Working Capital Management The nature, elements and importance of working capital Working Capital equals value of raw materials, work-in-progress, finished goods inventories and accounts receivable less accounts payable. Net working Capital = Current Assets Current Liabilities This is a very important topic for your exam. Working capital directly affects our liquidity. Different types of organisations will have different levels of working capital. Working capital will be used or released through management of the following; (a) Holding inventory - From purchase of raw materials through processing and storage until sale. (b) Taking time to pay suppliers and other accounts payable (within 1 year). (c) Allowing customers time to pay. Consider the working capital needs of; A supermarket An accountant A grocery wholesaler Why do we try to manage Working Capital? 1. To ensure liquidity To be able to pay our bills as they fall due 2. To increase profitability To ensure that, where possible, assets are invested in a way that maximises profit. Liquid assets do not give a high return and so these two objectives conflict with each other. Working capital management is an ongoing function of the finance department/manager. It is a crucial factor in an organisation's long-term success. It is important to have specific policies around the management of cash, marketable securities, accounts receivable, accounts payable, accruals and other means of short-term financing. The cash operating cycle is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser. Example I buy my raw materials on 30 days credit. It takes an average of 15 days to convert them to finished goods which are displayed immediately. Goods are sold 25 days after being displayed on credit of 20 days. What is my cash operating cycle? [Type text]
15 + 25 + 20-30 = 30 days What increases the Cash Operating Cycle? Longer accounts receivable Longer time for stock in inventory Shorter accounts payable Which ties up more cash in Working Capital leaving less to be invested in profit making assets and activities. Working Capital Ratios may help to indicate whether a company is over-capitalised, with excessive working capital, or if a business is likely to fail. A business which is trying to do too much too quickly with too little long-term capital is overtrading. Current Ratio = Current Assets/Current Liabilities In order to meet debts as they fall due this needs to be comfortably in excess of 1. Dependant on the nature of the business it may need to be higher in one organisation than another. Quick Ratio = Current Assets less Inventories/ Current Liabilities Where inventory turnover is very slow, it is more difficult to convert inventories into cash. The quick ratio takes this into account by excluding inventories from current assets for calculation. An ideal quick ratio for a company with slow inventory turnover is 1 and lower than 1 is acceptable where the inventory turnover is rapid. Accounts Receivable Days (AR Payment Period) = (Trade receivables/credit Sales) x 365 This ratio tells us how long it takes our customers to pay us. Issues with this ratio may be; Closing position for AR may not reflect normal figures Cenit Online 2015 31
We need to either include or exclude VAT in both figures Inventory turnover = Cost of sales /Average inventory (Number of times stock is replaced in the period) The inventory turnover period can also be calculated: Inventory turnover period (Finished goods) = Average inventory /Cost of sales x 365 days Raw materials inventory holding period = Average raw materials inventory/annual purchases x 365 days Average production (work-in-progress) period = Average WIP/Cost of sales x 365 days A lengthening inventory turnover period indicates: (a) A slowdown in trading, or (b) A build-up in inventory levels Investigate why this is happening (Inventory days PLUS AR days = inventory to cash) Accounts payable payment period= Average trade payables / Purchases or Cost of sales x 365 days This might be used to judge a business s liquidity. It is viewed as poor long term Managerial Finance to use overdrafts or extended credit from suppliers as a Managerial Finance tool. The following can be used to calculate the operating cycle; Raw materials inventory holding period Accounts payable payment period Average production period Inventory turnover period (Finished goods) Accounts receivable payment period Operating cycle Days X (X) X X X X The sales revenue/net working capital ratio = Sales Revenue/Current Assets Current Liabilities This ratio shows how much working capital is being used to support sales. Working capital must increase in line with sales to avoid liquidity problems and this ratio can be used to forecast the level of working capital needed for a projected level of sales. Using Short-term credit to finance investments in current assets. It is very important to be able to convert current assets into cash quickly and easily, especially if there is a risk of short-term finance being suspended. Liquidity ratios help to show if a business is at a risk of insolvency. Companies may take the risk of increasing current liabilities and taking the maximum credit possible from suppliers in order to reduce working capital and use this cash for higher return investments. Cenit Online 2015 32
Consider the working capital needs of different organisations based on; Cash Sales versus Credit Sales Seasonal Nature of business Need for inventory Power to extract favourable credit terms Over Capitalisation If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be an over-investment by the company in current assets. Working capital will be excessive and the company will be over-capitalised. You will identify this by comparing your Liquidity Ratios with previous periods or other organisations. Over Trading In contrast to over-capitalisation, if the business does not have access to sufficient capital to fund the increase in business, it is said to be "overtrading". This can cause serious trouble for the business as it is unable to pay its business creditors. This is a too-much too soon scenario. You would identify Over Trading when; There is a rapid increase in turnover. There is a rapid increase in the volume of current assets and possibly also non-current assets. Slowdown in Inventory turnover and accounts receivable turnover. There is only a small increase in proprietors' capital (perhaps through retained profits). Increase in assets is financed by credit, especially: (these often out of terms agreed) o Trade accounts payable o A bank overdraft Some debt ratios and liquidity ratios alter dramatically. o Rapid change in gearing o The current ratio and the quick ratio fall. o An excess of current liabilities over current assets. Possible solutions to over trading are; New capital from the shareholders could be injected. Better control could be applied to inventories and accounts receivable. The company could reassess its expansion plans until it can meet them from reserves or more sustainable funding. Non Trading causes of Over Trading might be; Repaying a loan without refinancing Inability to pay for inventories in an inflationary time Difficulties relating to replacement of non-current assets Cenit Online 2015 33
Working Capital Cycle Calculation Cenit Online 2015 34
Managing Inventories Managing Inventories Economic Order Quantity (EOQ) is the order quantity at which inventory management costs the least. Note that if there are discounts for bulk purchases a different quantity might be better. Inventories include consumables such as stationary, raw materials, work in progress and finished goods. Some businesses use a calculation to find the optimal level between ready access to stock and the cost of holding stock. If using this calculation managers also need to consider; The EOQ minimises the cost of ordering versus the cost of holding inventory If there are discounts to be had it may still be cheaper to buy in bigger bulk If there is uncertainty of demand a manager might buy buffer stock to avoid shortfalls. The costs associated with inventory fall into four categories. Holding costs The cost of capital Warehousing and handling costs Deterioration Obsolescence Insurance Pilferage Procuring costs Ordering costs Delivery costs Shortage costs Contribution from lost sales Extra cost of emergency inventory Cost of lost production and sales in stock-out Purchase Cost of inventory Relevant particularly when calculating discounts Calculating Economic Order Quantity (Equation will be given in exam, but not explanation.) EOQ = 2 Co = Cost of placing one order. D = Demand for one period. Ch = Holding cost for one Re-order Levels = Maximum Use x Maximum Lead time A business wants to ensure that it always has stock on hand to fill orders as they come in from customers. We have calculated above how many units we should order, but now we need to look at when to place the order. If we order to late we run the risk of not having stock to fill our orders. If we order too soon we have too much cash tied up in inventory and our holding costs increase. The use of a properly calculated reorder level acts as a safety measure against the organisation running out of stock and this is particularly important in times of fluctuating demand or supply. Maximum inventory level = re-order level + re-order quantity (minimum usage x minimum lead time) Above this level of inventory becomes wasteful. Buffer safety inventory = re-order level (average usage x average lead time) This tells us that inventory is running dangerously low and that we are at risk of stock shortages. Cenit Online 2015 35
Average inventory = buffer safety inventory + (re - order amount/2) If we decide that it is worth running the risk of stock outage we would need to be able to calculate the following for each possible reorder level; The costs of holding buffer inventory per annum The costs of stock-outs (Cost of one stock-out x expected number of stock-outs per order x number of orders per year) The expected number of stock-outs per order reflects the various levels by which demand during the lead time could exceed the re-order level. Calculating the possibility of Stock Out. If re-order level is 4 units, but there was a probability of 0.2 that demand during the lead time would be 5 units, and 0.05 that demand during the lead time would be 6 units, then expected number of stock-outs = ((5 4) x 0.2) + ((6 4) x 0.05) = 0.3 If a bulk discount is available you will need to be able to calculate which of the following is more economical; The EOQ The Minimum order level for discount. Just In Time (JIT) JIT Procurement If a company decides to hold the lowest stock levels possible, they would implement a JIT system. Stock is ordered only at the latest possible time avoiding most or all holding costs. JIT Production This means manufacturing to order. It allows better customisation, little or no obsolescence, low/no holding costs. This requires flexibility in the manufacturing process which includes flexibility in labour, plant and resources. Introduction of JIT System Benefits Reduction in holding costs Reduction in lead times Improved productivity Reduced scrap/reworking costs Reduced Working Capital tied up in Stock Removal of obsolescence Disadvantages Impacts on employment contracts Idle time Inappropriate for some environments. Cenit Online 2015 36
Inventory Calculation Example Cenit Online 2015 37
Managing Accounts Receivable (AR) When a business decides to extend credit they must balance the cost of interest on the extended credit or the loss of interest that they would have gained on that amount invested against the additional sales that they will achieve as a result of offering credit. It is possible that the cost of extending credit may wipe out your entire profit if the credit period extends too long. Credit should be extended on the basis that it improves profitability by creating extra profitable sales. This would be balanced against the costs of interest and implementation of credit to see whether the extension of credit meets with our expected Rate of Return. Additional sales will also mean that; You may need to hold extra stock to reduce stock outs The amount you owe your trade creditors will increase. Winterson Tools has an average level of accounts receivable of $2m at any time representing 60 days outstanding. (Their terms are thirty days.) The firm borrows money at 10% a year. The managing director is proud of the credit control: 'I only had to write off $10,000 in bad debts last year,' she says proudly. Is she right to be proud? What do you say? Credit Control Policy An organisation s Credit Control Policy needs to take account of; Admin costs of collection Procedures around advancing credit and controlling and collecting debt especially late payers Capital required to extend credit Implementation of settlement discounts Suitable repayment timeframe Issues that might encourage bad debt e.g. giving too lengthy a credit period. Creditworthiness In the first instance it is essential that the risk of a customer defaulting can be balanced against the potential profit to the company being brought by dealing with that customer. Credit Control is about assessing the creditworthiness of a customer initially and the continuing control of accounts outstanding. Good practice would be to; Obtain two good references for each new customer including one from a bank. Use a credit rating agency Set low credit limits and gradually increase with caution based on history and trading pattern Keep abreast of their financial situation of high value clients o See Annual reports o See press reports o Conduct site visits o Get government assistance where possible for details of overseas clients Cenit Online 2015 38
Devise a credit rating system Keep accounts up to date (Do not allow a time lag between transactions and posting to accounting system.) Constantly monitor aged debtors reports, individually and as a group Collecting Amounts Owing Debt collection should benefit more than it costs. Look at collection as a two stage process; 1 Within agreed terms Agree terms and ensure that your customer understands what you have agreed Issue correct invoices in a timely manner Resolve queries promptly Issue statements promptly 2 Outside agreed terms Establish chasing procedures Issue reminders or final demands Telephone contact Personal approach Notify collection department and revoking credit Institute legal proceedings Hand over to Debt Collection Agency Early Settlement discount These discounts are given to encourage early payment by debtors. This reduces interest payments and working capital tied up in accounts receivable. The benefit must exceed the cost. An extension of the payment period allowed to accounts receivable may be introduced in order to increase sales volume. To calculate the percentage cost of an early settlement discount use the formula: A company offers its goods to customers on 30 days' credit, subject to satisfactory trade references. It also offers a 2% discount if payment is made within ten days of the date of the invoice. Required Calculate the cost to the company of offering the discount, assuming a 365 day year. Solution {( { ( ) 1} % Where d= discount and t = reduction in settlement period 100 365 ) 1} % = {( 100 365 100 100 2 ) 20 1} % = (1.02041 18.25 ) -1 = 44.6% (Note make sure to be able to make this calculation on your scientific calculator.) Bad Debt Risk Different policies will bring different levels of bad debt risk. So easing credit terms should be profitable enough to cover: 1- Additional bad debt 2- The additional investment needed to achieve the higher sales. Cenit Online 2015 40
Credit Insurance A company may be able to get insurance for bad debts above a normal level. Factoring and Invoice Discounting Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money it is due to collect. Services of a factor may include; Administration of invoicing, sales accounting and debt collection Credit Protection whereby the factor insures the client against bad debt. Advance payments of monies that will be collected Benefits of factoring; Early payment of debts Optimum inventory levels Growth through cash flow instead of new capital Cash flow linked to sales volume Frees up management time Reduced in house accounting costs Disadvantage of factoring Loss of relationship with customer Reputational risk of seeming strapped for cash. Invoice discounting is the purchase (by the provider of the discounting service) of trade debts at a discount. Invoice discounting enables the company from which the debts are purchased to raise working capital. Managing Foreign AR Because of additional inventories, transport and paperwork, exporters have additional problems dealing with accounts receivable including the fact that there may be less of a relationship between the parties. Solutions to be considered; Advance payment or short settlement terms Discounting bills of exchange Documentary credits Letter of credit in favour of the seller from the buyers bank Negotiation of Bills or Cheques Export credit insurance In general all the rules around insurance and creditworthiness and best practice should be even more carefully applied. Countertrade could be entered into whereby goods are exchanged for other goods. This may involve more than two parties. Cenit Online 2015 41
Managing Accounts Payable ( Managing Accounts Payable (AP) Effective management of trade accounts payable involves seeking satisfactory credit terms from supplier, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers. Trade Credit is an important source of short term finance. It is usually a low cost source of finance because suppliers usually do not charge interest within agreed terms. The decision to take trade credit settlement discount is addressed with the same formula as that for accounts receivable. The cost of lost cash discounts can be calculated as follows: 100 365 { 100 ) 1} % Where d= discount and t = reduction in payment period Cenit Online 2015 42
Example: Working Capital Requirements The Following data relates to Corn Ltd, a manufacturing company: Turnover 1,500,000 Costs: Direct materials 450,000 Direct labour 375,000 Variable Overheads 150,000 Fixed Overheads 225,000 Selling and distribution 75,000 On average - Debtors take 2.5 months before repayment - Raw materials are in stock for 3 months - Work in progress represents one months worth of produced goods - Finished goods represent one month s production - Credit is taken as follows: (i) Direct materials 2 months (ii) Direct labour 1 week (iii) Variable Overheads 1 month (iv) Fixed Overheads 1 month (v) Selling and distribution 0.5 months Work-in-progress and finished goods are valued at material, labour and variable expense cost. Required: Compute the working capital requirement of Corn Ltd assuming the labour force is paid for 50 working weeks a year. Cenit Online 2015 43
Solution: Average value of current assets: Debtors 1,500,000 x 2.5/12 312,500 Raw Materials 450,000 x 3/12 112,500 Work-in-progress Materials 450,000 x 1/12 37,500 Labour 375,000 x 1/12 31,250 Variable Overheads 150,000 x 1/12 12,500 Finished goods Materials 450,000 x 1/12 37,500 Labour 375,000 x 1/12 31,250 Variable Overheads 150,000 x 1/12 12,500 587,500 Average value of current liabilities Materials 450,000 x 2/12 75,000 Labour 375,000 x 1/50 7,500 Variable Overheads 150,000 x 1/12 12,500 Fixed Overheads 225,000 x 1/12 18,750 Selling and distribution 75,000 x 0.5/12 3,125 116,875 The working capital required is 587,500 116,875 = 470,625 Potential 6/7 marks at end of question what unforeseen changes may affect cash flow patterns? - A change in general economic environment i.e. recession - A new product launched by a competitor reduces our sales - New technology which must be invested in to remain competitive - A price war with competitors reducing our sales revenue streams - Strikes or industrial action - Natural disasters such as fires or floods - Government legislation reducing sales revenue e.g. smoking ban Cenit Online 2015 44
Managing Cash Three reasons for holding cash; 1- To pay regular transactions Transactionary Motive 2- As a contingency for unexpected events Precautionary Motive 3- In order to take advantage of interest rate rises or business opportunities Speculative Motive How cash flow problems arise; Making a loss Inflation Growth Seasonal Business One off expenditure A cash flow forecast is a detailed forecast of cash inflows and outflows incorporating both revenue and capital items. This is used to identify surpluses or deficits over a period of time. The following management actions would be appropriate; Short-term surplus Short-term deficit Long-term surplus Long-term deficit Pay accounts payable early to obtain discount Attempt to increase sales by increasing accounts receivable and inventories Make short-term investments Increase accounts payable Reduce accounts receivable Arrange an overdraft Make long-term investments Expand Diversify Replace/update non-current assets Raise long-term finance (such as via issue of share capital) Consider shutdown/disinvestment opportunities Don t forget that your cash flow forecast only reflects actual payments and receipts as they happen. The timing will be different from your Profit and Loss Account. If it is not actual cash, do not include it. (e.g. no depreciation on a cash flow) Only record at the date of payment or receipt (e.g. on payment of invoice not on purchase date) Cenit Online 2015 45
Cash Flow Template Inflows Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Total Inflows Outflows Total Outflows Net Cash Flow Opening Cash Closing Cash Working Capital Funding Strategies The Financial Manager must decide how to fund working capital. He can fund it through a mixture of short and long term sources. Remember from our working capital cash cycle that working capital equals current assets less current liabilities. In order to make the correct choice in how to fund working capital we need to know the distinction between the different types of Assets. Non-current (fixed) assets are long-term assets from which an organisation expects to derive benefit over a number of periods. For example, buildings or machinery. Permanent current assets are the amount required to meet long-term minimum needs and sustain normal trading activity. For example, inventory and the average level of accounts receivable. Fluctuating current assets are the current assets which vary according to normal business activity. For example due to seasonal variations. Fluctuating current assets together with permanent current assets form part of the working capital of the business, which may be financed by either long-term funding (including equity capital) or by current liabilities (short-term funding). We will look at these later in our sources of funding tutorials. Managers might choose a conservative, aggressive or moderate policy with regard to Working Capital Management. In a conservative approach, inventory and cash are kept high to avoid the risk of stock outs and cash shortages. In an aggressive approach profitability is kept as high as possible by minimising the cost of financing. Inventories and cash balances are kept low. A moderate approach searches for a balance between the two. Cenit Online 2015 46
CPA P1 Managerial Finance Cenit Online 2015 47
CPA P1 Managerial Finance Cenit Online 2015 48
CPA P1 Managerial Finance Cenit Online 2015 49
CPA P1 Managerial Finance Working Capital Management Past exam Questions Aug 2011 Q4 April 2011 Q4 April 2009 Q5b April 2008 Q2 Pilot Paper Q4 (5-82.5 marks each = 10 marks) (1-82.5 marks each = 20 marks) (20 marks) (20 marks) Q4 (1-22.5 marks each = 5 marks) (1-32.5 marks = 7.5 marks) Discursive: April 2010 Q5 (b) Credit Control (9 marks) Aug 2008 Q3 (b) Debt factoring (5 marks) April 2008 Q3 (b) Overtrading (7.5 marks) Cenit Online 2015 50