WORKING CAPITAL MANAGEMENT

INTRODUCTION

One of the key functions of a finance manager is the liquidity decision. Liquidity management
entails ensuring that the obligations of an entity are settled as of when they fall due. Finance
managers spend more than 60% of their time in handling the short term financing positions of the
organization.

Working capital management entails managing the current assets and liabilities of an entity to
ensure that a firm has a favourable liquidity position and to maximize on profitability. In this
chapter we will consider the working capital items and how to attain the optimal mix of the
working capital items

Lecture outline

i. Introduction
ii. Working capital components
iii. Financing strategies
iv. Over trading and over capitalization
v. Cash conversion cycle
vi. Management of stock
vii. Management of cash
viii. Management of receivables

Learning outcomes

By the end of this chapter you should be able to

i. Determine the cost of each of the components of working capital

ii. Determine the cash conversion cycle and explain how to manage it
iii. Explain the three funding strategies

WORKING CAPITAL MANAGEMENT

Working capital is the capital available for conducting the day-to-day operations of an
organisation; normally the excess of current assets over current liabilities.

Working capital management is the management of all aspects of both current assets and current
liabilities, to minimise the risk of insolvency while maximising the return on assets.
The main objective of working capital management is to get the balance of current assets and
current liabilities right.

Importance of working capital management

Current assets are a major financial position statement item and especially significant to smaller
firms. Mismanagement of working capital is therefore a common cause of business failure, e.g.:

 inability to meet bills as they fall due

 demands on cash during periods of growth being too great (overtrading)
 overstocking

Objectives of working capital management

 To determine the optimal mix of the various components of working capital to be
employed by the firm.
 To reduce the costs associated with working capital management.
 To ensure that the liquidity of the firm enables it to meet its short-term maturity
obligations as and when they fall due.
 To maximize the shareholders’ wealth by maximizing the market value of the firm.

Working capital management is a key factor in an organisation's long-term success.

The balancing act: Profitability v Liquidity

The decision regarding the level of overall investment in working capital is a cost/benefit trade-
off - liquidity versus profitability.

Unprofitable companies can survive if they have liquidity. Profitable companies can fail if they
run out of cash to pay their liabilities (wages, amounts due to suppliers, overdraft interest, etc.).

Liquidity in the context of working capital management means having enough cash or ready
access to cash to meet all payment obligations when these fall due. The main sources of liquidity
are usually:

 cash in the bank

 short-term investments that can be cashed in easily and quickly
 cash inflows from normal trading operations (cash sales and payments by receivables for
credit sales)
 an overdraft facility or other ready source of extra borrowing.

Cash balances and cash flows need to be monitored just as closely as trading profits.

Elements of working capital

Managing working capital involves managing the individual elements which make up working
capital:

 inventory (stock)
 receivables (debtors)
 payables (creditors)
 cash

Funding strategies

In the same way as for long-term investments, a firm must make a decision about what source of
finance is best used for the funding of working capital requirements.

The decision about whether to choose short- or long-term options depends upon a number of
factors:

 the extent to which current assets are permanent or fluctuating

 the costs and risks of short-term finance
 the attitude of management to risk

Permanent or fluctuating current assets

In most businesses a proportion of the current assets are fixed over time, i.e. 'permanent'. For
example:

 buffer inventory,
 receivables during the credit period,
 minimum cash balances.
The choice of how to finance the permanent current assets is a matter for managerial judgement,
but includes an analysis of the cost and risks of short-term finance.

The attitude of management to risk: aggressive, conservative and matching funding

policies

There is no ideal funding package, but three approaches may be identified.

 Aggressive - finance most current assets, including 'permanent' ones, with short-term
finance. Risky but profitable. Risk takers.
 Conservative - long-term finance is used for most current assets, including a proportion
of fluctuating current assets. Stable but expensive udesd by risk averter.
 Matching - the duration of the finance is matched to the duration of the investment used
by risk neutral inverstor.

A firm choosing to have a lower level of working capital than rivals is said to have an
'aggressive' approach, whereas a firm with a higher level of working capital has a 'conservative'
approach.

An aggressive approach will result in higher profitability and higher risk, while a conservative
approach will result in lower profitability and lower risk.

The following are the projected monthly working capital requirements a. of Tayari Ltd. for the
year ending 31 December 2015

Month Amount of
working capital
required
(Sh’000’)
January 3,500
February 3,500
March 5,250
April 7,000
May 10,500
June 15,750
July 21,000
August 24,250
September 15,750
October 8,750
November 7,000
December 5,250

The expected cost of short-term funds is 20% while that of long-term funds is 25%.

Required:
 i. A schedule showing the amount of permanent and seasonal working capital requirements
for each month.
ii. Average amount of long-term and short-term finance that would be required monthly.
iii. Total cost of working capital finance if the firm adopts an aggressive financing strategy.
iv. The total cost of working capital finance if the firm adopts a conservative financing
strategy.

Month Total w Permanent w Temporary w

capital capital capital
January 3,500 3,500 -
February 3,500 3,500 -
March 5,250 3,500 1,750
April 7,000 3,500 3,500
May 10,500 3,500 7,000
June 15,750 3,500 12,250
July 21,000 3,500 17,500
August 24,250 3,500 20,750
September 15,750 3,500 12,250
October 8,750 3,500 5,250
November 7,000 3,500 3,500
December 5,250 3,500 1,750
Total 42000 85,500

42000
Average permanent w capital = =3500 per month
12months

85,500
Temporary w capital = =Sh. 7125 per month
12

Please note: permanent working capital is the minimum working capital that a business must
have in any given period, temporary working capital is that working capital requirement over and
above the minimum, it fluctuates from time to time

i. In aggressive financing policy, all working capital will be financed using short-term
funds.
Cost =20% x (42,000 + 85500) = Sh25,500

ii. In conservative financing policy, all working capital will be financed using long-funds.
Cost =25% x (42,000 + 85500) = Sh31,875
 iii. In matching policy, permanent working capital will be financed using long-term funds
and temporary working capital will be financed by short-term funds.
Hence:
Permanent w capital = 25% x 42,000 = 10,500
Short-term w capital = 20% x 85,500 = 17,100
Total cost 27,600

Refer to the diagram above on the balancing act between liquidity and profitability.

In aggressive financing policy, funds are financing short term and long term capital are acquired from
short term sources. This sources are cheap (lead to high profits) but require to be repaid in a short
duration (lead to poor liquidity)

In Conservative financing policy funds are sourced in the long term, this is an expensive source (low
profitability) but gives more time for repayment hence the firm enjoys perfect liquidity

Over-capitalization

If there are excessive inventories, accounts receivable and cash, and very few accounts payable,
there will be an over-investment by the company in current assets. Working capital will be
excessive and the company will be over-capitalised.

Overtrading

Cash flow is the lifeblood of the thriving business. Effective and efficient management of the
working capital investment is essential to maintaining control of business cash flow.
Management must have full awareness of the profitability versus liquidity trade-off.

For example, healthy trading growth typically produces:

 increased profitability
 the need to increase investment in non-current assets and working capital.

In contrast to over-capitalisation, if the business does not have access to sufficient capital to fund
the increase, it is said to be"overtrading". This can cause serious trouble for the business as it is
unable to pay its business creditors.

The cash operating cycle

The elements of the operating cycle

The cash 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.
The faster a firm can 'push' items around the cycle the lower its investment in working capital
will be.

Calculation of the cash operating cycle

For a manufacturing business, the cash operating cycle is calculated as:

For a wholesale or retail business, there will be no raw materials or WIP holding periods, and the
cycle simplifies to:

The cycle may be measured in days, weeks or months. The holding periods are calculated using a
series of working capital ratios.

Factors affecting the length of the operating cycle

Length of the cycle depends on:

 liquidity versus profitability decisions

 terms of trade
 management efficiency
 industry norms, e.g. retail versus construction.

The optimum level of working capital is the amount that results in no idle cash or unused
inventory, but that does not put a strain on liquid resources.

Working capital ratios

Ratios to determine the operating cycle

The periods used to determine the cash operating cycle are calculated by using a series of
working capital ratios.

The ratios for the individual components (inventory, receivables and payables) are normally
expressed as the number of days/weeks/months of the relevant income statement figure they
represent.
Inventory holding period

This ratio calculates the length of time inventory is held between purchase and sale.

Calculated as:

In some cases, a more detailed breakdown of inventory may be required. Inventory holding
periods can be calculated for each type of inventory: raw materials, work-in-progress and
finished goods.

Raw material inventory holding period

The length of time raw materials are held between purchase and being used in production.

Calculated as:

WIP holding period

The length of time goods spend in production.

Calculated as:

Finished goods inventory period

The length of time finished goods are held between completion or purchase and sale.

Calculated as:
For all inventory period ratios, a low ratio is usually seen as a sign of good working capital
management. It is very expensive to hold inventory and thus minimum inventory holding usually
points to good practice.

Trade receivables days

The length of time credit is extended to customers.

Calculated as:

Generally shorter credit periods are seen as financially sensible but the length will also depend
upon the nature of the business.

Trade payables days

The average period of credit extended by suppliers.

Calculated as:

Generally, increasing payables days suggests advantage is being taken of available credit but
there are risks:

 losing supplier goodwill

 losing prompt payment discounts
 suppliers increasing the price to compensate.

The following information relates to Jabali Limited:

 Sh’000’
Purchase of raw materials 6,700
Usage of raw material 6,500
Sale of finished goods (all on credit) 25,000
Cost of sales (finished goods) 18,000
Average creditors 1,400
Average raw materials stock 1,200
Average work in progress 1,000
Average finished goods stock 2 1 0 0
Average debtors 4 , 7 0 0

Assume a 365-day year.

Required:
The length of the operating cash cycle

Days
Period of raw materials = Average raw materials x 365
Usage of Raw materials
= 1,200 x 365
6,500
=...................................................... 67.4

Period of WIP = Average WIP x 365

cost of sales (production)
= 1000 x 365
18,000
=...................................................... 20.3

Period of FG stock = Average finished goods stock x 365

cost of sales
= 2,100 x 365
18,000
=...................................................... 42.6

Period of trade debtors = average trade debtors x 365

credit sales
= 4,700 x 365
25,000
=...................................................... 68.6
Operating cycle period = .................................................... 198.9
Less period of creditors = Average trade creditors x 365
credit purchases
= 1,400 x 365
6,700
=.................................................... (76.3)
Cash Conversion cycle =....................................................122.6

MANAGEMENT OF STOCK

The management of stock/ inventory is a key aspect of working capital management.

The objectives of inventory management

Inventory is a major investment for many companies. Manufacturing companies can easily be
carrying inventory equivalent to between 50% and100% of the revenue of the business. It is
therefore essential to reduce the levels of inventory held to the necessary minimum.

Importance of inventory management

The challenge of of good inventory management is to determine:

 the optimum re-order level (how many items are left in inventory when the next order is
placed), and
 the optimum re-order quantity (how many items should be ordered when the order is
placed)

In practice, this means striking a balance between holding costs on the one hand and stock out
and re-order costs on the other.

Costs of high inventory levels

Keeping inventory levels high is expensive due to:

 purchase costs
 holding cost (storage, stores administration, risk of theft/damage/obsolescence)

Carrying inventory involves a major working capital investment and therefore levels need to be
very tightly controlled. The cost is not just that of purchasing the goods, but also storing,
insuring, and managing them once they are in inventory.

Costs of low inventory levels

If inventory levels are kept too low, the business faces alternative problems:

 stock outs (lost contribution, production stoppages, emergency orders)

 high re-order/setup costs
 lost quantity discounts.
The balancing act: Profitability v Liquidity

The balancing act between liquidity and profitability is key to good inventory management. This
could also be considered to be a trade-off between holding costs and stockout/re-order costs.

Economic Order Quantity (EOQ)

The challenge of of good inventory management is to determine:
  the optimum re-order level (how many items are left in inventory when the next order is
placed), and
 the optimum re-order quantity (how many items should be ordered when the order is
placed)

In practice, this means striking a balance between holding costs on the one hand and stockout
and re-order costs on the other. The economic order quantity formula is one approach to striking
this balance.

Economic order quantity (EOQ)

For businesses that do not use just in time (JIT) inventory management systems, there is an
optimum order quantity for inventory items, known as the EOQ.

The aim of the EOQ model is to minimise the total cost of holding and ordering inventory. To do
this, it is necessary to balance the relevant costs. These are:

 the variable costs of holding the inventory (holding costs)

 the fixed costs of placing the order (ordering costs)

Assumptions
The following assumptions are made:

 demand and lead time are constant and known

 purchase price is constant
 no buffer inventory held (not needed).

The calculation
The EOQ can be more quickly found using a formula:

where:
CO = cost per order
D = annual demand
CH = cost of holding one unit for one year.

Illustration
The annual purchases of XYZ Ltd. are Sh1,080,000. The unit cost is Sh30 and carrying cost is 15% of
stock value. The ordering cost is Sh120 per order and the delivery or lead time is 7 days. The desired
minimum stock level is 1,500 units.
Required:
Determine the optimal quantity for the company to order.

Solution:
Co = 120 = ordering cost
D = 1080000 = 36,000 units
30
Ch = 15% x 30 = Sh4.50

=
√ 2 x 120 x 36,000
4.50
=1386 units

Re-Order Level
The re-order level is the level at which an order should be placed. Under EOQ and when the consumption
rate is constant, the re-order level is calculated using the following formula;
Re-order level = Min stock level + lead time consumption
= Lead time consumption
= Demand for 365 days = 36,000 units
Demand for 7 days = ?
= 7/365 x 36,000
= 690 units
Re-order level = 15,00 + 690
= 2,190 units
Maximum stock level = Reorder level + lead time consumption
= 2,190 + 690
= 2,880 units.

EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:

i) The demand is known and constant over the year

ii) The ordering cost is constant per order and certain

iii) The holding cost is constant per unit per year

iv) The purchase cost is constant (Thus no quantity discount)

 v) Back orders are not allowed.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming year which
costs Sh.50 each. The items are available locally and the leadtime in one week. Each order costs Sh.50
to prepare and process while the holding cost is Shs.15 per unit per year for storage plus 10% opportunity
cost of capital..

Required
a) How many units should be ordered each time an order is placed to minimize inventory costs?

b) What is the reorder level?

c) How many orders will be placed per year?

d) Determine the total relevant costs.

Suggested Solution:

a)
Q=
√ 2 DC o
Cn

Where: D = 2,000 units

Co = Sh.50

Cn = Sh.15 + 10% x 50 = Sh.20

L = 7 days

Q=
√ 2 x 2 ,000x 50
20
=100units

DL
b) R = 360
days
 2 ,000 x 7
= 360

= 39 units

D
c) No. of orders = Q

2 ,000
= 100

= 20 orders

D
Co
d) TC = ½QCn + Q

2 ,000
(50 )
= ½(100)(20) + 100

= 1,000 + 1,000

= Sh.2,000

Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is received.

Inventory management systems

A number of systems have been developed to simplify the inventory management process.

 bin systems
 periodic review
 JIT.

Bin systems

A simple visual reminder system for re-ordering is to use a bin system.

Two-bin system

This system utilises two bins, e.g. A and B. Inventory is taken from A until A is empty. An order
for a fixed quantity is placed and, in the meantime, inventory is used from B. The standard
inventory for B is the expected demand in the lead time (the time between the order being placed
and the inventory arriving), plus some 'buffer' inventory.

When the new order arrives, B is filled up to its standard level and the rest is placed in A.
Inventory is then drawn as required from A,and the process is repeated.

One-bin system

The same sort of approach is adopted by some firms for a single bin with a red line within the bin
indicating the ROL.
These methods rely on accurate estimates of:

 lead time
 demand in lead time.

Action must therefore be taken if inventory levels:

 fall below a preset minimum

 exceed a preset maximum.

Control levels

Minimum inventory level usually corresponds with buffer inventory.If inventory falls below that
level, emergency action to replenish maybe required.

Maximum inventory level would represent the normal peak holding,i.e. buffer inventory plus the
re-order quantity. If the maximum is exceeded, a review of estimated demand in the lead time is
needed.

Periodic review system (constant order cycle system)

Inventory levels are reviewed at fixed intervals, e.g. every four weeks. The inventory in hand is
then made up to a predetermined level,which takes account of:

 likely demand before the next review

 likely demand during the lead time.

Thus a four-weekly review in a system where the lead time was two weeks would demand that
inventory be made up to the likely maximum demand for the next six weeks.

Just in Time (JIT) systems

JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory
levels and improve customer service by manufacturing not only at the exact time customers
require, but also in the exact quantities they need and at competitive prices.

In JIT systems the balancing act is dispensed with. Inventory is reduced to an absolute minimum
or eliminated altogether.

Aims of JIT are:

 a smooth flow of work through the manufacturing plant

 a flexible production process which is responsive to the customer's requirements
 reduction in capital tied up in inventory.

This involves the elimination of all activities performed that do not add value = waste.
Examples of waste are:

 raw material inventory

 WIP inventory
 finished goods inventory
 materials handling
 quality problems (rejects and reworks, etc.)
 queues and delays on the shop floor
 long raw material lead times
 long customer lead times
 unnecessary clerical and accounting procedures.

JIT attempts to eliminate waste at every stage of the manufacturing process. Jit should result in:

 a smooth flow of work through the manufacturing plant

 a flexible production process which is responsive to the customer's requirements
 reduction in capital tied up in inventory.

A JIT manufacturer looks for a single supplier who can provide high quality, frequent and
reliable deliveries, rather than the lowest price. In return, the supplier can expect more business
under long-term purchase orders, thus providing greater certainty in forecasting activity levels.
Very often the suppliers will be located close to the company. Smaller, more frequent deliveries
are required at shorter notice.

JIT therefore has inventory holding costs which are close to zero, however, inventory ordering
costs are high.

Using the EOQ EXAMPLE COMPUTE THE TOTAL COST OF HOLDING THE
INVENTORY

Cash Management

Cash is a key part of working capital management.

Companies need to carry sufficient levels of cash in order to ensure they can meet day-to-day
expenses. Cash is also required to be held as a cushion against unplanned expenditure, to guard
against liquidity problems. It is also useful to keep cash available in order to be able to take
advantage of market opportunities.

The cost of running out of cash may include not being able to pay debts as they fall due which
can have serious operational repercussions, including the winding up of the company if it
consistently fails to pay bills as they fall due.

However, if companies hold too much cash then this is effectively an idle asset, which could be
better invested and generating profit for the company.
Cash management models

Cash management models are aimed at minimising the total costs associated with movements
between a company's current account (very liquid but not earning interest) and their short-term
investments (less liquid but earning interest).

The models are devised to answer the questions:

 at what point should funds be moved?

 how much should be moved in one out?

The Baumol cash management model

Baumol noted that cash balances are very similar to inventory levels, and developed a model
based on the economic order quantity (EOQ). Assumptions:

 cash use is steady and predictable

 cash inflows are known and regular
 day-to-day cash needs are funded from current account
 buffer cash is held in short-term investments.

The formula calculates the amount of funds to inject into the current account or to transfer into
short-term investments at one time:

where:

CO = transaction costs (brokerage ,commission, etc.)

D = demand for cash over the period

CH = cost of holding cash.

The model suggests that when interest rates are high, the cash balance held in non-interest-
bearing current accounts should be low. However its weakness is the unrealistic nature of the
assumptions on which it is based.
Example using the Baumol model

A company generates Kshs10,000 per month excess cash, which it intends to invest in short-term
securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs
associated with each separate investment of funds is constant at Kshs.50.

Required:

(a)What is the optimum amount of cash to be invested in each transaction?

(b)How many transactions will arise each year?

(c)What is the cost of making those transactions pa?

(d)What is the opportunity cost of holding cash pa?

USING THE BOUMOLS MODEL COMPUTE THE TOTAL COST OF HOLDING THE
ABOVE CASH.

MILLER –ORR MODEL

The Miller-Orr model of cash management is developed for businesses with uncertain cash
inflows and outflows. This approach allows lower and upper limits of cash balance to be set and
determine the return point (target cash balance). This is different from the Baumol-Tobin model,
which is based on the assumption that the cash spending rate is constant.
Assumptions

The Miller-Orr model of cash management can be used if the following assumptions are met:

1. The cash inflows and cash outflows are stochastic. In other words, each day a business
may have both different cash payments and different cash receipts.
2. The daily cash balance is normally distributed, i.e., it occurs randomly.
3. There is a possibility to invest idle cash in marketable securities.
4. There is a transaction fee when marketable securities are bought or sold.
5. A business maintains the minimum acceptable cash balance, which is called the lower
limit.

Formula

The return point for the cash balance under the Miller-Orr model can be calculated as follows:

Return Point = Lower Limit + 1/3 × Spread

The lower limit is set by management. It depends on the acceptable risk of cash flows gap,
creditworthiness of a business, and expected needs in cash. However, the lower limit can be set
as zero if a business has sufficient investments in marketable securities or perfect
creditworthiness and can raise additional short-term debt at any time.

The equation to compute the spread is as follows:

where F is the transaction cost, K is the opportunity cost of holding cash, and σ2 is a variance of
a daily cash balance.

To find the upper limit of the cash balance, the following formula should be used:

Upper Limit = Lower Limit + Spread

Limitations

When the Miller-Orr model of cash management is applied, we should take into account the
following limitations:

1. An increase in transaction cost results in an increase of spread and a higher return point.
2. The higher the standard deviation (σ) of daily cash balance, the wider the spread and
higher return point. A higher volatility of the daily cash balance also means a higher
probability of reaching the lower or upper limit.
 3. By contrast, an increase in the return on investment in marketable securities will lead to a
narrower spread and lower return point because the opportunity cost of holding cash is
also growing, so a business will seek to decrease its cash holdings.

Graph

As mentioned above, the lower limit or safety cash balance is set by a company’s management,
but both the upper limit and return point depend on the spread. The return point under the Miller-
Orr model is a cash balance that has to be restored if the actual cash balance reaches a lower or
upper limit.

See the graph below to illustrate such situations.

1. A is when the actual cash balance drops to the lower limit. A company’s management
should replenish it to reach the return point, which can be done by selling investments in
marketable securities.
2. B is when the actual cash balance touches the upper limit. In such cases, it is necessary to
buy marketable securities and restore the cash balance down to the return point. The
amount to be invested is the difference between the upper limit and return point.
Example

The management of Stilmill Inc. has set a safety cash balance of $50,000. The standard deviation
(σ) of the daily cash balance during the last year was $37,500, and the transaction cost was $75.
The company also has the opportunity to invest idle cash in marketable securities at an annual
interest rate of 8%.

8%
Daily interest rate = = 0.022%
365

1
Return point = $50,000 + × $213,325 = $121,108
3

Upper limit = $50,000 + $213,325 = $263,325

Illustration

XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The standard deviation
of daily cash flow is Sh.2,500 and the interest rate on marketable securities is 9% p.a. The transaction
cost for each sale or purchase of securities is Sh.20.

Required
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread

Solution

[ ]
1/3
3 bδ ²
Z= +L
a) 4i
 [ ]
3 x 20x(2,500)²
+10,000
9%
4x
= 360

= 7,211 + 10,000 = Sh.17,211

b) H = 3Z – 2L

= 3 x 17,211 – 2(10,000)

= Shs.31,633

4 Z−L
c) Average cash balance = 3

4 x 17 , 211−10 , 000
= 3

= shs 19,614

d) The spread = H–L

= 31,633 – 10,000

= Shs.21,633

Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 i.e (31,633 – 17,211) in
marketable securities and if the balance falls to Shs.10,000, the firm should sell Shs.7,211 i.e (17,211 –
10,000) of marketable securities.
RECEIVABLES (debtors) MANAGEMENT
Receivables result from credit sales. Companies normally sell on credit due to the following
reasons:
 In order to increase its sales volume.
 In order to avoid stock from being out dated.
 In order to maintain the existing customers and acquire other new
 In order to avoid price fluctuations
Collection policy
This is the company’s procedure of collecting payments from customers when they become due.
The credit policy of the company should be balanced so that it is neither too lenient nor too
stringent.
Credit selection/screening
The traditional method of customer selection and screening analysis involves the use of the 5Cs.
These include:
Capacity
This is the assessment of the customer’s ability to repay debt. This may involve assessing the
financial position of the customer’s account with emphasis on liquidity, gearing and profitability.
Capital
This involves the assessment of the customer’s capital by analyzing his capital structure.
Collateral
This involves the evaluation of the assets of the customer which can be available as a security for
credit to be granted.
Character
This is the assessment of the personal character, integrity and the willingness of the customer to
repay within the credit terms.
Conditions
The decision to grant credit may also be influenced by the existing conditions at the time the
credit is to be offered e.g. if the company is finding it difficult to sell a given product then the
company should adopt a lenient credit policy and vice versa.
The following are the general steps of credit management

Step 1: Gathering information

Gather credit information from various sources to assess the credit worthiness of a credit
applicant.
Step 2: Credit investigation
This may include establishing factors such as:
 Type of credit applicant i.e. new or existing?
 Nature of his business and level or risk.
 The amount of credit sales the credit applicant requires.
 The seller’s credit policies and practices.
Step 3: Credit analysis
This will involve analyzing the credit applicant based on his business performance using ratio
analysis, financial strength, the type of system management team and the past experience with
the customer.
 In carrying out credit analysis, the seller should analyze the 5CS of credit.
Step 4: Get the credit limit
This involves determining:
 The amount of credit sales to extend.
 The credit period.
The two limits will influence the amount of capital tied in Receivables and the expected
amount of bad debts.
Step 5: Collection policy and procedure
Once the goods are sold on credit and the credit period is set, the firm should have a definite
policy on debt collection. And in case a debtor has failed to pay after the lapse of the credit
period, the following should be done:
 Send a reminder letter.
 Send progressively tough worded reminder letters.
 Make a reminder telephone call.
 Send a representative of the firm to go and negotiate with the debtor who may be having
temporary liquidity problems.
 Take a legal action.
Financing of Receivables
Two methods are commonly used to finance Receivables. These include:
1.Pledging or assigning of debts
This involves assigning the task of debt collection to an agent who charges a commission.
Sometimes, the agent may advance the company a certain percentage of the debts invoiced such
as 80%.

The company may take advantage of this advance and will finally repay the amount advanced
plus the interest charged by the agent. Since the debt has only been assigned to the agent for debt
collection purposes, in case the debtor defaults then the agent can have recourse to the company

2. Factoring of debts

This involves selling the debts to a factor. It is similar to pledging of debts only that should the
debtor default then the factor will have no recourse and hence he cannot go back to the company
to claim the amount advanced.

MANAGEMENT OF ACCOUNT RECEIVABLE

In order to keep current customers and attract new ones, most firms find it necessary to offer credit.
Accounts receivable represents the extension of credit on an open account by a firm to its customers.
Accounts receivable management begins with the decision on whether or not to grant credit.

The total amount of receivables outstanding at any given time is determined by:
a) The volume of credit sales

b) The average length of time between sales and collections.

Accounts receivables = Credit sales per day x Length of collection period

The average collection period depends on:

a) Credit standards which is the maximum risk of acceptable credit accounts

b) Credit period which is the length of time for which credit is granted

c) Discount given for early payments

d) The firm’s collection policy.

a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends
to sell on credit to customers on a very liberal terms and credit is granted for a longer period.

A firm following a stringent credit policy on the other hand, sell on credit on a highly selective basis only
to those customers who have proven credit worthiness and who are financially strong.

A lenient credit policy will result in increased sales and therefore increased contribution margin.
However, these will also result in increased costs such as:

1. Increased bad debt losses

2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments

The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the
evaluation of investment in receivables should involve the following steps:
 1. Estimation of incremental operating profits from increased sales
2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs

b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount given. The terms 2/10, n/30
means that a 2% discount is given if the bill is paid before the tenth day after the date of invoice otherwise
the net amount should be paid by the 30th day.

In considering the credit terms to offer the firm should look at the profitability caused by longer credit
and discount period or a higher rate of discount against increased cost.

c) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of receivables. It can also result in
reduced bad debt losses.

d) COLLECTION POLICY
The firm’s collection policy may also affect our analysis. The higher the cost of collecting account
receivables the lower the bad debt losses. The firm must therefore consider whether the reduction in bad
debt is more than the increase in collection costs.

As saturation point increased expenditure in collection efforts does not result in reduced bad debt and
therefore the firm should not spend more after reaching this point.

Illustration
Riffruff Ltd is considering relaxing its credit standards. The firms current credit terms is net 30 but the
average debtors collection period is 45 days. Current annual credit sales amounts to Sh.6,000,000. The
firm wants to extend credit period net 60. Sales are expected to increase by 20%. Bad debts will increase
from 2% to 2.5% of annual credit sales. Credit analysis and debt collection costs will increase by
Sh.84,,000 p.a. The return on investment in debtors is 12% for Sh.100 of sales, Sh.75 is variable costs.
Assume 360 days p.a. Should the firm change the credit policy?

Suggested Solution
Current sales = Sh.6,000,000
New sales = Sh.6,000,000 x 1.20 = Sh.7,200,000

Contribution margin = Sh.100 – Sh.75 = Sh.25

Sh . 25
x100
Therefore contribution margin ratio = Sh . 100 = 25%

Cost benefit analysis

Contribution Margin 000 000

New policy 25% x 7,200,000 = 1,800

Current policy 25% x 6,000,000 = 1,500 = 300

Credit analysis and debt collection costs (84)

Bad debts

New bad debts = 2.5% x 7,200,000 = 180

Current bad debts = 2% x 6,000,000 = 120 (60)

Debtors

Cr . period
New debtors = 360days x cr. Sales p.a.

60
x7 ,200 , 000
= 360 = 1,200

45
x 6 , 000 ,000
Current debtors = 360 = 750

Increase in debtors (tied up capital) 450

Forgone profits = 12% x 450 (54)

Net benefit (cost) 102

Therefore, change the credit policy.

EVALUATION OF THE CREDIT APPLICANT

After establishing the terms of sale to be offered, the firm must evaluate individual applicants and
consider the possibilities of bad debt or slow payments. This is referred to as credit analysis and can be
done by using information derived from.

a) The applicant’s financial statement

b) Credit ratings and reports from experts

c) Banks

d) Other firms

e) The company’s own experience

Activities

The following are the projected monthly working capital requirements of Tayari Ltd. for the year
ending 31 December 2008:

Month Amount of working capital required

(Sh.’000’)
January 7,000
February 7000
March 10,500
April 14,000
May 21,000
June 31500
July 42000
August 49000
September 32000
October 17000
November 15000
December 10500

The expected cost of short-term funds is 20% while that of long term funds is 25%.

Ignore taxation.

Required:
A schedule showing the amount of permanent and seasonal working capital requirements for
each month.
Average amount of long-term and short-term finance that would be required monthly.

Total cost of working capital finance if the firm adopts an aggressive financing strategy.

The total cost of working capital finance if the firm adopts a conservative financing strategy.

Activity ii
The following information relates to Maendeleo Limited:

Sh’000’
Purchase of raw 6,700
materials
Usage of raw 6,500
material
Sale of finished 25,000
goods (all on credit)
Cost of sales 18,000
(finished goods)
Average creditors 1,400
Average raw 1,200
materials stock
Average work in 1,000
progress
Average finished 2,100
goods stock
Average debtors 4,700

Assume a 365 day year

Required:
The length of cash conversion cycle
Activity iii
The following information was extracted from the books of Bermuda Ltd. at the end of the
financial years ended 31 October 2010 and 2011.

Sh Sh
Stock of raw 40,000 60,000
materials
Work-in-progress 10,000 18,000
Finished goods 50,000 70,000
stock
Trade debtors 140,000 180,000
Annual sales 2,000,000 2,200,000
Cost of 1,000,000 1,050,000
production
Annual cost of 1,200,000 1,250,000
sales
Trade creditors 110,000 100,000
Annual purchases 700,000 780,000
of raw materials
Required:
The working capital cycle (in days) of Bermuda Ltd.

Fanuel Ltd, a large multi-national company, is in the process of determining the optimal cash balance for
the year ending 31 December 2009.
The management of the company has established the following information:
The company’s annual cash requirements amount to Sh2,500 million.
The cost of each cash conversion transaction is Sh500.
The opportunity cost of funds is 12%.
Required;
(a) Optimal cash balance that the company should hold.
 (b) Total cost of maintaining the cash balance determined in (i) above

Baren Ltd. projects that cash outlays of Sh.45 million will occur uniformly throughout the year.
The company plans to meet its cash requirements by selling marketable securities from its
portfolio. The expected return from the company’s marketable securities is 8 per cent per
annum, and the cost per transaction of converting securities into cash is Sh.30.

Required:
(i) The optimal cash balance. (2 marks)
(ii) The average cash balance. (2 marks)
(i) The number of transfers between cash and marketable securities per year