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Attention needs to be paid by a company in managing

 working capital
• Working capital = the requirement for cash to finance
any work from day-to-day basis, having paid out the costs
of production but not having received payment for any
work done.

• The working capital of a company = a company’s total
current assets.

• Current assets are made up of cash, stocks or raw
materials and those incorporated in work in progress, the
debtors of the company or current accounts receivable
and short-term securities.

• Short-term securities may, for example, include tax
reserve certificates bought against the future payment of
company tax.
• Working capital is required by a company for many of its
regular short-term commitments:

• to pay salaries and wages
• to buy raw materials for the construction of the
• to pay for hiring and operating plant
• to provide the money required for the payment of
interest, dividends and taxes as they fall due
• to cover a delay between the expenditure on
resources and the payment for goods subsequently
• The restricted availability of working capital may often
limit the progress which the firm can make in expanding
its business by taking on new work.

• For a contractor, in order to have a ready and
continuous supply of working capital, it is desirable that a
firm is profitable.

• For a small firm, accurate and detailed consideration of
working capital requirements should be a particular
concern. (to avoid from turning to trade credit and bank
overdraft for finance purposes; may lead to increase their
current liabilities)
• It is necessary to have a plan and framework to ease
future operations.

• Forecast can be made depends on the future period
which it is intended to cover and the depth and extent of
relevant information which is available about the
economic, commercial and governmental activities
influencing the industry (five years is likely to be a
realistic period for most situations in construction).

• Among the most important items of working capital are
levels of inventory, accounts receivable, and accounts
payable. Analysts look at these items for signs of a
company's efficiency and financial strength.

• Take a simplistic case:

a spaghetti sauce company uses RM100 to build up its
inventory of tomatoes, onions, garlic, spices, etc.

A week later, the company assembles the ingredients into
sauce and ships it out.

A week after that, the cheque arrive from customers.

That RM100, which has been tied up for two weeks, is
the company's working capital.
• The quicker the company sells the spaghetti sauce,
the sooner the company can go out and buy new
ingredients, which will be made into more sauce sold at a

• If the ingredients sit in inventory for a month, company
cash is tied-up and can't be used to grow the spaghetti

• Even worse, the company can be left strapped for cash
when it needs to pay its bills and make investments.

• Working capital also gets trapped when customers do
not pay their invoices on time or suppliers get paid too
quickly or not fast enough.
• Normally, a big retailer like Carrefour has little to worry
about when it comes to accounts receivable: customers
pay for goods on the spot (cash).

• However, inventories represent the biggest problem for
retailers; as such, they must perform rigorous inventory
forecasting or they risk being out of business in a short
Formula of Working Capital Turnover Ratio:

• Following formula is used to calculate working capital
turnover ratio:

[Working Capital Turnover Ratio = Cost of Sales / Net
Working Capital]

• The two components of the ratio are cost of sales and
the net working capital.
• If the information about cost of sales is not available the
figure of sales may be taken as the numerator.
• Net working capital is found by deduction from the total
of the current assets and the total of the current

The working capital turnover ratio measure the efficiency
with which the working capital is being used by a firm. A
high ratio indicates efficient utilization of working capital
and a low ratio indicates otherwise. But a very high
working capital turnover ratio may also mean lack of
sufficient working capital which is not a good situation.

Calculate working capital turnover ratio

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital
Current Assets = RM10,000+RM5000+RM25,000+RM20,000
Current Liabilities = RM30,000
Net Working Capital = Current assets – Current liabilities
= RM60,000 − RM30,000
= RM30,000
The Working Capital Turnover Ratio = 150,000 / 30,000 = 5 times
Items RM
Cash 10,000
Bills Receivables 5,000
Sundry Debtors 25,000
Stock 20,000
Sundry Creditors 30,000
Cost of sales 150,000
Negative Working Capital Can Be Good ... Sometimes

• Some companies can generate cash so quickly they
actually have a negative working capital. This is
generally true of companies in the restaurant business
(McDonald's had a negative working capital of $698.5
million between 1999 and 2000). is
another example.

•This happens because customers pay upfront and so
rapidly, the business has no problems raising cash.
• Don't understand how a company can have a negative
working capital?
• Think back to Warner Brothers / Wal-Mart example.
When Wal-Mart ordered the 500,000 copies of a DVD,
they were supposed to pay Warner Brothers within 30
days. What if by the sixth or seventh day, Wal-Mart had
already put the DVDs on the shelves of its stores across
the country? By the twentieth day, they may have sold all
of the DVDs.

•In the end, Wal-Mart received the DVDs, shipped them
to its stores, and sold them to the customer (making a
profit in the process), all before they had paid Warner
Brothers! If Wal-Mart can continue to do this with all of
its suppliers, it doesn't really need to have enough cash
on hand to pay all of its accounts payable. As long as the
transactions are timed right, they can pay each bill as it
comes due, maximizing their efficiency.
Management of working capital

Management will use a combination of policies and techniques
for the management of working capital. These policies aim at
managing the current assets (generally cash, inventories and
debtors) and the short term financing, such that cash flows and
returns are acceptable.

1. Cash management. Identify the cash balance which allows for
the business to meet day to day expenses, but reduces cash
holding costs.

2. Inventory management. Identify the level of inventory which
allows for uninterrupted production but reduces the
investment in raw materials - and minimizes reordering costs -
and hence increases cash flow; eg. Supply chain management;
Just In Time (JIT)
3. Debtors management. Identify the appropriate credit policy,
i.e. credit terms which will attract customers

4. Short term financing. Identify the appropriate source of
financing, the inventory is ideally financed by credit granted
by the supplier; however, it may be necessary to utilize a
bank loan (or overdraft)

5. Understand the operating cycle

6. Identify the controllable factors

7. Manage all factors in the cycle

8. Calculate the costs of working capital

9. Strategically invest in shortening the operating cycle

10. Communicate with management and board leaders
• Profit = what is left from what is received as a result of carrying
out the work after paying all the charges that arise out of a

• Profit/loss is expressed in absolute terms as money and it gives
no measure of the productivity or efficiency of operations on

• Profitability = rate of making profit in relation to a company’s
investment that is required to carry out the work.

• Since it is a rate of making profit, it is implied that profitability
is related to a specific contract duration. Therefore, the three
factors which determine profitability must be:
• the amount of profit
• the duration of the contract
• the company’s investment that is required
• For example:
Items Contract 1 Contract 2
Profit RM5000 RM6000
Investment RM10,000 RM8000
Durations 12 months 18 months
 Contract 1:
Return on the capital = profit / investment
= RM5000/RM10,000
= 0.5 = 50% (for a year)

 Contract 2:
Return on the capital = RM6000/RM8000
= 0.75 = 75% (for a year and half)
= 50% (for a year)

• It can be seen therefore that with quite different contract
conditions, the two projects are equally profitable.
Definition of gross profit ratio:

Gross profit ratio (GP ratio) is the ratio of gross profit to net
sales expressed as a percentage. It expresses the relationship
between gross profit and sales.

The basic components for the calculation of gross profit ratio
are gross profit and net sales.

*Net sales means that sales minus sales returns.
*Gross profit would be the difference between net sales and
cost of goods sold.
*Cost of goods sold in the case of manufacturing concern, it
would be equal to the sum of the cost of raw materials, wages,
direct expenses and all manufacturing expenses.
Following formula is used to calculate gross profit ratios:

[Gross Profit Ratio = (Gross profit / Net sales) × 100]


Required: Calculate gross profit ratio.
Net sales = 520,000 – 20,000 = 500,000
Gross profit = [(520,000 – 20,000) – 400,000]
= 100,000
Gross Profit Ratio = (100,000 / 500,000) × 100
= 20%
Total sales RM520,000
Sales returns RM20,000
Cost of goods sold RM400,000

*Gross profit ratio may be indicated to what extent the selling
prices of goods per unit may be reduced without incurring
losses on operations.

*It reflects efficiency with which a firm produces its products.

*As the gross profit is found by deducting cost of goods sold
from net sales, higher the gross profit better it is.

*There is no standard GP ratio for evaluation. It may vary from
business to business.

*However, the gross profit earned should be sufficient to
recover all operating expenses and to build up reserves after
paying all fixed interest charges and dividends.
Causes / reasons of increase or decrease in gross profit

It should be observed that an increase in the GP ratio may
be due to the following factors:

•Increase in the selling price of goods sold without any
corresponding increase in the cost of goods sold.

•Decrease in cost of goods sold without corresponding
decrease in selling price.

•Omission of purchase invoices from accounts.

•Under valuation of opening stock or overvaluation of
closing stock.
On the other hand, the decrease in the gross profit ratio
may be due to the following factors:

•Decrease in the selling price of goods, without
corresponding decrease in the cost of goods sold.

•Increase in the cost of goods sold without any increase
in selling price.

•Unfavorable purchasing or markup policies.

•Inability of management to improve sales volume, or
omission of sales.

•Over valuation of opening stock or under valuation of
closing stock
Top 7 Ways To Increase Profits

1. Marketing: Don’t advertise -- until you’ve maximized use of
free or inexpensive promotion. Market test every new
product/service before investing in production or marketing.
Evaluate your marketing efforts. Do more of what’s working,
discontinue what’s not.

2. Customers: Customers don’t want money back guarantees.
They want the product or service to be right. Get it right and
customers become your best sales people. Get to know your
customers and what’s important to them.

3. Competition: Look for ways to add value without adding to
the cost. Stay at the cutting edge of your industry. Know the
players and what they’re doing. Stay flexible. Differentiate
your product.
4. Pricing: When you need to lower your price to get the
business, try to cut your costs, not your profit. Be sure to use
accurate historical financial information to determine costs.

5. Cost Containment: Discontinue services that don’t add to the
bottom line. Keep operating costs as low as possible without
jeopardizing outcomes. Justify every expenditure.

6. Debt: Borrow money only when you must. The additional
burden of loan repayment eats into your cash flow, so be sure
you have a flexible plan and budget to cover this additional

7. Losses: Cut losses early. Monitor financials and operations
monthly. Determine what has created the loss. Rethink your
strategy. Double your marketing efforts.
Definition of 'Holding Costs'
The associated price of storing inventory or assets that remain unsold. Holding
costs are a major component of supply chain management, since businesses
must determine how much of a product to keep in stock. This represents an
opportunity cost, as the presence of the goods means that they are not being
sold while that money could be deployed elsewhere. In addition, holding costs
include the costs of goods being damaged or spoiled over time and the general
costs, such as space, labor and other direct expenses.

Read more:

Definition of 'Supply Chain Management - SCM'
Supply chain management is the streamlining of a business' supply-side activities
to maximize customer value and to gain a competitive advantage in the
marketplace. Supply chain management (SCM) represents an effort by suppliers
to develop and implement supply chains that are as efficient and economical as
possible. Supply chains cover everything from production, to product
development, to the information systems needed to direct these undertakings.

Read more:

Investopedia explains 'Supply Chain Management - SCM'
Typically, SCM will attempt to centrally control or link the production, shipment
and distribution of a product. By managing the supply chain, companies are able
to cut excess fat and provide products faster. This is done by keeping tighter
control of internal inventories, internal production, distribution, sales and the
inventories of the company's product purchasers.

Read more:

Definition of 'Just In Time - JIT'
An inventory strategy companies employ to increase efficiency and decrease
waste by receiving goods only as they are needed in the production process,
thereby reducing inventory costs.

This method requires that producers are able to accurately forecast demand.

Read more:

Investopedia explains 'Just In Time - JIT'
A good example would be a car manufacturer that operates with very low
inventory levels, relying on their supply chain to deliver the parts they need to
build cars. The parts needed to manufacture the cars do not arrive before nor
after they are needed, rather they arrive just as they are needed.

This inventory supply system represents a shift away from the older "just in
case" strategy where producers carried large inventories in case higher
demand had to be met.

Read more: