Working Capital

Management
CHAPTER 6
 Working Capital Management

 Working Capital Management involves the

determination of:

– The optimal investment in current assets – that is, the

level of current assets that maximises the overall
profitability of the firm; and
– The appropriate mix of long term and short term capital
– that is, the combination of long and short term debt
that minimises the company's cost of capital.
 The Operating Cycle
 Financial manager must be aware of the relationship between
different current assets and current liabilities. The concept of
the ‘operating cycle’ explains these relationships.
 Operating cycle refers to the time that elapses between the
purchase of new materials and the payment of suppliers of
those materials.
 Operating cycle usually consists of five steps:
– The purchase of raw materials on credit;
– The conversion of those materials into finished goods;
– The sale of those finished goods;
– The collection of accounts receivable; and
– The payment of accounts payable.
 The Operating Cycle
 Table 6.1 on page 171 of your text book
summarises the effect on the business of the
operating cycle

A business should reduce its operating cycle

to the point where the marginal savings
obtained are equal to the marginal cost of
implementation.
 The Matching Principle

 One of the most important principles of financial

management is that of matching the repayment term
of borrowings with the life of the asset acquired with
those borrowings.

 This is so that cash flow generated through the use of

the asset will provide the necessary funds required to
repay the loan.
 The Matching Principle and
Current Assets
 Current assets have both temporary and permanent
components.
 Some current assets never fall below a certain minimum
level and these assets are therefore a permanent investment
in the business.
 Many businesses have peak periods of manufacturing and
sales, resulting in increased levels of inventory, accounts
receivable and cash in those times.
 Have to finance large inventories until the selling season;
when those inventories are sold, accounts receivable will
peak and then decrease as they are collected.
 The matching principle requires that the
maturity of all assets – fixed, permanent
current and temporary current – be matched
with the maturity of liabilities.
 Figure 6.1 on pg 173 illustrates this
concept.
 Inventory Management
 As inventory is an important segment of most
businesses, an efficient inventory management is
necessary.
 There are three categories of inventory: raw
materials, work in process, and finished goods.
 Aim to have sufficient to meet normal operating
requirements, plus a quantity, known as safety
stocks, to meet unforeseen contingencies.
 ‘Stockout costs’.
 Inventory-associated Costs.
 There are two types of costs associated with inventories:
carrying and order costs.
 Carrying costs are:
– The cost of funds invested in inventory;
– Storage costs; Insurance costs; and
– Deterioration and obsolescence.
 Order costs are:
– The costs of placing and order;
– The costs of receiving an order.
 As size of orders increase, so does the average level of
inventories, resulting in higher carrying costs. If larger
quantities are ordered, fewer orders will have to be
placed and so order costs will be reduced.
 Economic Order Quantity
 The total cost of inventory consists of carrying costs
plus ordering costs.
 Figure 6.2 on pg 175
 Review the figure
 The total cost curve begins to rise after point EOQ
because the rate of increase in carrying costs exceeds
the decrease in ordering costs.
 The EOQ represents the order size which results in
the minimum total inventory costs. For this reason it
is referred to as the economic order quantity.
 Economic Order Quantity
 A formula has been developed which enables economic order
quantity to be calculated:

EOQ = 2UO
C
Where:
U = unit usage per period , O = cost per order
C = carrying cost per unit per period
See Figure 6.2. Page 175 and Example 6.1 p176
Complete STQ 6.1 page 177
 Stock Reorder Points
 When reordering inventories ensure that there are
sufficient stocks on hand to allow for usage which
will occur between the raising of the order and the
receipt of the goods.
 That stock level is known as the reorder point and
each time inventory falls to that level a new order
is raised.
Reorder point = Daily usage x Delivery lead
time
Review Example 6.2 and Complete STQ 6.2
 Safety Stocks
 There is often some uncertainty as to the usage
rates and/or delivery lead times.
 Additional safety stocks can me carried to the
level at which the additional costs incurred are
equal to the savings from avoiding stockout costs.
 See figures 6.5 and 6.6 on pp 179/80 of your text
book.
 See Example 6.3. Page 179
– Complete STQ 6.3
 Quantity Discounts
 Quantity discounts are often offered by suppliers as
an inducement to purchasers to place larger orders.
 In order to decide whether it is economical to claim
a quantity discount, it is necessary to compare the
discounts that will be derived per period with the
net costs involved increasing order size above
economic order quantity.

 See Example 6.4. Complete STQ 6.4

– Complete Ex 6.17, 18, 19, 20, 21, 22
FPM Chapter 6 Sol 617 onwards.doc