Session 1

Introduction and
working capital management

SYLLABUS CONTENT
 Importance of working capital

 Working capital cycle

WHAT DOES MANAGING FINANCES INVOLVE?

Managing finances (or financial management) covers all the functions concerned in attempting
to ensure that financial resources are obtained and used in the most effective way to achieve
the objectives of the organisation.

Thus the role of the financial manager is separated into three main areas:

1 The raising of finance.

2 The efficient allocation of financial resources.

3 Maintaining control over resources to ensure objectives are met.

Raising of finance
Organisations need the right amount of finance at the right time to achieve its objectives. They
need to know about short, medium and long-term funds that are needed to invest in fixed assets
and working capital.

Once funding requirements are identified the financial manager will need to identify the
appropriate sources of finance taking into account cost availability, terms of finance and risk.

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

The mix of funds between internal and external will need to be considered and in using internal
funds the manager will need to take into account dividend policy and the effect on the capital
structure of the organisation. External funds can be raised from both individuals and other
organisations. This could be in the form of both equity and debt. In raising funds externally the
manager must try to match the characteristics of the chosen source to the requirements of the
firm.

Allocation of financial resources

Funds must be allocated in the most efficient and productive way to meet corporate objectives.
The manager must advise on the allocation of funds both in terms of the total investment and
how this total is divided between fixed and current assets (working capital). Advice will also
need to be given on how finance is related to the level of risk and return expected.

Control over resources

It is important that the allocated resources are continually monitored to ensure that the various
activities undertaken by the organisation continue to make the maximum contribution to the
achievement of the organisation’s objectives. This implies that the efficiency of investments
must be measured in terms of a comparison between actual and forecast results.

FINANCIAL STRATEGY
This is a course of action to achieve a specific objective and includes the specification of the
resources needed to achieve this objective. Financial strategy is part of the overall
organisational strategy and involves consideration of the following issues:

 From which sources should funds be raised?

 Should proposed investments be undertaken?

 How large a dividend should be paid?

 How should working capital be controlled? E.g. should we offer discounts to prompt
payers?

 Should we use hedging strategies to avoid currency risk or interest rate risk? (This topic
is not in our syllabus.)

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT

Definition
Working capital is the finance required for the company’s day-to-day operations. It can be
defined as:

CURRENT MINUS
CURRENT
ASSETS LIABILITIES

Inventory Payables

Receivables

Cash and bank Balancin

Bank overdraft
g figure =
Wrk. Cap.

Require funding Provide funding

Aim: Minimise current Aim: Maximise current

assets liabilities
(within reason) (within reason)

Working capital can be described as the oil in the engine of the firm. It is the fixed assets that
are the petrol. The oil does not make the car run but we need the oil to make the engine work.
In other words it is the fixed assets that generate the profits but we need the oil or working
capital to get the engine to work.

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Working capital policy

Working capital
balancing act

Ensuring current Maximising the return on

assets are sufficiently capital employed hence
liquid to minimise the minimising investment in
risk of insolvency working capital

Leading to two fundamental questions…

What is the appropriate How should the

level of investment in investment in working
working capital? capital be funded?

Given these two questions there are basically two extremes with regard to policy which can be
either:

 Aggressive

 Conservative or defensive

This is in respect of both:

 Investment in working capital

 Financing of working capital

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

INVESTMENT IN WORKING CAPITAL

The level of investment in working capital required is affected by the following factors:

1 The nature of the business, e.g. manufacturing companies need more inventory than
service companies.

2 Uncertainty in supplier deliveries. Uncertainty would mean that extra inventories need to
be carried in order to cover fluctuations.

3 The overall level of activity of the business. As output increases, receivables, inventory,
etc. all tend to increase.

4 The company’s credit policy. The tighter the company’s policy the lower the level of
receivables.

5 The length of the operating cycle. The longer it takes to convert material into finished
goods into cash the greater the investment in working capital.

Aggressive policy
An aggressive policy would be:

 keeping low inventory levels

 giving customers little credit

 taking as much trade credit as possible from your suppliers.

All of these are aimed at trying to minimise the investment in working capital.

Purpose

To minimise the costs of finance invested in working capital.

(NB. Investment in working capital is essentially non-productive: it is the investment in fixed

assets that generates the profits.)

Dangers

Stockouts – production downtime and lost sales to customers – customer dissatisfaction.

(NB. Giving credit is a marketing device so if we restrict credit to customers this will result in lost
sales. If the company takes too much credit from its suppliers it runs the risk of a bad credit
rating and in the future being refused goods on credit. Remember that this is a cheap form of
finance that would be lost as it is equivalent to an interest free loan.)

Conservative policy
High inventories. Give plentiful credit to customers. Pay suppliers on time.

Purpose

Avoid the dangers of an aggressive policy, i.e. stockout and downtime and lost sales.

Risk

High cost of capital/finance tied up in working capital. Working capital does not generate profits.

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

FINANCING WORKING CAPITAL

The traditional approach

Traditionally current assets were seen as fluctuating, originally with a seasonal pattern. Current
assets would then be financed out of short-term credit, which could be paid off when not
required, whilst fixed assets would be financed by long-term funds.

Current assets
Total
assets
$
Short-term credit

Long-term finance
Fixed assets

Time

This approach to the analysis is rather simplistic. In most businesses a proportion of the current
assets are fixed over time, thus being expressed as ‘permanent’. For example, certain base
levels of inventory are always carried, cash balances never fall below a certain level, and a
certain level of ready credit is always extended. If growth is added to this situation a more
realistic business picture would be as follows:

The investment in working capital will vary with the level of business activity. An increase in
sales will lead to an increased need for working capital. A reduction in sales will lead to a
reduction in the need for working capital. We are considering the seasonality of the sales
pattern and its impact upon working capital. From this idea it is possible to differentiate between
the permanent working capital and the fluctuating or variable working capital.

Time

It is the seasonal nature of business that creates the fluctuations that occur in working capital
needs.

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

Financing policies
Current assets may be financed by current liabilities or by long-term funds. The ‘ideal’ current
ratio is 2:1. This would mean that half of the current assets are financed by current liabilities and
therefore half by long-term funds. Similarly the ideal quick ratio is 1:1.

These liquidity ratios are a guide to the risk of cash-flow problems and insolvency. If a company
suddenly finds that it is unable to renew its short-term liabilities (for instance if the bank
suspends its overdraft facilities) there will be a danger of insolvency unless the company is able
to turn enough of its current assets into cash quickly. A current ratio of 2:1 and a quick ratio of
1:1 are thought to indicate that a company is reasonably well protected against the danger of
insolvency.

Aggressive policy

Time

This would involve using long-term finance for some of the permanent working capital and
short-term finance for the rest of permanent working capital and for the variable working capital.

LT finance  equity etc.

ST finance  bank loans etc.

The purpose behind an aggressive working capital policy is that it will minimise finance costs.
Interest charges on ST finance are lower than LT finance. Thus with this type of policy we are
trying to use as much ST finance as possible. The risk of such a policy is that the business may
become short of finance e.g. technically overdrafts are repayable on demand and therefore
relying on them as a source of finance imposes risks.

Conservative policy

This would use LT finance for all the permanent working capital plus some of the variable
working capital and ST finance for the rest of the variable working capital. The purpose would
be to attain safety/security, i.e. you know that you will always have the necessary funds
available.

Problem lies in the higher costs that are involved.

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

WORKING CAPITAL MANAGEMENT AND BUSINESS

SOLVENCY
Business needs flow of cash to carry on its day-to-day operations. Some cash payments cannot
be delayed without risk to the business, e.g. debenture interest, wages and salaries.

Cash needs to be in place to meet obligations as they fall due. If there is inadequate cash the
business may fail due to illiquidity. Profit to some extent alleviates illiquidity. Management of
cash flows involves interrelationship between:

 Profits

 Working capital levels

 Capital expenditure

 Dividend policy

 Taxation

Overcapitalisation v overtrading
Overcapitalisation is where capital is excessive for its needs and can normally be recognised by
liquidity ratios being too high or inventory turnover periods being too long.

Overtrading is where a company is trying to carry on too large a volume of activities with its
current level of working capital.

Overtrading

This describes the situation of a successful growing company which is in danger of going bust
because it has insufficient investment in working capital.

Telltale ratios are:

 A very high return on capital employed: ROCE (EBIT/Net assets)

 Low liquidity: current ratio (Current assets/Current liabilities)

 Lengthy creditors days ratio (Trade creditors/Annual purchases x 365)

 Rapid increase in turnover

 Sharp increase in sales to fixed assets ratio

 Increase in stocks in relation to turnover.

 Increase in receivables.

 Increase in short term borrowing and decline in cash balances

 Increase in gearing

 Fall in profit margin

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

WORKING CAPITAL RATIOS

Cash operating cycle
Also known as the cash cycle or trading cycle. The operating cycle is the length of time between
the company’s outlay on raw materials, wages and other expenditures and the inflow of cash
from the sale of goods. In a manufacturing business this is the average time that raw materials
remain in inventory less the period of credit taken from suppliers plus the time taken for
producing the goods plus the time the goods remain in finished inventory plus the time taken for
customers to pay for the goods. This is illustrated in the diagram below:

Issue to Completion of Sale of units Receipt

Purchases production production produced from sale

RM inventory WIP inventory FG inventory Receivables

period

Time line (days)

Payables period

Payment for Operating cycle

materials (in days)

The longer the cash operating cycle the greater the investment in working capital. In trying to
measure the cash operating cycle we are trying to get an indication of how long cash is tied up
in the business. Cash is tied up in our raw material inventories and work in progress. However,
this is offset to the extent that our suppliers grant us credit. Again we invest cash in extending
credit to our customers. In trying to measure the cash operating cycle we make use of working
capital ratios. Below is given the ‘proper’ way to measure each of these. However, it may be
necessary to make use of approximations where data is not forthcoming. For example in
calculating the debtor day ratio we often use the annual sales figure rather than the credit sales
figure on the assumption that all the sales are on credit.

The length of the cash operating cycle is a function of two things:

 The nature of the company’s business

 The effectiveness of the management’s ability to manage working capital

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

Basic ratios
We use the following information in order to see how to calculate the basic working capital
ratios: extracts from the statement of profit or loss for the year and the statement of financial
position at the end of the year for a company show the following:

$
Sales 1,600,000
Cost of goods sold 1,100,000
Purchases 900,000
Trade receivables 105,000
Trade payables 250,000
Raw material inventory 75,000
Finished goods inventory 86,000
Work in progress 100,000
Taxation payable 50,000
Bank 25,000

Inventory holding period

Stocks x 365 = Stock day ratio This figure tells you

how many days’
Cost of sales
supply of stocks we
$86,000
have without
x 365 = 28.5 days
producing. i.e. we
$1,100,000
could meet this
number of days
demand without
d i
Raw material stocks x 365 = Raw material stock day ratio
Annual purchases

Trade payables payment period

Trade creditors x 365 = Creditor days ratio

Annual purchases
This tells you how long
on average you take to
pay your suppliers
$250,000 x 365 = 101.4 days i i
$900,000
Currently you take over
3 months to pay your
suppliers invoices.

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

Receivables collection period

Trade debtors x 365 = Debtor days ratio

Annual sales

This ratio tells you the number of day’s credit your customers take
On average
$105,000 your customers
x 365 = 24 days
take just over 3
$1,600,000
weeks to pay

This ratio can be inverted to give the debtor turnover ratio, but this is probably not as
meaningful as the previous ratio.

Annual sales = Debtor turnover

Trade debtors
The higher the
turnover figure,
Example:
$1,600,000 the quicker your
= 15.2
customers pay
$105,000

Credit period x Sales = Average level of debtors

turnover
One year
Cash
The following ratios are important and are likely to turn up in subsections of questions for you to
comment on in the exam. In such questions you are likely to also be given the figures for a
comparable firm or for the industry. If you are not then you need to explain that without other
comparable figures it may be difficult to comment. In general the higher the ratio the ‘safer’ is
the business but this may also mean that it is foregoing profitable opportunities. Similar
comments apply to acid test or quick ratio.

Current ratio
A simple measure of how much of the total current assets is financed by current liabilities. A
safe measure is considered to be 2:1 or greater meaning that only a limited amount of the
assets are funded by the current liabilities.

Current Assets = Current ratio

Current Liabilities
This figure is
$1.6M = 1.33 used as a
$1.2M test of
liquidity. The
more
aggressive
th ki
If the current ratio < 2 the WC policy is aggressive and there is a risk of illiquidity.

If the current ratio > 2 the WC policy is conservative and the safer is the company.

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

Acid test or quick ratio

An alternative test is the acid test or quick ratio. This measures liquidity/illiquidity but is a much
fiercer test – measure of how well current liabilities are covered by liquid assets. A safe
measure is considered to be 1:1 meaning that we are able to meet our existing liabilities if they
all fall due at once.
Cash + Near cash *
The lower this ratio, the more aggressive the policy
Current liabilitie s

* This includes receivables but not inventories.

How to measure the cash operating cycle

Using the previous values we now calculate the cash operating cycle for our business based on
the calculated ratio values.
Today (12 months ago)
Days Days
Raw material inventory × 365 : 70 50
–––––––––––––––––
Annual purchases

– Trade payables × 365 : (60) (88)

–––––––––––––––
Annual purchases ––––
10 (38)
+ Work in progress × 365 : 5 30
–––––––––––––––
Cost of sales

+ Finished goods inventory × 365 : 70 30

––––––––––––––––––––
Cost of sales

+ Receivables × 365 : 90 18
––––––––––
Sales ––––
Cash operating cycle 175 days 40

Implications of the cash operating cycle

The operating cycle is a critical measure of the overall cash requirements for working capital.
This can be summed up from two perspectives:

1 Where level of activity (sales) is constant and the number of days of the operating cycle
increase, the amount of funds required for working capital will increase in approximate
proportion to the number of days.

2 Where the cycle remains constant but activity (sales) increase the funds required for
working capital will increase in approximate proportion to sales.

By monitoring the operating cycle the manager gains a macro view of the relative efficiency of
the working capital utilisation. Further it may be a key target to reduce to improve the efficiency
of the business.

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 SESSION 1 – INTRODUCTION AND WORKING CAPITAL MANAGEMENT

CASH OPERATING CYCLE QUESTIONS

EXERCISE 1
Below are extracts from the statement of profit or loss for the year and the statement of financial
position as at the end of the year for a company.
$
Sales 500,000
Cost of goods sold 420,000
Purchases 280,000
Receivables 72,500
Payables 42,000
Inventory 185,000

Assume all sales and purchases are on credit terms.

Required:

Calculate the length of the cash operating cycle.

EXERCISE 2
Below are extracts from the statement of profit or loss for the year and the statement of financial
position as at the end of the year for an accountancy tuition company.

$
Sales 3,800,000
Cost of goods sold 2,653,000
Purchases 1,788,000
Receivables 345,000
Payables 1,928,000
Inventory 12,000

Assume all sales and purchases are on credit terms.

Required:

Calculate the length of the cash operating cycle. Comment on the figure that you have obtained.

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FFM – FOUNDATIONS IN FINANCIAL MANAGEMENT

EXERCISE 3
Tutorial note: This question demonstrates how questions often need to be unravelled in order
to arrive at the answer. It can pay to write down the key information first and then look at it in
order to see how it is related.

A company has annual sales of $10m with a mark up on cost of 40%. It normally pays its
payables three months after purchases are made and holds two months’ worth of demand as
inventory. On average it allows receivables six weeks’ credit. Its cash balance currently stands
at $1,500,000.

Required:

What are its current and quick ratios?

EXERCISE 4
Below is a section from a company’s statement of financial position and statement of profit or
loss.

Statement of profit or loss extract $

Turnover 350,000
Gross profit 85,600

Statement of financial position extract $ $

Current assets

Inventory

Raw materials 25,000

Work in progress 33,500

Finished goods 46,500

––––––
105,000

Receivables 35,200
–––––––
140,200

Current liabilities

Payables 55,200

Required:

Using the information given calculate the cash operating cycle for the business.

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