WORKING CAPITAL MANAGEMENT

Working capital is the capital available for conducting the day-to-day operations of the business and consists of current
assets and current liabilities.
Working capital = current assets – current liabilities

Current assets Current liabilities

Inventories Trade payables
Trade receivables Bank overdrafts
Cash
Short term investments
Working capital can be viewed as a whole but interest is usually focussed on the individual components such as
inventories or trade receivables. Working capital is effectively the net current assets of a business.

Working capital can either be:

Positive Current assets are greater than current liabilities.

It means that the company is able to pay off its short-term liabilities.
Negative Current assets are less than current liabilities
It means that a company currently is unable to meet its short-term liabilities with its
current assets

Working capital management

Working capital management is the administration of current assets and current liabilities. Effective management of
working capital ensures that the organisation is maximising the benefits from net current assets by having an optimum
level to meet working capital demands.

Objectives of working capital management

The two main objectives of working capital management are:

 To increase the profits of a business

 Provide sufficient liquidity to meet short term obligations as they fall due

There is often a conflict between the two main objectives of working capital management:

 If we maintain more liquid assets, profitability will be reduced.

 If we maintain less liquid assets, profitability will be increased as more assets are invested but risk of insolvency
increased

Management need to carefully consider the level of investment in working capital and to consider the impact that this
is having on a company’s liquidity position; an overview of this is given by the cash operating cycle

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Working capital cycle (operating/trading/cash cycle)

The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash to
you from their sale. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working
capital. The diagram below shows how the cycle works.

Days

Average time raw materials are in stock X

Average time work in progress is in production X

Average time finished goods are in stock X

Average receivable collection period X

Less: (Average payable period) (X)

Cash operating cycle X

Average time raw materials are in stock Raw materials

x 365 days
Purchases

Average time work in progress is in production Work in progress

x 365 days
Cost of production (or Cost of sales)

Average time finished goods are in stock Finished goods

x 365 days
Cost of sales

Average receivable collection period Accounts receivables

x 365 days
Credit Sales (or turnover)

Average payable period Accounts payables

x 365 days
Credit purchases (or cost of sales)

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  The optimal length of the cycle depends on the industry.
 Measure in Days, Weeks and Months
 Short Conversion Cycle is a good sign
 By comparing the cash operating cycle from one period to the next or one company to another it should be
possible to identify potential deficiencies.
Generally closing balances will be considered as average balances.
If not mentioned, all the sales and purchases are considered to be on credit.
In the absence of purchases, cost of sales will be used.
If not given, all inventory will be considered as finished goods

Lecture Example:

The information below is extracted from the annual accounts of Management plc for the past year.
Management plc – Extracts from annual accounts

Inventory: raw materials 108,000

work in progress 75,600
finished goods 86,400
Purchases of raw materials 518,400
Cost of production 675,000
Cost of goods sold 756,000
Sales 864,000
Receivables 172,800
Payables 86,400
Required:

Calculate the length of the working capital cycle (assuming 365 days in the year).

Solution

Days
Average time raw materials are in stock (108,000÷518,400) x 365 days =
+ +
Average time work in progress is in production (75,600÷675,000) x 365 days =
+ +
Average time finished goods are in stock (86,400÷756,000) x 365 days =
+ +
Average receivable collection period (172,800÷864,000) x 365 days =
- -
Average payable period (86,400÷756,000) x 365 days =
=
Cash operating cycle

The shorter the cycle, the better it is for the company as it means:
 Inventories are moving through the organization rapidly.
 Trade receivables are being collected quickly.
 The organization is taking the maximum credit possible from suppliers.
The shorter the cycle, the lower the company’s reliance on external supplies of finance like bank overdraft which
is costly.

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 Excessive working capital means too much money is invested in inventories and trade receivables. This represents
lost interest or excessive interest paid and lost opportunities (the funds could be invested elsewhere and earn a
higher return).
The longer the working capital cycle, the more capital is required to finance it.

Forecasting cash flow needs

The cash operating cycle can be used to determine the amount of cash needed at any sales level, and to identify the
possibility of a cash shortfall if sales rise too rapidly. Referring back to the previous lecture example, we can identify a
relationship between sales and cash required by using the sales / net working capital ratio.

Management plc – Extracts from annual accounts

Sales 864,000
Inventory: raw materials 108,000
work in progress 75,600
finished goods 86,400
Receivables 172,800
Payables (86,400)
Net working capital 356,400

Sales / net working capital ratio = 864,000 / 356,400 = 2.42

Required:

What level of net working capital (i.e. cash) is needed to support sales, if sales rise by 30% over the next year?

Working capital ratios

Ratios are way of comparing financial values and quantities to improve our understanding. In particular, they are used
to assess the performance of a company.
When analysing performance through the use of ratios it is important to use comparisons as a single ratio is
meaningless.
The use of ratios
 To compare results over a period of time
 To measure performance against other organisations
 To compare results with a target
 To compare against industry averages
We shall now look at some of the working ratios in detail and explain how they can be interpreted.
1. Current ratio (CA) or working capital ratio
current assets
Current ratio = (number of times)
current liabilities
The current ratio measures the short term solvency or liquidity; it shows the extent to which the claims of short-
term creditors are covered by assets. The current ratio is essentially looking at the working capital of the
company. Effective management of working capital involves low investment in non-productive assets like trade
receivables, inventory and current account bank balances. Also maximum use of free credit facilities like trade
payables ensures efficient management of working capital.
The normal current ratio is around 2:1 but this varies within different industries. Low current ratio may indicate
insolvency. High ratio may indicate not maximising return on working capital. Valuation of inventories will have
an impact on the current ratio, as will year end balances and seasonal fluctuations.

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2. Quick ratio or acid test
current assets−inventory
Acid – Test Ratio = (number of times)
current liabilities
This ratio measures the immediate solvency of a business as it removes the inventories out of the equation,
which is the item least representing cash, as it needs to be sold. Normal is around 1: 1 but this varies within
different industries.
3. Trade payable days (turnover)
End of year accounts payables
x 365 days
Credit purchases (or cost of sales)
This is the length of time taken to pay the suppliers. The ratio can also be calculated using cost of sales, as
credit purchases are not usually stated in the financial statements. High trade payable day’s is good as credit
from suppliers represents free credit. If it’s too high then there is a risk of the suppliers not extending credit in
the future and may lose goodwill. High trade payable days may also indicate that the business has no cash to
pay which indicates insolvency problems.

4. Trade receivable days (turnover)

End of year accounts receivables
x 365 days
Credit Sales (or turnover)

This is the average length of time taken by customers to pay. A long average collection means poor credit
control and hence cash flow problems may occur. The normal stated credit period is 30 days for most
industries. Changes in the ratio may be due to improving or worsening credit control. Major new customer pays
fast or slow. Change in credit terms or early settlement discounts are offered to customers for early payment
of invoices.

5. Inventory days
Average Inventory
x 365 days
Cost of sales
Average inventory can be arrived by taking this year’s and last year’s inventory values and dividing by 2 -
(Opening inventories + closing inventories) / 2. This ratio shows how long the inventory stays in the company
before it is sold. The lower the ratio the more efficient the company is trading, but this may result in low levels
of inventories to meet demand. A lengthening inventory period may indicate a slowdown in trade and an
excessive build-up of inventories, resulting in additional costs.

6. Inventory turnover is the reciprocal of inventory days.

Cost of sales
(Number of times)
Average Inventory

This shows how quickly the inventory is being sold. It shows the liquidity of inventories, the higher the ratio the
quicker the inventory is sold.

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Exercise 1:

The following are extracts of the Income Statement and Statement of Financial Position (Balance Sheet) for Muna plc.

Extract Balance Sheet as at 30 June

2018 2017
K’000 K’000 K’000 K’000
Current assets:
Inventories 84 74
Trade receivables 58 46
Bank 6 10
148 130
Current liabilities:
Trade payables 72 82
Taxation 20 20
92 102
Net current assets 56 28

Extract Income Statement for the year ended 30 June

2018 2017
K’000 K’000 K’000 K’000
Turnover (sales) 418 392
Opening inventory 74 58
Purchases 324 318
398 376
Closing inventory (84) (74)
Cost of sales (314) (302)
Gross profit 104 90

Calculate and comment on the following ratios for Muna plc:

(i) Current ratio [Answer: 1.61 (2018), 1.27 (2017)]

(ii) Quick ratio
(iii) Inventory days
(iv) Trade receivable days
(v) Trade payable days
(vi) Working capital cycle in days
Comments:
[Answer: 0.70 (2018), 0.55 (2017)]
[Answer: 91.8 days (2018), 79.8 days (2017)]
[Answer: 50.6 days (2018), 42.8 days (2017)]
[Answer: 81.1 days (2018), 94.1 days (2017)]
[Answer: 61.3 days (2018), 28.5 days (2017)]

(i) The current ratio has increased, meaning that the organisation is more liquid. This is due to the fact that
inventory and trade receivables have increased (which are non-productive assets) and trade payables
have been reduced. Although this may be better for the current ratio it may not necessarily mean that the
company is operating more efficiently. Has it increased its inventory piles because it anticipates higher
sales and doesn’t want to run-out? Is it offering its credit customers longer time to pay to increase sales?
Why are they paying their suppliers quicker?
(ii) In 2018 current liabilities are better covered than 2017. Bad management of working capital
perhaps…investigate further.
(iii) Inventory is taking longer to sell; this could indicate poor inventory management. Why have inventory levels
risen? May be the company is taking a cautious approach and want to ensure enough is available to meet
customer needs. But this is resulting in additional costs.
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 (iv) The collection of debts is worsening. Have the credit terms been extended to increase sales? Are there
new customers who were not screened properly, resulting in delayed payment? Is there a delay in issuing
invoices, lack of screening of new customers? Are the year-end figures representatives of the year? Further
investigation required as yet again this is an unproductive asset.
(v) The suppliers are being paid quicker, which is good for relationship with the suppliers, but bad for cash
flow purposes. Trade credit is a free source of finance, and the company must try to maximise this.
(vi) In 2018, the WCC increased to 61.3 days from 28.5 days in 2017. The company is taking longer to convert
its inventories into cash. The management of inventories, receivables and payables has deteriorated, and
this needs to be investigated and corrected.
Exercise:

The following financial data is available for Diamond Co.

Extracts from the financial statements:
K’000
Income statement:
Revenue 14,687
Gross profit 4,386
Profit from operations 2,159
Statement of Financial Position:
Non-current assets 7,340
Inventory 936
Trade receivables 2,626
Trade payables 1,296
Other payables 537
Overdraft 1,237
Net current assets 492

Calculate the current ratio, quick ratio, inventory turnover ratio, average collection period, average payable period
and sales revenue/net working capital ratio for Diamond Co.

Overtrading
“A business which is trying to do too much too quickly with too little long-term capital is overtrading”

Overtrading means carrying on an excessive volume of trading in relation to the amount of long-term capital invested
in the business. A company that is overtrading has inadequate capital for the volume of sales revenue it is earning.

Although it is possible for any business entity to overtrade, it is probably most common in small companies that are
now expanding rapidly, with a very high rate of sales growth.

Symptoms of overtrading Remedies for overtrading

 Rapid increase in sales/turnover.
 Fixed Assets increasing rapidly
 Cash Operating Cycle increasing rapidly
 Receivables increasing rapidly
 Payables increasing rapidly
 Stocks increasing rapidly
 Bank Overdraft increasing rapidly
 Cash decreasing rapidly
 Current Ratio decreasing rapidly
 Quick Ratio decreasing rapidly
Short-term solutions:
 Speeding up collection from customers.
 Slowing down payment to suppliers.
 Maintaining lower inventory levels.
 The company could postpone ambitious
plans for increased sales and fixed asset
investment
Long term solutions:
 Increase the capital by equity or long-
term debt.

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Over Capitalized
“If there are excessive inventories, accounts receivable and cash and very few accounts payable, there will be an over-
investment by company in current assets and the company will be in this respect over-capitalized.”

Symptoms:

Rapid increase in turnover.

Rapid increase in the volume of current assets e.g. inventory and receivable.
High Inventory and accounts receivable period.
Not much rise in Trade accounts payable and overdraft.
Current ratio and quick ratio rise significantly. Current assets are more than current liabilities
Sales/working capital ratio is decreasing over time, working capital should be increased in line with sales.

INVENTORY MANAGEMENT
Inventory management has traditionally been about minimizing the total cost of inventory without running the risk
of stock-outs.

The inventory days ratio gives an overview of a company’s overall inventory position and is a useful method of
monitoring a company’s overall stock position; but major companies may well have thousands of items in stock, and
will want to calculate how much stock to hold of each individual item.

Inventory Costs

Holding Costs Ordering costs Stock out costs Cost of inventory

 Warehousing and  Ordering costs  Contribution from lost  Purchase Cost

handling costs sales
 Deterioration cost  Delivery costs  Extra cost of emergency
inventory
 Obsolescence cost  Freight Charges  Reputation loss
 Insurance cost
 Pilferage cost

Economic order quantity (EOQ)

The economic order quantity (EOQ) is the order quantity which minimizes inventory costs.

Assumptions of using EOQ

The following assumptions are applicable in EOQ which limits its applicability:

Demand and lead time are assumed to remain constant.

Purchase price is also assumed to remain
No buffer inventory
Holding costs are assumed to be constant.

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EOQ formula

2CoD
EOQ =
Ch

Where: Ch= cost of holding one unit of inventory for one-time period
Co = cost of ordering a consignment from a supplier
D = demand during the time period

And Total Cost = carrying cost + ordering cost

= (Q/2) Ch + (D/Q) Co

Where Q = Reorder quantity (EOQ)

Example:

Paton Co uses components at the rate of 500 units per month, which are bought in at a cost of $1.20 each from the
supplier. It costs $20 each time an order is placed, regardless of the quantity ordered.

The total holding cost is 20% per annum of the value of stock held.

What are the EOQ and TAC?

2 x 20 x 6,000
EOQ   1,000units
1.20 x 0.20

TAC = (Q/2) Ch + (D/Q) Co

= (1,000 ÷ 2) 0.24 + (6,000 ÷ 1,000) 20

= 120 + 120

= $240

EOQ and bulk discounts

Sometimes a supplier will offer a bulk discount if a certain quantity of inventory is ordered. To calculate the best order
quantity if a discount is offered:
1. Calculate the EOQ ignoring the discounts.
2. If the EOQ is above the first discount point recalculate the EOQ allowing for the discount
3. Then calculate the total annual cost (including the total purchase cost) at the new EOQ and all discount points
above the EOQ: = (Q/2) Ch + (D/Q) Co + PD
4. The point at which the total annual cost is lowest is the best order quantity

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Example:

The maintenance department of a large hospital uses about 816 cases of liquid cleanser annually. Ordering costs are
$12, carrying costs are $4 per case a year, and the new price schedule indicates that orders of less than 50 cases will
cost $20 per case, 50 to 79 cases will cost $18 per case, and 80 to 99 cases will cost $17 per case. And larger orders
will cost $16 per case. Determine the optimal order quantity and the total cost.

D = 816 cases per year,

Range Price
S = $12

H = $4 per case per year. 1 to 49 $20

The price schedule is:

50 to 79 18

80 to 99 17
1. Compute the common EOQ
2 DS 2(816)12
EOQ =   69.97  70 100 and more 16
H 4
2. The 70 cases can be bought at $18 per case because 70 fall in the
range of 50 to 79 cases. Therefore, the total cost to purchase 816 cases a year, at the rate of 70 cases per order,
will be:

TC70 = carrying cost + ordering cost + purchasing cost

= (Q0/2) H + (D/Q0) S + PD

= (70/2)4 + (816/70) 12 + 18 (816) = $14,968

 Because lower cost ranges exist, each must be checked against the minimum total cost generated
by 70 cases at $18 each. In order to buy at $17 per case, at least 80 cases must be purchased.
The total cost at 80 cases will be:

TC80 = (80/2) 4 + (816/80)12 + 17(816) = $14,154

• To obtain a cost of $16 per case, at least 100 cases per order are required and the total cost at
that price break point will be:

TC100 = (100/2)4 + (816/100) 12 + 16(816) = $13,354

Therefore, because 100 cases per order yield the lowest cost, 100 cases is the overall optimal order quantity.

Other formulas to remember

Reorder level = maximum usage x maximum lead time

Minimum level (Buffer safety inventory) = reorder level – (average usage x average lead time)
Maximum level = reorder level + reorder quantity – (minimum usage x minimum lead time)
Average inventory = safety inventory + ½ reorder quantity

Exercise:
A large retailer with multiple outlets maintains a central warehouse from which the outlets are supplied. The following
information is available for Part Number SF525.
Average usage 350 per day
Minimum usage 180 per day
Maximum usage 420 per day

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Lead time for replenishment 11-15 days
Re-order quantity 6,500 units
Re-order level 6,300 units
(a) Based on the data above, what is the maximum level of inventory? Ans 10,820
(b) Based on the data above, what is the approximate number of Part Number SF525 carried as buffer inventory? Ans
1,750

JIT (Just-in-Time) Procurement

o Just-in-time procurement is a term which describes a policy of obtaining goods from suppliers at the latest possible
time, so avoiding the need to carry any inventory level.
o The objective is zero inventory level which results in zero holding costs.

Advantages
Reduction in inventory holding
costs
Reduced manufacturing lead
times
Improved labor productivity
Reduced scrap/rework/warranty
costs.
Increased flexibility
Disadvantages
Just-in-time manufacturing system is vulnerable to
unexpected disruptions in supply chain. A production line can
quickly come to a halt if essential parts are unavailable
JIT can only be implemented in case of reliable suppliers that
are located close
Less opportunity for bulk discounts
Low staff morale due to unpredictable production schedule

ACCOUNTS RECEIVABLE MANAGEMENT

The main advantage of offering credit is that you may sell more and hence make more profit. However, this also
worsens the liquidity of the organization and if the debt went bad, could result in no benefit what so ever from the sale.

Major roles of credit control department/Receivable management:

1) To formulate credit policies

Lenient policy
Strict policy
Early settlement discount
2) Assess credit worthiness of customers
3) Collection of debt from customers efficiently
4) Collection of overdue debt
5) Receivable as sources of finance
Factoring
Invoice discounting
6) Foreign receivable management
7) Cost of Receivable
Administrative cost to record and collecting debts
Cost of irrecoverable debts (Sales X % of bad debt)
Cost of early Settlement Discount = (Sales X % of discount X % of customers taken the discount)
Finance Cost (Average Receivable X % of interest rate)

Advantages and Disadvantages of using different polices for Receivables Management

Page 11 of 24
 Lenient Policy Strict policy
Advantages Increase in contribution Decrease in potential bad debt
Decrease in administration cost Less overdraft cost
Disadvantages Increase in potential bad debt Decrease in contribution
High overdraft cost Increase in administration cost

How to tackle in Exam

Current Policy Proposed policy

𝐀𝐜𝐭𝐮𝐚𝐥 𝐝𝐚𝐲𝐬 𝐀𝐜𝐭𝐮𝐚𝐥 𝐝𝐚𝐲𝐬

Cost of receivables= (Credit sales x )× OD Cost of receivables= (Credit sales x )× OD
𝟑𝟔𝟓 𝟑𝟔𝟓
Interest rate Interest rate

Contribution =Sales × C/S ratio% Contribution =Sales × C/S ratio%

Bad debt = sales × % of bad debt Bad debt = sales × % of bad debt

Admin cost Admin cost

Total cost/Benefit Total cost/Benefit

Early Settlement Discount

Current Policy Proposed Policy

𝐀𝐜𝐭𝐮𝐚𝐥 𝐝𝐚𝐲𝐬 Cost of receivables availing discount =(Credit
Cost of receivables= (Credit sales x )× OD
𝟑𝟔𝟓 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
Interest rate sales x )× % of availing discount x OD
𝟑𝟔𝟓
Interest rate

Contribution = Sales × C/S ratio% Cost of receivables not availing discount

𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
=(Credit sales x )× % of not availing
𝟑𝟔𝟓
discount x OD rate

Bad debt=sales×% of bad debt Discount allowed= Sales × % of discount × % of

availing discount

Admin cost Contribution = Sales × C/S ratio%

Total cost Bad debt = sales × % of bad debt

Admin cost

Total cost

Cost of Early Settlement Discount

The percentage cost of early settlement discount to the company offering the discount can be calculated by the
following formula

Page 12 of 24
 𝟏𝟎𝟎
Cost of early settlement discount= ( )^365/t - 1
𝟏𝟎𝟎−𝒅
Where
d = discount offered
t = reduction in payment period in days that is necessary to obtain early payment discount

Assessing Creditworthiness methods

 Bank reference: While a bank reference can be fairly easily obtained, it must be remembered that the other
company is the bank’s customer and so a bank reference will stick to the facts. It is most unlikely to raise any
fears the bank may have about the company.

 Trade reference: This is obtained from another company who has dealings with your potential
customer/customer. Due to the litigious nature of society these days, it may not be so easy to obtain a written
reference. However, you may be able to call contacts you have in the trade and obtain an informal oral reference

 Credit rating/reference agency: These agencies’ professional business is to sell information about companies
and individuals. Hence, they will be keen to give you the best possible information, so you are more likely to
return and use their services again.

 Financial Statements: Financial statements of a company are publicly available information and can be quickly
and easily obtained. While an analysis of the financial statements may indicate whether or not a company
should be granted credit, it must be remembered that the financial statements available could be out of date
and may have suffered from manipulation. For larger companies, an analysis of their accounting information
can generally be found through various sources on the internet

 Information from the financial media: Information in the national and local press, and in suitable trade
journals and on the internet, may give an indication of the current situation of a company. For example, if it
has been reported that a large contract has been lost or that one or more directors has left recently, then this
may indicate that the company has problems

 Visit: Visiting a potential new customer to discuss their exact needs is likely to impress the customer with regard
to your desire to provide a good service. At the same time, it gives you the opportunity to get a feel for whether
or not the business is one which you are happy to give credit to. While it is not a very scientific approach, it can
often work quite well, as anyone who runs their own successful business is likely to know what a good business
looks, feels and smells like!

Collection of Receivables
Collection of funds efficiently
 The customer is fully aware of the terms
 The invoice is correctly drawn up and issued promptly.
 They are aware of any potential quirks in the customer’s system
 Queries are resolved quickly
 Monthly statements are issued promptly
Collection of overdue debt
Instituting reminders or final demands
Chasing payment by telephone
Making a personal approach
Page 13 of 24
 Notifying debt collection section
Handling over debt collection to specialist debt collection section
Instituting legal action to recover the debt
Hiring external debt collection agency to recover debt.
Debt Factoring
Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money
it is due to collect.

Factoring can be used to help short-term liquidity or to reduce administrative costs.

Aspects of Factoring

The main aspects of factoring include the following:

 Administration of the client’s invoicing, sales accounting and debt collection service.
 Credit protection for the client’s debts, whereby the factor takes over the risk of loss from bad debts ad so insures
the client against such losses. This is known as non-recourse service.
 Making payments to the client in advance of collecting the debts. This is referred to as ‘factor finance’

Applying Debt Factoring

Before Factoring After factoring

𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔

Cost of receivables=(Credit sales x ) Cost of Factor advance = (Credit sales x )× %
𝟑𝟔𝟓 𝟑𝟔𝟓
× OD Interest rate of factor advance x Factor Interest rate
𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔
Cost of remaining receivable = (Credit sales x )
𝟑𝟔𝟓
× % of remaining finance x OD Interest rate

Bad debt = sales × % of bad debt Factor fee = Sales × % of fee

Bad debt = sales × % of bad debt ( if with recourse)

Admin cost Admin cost

Total cost Total cost

Example of Debt Factoring

A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt administration has been
poor and the average collection period has been 45 days with 0.5% of sales resulting in bad debts which are written
off.

A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of credit sales. The
company would save $30,000 a year in administration costs. The payment period would be 30 days.

It is assumed that the factor would advance an amount equal to 80% of the invoiced debts, and the balance 30 days
later.

Page 14 of 24
The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current
base rate). The company can obtain an overdraft facility to finance its accounts receivable at a rate of 2.5% over base
rate.

Required:

Should the factor's services be accepted? Assume a constant monthly turnover.

Solution (a)

The current situation is as follows, using the company’s debt collection staff and a bank overdraft to finance all debts.

Credit sales $1,500,000 pa

Average credit period 45 days
The annual cost is as follows:
$ 45/365 x $1,500,000 x 13.5% (11% + 2.5%) 24,966
Bad debts 0.5% x $1,500,000 7,500
Administration costs 30,000
Total cost 62,466

Solution (b)

The cost of the factor. 80% of credit sales financed by the factor would be 80% of $1,500,000 = $1,200,000. For a
consistent comparison, we must assume that 20% of credit sales would be financed by a bank overdraft. The average
credit period would be only 30 days. The annual cost would be as follows.

$
Factor’s finance 30/365 x $1,200,000 x 14% 13,808
Overdraft 30/365 x $300,000 x 13.5% 3,329
17,137
Cost of factor’s services: 2.5% x $1,500,000 37,500
Cost of the factor 54,637

Solution (c)

Conclusion. The factor is cheaper. In this case, the factor’s fees exactly equal the savings in bad debts ($7,500) and
administration costs ($30,000). The factor is then cheaper overall because it will be more efficient at collecting debts.
The advance of 80% of debts is not needed, however, if the company has sufficient overdraft facility because the
factor’s finance charge of 14% is higher than the company’s overdraft rate of 13.5%.

Advantages & Disadvantages of debt factoring

Advantages

Business can pay its suppliers on time and so be able to take advantage of early payment discounts.
Optimum inventory level can be maintained because management will have enough cash.
Growth can be financed through sales rather than injecting new capital
The cost of running sales ledger department is over.
Business can use the expertise of debtor management that the factor specializes.
Management time is saved because managers don’t have to spend their time on debtor management.
Business gets its finance linked to its volume of sales

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Disadvantages

Factoring is likely to be costlier than an efficiently run internal credit control department.
Customers may not like to deal with factors.
Company loses control to decide to whom to grant credit period and the length of credit period for each customer
Once a company hires a factor, it is difficult to go back to an internal credit control system again.
Factoring may have a bad reputation for the company. It may indicate that the company has financial issues.

Invoice Discounting
Invoice discount is the purchase of trade debts at a discount by the providers of the discounting service.

Invoice discount and factoring are linked and mostly factors also provide invoice discounting service too. It involves the
purchase of a selection of invoices by the factor at a discount but the invoice discounter doesn’t take over administration
of the client’s sales ledger.

 Confidential invoice discounting is an arrangement whereby a debt is assigned to the factor confidentially and the
client’s customer will only become aware of the arrangement if he doesn’t pay his debt to client.
 Non-confidential invoice discount is an arrangement whereby the client’s customer is aware of the relationship of
factor to client and acknowledges its liability towards factor.

Managing Foreign Accounts Receivables

Reducing investment in foreign accounts receivable
Forfaiting
Letter of credit
Countertrading
Export credit insurance
Export factoring

REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE

 A company can reduce its investment in foreign accounts receivable by asking for full or part payment in
advance of supplying goods. However, this may be resisted by consumers, particularly if competitors do not
ask for payment up front.

FORFAITING

 Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfeiter.
 The forfeiter takes on all of the credit risk from the transaction (without recourse) and therefore the forfeiter
purchases the receivables from the seller at a discount.
 The purchased receivables become a form of debt instrument (such as bills of exchange) which can be sold
on the money market.
 The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result
the cost of forfaiting is relatively high.

LETTER OF CREDIT

 This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-
free method of securing payment for goods or services.

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There are a number of steps in arranging a letter of credit:

Both parties set the terms for the sale of goods or services
The purchaser (importer) requests their bank to issue a letter of credit in favor of the seller (exporter)
The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions
specified in the letter have been complied with
The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank
The bank then issues a banker’s acceptance

Letter of credit (continued)

The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted
value
o It takes significant amount of time and therefore are slow to arrange.
o The use of letters of credit may be considered necessary if there is a high level of non-payment risk.
o Customers with a poor or no credit history may not be able to obtain a letter of credit from their own
bank. Letters of credit are costly to customers and also restrict their flexibility:
o Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only
occurs if the seller presents exactly the documents stated in the conditions.

COUNTERTRADING

In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash. The
benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a business
enter foreign markets that it may not otherwise be able to.

Disadvantage

 The value of the goods or services received in exchange may be uncertain.

 It includes complex negotiations and logistical issues, particularly if a countertrade deal involves more than two
parties.

EXPORT CREDIT INSURANCE

Export credit insurance protects a business against the risk of non-payment by a foreign customer. Exporters can
protect their foreign accounts receivable against a number of risks which could result in non-payment. Export credit
insurance usually insures insolvency of the purchaser or slow payment, insures against certain political risks, for
example war, and riots.

Disadvantages include the relatively high cost of premiums and the fact that the insurance does not typically cover
100% of the value of the foreign sales.

EXPORT FACTORING

An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic
accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be costlier
than export credit insurance and it may not be available for all countries, particularly developing countries.

GENERAL POLICIES FOR FOREIGN ACCOUNTS RECEIVABLE

None of the methods detailed above would allow the selling company to escape from the basic fact that credit should
only be given to customers who are creditworthy.

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MANAGING ACCOUNTS PAYABLE
There are three main objectives of accounts payable management.

Seeking satisfactory credit terms from suppliers.

Extending credit period during periods of cash shortage.
Maintaining good relationships with suppliers.

Trade Credit

The cost of lost cash discount can be calculated by the following formula:
𝟏𝟎𝟎
Cost of early settlement discount= ( )^365/t - 1
𝟏𝟎𝟎−𝒅

Where

d = discount offered

t = reduction in payment period in days that is necessary to obtain early payment discount

Example:

Product Q The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit
on 60 days’ credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30
days.

Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each
year.

Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q

Cash Management

Objective of holding Cash:

John Maynard Keynes identified three reasons for holding cash.

Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable
like employee wages, taxes, annual dividends …
Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies.
Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest
rates will rise in future.

Problems associated with cash flows:

Making losses: If a business is continually making losses, it will eventually have cash flow problems.
Inflation: Even if a business is making a profit, it can still face cash flow problems in during period of inflation.
Growth: During periods of growth, business has an ever increasing need for more non-current assets and for its
increasing working capital
Seasonal business: When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain
times during the year.
One-off items of expenditure: Sometimes, a single non-recurring item of expenditure may create a cash flow
problem.

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Managing Cash Flow Problems

Cash flow problems can be eased by taking a number of steps

(i) Postponing capital expenditure: Some capital expenditures can be postponed for a year or so without serious
effect on company’s long term performance.
(ii) Accelerating cash inflows: Business can encourage its account receivables to pay early through discounts on
early payments.
(iii) Reversing past investments: Some assets that are not crucial for business survival can be sold during period
of severe cash flow problem
(iv) Negotiations with accounts payable: This involves the following
 Longer credit can be taken from suppliers
 Loan repayments can be rescheduled through negotiations with bank
 Dividend payment can be reduced

Cash Flow Forecasts

Months 1 2 3 4

Cash Inflows

Receivable Collection X X X X

Dividends Received X X X X

Sale of non-current assets X X X X

Cash Outflow

Trade payable payment (X) (X) (X) (X)

Purchase of non-current assets (X) (X) (X) (X)

Wages (X) (X) (X) (X)

Net Cash Flows X X X X

Opening Balance X X X X

Closing Balance X X X X

Treasury Management
Treasury management can be defined as

Corporate handling of all financial matters,

The generation of external and internal funds for business,
The management of currencies and cash flows,
The complex strategies,
Policies and procedures of corporate finance

Treasury department can be centralized or decentralized in an organization depending on its needs. Both have certain
advantages associated with them.

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Advantages of Centralized Treasure Department

 Large volume of cash is available to invest, leading to better short-term investment opportunities.
 Borrowing can be arranged in bulk at lower interest rate.
 Foreign exchange risk management will be improved through matching foreign currency income earned by
one subsidiary with expenditure in the same currency by another subsidiary.
 Treasure management will be efficient because a centralized treasury department can employ experts.
 Liquidity management will be improved through centralized treasury department
o It avoids having a mix of cash surpluses and overdrafts in different localized banks
o It facilitates bulk cash flow which will result in less transaction costs.

Advantages of Decentralized Treasury Management

 Greater autonomy will be given to subsidiaries

 A decentralized treasury function may be more responsive to the needs of individual operating units.
 Sources of finance will be diversified

Cash Management (The Baumol model)

The Baumol model is based on the idea that an optimum cash balance is like deciding an optimum inventory level. It
uses the same EOQ formula that is used to calculate the optimum inventory level

2CS
Q =
I

Where:

Q = Optimum amount of cash to be raised

S = Amount of cash to be used in each time period C

C = Cost per sale of securities

I = Interest cost of holding cash or near cash equivalents (Interest rate on new borrowings – interest
earned on cash investment)

EXAMPLE
Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for $24,000 of cash over each
period of one year for the foreseeable future. The interest cost of new funds is 12% per annum; the interest rate earned
on short-term securities is 9% per annum.

Required:

How much finance should Finder raise at a time?

Solution

The cost of holding cash is 12% - 9% = 3%

The optimum level of Q (the ‘recorder quantity) is:

2 x 4,000 x 24,000 = $80,000

0.03

The optimum amount of new funds to raise is $80,000. This amount is raised every 80,000 ÷ 24,000 = 31/3 years.
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Advantages of Baumol Model

o The Baumol model enables companies to find out their desirable level of cash balance under certain
assumed conditions.
o It recognizes the cost of holding extra cash.

Disadvantages of Baumol Model

o It is unlikely to be possible to predict amounts required over future periods.

o No buffer inventory of cash is allowed.
o There may be a number of other costs associated with holding cash

The Miller-Orr Model

The Miller-Orr model focuses on an optimum amount of cash that a company should held which is called return point.
The model then sets an upper and lower limit of cash balances which should not be crossed. If a company reaches an
upper limit, it should buy market securities to return to the “return point” and if it reaches lower limit, it should sell some
securities to reach to the “return point”.

Calculating the Return Point

3 x Transaction cost x Variance of cash flows

 Spread = 3 ( )^1/3
4 Interest Rate

1
 Return point = lower limit + ( x Spread )
3

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Example

The following data applies to a company.

 The minimum cash balance is $8,000.

 The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of $2,000 per
 The transaction cost for buying or selling securities is $50. The interest rate is 0.025 per cent day.

Required:

You are required to formulate a decision rule using the Miller-Orr model.

Solution

The spread between the upper and the lower cash balance limits is calculated as follows:

3 x Transaction cost x Variance of cash flows

 Spread = 3( )^1/3
4 Interest Rate
3 x 50 x 4,000,000
 Spread = 3( )^1/3
4 0.00025
= 3 x (6 x 1011)1/3 = 3 x 8,434.33

= = $25,303, say $25,300

The upper limit and return point are now calculated.

Upper limit = Lower limit + $25,000 = $8,000 + $25,300 = $33,300

Return point = lower limit + 1/3 x spread = $8,000 + 1/3 x $25,300 = $16,433, say 16,400

The decision rule is as follows. If the cash balance reaches $33,300, buy $16,900 (= 33,300 – 16,400) in
marketable securities. If the cash balance falls to $8,000, sell $8,400 of marketable securities for cash.

Working Capital Investment Policy

A company can adopt a working capital strategy for managing its working capital depending on the
important risks associated with working capitals. It can choose from three different working capital
strategies. These strategies are as follows:

Conservative Approach
Aggressive Approach
Moderate Approach

Conservative Approach

“A conservative working capital management policy aims to reduce the risk of system breakdown by holding
high levels of working capital”

 Customers are allowed generous payments terms to stimulate demand,

 Finished goods inventories are high to ensure availability for customers,
 Raw material and work in progress are high
 Suppliers are paid promptly to ensure their goodwill.

Aggressive Approach

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“An aggressive working capital management policy aims to reduce financing cost and increase profitability:

 by cutting inventories to kept it at minimum level.

 speeding up collections:

Customers are allowed a limited payment period and discounts are given for prompt payment

 delaying payments to supplier.

Moderate Approach

A moderate working capital management policy is a middle way between the aggressive and conservative
approaches.

Working Capital Financing Policy

Assets can be divided into three types in order to understand different working capital management
strategies

Non-current assets: These are long term assets from which an organization expects to derive benefit
over a number of periods. For example, plant and machinery
Permanent current assets: This is the amount required to meet minimum long-term needs and sustain
normal trading activity. For example, inventory and average receivables…
Fluctuating current assets: These are current assets which vary according to normal business
activity. Example include fluctuate in working capital due to seasonal variations

Conservative Approach

Policy A can be characterized as a conservative approach to finance working capital where all non-current
assets, permanent current assets and part of fluctuating current assets are financed by long-term funding.

Aggressive Approach

Policy B can be characterized as an aggressive approach to finance working capital where non-current
assets and some part of permanent current assets are financed through long-term borrowings while
fluctuating current assets and part of permanent current assets are financed through short-term sources.

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Moderate Approach

Policy C describes a balance between risk and return which might be best achieved by moderate approach.
In this case, long-term sources of finance are used to finance fixed assets and permanent current assets
while short-term sources of finance are used to finance fluctuating current assets.

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