Working Capital Management


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On how to manage working capital

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  • The cash operating cycle estimates the time taken from the receipt of raw materials to actually receiving the cash from selling the finished good. It also measures the extent to which the investment in current assets is funded by free credit and how much is funded by long-term capital employed (working capital)
  • Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
  • Zero Cash Operating Cycle may not be achievable in practice Even if it is achievable, this may lead to liquidity problems
  • Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
  • Short-Term funding is cheaper since for example bank overdraft interest is charged on overdrawn amount only and limit is reviewed every year and can be reviewed upwards or downwards according to business needs Invoice Discounting – advantage is that the business can benefit from the credit worthiness of its customers (if this is better than that of business)
  • Although Equity from a financial accounting perspective appears to be cheap, it is in fact the most expensive source of funding A business is not legally obliged to pay dividends but if the company does not pay dividends it has to deliver capital gains. Capital Gains are delivered if the return on investment is greater than the required return of shareholders.
  • Deterioration in profit margins: Cash Discounts given by suppliers will be foregone Bank charges (returned cheques and encroachments) and interest burden will increase Cash Discounts given to debtors to raise cash Trade Discounts given to increase stock turnover with the objective of increasing cash flows from operations The best suppliers in the market will be reluctant to do business with you as you are no longer seen as a ‘good’ customer
  • Accessibility to financial markets most often depends on the size of the business. Small and Medium sized companies normally resort to overdraft facilities. Large companies can access other types of short-term funding such as Commercial Paper which gives them more flexibility in managing their working capital needs. In addition, it is easier for large companies to raise medium and long-term funding Business practices might also affect working capital management, for example bank overdrafts are not common in Italy, where they rely more on Invoice Discounting. In analyzing the level of working capital whether it is over-capitalized or not, ratio analysis may prove to be useful. Trends Peer Group Analysis
  • Food Retail Industry – Characteristics High Inventory Turnover Low Operating Margins (to mitigate this they diversify into non-food goods and also services). They can afford a higher gearing Stability of Revenue (although earnings from non-food sales are more volatile) Property Portfolio
  • Working Capital needs may increase due to food inflation Earnings fairly stable but prone exchange rate risk as company has a major presence in emerging countries.
  • For instance even among industries companies may have different production processes or different inventory management policies. On the other hand although debtors policies are formulated internally, these would be constrained by market practices The size of the company matters as well, since it can negotiate better terms with suppliers and also accessibility to capital markets.
  • Inventory management deals with minimizing these costs. These costs are negatively correlated and the objective is to strike a balance between these costs Examples: To minimize shortage costs, companies need to hold buffer stock and therefore incur holding costs Procurement costs and holding costs are negatively correlated – trade off between more frequent order (maximize procurement costs and minimize holding costs) or less frequent orders (minimize procurement and maximize holding costs) A model that helps us striking an optimal balance is the Economic Order Quantity
  • Reliable suppliers are essential as they have to deliver raw materials or components in time and of the right quality. Some companies might be willing to pay a premium over the normal purchase prices Since stock levels would be at a minimum, company cannot afford wastages due to bad workmanship Since the output of one process is the input of another, semi-finished goods must be of good quality otherwise the whole production process will stop Minimizing lead times is essential, otherwise in order that production continues a company would need to keep inventories If the company manages to achieve these, apart from the benefit of reduced inventories costs, efficiency in the organization would increase
  • Credit Analysis System It is important that before selling on credit to a particular customer, the company assesses his credit worthiness. In addition to looking at the accounts to analyze the financial health of the company and possibly evaluating the track record of management, one can use bank references, trade references and the services of credit rating agencies. Credit Control System After the analysis, the company will determine the credit limit and period to be offered. This would need to be reviewed from time to time. Company should also monitor that customers are respective the credit terms given. Debt Collection System Prepare an aged listing of debtors Issue regular statements and reminders Have clear procedures for taking legal action Analyze whether to use cash discounts to encourage early payment
  • The main benefit of invoice discounting is that you can borrow on the financial strength of your customers. In addition sales growth can be financed through sales Nonetheless the factor would not want to incur any bad debts and so can be quite aggressive. Apart from savings of administration costs, management can concentrate more on business rather than on collection of debtors.
  • Credit Terms are usually given either through market practice or by supplier. Large corporations may have negotiating power for example large food retailers such as Tosco, Wal-Mart they can negotiate favourable terms. Good Relations are important and so company must ensure that trade payables are settled within the allowable period. Reliability – delivery in expected time and of the right quantity and quality – link with Just-in-Time Early Settlement Discounts should be evaluated in terms of the impact on cash operating cycle. Early settlement will be funded from short-term or long-term funding Price although important, should not be the main decisive factor
  • Cash is not just vault cash and balances with bank but also unutilized amounts on overdraft facilities Holding cash is like holding inventory and there is a cost, more specifically an opportunity cost.
  • Permanent Surpluses Temptation to invest in long-term finance assets such as equities or bonds. Nonetheless these should be avoided. If there are no feasible long-term investments return cash to shareholders (share buy-backs or one-time dividends) as they can invest in equities or bonds themselves.
  • Money procurement costs can be lending processing fees, cost of transferring money or brokerage costs in selling short-term investments
  • Working Capital Management

    1. 1. Working Capital Management 1
    2. 2. PROGRAMME The nature of working capital The cash operating cycle Funding the cash operating cycle The objectives of working capital Inventory management Managing trade receivables Relationship with suppliers Managing Cash 2
    3. 3. The Nature ofWorking Capital 3
    4. 4. Definition of Working CapitalCurrent Assets less Current Liabilities Current Assets Current LiabilitiesInventories Trade Payables Raw Materials Accruals Work-in-Progress Taxation/Dividends Finished Goods Short-Term BorrowingsTrade ReceivablesPrepaymentsBank/Cash 4
    5. 5. Why Invest in Current Assets 5
    6. 6. Example: Raw MaterialsDespite running at full capacity, steelsuppliers in Japan and elsewhere in Asiastruggled to satisfy Japan’s boomingexportersNissan had to cut down its production by anestimated 40,000 vehicles to meet demand inMarch (March is the month where demandfor cars in Japan hits a peak)Source FT Dec 2004 6
    7. 7. Funding Current AssetsThe Cheapest way to finance currentassets is to use free credit fromsuppliersThis may lead to LIQUIDITY PROBLEMS.This risk can be illustrated using a Cash Operating Cycle 7
    8. 8. TheCash Operating Cycle 8
    9. 9. Cash Operating Cycle Inventory Turnover PeriodRaw Materials Avg Raw Materials x 365holding period Credit Purchases Production Average Work-in-Progress x 365 Period Cost of Production Finished Average Inventory x 365Goods holding Cost of Sales period 9
    10. 10. Cash Operating Cycle cont. The accounts receivable payment periodHow long ourcustomers take, Average Trade Receivables x 365on average, tosettle their bills Credit Sales 10
    11. 11. Cash Operating Cycle cont. Accounts payable payment periodHow long, onaverage, we Average Trade Payables x 365take to pay our Credit Purchasescustomers FREE CREDIT DAYS!! 11
    12. 12. Ratios are not perfectRatios have limitations particularlywhen comparing P/L items withBalance Sheet FiguresExample: In December retailers normallyhave below average stock levels andtherefore an average based on Decemberfigures may not reflect the annual average 12
    13. 13. Beware AveragesIf you are 6 feet tall and you don’tknow how to swim, would youwade across a pool with anaverage depth of 3 feet? 13
    14. 14. Cash Operating Cycle Financing current assets entirely from trade payables will keep the cost of interest down Raw Materials W-I-P Finished Goods Debtors Cash Inflow Trade Payables Cash Outflow BUT this may lead to liquidity problems 14
    15. 15. Liquidity Risk?Deferral of Cash InflowsStock becoming obsolete or out-of-fashionDisruptions in production processesDebtors failing to meet credit deadlinesForegone Cash InflowsBad DebtsOther Cash Outflows - Overheads 15
    16. 16. The need for working capitalThe duration of the trade payablesperiod is normally dictated by suppliersor the market in general. Therefore itmay not match the current assetturnover periodIn addition the conversion of currentassets into cash may be deferred or atworse foregone (Bad Debts) 16
    17. 17. Cash Operating Cycle Raw Materials W-I-P Finished Goods Debtors Trade Payables Funding the cash operating cycle 17
    18. 18. Funding theCash Operating Cycle 18
    19. 19. Funding the Cash Operating CycleShort-Term Borrowings Bank Overdraft Commercial Paper Invoice or Bills of Exchange DiscountingLong-Term Capital Employed Debt / Equity 19
    21. 21. Funding the Cash Operating CycleMATCHINGCurrent assets are assets which areeither cash or expected to beconverted into cash with one yearFor funding purposes these can beclassified into: Permanent Fluctuating 21
    22. 22. Funding the Cash Operating CycleExample: Toy ShopPermanent InventoryInventory required to stock the shops plus tokeep some buffer stock in warehouse/sFluctuatingInventory levels before the Easter, Summerand Christmas holidays will normally beabove average 22
    23. 23. Funding the Cash Operating Cycle1816 Fluctuating14 Current Assets12 financed by10 Short-Term8 Funding6 Permanent Current Assets4 financed by Long-term Capital20 r l r l r l r l Jan Ap Ju Oct Ja n Ap Ju Oct Ja n Ap Ju Oct Jan Ap Ju Oct 23
    24. 24. The Objective ofWorking Capital Management 24
    25. 25. Aim of Working Capital ManagementA business needs to invest in currentassets to sustain its business operationsThe aim of working capital managementis to strike off a balance betweenFINANCIAL STABILITY and PROFITABILITY 25
    26. 26. Over-Capitalization -Working CapitalToo much working capital will impinge onprofitabilityHigher interest rate burdenOpportunity Cost – long-term capital tiedin current assets can be used to financefeasible projects 26
    27. 27. Inadequate Working CapitalInadequate Working Capital may lead toliquidity problemsOvertradingRapid expansion in business withouthaving adequate working capital. 27
    28. 28. Inadequate Working Capital cont.Symptoms of OvertradingAccounts Payable period will increaseDevelopment of hard core element inbank overdraft plus encroachmentsProfit margins will start to decline asraising cash will be given priority toprofitability 28
    29. 29. Optimum Working CapitalSome textbooks suggest that: Over-Capitalised Under-CapitalisedCurrent Ratio >2:1 <2:1Quick Ratio >1:1 <1:1Cash Operating Cycle Long ShortHowever Working Capital needs dependon a number of factors. For example:  type of industry  accessibility to financial markets 29
    30. 30. Optimum Working Capital cont. J SAINSBURY – FOOD RETAIL INDUSTRY Inventory (13.8 days) Negative Working Capital Trade Payables (48.7 days)Source: Fitch Ratings figures as at 24-Mar-07 30
    31. 31. Optimum Working Capital cont. SABMILLER – BREWERYInventory processing period (31.2 days) Debtors (27.4 days) Trade Payables (30.7 days) Cash Operating Cycle (27.9 days) Source: Fitch Ratings figures as at 31-Mar-07 31
    32. 32. Conclusion on OptimalityWorking Capital Needs differ amongindustriesOptimality depends on themanagement of the constituents ofWorking Capital 32
    33. 33. ManagingWorking Capital 33
    34. 34. Inventory ManagementINVENTORY COSTSHOLDING COSTS funding storage insurancePROCUREMENT ordering deliverySHORTAGE COSTS lost contribution from missed sales 34
    35. 35. Economic Order Quantity 1/2 EOQ = 2 Co D Ch Where: EOQ (Q) economic order quantity Co Ordering Cost D Annual Demand Ch Cost of holding 1 unit 35
    36. 36. Economic Order Quantity cont.Example:The expected annual demand is 500,000.Purchase price is $100. It costs $ 500 toplace an order and the cost of holding oneunit in stock is 20%. 36
    37. 37. Economic Order Quantity cont. $ 000s Ch Co 300 TC 250 200 150 EOQ 100 50 - Q 00 00 00 00 00 0 0 00 00 00 00 00 ,0 0 0 0 0 ,0 ,0 ,0 1, 2, 3, 4, 5, 9, 10 6 7 8 37
    38. 38. 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 38
    39. 39. Just-in-Time JITToyota was the first company todevelop JITToyota needed to reduce costs ofproduction and JIT was the solutionKanban System – pull system ofproduction i.e. items are onlyproduced when they are needed 39
    40. 40. Just-in-Time JIT cont.Companies thinking of introducing JITwill first have to:Find reliable suppliersTrain employees to minimize wastagesand idle timeImprove qualityMinimize lead times 40
    41. 41. Trade ReceivablesA company which is selling on creditis actually lending moneyIt must have a debtors policy,composed of a:Credit Analysis SystemCredit Control SystemDebt Collection procedure 41
    42. 42. Trade ReceivablesThe objective of selling on credit is toincrease sales, however:Sales Growth is vanityProfit is sanityCash is kingUltimate objective should be profitabilitywithout jeopardizing liquidity 42
    43. 43. Increasing Trade ReceivablesMain benefit – increase in contributionCostsIncrease in debtors administrationcostsIncrease in the likelihood of bad debtsIncrease in funding costs 43
    44. 44. FactoringThree-tiered serviceAdministrationCredit ProtectionInvoice or Bills of Exchange Discounting 44
    45. 45. Factoring cont.Advantages DisadvantagesSaving in administration Can be expensivecosts Loss of goodwill if tooInvoice discounting: aggressive at chasing foralternative source of funds paymentCredit protection Can be deemed as a signal of liquidity problems 45
    46. 46. Trade PayablesFactors to consider in choosingSuppliers:Credit TermsReliabilityPrice 46
    47. 47. Management of Cash3 reasons for holding cashTransactions motivePrecautionary motiveSpeculative motive(John Maynard Keynes) 47
    48. 48. Cash Flow ForecastSimple and Effective Cash ManagementtoolObjective is to estimate futurecash shortagescash surpluses 48
    49. 49. Cash Flow Forecast cont.Temporary SurplusesBenefit from early settlement discountsIncrease current assetsMake short-term investmentsTemporary DeficitsArrange for short-term fundingGive early settlement discounts 49
    50. 50. Cash Flow Forecast cont.Permanent DeficitsRaise long-term financePermanent SurplusesLook for feasible long-term projectsReduce gearingExpand/Diversify 50
    51. 51. Large OrganizationsCash management in largeorganizations tends to be morecomplexMost organizations have centralizedtreasuries and apply moresophisticated models to managecash 51
    52. 52. Baumol ModelThe Baumol model is the same onewhich is used to estimate EOQCash is considered as inventory andtwo related costs are:Money Procurement costsOpportunity cost 52
    53. 53. Baumol Model example Division A Division B Cash flows Cash flows Treasury Cash flows Cash flows Division C Division D 53
    54. 54. Baumol Model example cont.According to the cash flow forecast,Division B’s annual cash requirementis $ 1 millionProcurement Costs - $ 700Opportunity Cost - 3.5% 54
    55. 55. Baumol Model example cont. 1/2 EOQ = 2 Co D ChUsing the same formula for inventories,the optimal amount to be raised andtransferred is U$ 200,000. 55
    56. 56. ConclusionCurrent Assets are essential insustaining the operations of a business.Working Capital Management deals withhow current assets are managed andfinanced.The objective of working capitalmanagement is to maximize profitabilitywithout jeopardizing liquidity. 56
    57. 57. QUESTION TIME 57