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Working Capital Management                             1
PROGRAMME The nature of working capital The cash operating cycle Funding the cash operating cycle The objectives of wo...
The Nature ofWorking Capital                  3
Definition of Working CapitalCurrent Assets less Current Liabilities      Current Assets            Current LiabilitiesInv...
Why Invest in Current Assets                               5
Example: Raw MaterialsDespite running at full capacity, steelsuppliers in Japan and elsewhere in Asiastruggled to satisfy ...
Funding Current AssetsThe Cheapest way to finance currentassets is to use free credit fromsuppliersThis may lead to LIQUID...
TheCash Operating Cycle                       8
Cash Operating Cycle                 Inventory Turnover PeriodRaw Materials           Avg Raw Materials       x 365holding...
Cash Operating Cycle cont.    The accounts receivable payment periodHow long ourcustomers take,      Average Trade Receiva...
Cash Operating Cycle cont.      Accounts payable payment periodHow long, onaverage, we       Average Trade Payables   x 36...
Ratios are not perfectRatios have limitations particularlywhen comparing P/L items withBalance Sheet FiguresExample: In De...
Beware AveragesIf you are 6 feet tall and you don’tknow how to swim, would youwade across a pool with anaverage depth of 3...
Cash Operating Cycle         Financing current assets entirely from trade         payables will keep the cost of interest ...
Liquidity Risk?Deferral of Cash InflowsStock becoming obsolete or out-of-fashionDisruptions in production processesDebtors...
The need for working capitalThe duration of the trade payablesperiod is normally dictated by suppliersor the market in gen...
Cash Operating Cycle Raw Materials   W-I-P   Finished Goods   Debtors      Trade Payables             Funding the cash    ...
Funding theCash Operating Cycle                       18
Funding the Cash Operating CycleShort-Term Borrowings   Bank Overdraft   Commercial Paper   Invoice or Bills of Exchang...
Funding the Cash Operating Cycle AGRESSIVE              CONSERVATIVESHORT-TERM FUNDING    LONG-TERM FUNDING               ...
Funding the Cash Operating CycleMATCHINGCurrent assets are assets which areeither cash or expected to beconverted into cas...
Funding the Cash Operating CycleExample: Toy ShopPermanent InventoryInventory required to stock the shops plus tokeep some...
Funding the Cash Operating Cycle1816                                                            Fluctuating14             ...
The Objective ofWorking Capital Management                      24
Aim of Working Capital ManagementA business needs to invest in currentassets to sustain its business operationsThe aim of ...
Over-Capitalization -Working CapitalToo much working capital will impinge onprofitabilityHigher interest rate burdenOpport...
Inadequate Working CapitalInadequate Working Capital may lead toliquidity problemsOvertradingRapid expansion in business w...
Inadequate Working Capital cont.Symptoms of OvertradingAccounts Payable period will increaseDevelopment of hard core eleme...
Optimum Working CapitalSome textbooks suggest that:                       Over-Capitalised   Under-CapitalisedCurrent Rati...
Optimum Working Capital cont.       J SAINSBURY – FOOD RETAIL INDUSTRY  Inventory (13.8 days)               Negative Worki...
Optimum Working Capital cont.                        SABMILLER – BREWERYInventory processing period (31.2 days)           ...
Conclusion on OptimalityWorking Capital Needs differ amongindustriesOptimality   depends   on     themanagement of the con...
ManagingWorking Capital                  33
Inventory ManagementINVENTORY COSTSHOLDING COSTS     funding                  storage                  insurancePROCUREMEN...
Economic Order Quantity                            1/2           EOQ =   2 Co D                     Ch     Where:     EOQ ...
Economic Order Quantity cont.Example:The expected annual demand is 500,000.Purchase price is $100. It costs $ 500 toplace ...
Economic Order Quantity cont.  $ 000s                                                                     Ch              ...
Economic Order Quantity cont.Assumptions – Practical ImplicationsGoods are delivered when they are ordered i.e. no lead t...
Just-in-Time JITToyota was the first company todevelop JITToyota needed to reduce costs ofproduction and JIT was the solut...
Just-in-Time JIT cont.Companies thinking of introducing JITwill first have to:Find reliable suppliersTrain employees to mi...
Trade ReceivablesA company which is selling on creditis actually lending moneyIt must have a debtors policy,composed of a:...
Trade ReceivablesThe objective of selling on credit is toincrease sales, however:Sales Growth is vanityProfit is sanityCas...
Increasing Trade ReceivablesMain benefit – increase in contributionCostsIncrease in debtors administrationcostsIncrease in...
FactoringThree-tiered serviceAdministrationCredit ProtectionInvoice or Bills of Exchange Discounting                      ...
Factoring cont.Advantages                     DisadvantagesSaving   in   administration   Can be expensivecosts           ...
Trade PayablesFactors to consider in choosingSuppliers:Credit TermsReliabilityPrice                                  46
Management of Cash3 reasons for holding cashTransactions motivePrecautionary motiveSpeculative motive(John Maynard Keynes)...
Cash Flow ForecastSimple and Effective Cash ManagementtoolObjective is to estimate futurecash shortagescash surpluses   ...
Cash Flow Forecast cont.Temporary SurplusesBenefit from early settlement discountsIncrease current assetsMake short-term i...
Cash Flow Forecast cont.Permanent DeficitsRaise long-term financePermanent SurplusesLook for feasible long-term projectsRe...
Large OrganizationsCash     management   in      largeorganizations tends to be     morecomplexMost organizations have cen...
Baumol ModelThe Baumol model is the same onewhich is used to estimate EOQCash is considered as inventory andtwo related co...
Baumol Model example  Division A                            Division B    Cash flows                            Cash flows...
Baumol Model example cont.According to the cash flow forecast,Division B’s annual cash requirementis $ 1 millionProcuremen...
Baumol Model example cont.                           1/2          EOQ =   2 Co D                    ChUsing the same formu...
ConclusionCurrent    Assets    are    essential  insustaining the operations of a business.Working Capital Management deal...
QUESTION TIME                57
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Working Capital Management

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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
  20. 20. Funding the Cash Operating Cycle AGRESSIVE CONSERVATIVESHORT-TERM FUNDING LONG-TERM FUNDING 20
  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

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