Why Invest in Current Assets Sales Inventories Debtors Sustain
Example: Raw Materials
Despite running at full capacity, steel suppliers in Japan and elsewhere in Asia struggled to satisfy Japan’s booming exporters
Nissan had to cut down its production by an estimated 40,000 vehicles to meet demand in March (March is the month where demand for cars in Japan hits a peak)
Source FT Dec 2004
Funding Current Assets
The Cheapest way to finance current assets is to use free credit from suppliers
This may lead to LIQUIDITY PROBLEMS . This risk can be illustrated using a
Cash Operating Cycle
The Cash Operating Cycle
Cash Operating Cycle Inventory Turnover Period Raw Materials holding period Production Period Finished Goods holding period
Cash Operating Cycle cont. The accounts receivable payment period How long our customers take, on average, to settle their bills
Cash Operating Cycle cont.
Accounts payable payment period
How long, on average, we take to pay our customers FREE CREDIT DAYS!!
Ratios are not perfect
Ratios have limitations particularly when comparing P/L items with Balance Sheet Figures
Example: In December retailers normally have below average stock levels and therefore an average based on December figures may not reflect the annual average
If you are 6 feet tall and you don’t know how to swim, would you wade across a pool with an average depth of 3 feet?
Cash Operating Cycle Trade Payables Raw Materials W-I-P Finished Goods Debtors Cash Outflow Cash Inflow Financing current assets entirely from trade payables will keep the cost of interest down BUT this may lead to liquidity problems
Deferral of Cash Inflows
Stock becoming obsolete or out-of-fashion
Disruptions in production processes
Debtors failing to meet credit deadlines
Foregone Cash Inflows
Other Cash Outflows - Overheads
The need for working capital
The duration of the trade payables period is normally dictated by suppliers or the market in general. Therefore it may not match the current asset turnover period
In addition the conversion of current assets into cash may be deferred or at worse foregone (Bad Debts)
Cash Operating Cycle Trade Payables Raw Materials W-I-P Finished Goods Debtors Funding the cash operating cycle
Current assets are assets which are either cash or expected to be converted into cash with one year
For funding purposes these can be classified into:
Funding the Cash Operating Cycle
Inventory required to stock the shops plus to keep some buffer stock in warehouse/s
Inventory levels before the Easter, Summer and Christmas holidays will normally be above average
Example: Toy Shop
Funding the Cash Operating Cycle Permanent Current Assets financed by Long-term Capital Fluctuating Current Assets financed by Short-Term Funding
The Objective of Working Capital Management
Aim of Working Capital Management
A business needs to invest in current assets to sustain its business operations
The aim of working capital management is to strike off a balance between FINANCIAL STABILITY and PROFITABILITY
Over-Capitalization -Working Capital
Too much working capital will impinge on profitability
Higher interest rate burden
Opportunity Cost – long-term capital tied in current assets can be used to finance feasible projects
Inadequate Working Capital
Inadequate Working Capital may lead to liquidity problems
Rapid expansion in business without having adequate working capital.
Inadequate Working Capital cont.
Symptoms of Overtrading
Accounts Payable period will increase
Development of hard core element in bank overdraft plus encroachments
Profit margins will start to decline as raising cash will be given priority to profitability
Optimum Working Capital Some textbooks suggest that:
However Working Capital needs depend on a number of factors. For example:
type of industry
accessibility to financial markets
Optimum Working Capital cont. Trade Payables (48.7 days) Inventory (13.8 days) J SAINSBURY – FOOD RETAIL INDUSTRY Negative Working Capital Source: Fitch Ratings figures as at 24-Mar-07
Optimum Working Capital cont. Trade Payables (30.7 days) Inventory processing period (31.2 days) Debtors ( 27.4 days) Cash Operating Cycle (27.9 days) SABMILLER – BREWERY Source: Fitch Ratings figures as at 31-Mar-07
Conclusion on Optimality
Working Capital Needs differ among industries
Optimality depends on the management of the constituents of Working Capital
Managing Working Capital
HOLDING COSTS funding
SHORTAGE COSTS lost contribution from missed sales
Economic Order Quantity Where: EOQ (Q) economic order quantity Co Ordering Cost D Annual Demand Ch Cost of holding 1 unit
Economic Order Quantity cont.
The expected annual demand is 500,000. Purchase price is $100. It costs $ 500 to place an order and the cost of holding one unit in stock is 20%.
Economic Order Quantity cont. EOQ
Economic Order Quantity cont.
Assumptions – Practical Implications
Goods are delivered when they are ordered i.e. no lead times
Demand is constant
Price is constant and no bulk purchases discounts
Toyota was the first company to develop JIT
Toyota needed to reduce costs of production and JIT was the solution
Kanban System – pull system of production i.e. items are only produced when they are needed
Just-in-Time JIT cont.
Companies thinking of introducing JIT will first have to:
Find reliable suppliers
Train employees to minimize wastages and idle time
Minimize lead times
A company which is selling on credit is actually lending money
It must have a debtors policy, composed of a:
Credit Analysis System
Credit Control System
Debt Collection procedure
The objective of selling on credit is to increase sales, however:
Sales Growth is vanity
Profit is sanity
Cash is king
Ultimate objective should be profitability without jeopardizing liquidity
Increasing Trade Receivables
Main benefit – increase in contribution
Increase in debtors administration costs
Increase in the likelihood of bad debts
Increase in funding costs
Invoice or Bills of Exchange Discounting
Factoring cont. Saving in administration costs Invoice discounting: alternative source of funds Credit protection Can be expensive Loss of goodwill if too aggressive at chasing for payment Can be deemed as a signal of liquidity problems Advantages Disadvantages
Factors to consider in choosing Suppliers:
Management of Cash
3 reasons for holding cash
(John Maynard Keynes)
Cash Flow Forecast
Simple and Effective Cash Management tool
Objective is to estimate future
Cash Flow Forecast cont.
Benefit from early settlement discounts
Increase current assets
Make short-term investments
Arrange for short-term funding
Give early settlement discounts
Cash Flow Forecast cont.
Raise long-term finance
Look for feasible long-term projects
Cash management in large organizations tends to be more complex
Most organizations have centralized treasuries and apply more sophisticated models to manage cash
The Baumol model is the same one which is used to estimate EOQ
Cash is considered as inventory and two related costs are:
Money Procurement costs
Baumol Model example Treasury Division A Division D Division C Division B Cash flows Cash flows Cash flows Cash flows
Baumol Model example cont.
According to the cash flow forecast, Division B’s annual cash requirement is $ 1 million
Procurement Costs - $ 700
Opportunity Cost - 3.5%
Baumol Model example cont. Using the same formula for inventories, the optimal amount to be raised and transferred is U$ 200,000.
Current Assets are essential in sustaining the operations of a business.
Working Capital Management deals with how current assets are managed and financed.
The objective of working capital management is to maximize profitability without jeopardizing liquidity.