depending on risk taking capability as adoption of any of the approaches specific impact on corporate profitability. Figure [3] below depict a typical working capital cycle of a manufacturing firm. firms prefers to hold more cash on hands and finance part of the current assets with long term funds which are more expensive.Firms may adopt conservative43. 2004]. This actually leads to low-risk but with associated low returns as excess cash in hand yield no returns. moderate44 and aggressive45 working capital policies [see figure 2b] above. 45 When a firm adopts aggressive policy. 2004] Figure [4] working capital cycle of manufacturing firm In conservative policy.

This report emphasis seriously. Figure [5] implications of overcapitalization and undercapitalization 3. raw material.3.3.3 Improving the Working capital cycle of Xyz Ltd Improvement in working capital cycle of xyz ltd requires efficient management of the various components of working capital.1 Managing inventory One of the most significant components of working capital of xyz with considerable impacts on corporate profitability is the inventory. A fundamental question in 22 . Manufacturing concern hold three classes of inventory namely. semi-finished goods and finished goods. on the implications of overcapitalization and overtrading as shown in figure [3] below.

requires efficient inventory management which in turn needs.g EOQ.inventory management is why firms hold stock? A good inventory management should address strategic inventory management questions shown on figure 3. To improve the working capital cycle. Xyz holds inventories for several motives.g e. but the most common is that of meeting the day-today production and customers demand requirements. Figure [5] Inventory trade-off [Risk of too low or too high 23 . there is always a trade –off of risk of too low and tool high inventory. JIT. So. ERP. appropriate forecast for future customer demand.MRP etc] to strike a balance between inventory trade-off as shown in figure[5]. Holding inventory is associated with costs. applying the use of models[ e. good recording & re-ordering system.

M Keynes (1936). Maynard Rafuse.emeraldinsight. cash budget are essentially good cash management tools.3. transactionary motives means holding cash for day-to-day operations. firms prefer to hold part of their assets in the form of cash for what they described as “transactionary”. xyz policy of giving customers cash discount encourages prompt (earlier) collection of receivables.com/Insight 24 . [1996]52. the use of factor agents where necessary and analysis of debtors and probably stop the supply of more goods to customers with load of excuses. London.org/reference/subject/economics/keynes/general-theory/ According to Keynesian economists. To improve cash inflow and outflow. 51 Exercising control over inflows and outflows of cash balance with models such as: upper and lower limit. Cash is the most sensitive components of working capital of firms of all kinds and may be held for reasons identified above.2 Managing of Debtors Strategically.3.3 Cash management The fundamental question48 of why do xyz ltd holds cash saw what is regarded as a convincing answer in the work of J. speculative motives denote holding cash for profit reason and precautionary motives is holding cash for emergency in the future. xyz may have allowed credit to their customers in attempt to the achieve corporate objective of gaining good market share and in order to improve working capital cycle. UK available @ http: //www. efficient debtors’ management which aim at striking a balancing the risk of illiquidity as consequence of reasonable amount in customers hands and losing customers. cash budgeting model. 52 50 Managing Director. should address certain questions47. speculative” and precautionary50” motive. The General Theory available at http://www. Process Analysis and Stock Management Consultants.3. 49J. The Keynesian economists posit that. 3. such as upper & lower limit cash balance. models51.M Keynes [1936]49. Bennecon Limited.marxists. Xyz should always make provision for bad and doubtful debts for the purpose of planning while finance managers are warn of the use of factoring agent in debt collection for it implications. noted that improving working capital cycle by delaying payment to creditors is counter-productive and has implication of reducing xyz credit standing with its 47 Do we allow all customers credit? Who should receive credit? Are there criteria for checking credit worthiness of customers? What is potential customers score for 5Cs of credit? What is the maximum credit period allowed to customers? How much credit do we allow? How do we encourage prompt payment? 48 Why do we prefer to hold part our assets in the form cash? How much cash should be held? Does amount of cash held impact on profitability? Studies have shown that cash management policies of successful firms tend to provide answers to these questions. cash operating cycles models are good means of enhancing cash management.

The shorter the cash operating cycle the better for xyz ltd [see figure 4 below]. Xyz can opt for earlier payment from customers and delay to make payments on the last due dates or negotiate for extension with their suppliers all aimed at boosting cash flows. 2007 p. 2006]. Outlined in figure [3] are. Proctor. Operating cash cycle Cash operating cycle is basically. the time lapse between cash out and cash in from sales. other techniques for improving cash management [Atrill and Mclaney. Although caution must be taken in reducing the level of inventory as consideration should be given to current customers demand. inventory reduction generates system-wide financial improvements. 2007. xyz should invest in marketable securities and sell the securities or arrange to borrow when cash shortage are envisaged through the cash budget.suppliers. Operating cash cycle 25 . In period of surplus cash. Source: [Atrill and Mclaney. 410] Figure 4. He added that.

their suppliers and other sundry creditors desires serious attention as an important element of working capital cycle. According to Maynard. recievables.3. suggestions on ways to reduce the length of cash operating cycle includes. the survival of the fittest . who in turn enforce their terms with those smaller yet. 26 . [1996]. making payments on the due date and negotiating a better credit terms are steps towards improving the trade payables [see figure 3]. and extending the period of credit taken to pay suppliers could all help. according to Maynard.0 Conclusion Efficient working capital cycle lies at the heart of successful firms. creditors’ management is essentially a Darwinian situation54. Negotiating a long period of payment with suppliers. playing increasing role towards shareholders wealth maximization. 4. Xyz manufacturing limited can successively improves its working capital cycle by optimizing inventory. 3. cash and payables.While Besley and Brigham. Care must be taken in employing delay tactics with suppliers. Large companies enforce their terms with smaller com panies. 54 53 Darwinian situation. offering discounts. lowering the level of inventories held. charging interests on overdue accounts. (2007). (2005) confirm that. The strategy of delaying payment to creditors may reduce xyz credit rating as suppliers may simply misconstrue the financial situation of xyz for a symptom of working capital deterioration which may brings drastic restrictions on supplies. described as implicit loan from suppliers. To improve the working capital cycle. summary of strategic approaches employed in reducing the operating cash cycle53 are highlighted in figure appendix 1. the average cash conversion cycle of European firms are twice that of US firms.4 Managing trade payables Managing the relationship between xyz ltd. imposing tighter credit control. creditors management need to optimize the use of trade payables otherwise known as interest-free source of finance or what Brealey et al.

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