CORPORATE FINANCE DECISION MAKING

WORKING CAPITAL MANAGEMENT

Question 1
Briefly describe what is meant by the term working capital and explain how it
is different from Long term capital.

Long term capital, business funding or simply 'capital' refers to sources of finance
that are called upon or issued to support the long term development of the
business. Net working capital is the balance of current assets and current
liabilities. The term 'current' means these assets and liabilities have durations of
less than 1 year.

The level of current assets is a key factor in the firm's liquidity position. The firm
must be able to generate enough cash to meet its short-term needs and so to
continue trading. Working capital, then, is a key factor in the firm's long-term
success. The greater the extent to which current assets exceed current liabilities,
the more solvent is the firm.

Question 2

What are the objectives of good working capital management? What are the
potential impacts if working capital is not managed effectively?

Working capital management has 2 overarching objectives; liquidity and

profitability.
A company must have sufficient liquidity to enable it to meet it's liabilities as they
fall due and to allow production capacity to fulfil the current level of demand.

This means that a company must have access to enough cash or highly liquid
assets to pay it's bills. Businesses have a cash cycle that sees cash tied up (in
production) before it grows (hopefully!) and is then released from customers. The
timing of cash inflows (receipts) and outflows (payments) therefore often doesn't
match so a balance of working capital is needed to keep the business afloat.

As well as cash, current assets comprise inventory (stock) and receivables

(debtors). Stock and debtor levels are often proportional to demand/revenue. This
means as the business grows then so does the amount of investment tied up in
working capital. In this respect if working capital cannot keep up with the demand
requirements, the business will struggle.

However, investment in working capital is expensive and therefore working

capital must be managed efficiently so as to not compromise the overall objective
of a commercial company which should be shareholder wealth maximisation.
Holding too much working capital (ie investing too heavily) is costly. This is
money that could be used to develop the business or returned to shareholders so
a balance needs to be struck between liquidity (risk) and profitability (return).

If a company gets working capital management wrong, the consequences can be

fatal. Overtrading occurs when the working capital base of a company is too
small to support it's trading volume. In these cases liquidity is insufficient and
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despite a company growing profitable business, short term cashflow problems
can cause it to fail.

Question 3 Tommy J plc

a. Describe the cash conversion cycle and explain it’s significance in
determining the working capital needed by a company.

b. On the basis of the following information, work out the length of the
company's Cash Conversion Cycle in days, stating any assumptions
you make. Assume a 365 day year.

Tommy J plc Ltd. Extract from annual accounts (£'000's)

Stocks: Raw materials: 250

Work in progress 115
Finished goods 186
Purchases 1,070
Cost of goods sold 1,458
Sales 1,636
Debtors 345
Trade Creditors 162

a) The Cash conversion cycle quantifies the time between paying for inputs and
receiving cash from sales. The length of the cash conversion cycle is a factor in
determining the level of working capital.

The cash conversion cycle (CCC) is given by the formula:

ICP + RCP - PDP (days)

ICP= Inventory conversion period

RCP= Receivables collection period
PDP= Payables deferral period

b)
Stocks:
Raw materials (250/1,070) x 365 = 85 days
Work in progress (115/1,458) x 365 = 29 days
Finished goods (186/1,458) x 365 = 47 days

Debtors (345/1,636) x 365 = 77 days

Creditors (162/1,070) x 365 = (55) days

Cash Conversion Cycle: = 183 days

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Question 4
Oleum are retailers and one of their most consistently popular lines is a brand of
soap called Fragro. Fragro can be bought wholesale in boxes of 1,000 bars and
buying costs are £5 per order regardless of size. An order is delivered eight
weeks after it is placed. Retail sales average 200,000 bars per 48 week year and
holding costs are 50 pence per year per 1,000 bars. Calculate the economic
order quantity, reorder stock level, and average stock level for Fragro.

F = £5 per order
S = 200,000 bars per year
H = £0.50 per 1,000 bars

EOQ = (2 x 5 x 200,000/(0.5/1,000))½ = 63,245 bars (63 boxes)

Re-order level = (8 x 200,000)/48 = 33,333 bars (34 boxes)
Average stock level = EOQ/2 = 63,000/2 = 31,500 bars

Question 5

Once credit has been agreed discuss the processes that should be put in place to
ensure good credit management

The key to good credit management is the consistent deployment of clear credit
policies upheld by unambiguous accountability within the company.

The credit terms offered to a customer should be clear to them and they should
be reviewed regularly. Credit limits should be revised downwards if a customer
becomes a default risk but also if the credit limit is not being used and is above
their needs.

The customer should be clear from the outset what will happen if the terms of the
agreement are breached. For example, what compensatory interest will be
charged? and when will debt collection procedures be invoked? A customer's
current credit position should always be reviewed before accepting further orders.

Once an efficient credit management and receivables process has been

embedded there are additional tools available to companies to improve credit
management.

Credit insurance is widely available and it enables a business to indemnify itself

against bad debt. Insurance can be against all debts (usually with a single
account maximum) or specific accounts. The proportional cost of the insurance
premium versus the likely bad debt cost needs to be compared when considering
this type of insurance policy.

Offering early payment incentives (eg discounts) can be considered as a method

to speed up cash inflow and potentially reduce bad debts. Like insurance, the
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WORKING CAPITAL MANAGEMENT
cost of the discount must be considered against the cashflow benefits and
reduced bad debt.

Early payments should not be confused with invoice discounting. Invoice

discounting is the concept of selling the debt to a third party for an amount less
than it’s face value. Whilst this yields a reduced return compared to collecting the
full debt directly, the earlier cash inflow and reduced bad debts offer potential
savings.

Finally, a company can outsource it's credit management and let a factoring
company take care of the whole process. A factoring company should ensure
good credit management as it is their core competence. A factor will provide
cashflow benefits by advancing money against invoiced debt and may also be
able to provide a reduced (or zero) bad debt liability if the arrangement is agreed
'without recourse'

Question 6

A company is planning to offer a discount for payment within 10 days to it’s

customers who currently pay after 45 days. Only 40% of credit customers would take
the discount, although administrative cost savings of £4450 per year would be
gained. If credit sales, which are unaffected by the discount, are £1,600,000 per year
and the cost of short term finance is 8%, what is the maximum discount that could be
offered?

£ £

Current level of trade receivables = 197,260

(1,600,000 x 45/365)

Proposed level of trade receivables:

Not taking the discount = 118,356

(60% x 1,600,000 x 45/365)

Taking the discount = 17,534

(40% x 1,600,000 x 10/365)
135,890
Change in level of trade receivables 61,370

Saving in financing costs = 4,910

(61,370 x 8%)

Administrative cost savings 4,450

Total savings 9,360

Calculation of maximum discount:

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1,600,000 x 40% x Maximum discount = 9,360

Hence maximum discount = 9,360/(1,600,000 x 0.4) = 0.0146 or 1.46%

The maximum discount that could be offered is therefore 1.46 per cent.
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Question 7

The following information has been extracted from the financial statements of
Rowett:
Income statement extracts
£000 £000
Turnover 12000
Cost of sales:
Raw materials 5800
Labour 3060
8860
Gross profit 3140
Administration/distribution 1680
Operating profit 1460

Financial position statement extracts

£000 £000
Current assets:
Inventories of raw materials 1634
Inventories of finished goods 2018
Trade receivables 1538
Cash and bank 500
5690
Current liabilities:
Trade payables 1092
Overdraft 300
Other expenses 76
1468
4222

Powell, a factoring company, has offered to take over the debt administration and
credit control of Rowett on a non-recourse basis for an annual fee of 1.8 per cent
of sales. This would save Rowett £160 000 per year in administration costs and
reduce bad debts from 0.5 per cent of sales to nil.

Powell would reduce trade receivables days to 40 days, and would advance 75
per cent of invoiced debts at an interest rate of 15 per cent.

Rowett finances working capital from an overdraft at 12 per cent.

(a) Calculate the length of the cash conversion cycle of Rowett and discuss its
significance to the company.

(b) Discuss ways in which Rowett could improve the management of its
receivables.

(c) Using the information given, assess whether Rowett should accept the
factoring service offered by Powell. What use should the company make of any
finance provided by the factor?
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(a) The cash conversion cycle is the receivables' conversion period (RCP) plus
the inventory conversion period (ICP), less the payables' deferral period (PDP).

RCP = (1538/ 12 000) x 365 = 47 days

ICP (Raw Materials) = (1634/ 5800) x 365 = 103 days
ICP (Finished Goods) = (2018/ 8860) x 365 = 83 days
PCP = (1092/ 5800) x 365 = 69 days
CCC = 47 + 103 + 83 - 69 = 164 days or 23.5 weeks

Investment in working capital must be financed: the longer the cash conversion
cycle, the more capital is tied up and the higher the cost to Rowett plc. The company
could reduce the cash tied up by optimising the components of the cash conversion
cycle. So, for example, shortening the inventory conversion period could reduce the
working capital requirement and increase profitability.

(b) See lecture slides and Question 5.

(c) £
Current level of trade receivables = 1,538,000
Trade receivables under factor = 12,000,000 x (40/ 365) = 1,315,000
Reduction in trade receivables 223,000

£ £
Reduction in financing cost due to lower receivables 26,760
(223,000 x 12%)

Avoided cost of financing new trade receivables w/o factor 157,800

(1,315,000 x 12%)

Cost of financing under factor:

1,315,000 x 12% x 25% = (39,450)
1,315,000 x 15% x 75% = (147,937)
(187,387)
Increased financing cost (2,827)

£ £
Reduction in bad debts = 12m x 0.5% = 60,000
Saving in administration costs = 160,000
Benefits 220,000

Increase in financing cost due to advance (2,827)

Annual fee of factor = 12m x 1.8% = (216,000)
Costs (218,827)
Net benefit 1,173

The finance provided by the factor is an accelerated cash flow derived from trade
receivables. It is therefore not appropriate to use it for a long-term finance need,
such as the purchase of non-current assets. Rather, it should be used for a short-
term need, such as the payment of trade payables or meeting forecast cash needs.
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In general, the matching of assets and liabilities is recommended. That said,
permanent current assets should be financed from a long-term source.