Pcf week 16 working capital management
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Pcf week 16 working capital management






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  • Business is paying suppliers before receiving cash from sales of FG. This leaves a gap in WC funding. Need to pay suppliers later to reduce gap.
  • The longer the CCC, the more finance is needed to fund WC
  • CCC Sainsbury = 0.6+19-39 = -19.4 daysCCC RR = 44+134-47 = 131 days
  • Finances fluctuating CA with ST funds and perm CA and FA with LT funds
  • Finances some fluctuating CA with LT funds – reduces profitability
  • Finances perm CA with ST funds – greatest risk but greatest return for shareholders

Pcf week 16 working capital management Pcf week 16 working capital management Presentation Transcript

  • Working Capital Management
  • Working CapitalIn this lecture we will look at short and medium term methods of financing short term financing concerns inventory levels, trade payables and receivables the cash conversion cycle why it is important to manage working capital 2
  • Short and medium term financing SHORT (repayment in under 1 year?) Overdraft Trade credit Factoring MEDIUM (repayment in 1 to 7 years?) Term loan Hire purchase Leasing 3 View slide
  • Overdraft facilities timescale of months interest charged on the daily outstanding balance flexible - no term structure available to smaller and riskier businesses lender can remove facility at short notice conditions:  cash flow projections  creditworthiness  commitment from the borrower  security in the form of assets 4 View slide
  • Trade Credit company receives goods and services invoice paid at a later time some flexibility in credit terms vital source of finance for large as well as small companies “Tesco and Asda typically have over twice as much owing to suppliers at any one time as the value of all the goods on their shelves – more than £2.2bn for Tesco and £1.5bn for Asda.” 5 Arnold, chapter 12, page 482
  • Factoring immediate transfer of cash to firms with outstanding receivables when invoices are paid then factoring company receives payment carried out by subsidiaries of major banks fee and interest charged on amount advanced comparable with overdraft interest rates transfer of risk to factoring company 6
  • Hire purchasing company takes possession of the goods a series of regular payments are made until the company owns the goods payments include principal repayment and interest no large payments up front plant and machinery; agricultural equipment; hotel equipment; office equipment; commercial vehicles 7
  • Leasing lessor gives right to use equipment in return for regular payments no transfer of legal ownership Operating lease  short term contract  asset then sold or leased to another client  photocopiers Finance lease  full cost of equipment recovered over the life of the lease  risks borne by lessee 8
  • IssuesBalance: cash too little/ too much payables risk inventory receivabl es9
  • What is working capital? Current assets less current liabilities  inventory  cash  receivables  payables 10
  • Working Capital Management inventory Conversion Period Receivables Conversion period Fin. Raw Mat WIP Goods £Credit from Suppliers Cash Conversion Cycle11
  • Cash conversion cycle Cash conversion cycle = inventory days + receivables days – payables days For example:  Buy raw materials on 33 days‟ credit  Takes 50 days to turn raw materials into finished product  Give 30 days‟ credit on finished product CCC = 50 + 30 – 33 = 47 days 12
  • Some ratios: LIQUIDITY Current ratio (working capital ratio) = CA / CLo a ratio of less than one might indicate liquid resources not enough to meet short term paymentso a ratio of more than one might indicate high levels of inventory and not enough cash 13
  • Some ratios: EFFICIENCY receivables (days) = (receivables/sales ) x 365 payables (days) = (payables/cost of sales ) x 365 inventory turnover (days) = (inventory / cost of sales ) x 365 14
  • Example – 2007 Balance Sheet Sainsbury Rolls Royce plc Group £m inventory 590 2,203 receivables 30 889 inventory + 620 3,092 receivables payables 1,706 77815
  • Example – 2007 P&L Sainsbury Rolls Royce plc Group £m Sales 17,151 7,435 Cost of Sales 15,979 6,00316
  • Example – 2007 Ratios Sainsbury plc Rolls Royce Group receivables days (30/17,151) x 365 (889/7,435) x 365 = 0.6 days = 44 days payables days (1706/15,979) x 365 (778/6,003) x 365 = 39 days = 47 days inventory (590/15,979) x 365 (2,203/6,003) x 365 turnover days = 13 days = 134 days17
  • Overtrading Not to be able to provide the level of working capital required to sustain a particular level of trading is known as overtrading  Failure to meet increases in turnover with appropriate increases in working capital requirement  Possible for a firm to double its sales and profits and yet become insolvent  Too much money is tied up in inventory and trade receivables? 18
  • Managing inventory Determined by what the firm does There will be large differences in inventory levels between traders due to  the nature of the goods  the speed of the inventory turnover  seasonal fluctuations Costs of holding inventory need to be balanced against the opportunity costs20
  • Balance Risks of holding high  Risks of holding low inventory inventory storage costs  loss of production handling costs  loss of sales money tied up  loss of customer obsolescence goodwill insurance costs 21
  • Policy decisions  Optimum reorder quantities need to be established for each item of inventory  Companies need to take into account how fast inventory is used up and how long orders take to be fulfilled  Many firms like to hold a “buffer” of inventory to meet unexpected changes in demand  Other firms operate “just in time” policies22
  • Managing Trade payables „Free‟ source of finance No interest Costs 23
  • Policy decisions Take into account  discounts offered  attitude of suppliers Exploit trade credit Manage exchange rate risk Use ratios for monitoring 24
  •  Companies that take the longest to pay are in the construction, manufacturing, pharmaceuticals and retail sectors Large number of small suppliers Average payment time is  44 days for all plcs  34 days for 350 largest plcs Based on article by David Oakley, FT, March 2008 25
  • Managing receivables Attitudes vary Credit sales = interest free loans A balance must be arrived at between the costs of granting credit and those associated with denying or restricting credit 26
  • Balance granting credit  denying credit  higher sales  loss of customers  customer goodwill  risk  costs of administration  costs of financing 27
  • Policy decisions Establish a credit policy Assess credit worthiness of customers Establish a policy on bad debts Consider cash discounts and factoring/ invoice discounting Manage exchange rate risk What are competitors offering? 28
  • Managing Cash Balances Cash needs to be held  to meet planned needs  transaction motive  to meet unplanned obligations  precautionary motive  to enable unexpected opportunities to be taken  speculative motive Surplus cash should be invested Cash needed varies over time 29
  • Balance Holding too much cash  Holding too little cash  loss of interest  liquidity risk  loss of goodwill  inability to meet emergency requirements  missed opportunities  borrowing costs  deterioration in liquidity measures 30
  • Financing WC Firms need mixture of LT and ST funds Assets needing to be financed  Fixed  Permanent CA  Fluctuating CA Policies  Matching  Conservative  Aggressive 31
  • Matching Funds Fluctuating CA Short-term finance Long-term Permanent CA finance Fixed Assets Time32
  • Conservative Funds Fluctuating CA Short-term finance Long-term Permanent CA finance Fixed Assets Time33
  • Aggressive Funds Fluctuating CA Short-term finance Permanent CA Fixed Assets Long-term finance Time34
  • Summary Efficient management of working capital – key to business success Relates to management of:  inventory  receivables  payables  Cash Poor working capital management one of the more common reasons for corporate failure 35
  • Further reading and prep for seminarWatson, D. and Head, A. Corporate Finance Principles and Practice, 5th edn Chap 3.Arnold, G. Corporate Financial Management, Chapter 12, Chapter 13 (pp 529-550)Self test questions page 91 of Watson and