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Working Capital & WOrking Capital Cycle

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How to calculate working capital & working capital cycle. Working Capital Management

Working Capital & WOrking Capital Cycle

  1. 1. Managing Resources Net Working Capital Working Capital Cycle Maroof Hussain Sabri
  2. 2. Contents <ul><li>Information Sources </li></ul><ul><li>Balance Sheet Overview </li></ul><ul><li>Working Capital </li></ul><ul><li>Elements of Working Capital </li></ul><ul><ul><li>Inventory / Receivables / Payables / Cash Short Term Investments </li></ul></ul><ul><li>Calculating Working Capital Requirement </li></ul>Maroof Hussain Sabri
  3. 3. The Balance Sheet <ul><ul><li>Fixed Assets </li></ul></ul><ul><ul><li>Current Assets </li></ul></ul><ul><ul><ul><li>Inventory </li></ul></ul></ul><ul><ul><ul><li>Debtors </li></ul></ul></ul><ul><ul><ul><li>Short Term Investments </li></ul></ul></ul><ul><ul><ul><li>Cash </li></ul></ul></ul><ul><ul><li>Current Liabilities </li></ul></ul><ul><ul><ul><li>Creditors, Accruals & Provisions </li></ul></ul></ul><ul><ul><ul><li>Current Portion of Long Term Debt </li></ul></ul></ul><ul><ul><ul><li>Overdrafts </li></ul></ul></ul><ul><ul><li>Σ EQUALS </li></ul></ul><ul><ul><li>Employment of Capital </li></ul></ul><ul><li>Equity </li></ul><ul><li>Long Term Debt </li></ul><ul><li>Σ EQUALS </li></ul><ul><li>Capital Employed </li></ul>Maroof Hussain Sabri
  4. 4. Working Capital Definition Current Assets minus Current Liabilities Capital tied up in the business for day to day operating requirements Maroof Hussain Sabri
  5. 5. Working Capital <ul><li>Current Assets </li></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Debtors </li></ul></ul><ul><ul><li>Short Term Investments </li></ul></ul><ul><ul><li>Cash </li></ul></ul><ul><li>Current Liabilities </li></ul><ul><ul><li>Creditors, Accruals & Provisions </li></ul></ul><ul><ul><li>Current Portion of Long Term Debt </li></ul></ul><ul><ul><li>Overdrafts </li></ul></ul><ul><li>Σ EQUALS </li></ul><ul><li>WORKING CAPITAL </li></ul>Maroof Hussain Sabri
  6. 6. <ul><li>Current Assets </li></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Debtors </li></ul></ul><ul><ul><li>Short Term Investments </li></ul></ul><ul><ul><li>Cash </li></ul></ul><ul><li>Current Liabilities </li></ul><ul><ul><li>Creditors, Accruals & Provisions </li></ul></ul><ul><ul><li>Current Portion of Long Term Debt </li></ul></ul><ul><ul><li>Overdrafts </li></ul></ul><ul><li>Σ EQUALS </li></ul><ul><li>WORKING CAPITAL </li></ul>Maroof Hussain Sabri
  7. 7. Cost of Goods Sold Model Beginning inventory £20 Purchases £100 Maroof Hussain Sabri Cost of goods available for sale £120 Ending inventory £30 Cost of goods sold £90
  8. 8. What Goes Into Inventory Cost? <ul><li>The cost of any asset, such as inventory, is the sum of all the costs incurred to bring the asset to its current location and condition </li></ul><ul><li>Inventory Costing </li></ul><ul><li>Generally accepted inventory costing methods: </li></ul><ul><ul><li>Specific unit cost </li></ul></ul><ul><ul><li>Weighted-average cost </li></ul></ul><ul><ul><li>First-in, first-out (FIFO) </li></ul></ul><ul><ul><li>Last-in, first-out (LIFO) </li></ul></ul>Maroof Hussain Sabri
  9. 9. Valuation Rules <ul><li>Cost or Market Rule </li></ul><ul><li>Inventory is reported at the lower of its historical cost or market (replacement) value. </li></ul><ul><li>If the replacement cost falls below its historical cost, the business must write down the value of its inventory. </li></ul><ul><li>Realisable Value </li></ul><ul><li>Realisable value is estimated sales proceeds minus cost of selling </li></ul><ul><li>Stocks should be valued at the lower of cost or net realisable value </li></ul>Maroof Hussain Sabri
  10. 10. Key Equations <ul><li>Opening Stock + Purchases – Closing Stock = COST OF SALES </li></ul><ul><li>If 3 of these variables are known it is possible to determine the 4 th variable </li></ul><ul><li>Sales Revenue – Cost of Sales = Gross Profit </li></ul>Maroof Hussain Sabri
  11. 11. Using Financial Statements for Decision Making Inventory turnover = Cost of goods sold ÷ Average inventory Gross profit percentage = Gross profit ÷ Net sales revenue Maroof Hussain Sabri
  12. 12. Working Capital <ul><li>Current Assets </li></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Debtors </li></ul></ul><ul><ul><li>Short Term Investments </li></ul></ul><ul><ul><li>Cash </li></ul></ul><ul><li>Current Liabilities </li></ul><ul><ul><li>Creditors, Accruals & Provisions </li></ul></ul><ul><ul><li>Current Portion of Long Term Debt </li></ul></ul><ul><ul><li>Overdrafts </li></ul></ul><ul><li>Σ EQUALS </li></ul><ul><li>WORKING CAPITAL </li></ul>Maroof Hussain Sabri
  13. 13. The Working Capital Cycle Finished Goods Work in Progress Cash Sales Trade Debtors Cash Bank Overdraft Raw Materials Trade Creditors Maroof Hussain Sabri
  14. 14. Cash Operating Cycle <ul><ul><li>(A ) 365 /Stock turnover </li></ul></ul><ul><ul><ul><li>365 / Cost of Sales / Average socks </li></ul></ul></ul><ul><ul><li>(B ) 365 /Debtors Turnover </li></ul></ul><ul><ul><ul><li>365 / Sales / Average Debtors </li></ul></ul></ul><ul><ul><li>(C )365 / Creditors turnover </li></ul></ul><ul><ul><ul><li>365 / Total Purchases / Average creditors </li></ul></ul></ul><ul><ul><li>Cash operating cycle = (A) + (B) – ( C ) </li></ul></ul>Materials Received Supplier Credit period Goods Sold Stock conversion period Cash Received from sales Customer credit period Cash conversion cycle Maroof Hussain Sabri
  15. 15. Short Term Investments Maroof Hussain Sabri
  16. 16. Short-Term Investments <ul><li>Short-term investments are investments that a company plans to hold for one year or less. </li></ul><ul><ul><li>Held-to-maturity securities </li></ul></ul><ul><ul><li>Trading investments </li></ul></ul><ul><ul><li>Available-for-sale investments </li></ul></ul><ul><li>Held-to-maturity and available-for-sale securities could also be long-term </li></ul><ul><li>Held-to-maturity investments are securities that the investor expects to hold until their maturity date </li></ul><ul><ul><li>They earn interest revenue for the investor </li></ul></ul><ul><ul><li>Accounting for these securities is the same as accounting for notes receivable </li></ul></ul>Maroof Hussain Sabri
  17. 17. Short-Term Investments <ul><li>Suppose that Sainsbury plc purchases Tesco plc shares on May 18,paying £100,000, with the intention of selling the stock within a few months </li></ul><ul><li>On May 27, Sainsbury receives a cash dividend of £4,000 from Tesco </li></ul><ul><li>Sainsbury’s financial year ends on May 31, and the investment in Tesco has a current market value of £102,000 on this date </li></ul>Maroof Hussain Sabri
  18. 18. Reporting on the Balance Sheet and Income Statement Balance Sheet Current Assets: $ XXX Cash XXX Short-term investments at market value 102,000 Accounts receivable XXX Income Statement Revenues $ XXX Expenses XXX Other revenues, gains, and (losses): Interest revenue XXX Dividend revenue 4,000 Unrealized gain on investment 2,000 Maroof Hussain Sabri
  19. 19. Accounts Receivable Maroof Hussain Sabri
  20. 20. Accounts Receivable <ul><li>Debtors (Receivables) are the third most liquid asset – after cash and short-term investments </li></ul><ul><li>Debtors (Receivables) are monetary claims against others. </li></ul><ul><li>Arise principally because Trade Credit is offered by seller </li></ul><ul><li>Types </li></ul><ul><ul><li>Sales Debtors (Accounts Receivable) </li></ul></ul><ul><ul><li>Notes Receivable </li></ul></ul><ul><ul><li>Other Debtors and Prepayments </li></ul></ul>Maroof Hussain Sabri
  21. 21. Why Offer Trade Credit <ul><li>Marketing decision – price </li></ul><ul><li>Trade off between credit risk and profit margin </li></ul><ul><li>Industry Practice </li></ul><ul><li>Access to Finance is a Competitive advantage – can offer generous credit </li></ul><ul><li>Information asymmetry between buyer & seller about condition of Goods – gives inspection period </li></ul>Maroof Hussain Sabri
  22. 22. Valuation of Accounts Receivable <ul><li>Short term receivables are reported at their net realizable value (NRV) </li></ul><ul><li>The NRV is the net amount expected to be collected </li></ul><ul><li>The NRV is gross accounts receivable less estimated non-collectible accounts </li></ul><ul><li>Estimating bad debt can be on a balance sheet basis or % of sales revenue basis </li></ul>Maroof Hussain Sabri
  23. 23. Notes Receivable <ul><li>Notes receivable are more formal than accounts receivable. </li></ul><ul><li>The creditor has a note receivable. </li></ul><ul><li>The debtor has a note payable. </li></ul><ul><li>The principal amount of the note is the amount borrowed by the debtor </li></ul><ul><li>The maker pays the payee the maturity value </li></ul><ul><li>The maturity value includes principal plus interest. </li></ul>Maroof Hussain Sabri
  24. 24. Notes Receivable PROMISSORY NOTE £1,000 August 31, 2005 Amount For value received, I promise to pay to the order of Lloyds Bank plc London One thousand and no/100………… …………D ollars on February 28, 2006 plus interest at the annual rate of 9 percent pa Interest period starts Payee (creditor) Interest rate Interest period ends on the maturity date Maker (Debtor) Maroof Hussain Sabri
  25. 25. Accounting for Notes Receivable <ul><li>Principal Amount of Note receivable shown as a current asset </li></ul><ul><li>Interest accrues over time </li></ul><ul><li>This interest is added to income </li></ul><ul><li>Corresponding entry is increase in Interest receivable </li></ul><ul><li>When note is paid cash is increased by actual amount paid </li></ul><ul><li>Notes Receivable (Principal value is reduced) </li></ul><ul><li>Interest receivable is reduced </li></ul>Maroof Hussain Sabri
  26. 26. Other Debtors <ul><li>Prepayments </li></ul><ul><li>Returnable deposits paid </li></ul>Maroof Hussain Sabri
  27. 27. Current Liabilities Maroof Hussain Sabri
  28. 28. Current Liabilities <ul><li>Current liabilities are obligations due within one year or within the company’s normal operating cycle if it is longer than one year </li></ul><ul><li>Either </li></ul><ul><li>Known amount </li></ul><ul><li>Or </li></ul><ul><li>Amount must be estimated </li></ul>Maroof Hussain Sabri
  29. 29. Current Liabilities <ul><li>Accounts Payable </li></ul><ul><li>Short-term notes payable </li></ul><ul><ul><li>Interest to balance sheet date must be accrued </li></ul></ul><ul><li>Sales tax / VAT payable </li></ul><ul><li>Current portion of long-term debt </li></ul><ul><li>Accrued expenses </li></ul><ul><li>Returnable Deposits </li></ul><ul><li>Payroll liabilities </li></ul><ul><li>Unearned revenues </li></ul><ul><li>Dividend Payable </li></ul>Maroof Hussain Sabri
  30. 30. Creditors, Accruals and Provisions <ul><li>Creditors – </li></ul><ul><ul><li>Amounts owing which are Known </li></ul></ul><ul><ul><li>Goods received on credit & Invoice received </li></ul></ul><ul><li>Accruals </li></ul><ul><ul><ul><li>Not known with certainty – Invoice not received </li></ul></ul></ul><ul><li>Provisions </li></ul><ul><ul><ul><li>General / specific </li></ul></ul></ul><ul><ul><ul><ul><ul><li>Bad Debts, IBNR, </li></ul></ul></ul></ul></ul>Maroof Hussain Sabri
  31. 31. Accounts Payable <ul><li>Accounts payable, are: </li></ul><ul><ul><li>Balances owed for goods, supplies, or services purchased on open account. </li></ul></ul><ul><ul><li>Valuation is based on invoice amount. </li></ul></ul>Maroof Hussain Sabri
  32. 32. Trade Credit <ul><li>Obtained for period between delivery & Payment </li></ul><ul><ul><li>Part of Normal trading relationship </li></ul></ul><ul><ul><li>Early payment discount Terminology </li></ul></ul><ul><ul><ul><li>2/10 net 30 </li></ul></ul></ul><ul><li>Affected by </li></ul><ul><ul><li>Industry custom & Practice </li></ul></ul><ul><ul><li>Relative Bargaining power </li></ul></ul><ul><ul><li>Type of product small margin less credit </li></ul></ul><ul><li>Taking excessive credit harms supplier relationship </li></ul><ul><li>Late Payment & Commercial debts (interest) act 1998 </li></ul>Maroof Hussain Sabri
  33. 33. Value of Discounts <ul><li>Example of value of discount </li></ul><ul><li>£100000 if paid in 30 days or £97500 if paid in 10 days </li></ul><ul><li>Saving £2500 </li></ul><ul><li>Interest rate is 5% per Annum </li></ul><ul><li>Cost of Early Payment </li></ul><ul><li>£97500 x .05 = £4875 x 20 / 360 = £271 </li></ul>Maroof Hussain Sabri
  34. 34. Unearned revenues <ul><li>Unearned revenues represent receipts of cash for sales before goods or services are delivered </li></ul><ul><ul><li>Magazine Subscription </li></ul></ul><ul><ul><li>Licences </li></ul></ul><ul><ul><li>Air Tickets </li></ul></ul>Maroof Hussain Sabri
  35. 35. Current Installment of Long-Term Debt <ul><li>It is the amount of the principal that is payable within one year. </li></ul><ul><li>At the end of the year, a company reclassifies the amount of its long-term debt that must be paid during the upcoming year </li></ul>Maroof Hussain Sabri
  36. 36. Accrued Expenses These are expenses that have been incurred but not recorded . Salaries Taxes withheld Interest Utilities Maroof Hussain Sabri
  37. 37. Current Liabilities which must be estimated <ul><li>Estimated Warranty Payable </li></ul><ul><ul><li>Assume that Black & Decker made sales of $200,000,000 subject to product warranties of 1 year. </li></ul></ul><ul><ul><li>Black & Decker estimates that 3% of the products it sells this year will require repair or replacement </li></ul></ul><ul><ul><li>$200,000,000 × .03 = $6,000,000 </li></ul></ul><ul><ul><li>This Amount would be accrued as an expense and shown as a liability on the Balance Sheet in the year of sale </li></ul></ul><ul><ul><li>In the following year the costs of meeting these warranties would be charged against the provision rather than being charged as an expense on the Income Statement </li></ul></ul><ul><ul><li>At the end of this year any balance remaining would be included in Income </li></ul></ul>Maroof Hussain Sabri
  38. 38. Working Capital Requirement Calculation <ul><li>Turnover £1,500,000 </li></ul><ul><li>Costs as % of sales </li></ul><ul><ul><ul><li>Materials 30% </li></ul></ul></ul><ul><ul><ul><li>Labour 25% </li></ul></ul></ul><ul><ul><ul><li>Other Variable costs 10% </li></ul></ul></ul><ul><ul><ul><li>Fixed costs (Rent) 15% </li></ul></ul></ul><ul><ul><ul><li>Distribution 5% </li></ul></ul></ul><ul><li>Operating Cycle </li></ul><ul><ul><ul><li>Customers take 2.5 months to pay </li></ul></ul></ul><ul><ul><ul><li>Materials are in stock for 3 months </li></ul></ul></ul><ul><ul><ul><li>Finished goods are 1 months production </li></ul></ul></ul><ul><ul><ul><li>Credit is as follows </li></ul></ul></ul><ul><ul><ul><ul><li>Materials 2 Months Variable costs 1 month </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fixed Costs 1 month Distributio n 2 weeks </li></ul></ul></ul></ul>Maroof Hussain Sabri
  39. 39. Working Capital Requirement Calculation Maroof Hussain Sabri
  40. 40. Is it too late to do some individual work? Maroof Hussain Sabri
  41. 41. Is it too late to do some individual work Maroof Hussain Sabri
  42. 42. Using Financial Statements for Decision Making Debtors turnover = Sales Revenue ÷ Average Trade Debtors Days Creditors Outstanding = 365 ÷ (Credit Purchases ÷ Average Trade Creditors) Maroof Hussain Sabri
  43. 43. Using Financial Statements for Decision Making Maroof Hussain Sabri
  44. 44. Recap <ul><li>Short-term investments are investments that a company plans to hold for one year or less. </li></ul><ul><li>Debtors (Receivables) are the third most liquid asset – after cash and short-term investments </li></ul><ul><li>Short term receivables are reported at their net realizable value (NRV) </li></ul><ul><li>Current liabilities are obligations due within one year or within the company’s normal operating cycle if it is longer than one year </li></ul>Maroof Hussain Sabri
  45. 45. Recap <ul><li>Short Term Liabilities </li></ul><ul><ul><li>Accounts Payable </li></ul></ul><ul><ul><li>Short-term notes payable </li></ul></ul><ul><ul><ul><li>Interest to balance sheet date must be accrued </li></ul></ul></ul><ul><ul><li>Sales tax / VAT payable </li></ul></ul><ul><ul><li>Current portion of long-term debt </li></ul></ul><ul><ul><li>Accrued expenses </li></ul></ul><ul><ul><li>Returnable Deposits </li></ul></ul><ul><ul><li>Payroll liabilities </li></ul></ul><ul><ul><li>Unearned revenues </li></ul></ul><ul><ul><li>Dividend Payable </li></ul></ul>Maroof Hussain Sabri
  46. 46. Recap <ul><li>Working Capital </li></ul><ul><li>Definition </li></ul><ul><ul><li>Current Assets minus Current Liabilities </li></ul></ul><ul><ul><li>Capital tied up in the business for day to day operating requirements </li></ul></ul><ul><li>Calculation of the working capital requirement is a fundamental task for Financial Planning </li></ul>Maroof Hussain Sabri

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