The management of Working Capital and its relevance to Profitability

Transcription

1 The management of Working Capital and its relevance to Profitability Dr.Ivan Grixti PhD(Soton) Lecturer in Financial Accounting at the University of Malta

2 Defining Working Capital 2 In absolute terms Working Capital is defined as CURRENT ASSETS less CURRENT LIABILITIES

3 Defining Working Capital 3 Alternatively, we can also define Working Capital as a ratio, as follows CURRENT ASSETS CURRENT LIABILITIES

4 from any SFP major components 4 Current Assets Current Liabilities Inventories Trade Receivables Trade Payables Cash at bank and in hand

5 so for e.g. SFC plc 2017/ s s Total Current Assets 33,682 33,407 Total Current Liabilities 24,297 24,156 WORKING CAPITAL 9,385 9,251 WORKING CAPITAL RATIO 1.38:1 1.38:1

6 a glimpse at TESCO plc s SFP reveals m 2016 m Total Current Assets 15,073 14,448 Total Current Liabilities 19,234 17,886 WORKING CAPITAL (4,161) (3,438) WORKING CAPITAL RATIO 0.78:1 0.80:1

7 SFC plc Income Statement s s Revenue 88,119 86,013 Cost of Sales (53,683) (53,039) GROSS PROFIT 34,436 32,994

8 SFC plc Income Statement 8 000s s 000s s Revenue 88,119 86,013 Cost of Sales Opening Inventories 12,334 11,117 Add: Purchases 55,918 54,256 68,252 65,373 Less: Closing Inventories 14,569 12,334 (53,683) (53,039) GROSS PROFIT 34,436 32,994

9 SFC plc Income Statement 9

10 Statement of Cash Flows 10 In calculating net cash generated from operating activities using the indirect method the selected figure of profit is adjusted with: Items not involving the movement of cash e.g. depreciation Changes in Working Capital Increase/Decrease in Inventories Increase/Decrease in Trade Receivables Increase/Decrease in Trade Payables

11 Working Capital Management 11 Management of working capital is an important component of any commercial organisation s financial management because it directly affects the profitability of the firms. In terms of Deloof (2003) It can be expected that the way in which working capital is managed will have a significant impact on the profitability of firms

12 Working Capital Management 12 A commercial organisation s value can be maximised given an optimal level of working capital From one end, possessing a large inventory and a generous trade credit policy may lead to a higher volume of sales. Large inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it allows customers to assess product quality before paying. - (Long, Malitz & Ravid, 1993; Deloof & Jegers, 1996)

13 Working Capital Management 13 Also, because suppliers may have significant cost advantages over commercial banks in providing credit to their customers, it can also be an inexpensive source of credit for customers - (Peterson and Rajan, 1997) The flip side of granting trade credit and keeping inventories is that money is locked up in working capital.

14 Working Capital Management 14 Another component of working capital is trade payables. Delaying payments to suppliers allows a commercial organisation to assess the quality of the products bought, and can be an inexpensive and flexible source of financing for the firm. On the other hand, delaying payment of invoices can be very costly if the firm is offered a discount for early payment.

15 so is there a measure of WCM? 15 Indeed, a popular measure of WCM is the

16 Working Capital Management 16 The longer the CCC, the larger the investment in working capital. A longer CCC might increase profitability because it leads to higher sales. However, corporate profitability might also decrease with the CCC, if the costs of higher investment in working capital rise faster than the benefits of holding more inventory and/or granting more trade credit to customers.

17 Working Capital Management 17 So, how is the CCC calculated. Debtor Days (Trade Receivables/Sales)*365 + Stock Turnover Ratio (in days) (Closing Inventories/Cost of Sales)*365 - Creditor Days (Trade Payables/Purchases)*365

18 DAYS EFFICIENCY RATIOS & CCC SFC plc Stock turnover ratio Debtor days 140 Creditor days Cash Conversion Cycle YEAR

19 Academic Research 19 Deloof (2003) based on a sample of 1,009 large Belgian non-financial firms for a 5-year period and using correlation and regression tests, found significant relationship between gross operating income and the number of Debtor Days, Stock Turnover Ratio and Creditor Days. Deloof suggests that managers can increase corporate profitability by reducing the number of Debtor Days and Stock Turnover

20 Academic Research 20 Lazaridis & Tryfonidis (2007) conducted a cross sectional study by using a sample of 131 firms listed on the Athens Stock Exchange for the period The authors found statistically significant relationship between profitability, measured through gross operating profit, and the cash conversion cycle and its components. Applying once again correlation and regression tests to data analysis emanating from annual reports, they suggest that managers can generate profits for their companies by correctly handling the cash conversion cycle and by maintaining each component of the cash conversion cycle, namely, Debtor Days, Creditor Days and Stock Turnover at an optimal level.

21 Academic Research 21 Gill, Biger & Mathur (2010) sought to extend the previous study by Lazaridis & Tryfonidis by taking a sample of 88 American companies listed on the New York Stock Exchange for a period of 3 years from 2005 to The authors have found statistically a significant relationship between the cash conversion cycle and profitability, measured through gross operating profit. Once again, in terms of the authors they suggest that managers can create profits for their companies by correctly handling the cash conversion cycle and by maintaining each component of the cash conversion cycle, namely, Debtor Days, Creditor Days and Stock Turnover at an optimal level.

22 Tesco s six strategic drivers 2017AR 22

23 Tesco s six strategic drivers 2017AR 23

24 Tesco s third out of six strategic drivers 24

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