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Accounting and Finance
An Introduction
Tenth Edition
Part 3
Financial management
Chapter 16
Managing working capital
Copyright © 2020, 2016, 2014 Pearson Education, Inc. All Rights Reserved
LEARNING OUTCOMES
You should be able to:
Identify the main elements of working capital
Discuss the purpose of working capital and

the nature of the working capital cycle
Explain the importance of establishing policies for

the control of working capital
Explain the factors that have to be taken into

account when managing each element of working
capital
The nature and purpose of working capital
Major elements Major element
Inventories
Trade payables
Trade receivables
Cash (in hand and at bank)
Working
Current assets Current liabilities
capital
equals less
Figure 16.1 The working capital cycle
Cash sales
Cash/
Finished bank
goods overdraft
Trade
Credit sales Cash
receivables
Work in Raw Trade

progress materials payables
Figure 16.2 Average investment (in days) for the
main working capital elements
Trade receivables Inventories Trade payables
Days
settlement period turnover period settlement period
68.0 67.7
70
62.9
58.9 60.4
58.2 58.8
60 56.4
51.9 51.8 53.1 54.0
47.9 48.1
50
41.0
40
30
20
2015
2016
2013
2017
2014
10
2015
2017
2016
2013
2014
2015
2016
2017
2013
2014
0
Source: Compiled from information in PwC (2018) Navigating Uncertainty: PwC’s Annual Global Working Capital Study 2018/19,
www.pwc.com.
Inventories financing cost
Business Type of Cost Average Financing Operating Financing

operations of inventories cost of profit/ cost as % of
capital held holding (loss) operating
inventories profit/(loss)
(a) (b) (a) × (b)
% %
Associated Food 14.2 £2,144m £304.4m £1,404m 21.7

British producer
Foods
BT Group Telecoms 8.4 £233m £19.5m £20,342m 0.1
Go-Ahead Transport 5.2 £17m £0.9m £161m 0.6
Kingfisher DIY 10.1 £2,437m £246.1m £685m 35.9
Tesco Supermarket 9.5 £2,282m £216.8m £1,837m 11.8
Source: Annual reports of the businesses for the years ended during 2018.
Managing inventories
Procedures and techniques that can be used to
ensure the proper management of inventories
Budgeting future demand
Financial ratios
Recording and reordering systems
Levels of control
Inventory management models
Enterprise resource planning (ERP) systems
Just-in-time (JIT) stock management

Financial ratios
Average inventories
turnover period = Average inventories held × 365
Cost of sales
Figure 16.4 ABC method of analysing and controlling
inventories
100
Cumulative
value of
inventories
items
(%)
A B C 100
Volume of inventories items held (%)
Figure 16.5 Patterns of inventories movements over time
Inventories level
0 Time
Figure 16.6 Inventories holding and order costs
Ordering
Annual
costs Total costs
costs
(£)
Holding
costs
0 E Average inventories
level (units)
The economic order quantity (EOQ) model
EOQ = 2DC
H
Where:
D = the annual demand for the
inventories item (expressed in
units of the inventory item)
C = the cost of placing an order
H = the cost of holding one unit of
the inventories item for one year
Just-in-time inventories management
Requires close relationship with

suppliers
May require re-engineering

production process
May result in hidden costs (taking advantage

of cheap sources of supply)
Can be seen as part of TQM approach
Managing trade receivables
Questions to ask
Which customers should receive credit
How much credit should be offered
What length of credit it is prepared to offer
Whether discounts will be offered for

prompt payment
What collection policies should be adopted
How the risk of non-payment can be

reduced
Which customers should receive credit?
The five Cs of credit
Capital
Capacity
Collateral
Conditions
Character
Sources of credit information
Trade references
Bank references
Published financial statements
The customer
Credit agencies
Register of County Court Judgements
Length of credit period
May be influenced by:
The typical credit terms operating

within the industry
The degree of competition within the industry
The bargaining power of particular customers
The risk of non-payment
The capacity of the business to offer credit
The marketing strategy of the business

Collection policies
Develop customer relationships
Publicise credit terms
Issue invoices promptly
Monitor outstanding debts
Produce an ageing schedule of receivables
Answer queries quickly
Deal with slow payers
Figure 16.7 UK large businesses – average time to
pay suppliers
Source : Extracts from Elmes, S. (2018) payment practices of large companies, www.mycreditcontrollers.co.uk/research/payment-practices-18-03.html, 12 March.
Controlling trade receivables
Ratios
Average settlement
period for trade
receivables
= Average trade receivables × 365
Credit sales
Trade receivables to
sales = Trade receivables at end of period
Credit sales for period
Ageing schedule of trade receivables at 31 December
Customer Days outstanding Total
1 to 30 31 to 60 61 to 90 More than
days days days 90 days
£ £ £ £ £
A Ltd 12,000 13,000 14,000 18,000 57,000
B Ltd 20,000 10,000 – – 30,000
C Ltd – 24,000 – – 24,000
Total 32,000 47,000 14,000 18,000 111,000
Figure 16.8 Comparison of actual and expected (target)
receipts over time for Example 16.5
Budgeted
40
Actual
30
%
20
10
June July August September

Time
Why hold cash?
There are three reasons:
To meet day-to-day commitments
To deal with uncertain cash flows
To exploit profitable opportunities
Factors influencing the amount of cash held
Possible factors may include:
The nature of the business
The opportunity cost of holding cash
The level of inflation
The availability of near-liquid assets
The cost of borrowing
Economic conditions
Relationships with suppliers

Managing cash
Main techniques
Controlling the cash balance

(using control limits)
Preparing cash budgets
Managing the operating

cash cycle
Figure 16.9 Controlling the cash balance
Outer limit
Cash balance (£)
Inner limit
Target cash balance
Inner limit
Outer limit
0 1 2 3 4 5 6 7 8 9 10 11 12
Time (days)
Figure 16.10 The operating cash cycle
Cash
Purchase Payment Sale of received
of goods for goods on from credit
on credit goods credit customer
Inventories
turnover period
Operating cash
cycle
Figure 16.11 Calculating the operating cash cycle
Average inventories
turnover period
plus
Average settlement
period for receivables
minus
Average settlement
period for payables
equals
Operating cash cycle
Figure 16.12 Working capital performance European
businesses 2002–2015
Europe US
OCC
50
48
46
44
42
40
38
36
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Adapted from figure in All Tied Up: Working Capital Management Report 2014, Ernst and Young, p. 7, www.ey.com.
Controlling trade payables
1. Ratios
Average settlement
period for trade payables = Average trade payables × 365
Credit purchases
2. Ageing schedule for trade payables

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Accounting and Finance

Identify the main elements of working capital

Discuss the purpose of working capital and

Explain the importance of establishing policies for

Explain the factors that have to be taken into

Major elements Major element

Cash (in hand and at bank)

Work in Raw Trade

settlement period turnover period settlement period

Business Type of Cost Average Financing Operating Financing

(a) (b) (a) × (b)

Associated Food 14.2 £2,144m £304.4m £1,404m 21.7

Go-Ahead Transport 5.2 £17m £0.9m £161m 0.6

Kingfisher DIY 10.1 £2,437m £246.1m £685m 35.9

Tesco Supermarket 9.5 £2,282m £216.8m £1,837m 11.8

Budgeting future demand

Recording and reordering systems

Inventory management models

Enterprise resource planning (ERP) systems

Just-in-time (JIT) stock management

Requires close relationship with

May require re-engineering

May result in hidden costs (taking advantage

Can be seen as part of TQM approach

Which customers should receive credit

How much credit should be offered

What length of credit it is prepared to offer

Whether discounts will be offered for

What collection policies should be adopted

How the risk of non-payment can be

The five Cs of credit

Published financial statements

Register of County Court Judgements

The typical credit terms operating

The degree of competition within the industry

The bargaining power of particular customers

The risk of non-payment

The capacity of the business to offer credit

The marketing strategy of the business

Develop customer relationships

Publicise credit terms

Issue invoices promptly

Monitor outstanding debts

Produce an ageing schedule of receivables

Answer queries quickly

Deal with slow payers

Customer Days outstanding Total

B Ltd 20,000 10,000 – – 30,000

C Ltd – 24,000 – – 24,000

Total 32,000 47,000 14,000 18,000 111,000

June July August September

There are three reasons:

To meet day-to-day commitments

To deal with uncertain cash flows

To exploit profitable opportunities

The nature of the business

The opportunity cost of holding cash

The level of inflation

The availability of near-liquid assets

The cost of borrowing

Relationships with suppliers

Controlling the cash balance

Preparing cash budgets