Chapter 7 Working capital Flashcards
1.1 Introduction to working capital
Working capital = current assets – current liabilities
A company invests in its working capital to ‘oil the wheels’ of the business. When managing its working capital, a balance sheet needs to be struck between two conflicting objectives.
Profitability (long term growth and returns to investors) vs liquidity (short term survival)
2.1 How to finance an investment in working capital
Classic rule of thumb is that:
- Long-term assets should be financed by long-term funds
- Short-term assets should be financed by short-term funds
But short-term finance has advantages and disadvantages. The advantages are it is relatively cheap (shorter period of risk exposure for lenders, so less interest rates) and it is flexible (for example a bank overdraft). The disadvantages is a renewal risk (an overdraft can be recalled on demand) and an interest rate risk as short-term rates can fluctuate.
3.1 Analysing the liquidity position using ratios
The following ratios are used:
- Current ratio: current assets / current liabilities - a ratio of less than 1 indicates a business will struggle to pay its current liabilities as they fall due
- Quick (or liquidity) ratio: current assets – inventory / current liabilities – more realistic measure of business’ liquidity to meet short-term debts.
- Inventory period (in days): inventory / cost of sales x 365
- Rate of inventory turnover: cost of sales /average inventory
- Receivables collected period (in days): receivables / sales x 365
- Payable’s payment period (in days): payables / cost of sales x 365
Manufacturing industries also have:
- Raw materials inventory holding period: (average inventory of raw materials / annual usage) x 365
- WIP inventory holding period: (average inventory of WIP / annual cost of sales) x 365
- Finished goods inventory holding period: (average inventory of finished goods / annual cost of sales) x 365
4.1 The working capital cycle
The working capital cycle (cash operating cycle) is defined as the length of time between paying for the purchase of goods and receiving cash for the subsequent sale. It can be calculated as:
- Receivable’s collection period + raw materials inventory holding period + WIP inventory holding period + finished goods inventory holding period – payables payment period
These items are calculated as follows:
- Receivable’s collection period: average receivables / annual sales revenue x 365
- Raw materials inventory holding period: average inventory of raw material / annual usage x 365
- WIP inventory holding period: average inventory of WIP / annual cost of sales x 365
- Finished goods inventory holding period: average inventory of finished goods / annual cost of sales x 365
- Payable’s payment period: average payables / annual purchases x 365
- Time period: B/S figure / income statement figure x 365
The cycle can be measured in days, weeks or months. You can use year-end figures where averages are not available. Comparison to prior year, industry average and budgeted ratios. The faster a firm can push items around the cycle the lower its investment in working capital will be.
The significance of the cash operating cycle is that as the cycle gets longer and sales increase (hence inventory and purchases increase), more cash is tied up in the cycle. If the cycle is out of balance, extra short-term finance is needed.
5.1 Liquidity problems – causes and cures
Cause can be overtrading. This occurs when a small business grows quickly but on a small capital base, and although revenue and profits are healthy, the business runs out of cash. This is because the amount of cash needed to fund the cash operating cycles increases as:
- Sales (and hence purchases of inventory) increase
- The cycle gets longer as suppliers insist on short periods of credit and customers insist on long terms of credit from a business with no established reputation as yet
The cures can be the following:
- Inject some further long-term capital into the business
- Raise cash by selling off non-essential non-current assets
- Slow down the rate of growth of the business
- Reduce the length of the cash operating cycle through lower levels of inventory, faster collection of debts from credit customers, increasing the proportion of cash sales and slower payment of debts to suppliers.
6.1 Managing the components of working capital (inventory)
Inventory: levels of inventory a business holds is the result of judging the right balance between the benefits from holding inventory (continuity of production or sales) and the costs of holding inventory (warehousing and capital tied up). The two issues are how much to order and when to order.
The economic order quantity model calculates how much inventory to order each time if the objective is to minimise the costs that are directly affected by the order size (annual inventory holding costs plus annual inventory order costs).
EOQ = √ 2cd/h
Where:
- C is the cost of placing one order
- D is the demand for the inventory item over the particular period (usually annual demand)
- H is the holding cost of one unit of inventory for that period
This model does not factor bulk-discounts for higher order sizes. Other systems for inventory control are:
- Re-order level system: this is a pre-calculated economic order size; you place an order when inventory falls to a predetermined level
- Periodic review system: this is variable, and an order is placed at regular inspections of inventory levels
- ABC system: this is variable, and an order is placed with inspections prioritised according to the importance of each item
- Just-in-time system: the supplier delivers to customer order and the supplier gets the customer order book on a regular basis
- Perpetual inventory system: this is an economic order size, and an order is placed automatically by a computerised system
6.2 Managing the components of working capital (trade payables)
Trade credit is a cheap form of short-term finance. If the business does not pay debts for a month, it obtains a further month’s use of its cash. Excessive use of this facility for liquidity reasons have consequences on profitability:
- Favoured customer status is lost and future supplies disrupted
- Supplier raises prices to compensate for the extra interest being incurred
- Opportunity of a cash discount for prompt payment has been forgone
6.3 Good, fair payment practices
Prompt payment is essential for long-term economic sustainability. Small businesses often accept unfair payment terms from large businesses to secure the relationship. Late payment of invoices to those small businesses can have severe impacts on cash flow, the ability to invest/grow and to survive.
Some countries have a legal obligation for businesses to report their payment practices and policies (for example the small business, enterprise and employment act 2015). Good practices include the following principles:
- Deliberate late payment is ethically unacceptable
- Businesses have the right to receive correct full payment as and when due
- Payment processes should be clear so that suppliers know when and how much they will be paid
6.4 Managing the components of working capital (trade receivables
The only benefit from granting trade credit to customers comes from maintaining/increasing sales volumes. The costs of extending credit are:
- Finance costs of capital tied up in trade receivables
- The risk of irrecoverable debts
- Administrative costs of running a credit control department
Policies need to be established for the control and collection of customer debts. These include:
- Setting the terms of credit: the length of the credit period and whether a cash discount is to be offered. This can be an expensive form of short-term finance
- Assess the risk the customer won’t pay by giving it a credit rating
- Consider whether to outsource credit collection and/or financing through receivables factoring (factor advance x% of the funds immediately and takes responsibility for collecting the debt efficiently) and invoice discounting (no outsourcing of debt collection but the debts are sold at a discount for an immediate cash sum)
- Minimise the time taken between the placement of the order and the receipt of cash from the customer. This can involve encouraging on-line ordering, prompt despatch of goods, invoices and reminder statements and preparation of credit control reports which highlight slow-paying customers.
- Consider whether to take out trade credit insurance against the possible default and insolvency of its credit customers
7.1 Treasury (cash) management
There are four reasons why a company would want to hold cash either in a cash float or a bank current account:
- Transaction’s motive: meet day to day obligations
- Finance motive: cover major items
- Precautionary motive: to cover against unexpected outlays
- Investment/speculative motive: take advantage of new investment opportunities
The profitability objective would minimise the holdings of cash – as an idle asset, profit is being forgone by failing to invest the funds.
The liquidity objective would maximise the holdings of cash to ensure the firms cash obligations would be met – payments of supplier’s invoices, wages to staff and dividends to shareholders.
Therefore, the primary aims of cash management is to have the right amount of cash available at the right time. The elements in this process are:
- Efficient cash transmission procedures: prompt banking of receipts and the allowing of 3-4 days before the funds can be drawn upon
- The preparation of timely and accurate cash budgets
8.1 Cash budgets
A cash budget is a detailed budget of estimated cash inflows and outflows incorporating both revenue and capital items. The preparation has two main objectives:
- Provide periodic budgeted cash balances for the budgeted balance sheet
- To anticipate cash shortages/surpluses and thus provide information to assist management in short- and medium-term cash planning and longer-term financing for the organisation
9.1 Potential cash positions
If in a short-term surplus, management should pay suppliers early, increase spending and make investments.
If in a short-term shortfall, management should delay payments, tighten credit control and use an overdraft.
If in a long-term surplus, management should make investments, acquisitions, pay dividends, replace assets and offer a share buy-back.
If in a long-term shortfall, management should raise new finance, debt or equity, sell assets, divest or close the business.
