Working Capital Management
Working CapitalIn this lecture we will look at       short and medium term methods of financing       short term financi...
Short and medium term financing       SHORT (repayment in under 1 year?)        Overdraft        Trade credit        F...
Overdraft facilities       timescale of months       interest charged on the daily outstanding balance       flexible -...
Trade Credit   company receives goods and services   invoice paid at a later time   some flexibility in credit terms  ...
Factoring       immediate transfer of cash to firms with outstanding        receivables       when invoices are paid the...
Hire purchasing       company takes possession of the goods       a series of regular payments are made until the       ...
Leasing       lessor gives right to use equipment in return for        regular payments       no transfer of legal owner...
IssuesBalance:                        cash       too little/                                  too much           payables ...
What is working capital?    Current assets less current liabilities        inventory        cash        receivables   ...
Working Capital Management                inventory Conversion Period                Receivables                          ...
Cash conversion cycle    Cash conversion cycle = inventory days +     receivables days – payables days    For example:  ...
Some ratios: LIQUIDITY    Current ratio (working capital ratio)                      =    CA / CLo    a ratio of less tha...
Some ratios: EFFICIENCY    receivables (days)                       = (receivables/sales ) x 365    payables (days)     ...
Example – 2007     Balance Sheet Sainsbury   Rolls Royce                   plc         Group     £m     inventory         ...
Example – 2007     P&L             Sainsbury   Rolls Royce                     plc         Group     £m     Sales         ...
Example – 2007     Ratios             Sainsbury plc         Rolls Royce                                              Group...
Overtrading    Not to be able to provide the level of working capital     required to sustain a particular level of tradi...
Managing working capital    INVENTORY    TRADE PAYABLES    TRADE RECEIVABLES    CASH    19
Managing inventory    Determined by what the firm does    There will be large differences in inventory     levels betwee...
Balance    Risks of holding high      Risks of holding low     inventory                   inventory      storage costs...
Policy decisions        Optimum reorder quantities need to be         established for each item of inventory        Comp...
Managing Trade payables    „Free‟ source of finance    No interest    Costs    23
Policy decisions    Take into account        discounts offered        attitude of suppliers    Exploit trade credit  ...
    Companies that take the longest to pay are in the     construction, manufacturing, pharmaceuticals and     retail sec...
Managing receivables    Attitudes vary    Credit sales = interest free loans    A balance must be arrived at between th...
Balance    granting credit                  denying credit        higher sales                     loss of customers  ...
Policy decisions    Establish a credit policy    Assess credit worthiness of customers    Establish a policy on bad deb...
Managing Cash Balances    Cash needs to be held        to meet planned needs            transaction motive        to m...
Balance   Holding too much cash      Holding too little cash        loss of interest          liquidity risk          ...
Financing WC    Firms need mixture of LT and ST funds    Assets needing to be financed        Fixed        Permanent C...
Matching     Funds                Fluctuating CA                                        Short-term finance                ...
Conservative     Funds                  Fluctuating CA                                          Short-term finance        ...
Aggressive     Funds                Fluctuating CA                                        Short-term finance              ...
Summary    Efficient management of working capital – key to     business success    Relates to management of:        in...
Further reading and prep for seminarWatson, D. and Head, A. Corporate Finance Principles and Practice, 5th edn Chap 3.Arno...
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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

    1. 1. Working Capital Management
    2. 2. 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
    3. 3. 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
    4. 4. 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
    5. 5. 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
    6. 6. 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
    7. 7. 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
    8. 8. 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
    9. 9. IssuesBalance: cash too little/ too much payables risk inventory receivabl es9
    10. 10. What is working capital? Current assets less current liabilities  inventory  cash  receivables  payables 10
    11. 11. Working Capital Management inventory Conversion Period Receivables Conversion period Fin. Raw Mat WIP Goods £Credit from Suppliers Cash Conversion Cycle11
    12. 12. 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
    13. 13. 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
    14. 14. 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
    15. 15. 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
    16. 16. Example – 2007 P&L Sainsbury Rolls Royce plc Group £m Sales 17,151 7,435 Cost of Sales 15,979 6,00316
    17. 17. 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
    18. 18. 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
    19. 19. Managing working capital INVENTORY TRADE PAYABLES TRADE RECEIVABLES CASH 19
    20. 20. 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
    21. 21. 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
    22. 22. 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
    23. 23. Managing Trade payables „Free‟ source of finance No interest Costs 23
    24. 24. Policy decisions Take into account  discounts offered  attitude of suppliers Exploit trade credit Manage exchange rate risk Use ratios for monitoring 24
    25. 25.  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
    26. 26. 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
    27. 27. Balance granting credit  denying credit  higher sales  loss of customers  customer goodwill  risk  costs of administration  costs of financing 27
    28. 28. 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
    29. 29. 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
    30. 30. 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
    31. 31. 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
    32. 32. Matching Funds Fluctuating CA Short-term finance Long-term Permanent CA finance Fixed Assets Time32
    33. 33. Conservative Funds Fluctuating CA Short-term finance Long-term Permanent CA finance Fixed Assets Time33
    34. 34. Aggressive Funds Fluctuating CA Short-term finance Permanent CA Fixed Assets Long-term finance Time34
    35. 35. 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
    36. 36. 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

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