Working Capital Management


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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. Maroof Hussain Sabri
    2. 2. <ul><li>The nature of working capital </li></ul><ul><li>The cash operating cycle </li></ul><ul><li>Funding the cash operating cycle </li></ul><ul><li>The objectives of working capital </li></ul><ul><li>Inventory management </li></ul><ul><li>Managing trade receivables </li></ul><ul><li>Relationship with suppliers </li></ul><ul><li>Managing Cash </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    3. 3. <ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    4. 4. <ul><li>Current Assets less Current Liabilities </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    5. 5. <ul><li></li></ul>Sales Inventories Debtors Sustain <ul><li>Maroof Hussain Sabri </li></ul>
    6. 6. <ul><li>Despite running at full capacity, steel suppliers in Japan and elsewhere in Asia struggled to satisfy Japan’s booming exporters </li></ul><ul><li>Nissan had to cut down its production by an estimated 40,000 vehicles to meet demand in March (March is the month where demand for cars in Japan hits a peak) </li></ul><ul><li>Source FT Dec 2004 </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    7. 7. <ul><li>The Cheapest way to finance current assets is to use free credit from suppliers </li></ul><ul><li>This may lead to LIQUIDITY PROBLEMS . This risk can be illustrated using a </li></ul><ul><li></li></ul>Cash Operating Cycle <ul><li>Maroof Hussain Sabri </li></ul>
    8. 8. <ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    9. 9. <ul><li></li></ul>Inventory Turnover Period Raw Materials holding period Production Period Finished Goods holding period <ul><li>Maroof Hussain Sabri </li></ul>
    10. 10. <ul><li></li></ul>The accounts receivable payment period How long our customers take, on average, to settle their bills <ul><li>Maroof Hussain Sabri </li></ul>
    11. 11. <ul><li>Accounts payable payment period </li></ul><ul><li></li></ul>How long, on average, we take to pay our customers FREE CREDIT DAYS!! <ul><li>Maroof Hussain Sabri </li></ul>
    12. 12. <ul><li>Ratios have limitations particularly when comparing P/L items with Balance Sheet Figures </li></ul><ul><li>Example: In December retailers normally have below average stock levels and therefore an average based on December figures may not reflect the annual average </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    13. 13. <ul><li>If you are 6 feet tall and you don’t know how to swim, would you wade across a pool with an average depth of 3 feet? </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    14. 14. <ul><li></li></ul>Trade Payables Raw Materials W-I-P Finished Goods Debtors Cash Outflow Cash Inflow Financing current assets entirely from trade payables will keep the cost of interest down BUT this may lead to liquidity problems <ul><li>Maroof Hussain Sabri </li></ul>
    15. 15. <ul><li>Deferral of Cash Inflows </li></ul><ul><li>Stock becoming obsolete or out-of-fashion </li></ul><ul><li>Disruptions in production processes </li></ul><ul><li>Debtors failing to meet credit deadlines </li></ul><ul><li>Foregone Cash Inflows </li></ul><ul><li>Bad Debts </li></ul><ul><li>Other Cash Outflows - Overheads </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    16. 16. <ul><li>The duration of the trade payables period is normally dictated by suppliers or the market in general. Therefore it may not match the current asset turnover period </li></ul><ul><li>In addition the conversion of current assets into cash may be deferred or at worse foregone (Bad Debts) </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    17. 17. <ul><li></li></ul>Trade Payables Raw Materials W-I-P Finished Goods Debtors Funding the cash operating cycle <ul><li>Maroof Hussain Sabri </li></ul>
    18. 18. <ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    19. 19. <ul><li>Short-Term Borrowings </li></ul><ul><li>Bank Overdraft </li></ul><ul><li>Commercial Paper </li></ul><ul><li>Invoice or Bills of Exchange Discounting </li></ul><ul><li>Long-Term Capital Employed </li></ul><ul><li>Debt / Equity </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    20. 20. <ul><li></li></ul>AGRESSIVE CONSERVATIVE SHORT-TERM FUNDING LONG-TERM FUNDING Flexible / Low Cost Liquidity Risk Rigid / High Cost Financially Stable <ul><li>Maroof Hussain Sabri </li></ul>
    21. 21. <ul><li>MATCHING </li></ul><ul><li>Current assets are assets which are either cash or expected to be converted into cash with one year </li></ul><ul><li>For funding purposes these can be classified into: </li></ul><ul><li></li></ul>Permanent Fluctuating <ul><li>Maroof Hussain Sabri </li></ul>
    22. 22. <ul><li>Permanent Inventory </li></ul><ul><li>Inventory required to stock the shops plus to keep some buffer stock in warehouse/s </li></ul><ul><li>Fluctuating </li></ul><ul><li>Inventory levels before the Easter, Summer and Christmas holidays will normally be above average </li></ul><ul><li></li></ul>Example: Toy Shop <ul><li>Maroof Hussain Sabri </li></ul>
    23. 23. <ul><li></li></ul>Permanent Current Assets financed by Long-term Capital Fluctuating Current Assets financed by Short-Term Funding <ul><li>Maroof Hussain Sabri </li></ul>
    24. 24. <ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    25. 25. <ul><li>A business needs to invest in current assets to sustain its business operations </li></ul><ul><li>The aim of working capital management is to strike off a balance between FINANCIAL STABILITY and PROFITABILITY </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    26. 26. <ul><li>Too much working capital will impinge on profitability </li></ul><ul><li>Higher interest rate burden </li></ul><ul><li>Opportunity Cost – long-term capital tied in current assets can be used to finance feasible projects </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    27. 27. <ul><li>Inadequate Working Capital may lead to liquidity problems </li></ul><ul><li>Overtrading </li></ul><ul><li>Rapid expansion in business without having adequate working capital. </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    28. 28. <ul><li>Symptoms of Overtrading </li></ul><ul><li>Accounts Payable period will increase </li></ul><ul><li>Development of hard core element in bank overdraft plus encroachments </li></ul><ul><li>Profit margins will start to decline as raising cash will be given priority to profitability </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    29. 29. <ul><li></li></ul>Some textbooks suggest that: <ul><li>However Working Capital needs depend on a number of factors. For example: </li></ul><ul><ul><li>type of industry </li></ul></ul><ul><ul><li>accessibility to financial markets </li></ul></ul><ul><li>Maroof Hussain Sabri </li></ul>
    30. 30. <ul><li></li></ul>Trade Payables (48.7 days) Inventory (13.8 days) J SAINSBURY – FOOD RETAIL INDUSTRY Negative Working Capital Source: Fitch Ratings figures as at 24-Mar-07 <ul><li>Maroof Hussain Sabri </li></ul>
    31. 31. <ul><li></li></ul>Trade Payables (30.7 days) Inventory processing period (31.2 days) Debtors ( 27.4 days) Cash Operating Cycle (27.9 days) SABMILLER – BREWERY Source: Fitch Ratings figures as at 31-Mar-07 <ul><li>Maroof Hussain Sabri </li></ul>
    32. 32. <ul><li>Working Capital Needs differ among industries </li></ul><ul><li>Optimality depends on the management of the constituents of Working Capital </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    33. 33. <ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    34. 34. <ul><li>INVENTORY COSTS </li></ul><ul><li>HOLDING COSTS funding </li></ul><ul><li>storage </li></ul><ul><li>insurance </li></ul><ul><li>PROCUREMENT ordering </li></ul><ul><li>delivery </li></ul><ul><li>SHORTAGE COSTS lost contribution from missed sales </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    35. 35. <ul><li></li></ul>Where: EOQ (Q) economic order quantity Co Ordering Cost D Annual Demand Ch Cost of holding 1 unit <ul><li>Maroof Hussain Sabri </li></ul>
    36. 36. <ul><li>Example: </li></ul><ul><li>The expected annual demand is 500,000. Purchase price is $100. It costs $ 500 to place an order and the cost of holding one unit in stock is 20%. </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    37. 37. <ul><li></li></ul>EOQ <ul><li>Maroof Hussain Sabri </li></ul>
    38. 38. <ul><li>Assumptions – Practical Implications </li></ul><ul><li>Goods are delivered when they are ordered i.e. no lead times </li></ul><ul><li>Demand is constant </li></ul><ul><li>Price is constant and no bulk purchases discounts </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    39. 39. <ul><li>Toyota was the first company to develop JIT </li></ul><ul><li>Toyota needed to reduce costs of production and JIT was the solution </li></ul><ul><li>Kanban System – pull system of production i.e. items are only produced when they are needed </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    40. 40. <ul><li>Companies thinking of introducing JIT will first have to: </li></ul><ul><li>Find reliable suppliers </li></ul><ul><li>Train employees to minimize wastages and idle time </li></ul><ul><li>Improve quality </li></ul><ul><li>Minimize lead times </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    41. 41. <ul><li>A company which is selling on credit is actually lending money </li></ul><ul><li>It must have a debtors policy, composed of a: </li></ul><ul><li>Credit Analysis System </li></ul><ul><li>Credit Control System </li></ul><ul><li>Debt Collection procedure </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    42. 42. <ul><li>The objective of selling on credit is to increase sales, however: </li></ul><ul><li>Sales Growth is vanity </li></ul><ul><li>Profit is sanity </li></ul><ul><li>Cash is king </li></ul><ul><li>Ultimate objective should be profitability without jeopardizing liquidity </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    43. 43. <ul><li>Main benefit – increase in contribution </li></ul><ul><li>Costs </li></ul><ul><li>Increase in debtors administration costs </li></ul><ul><li>Increase in the likelihood of bad debts </li></ul><ul><li>Increase in funding costs </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    44. 44. <ul><li>Three-tiered service </li></ul><ul><li>Administration </li></ul><ul><li>Credit Protection </li></ul><ul><li>Invoice or Bills of Exchange Discounting </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    45. 45. <ul><li></li></ul>Saving in administration costs Invoice discounting: alternative source of funds Credit protection Can be expensive Loss of goodwill if too aggressive at chasing for payment Can be deemed as a signal of liquidity problems Advantages Disadvantages <ul><li>Maroof Hussain Sabri </li></ul>
    46. 46. <ul><li>Factors to consider in choosing Suppliers: </li></ul><ul><li>Credit Terms </li></ul><ul><li>Reliability </li></ul><ul><li>Price </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    47. 47. <ul><li>3 reasons for holding cash </li></ul><ul><li>Transactions motive </li></ul><ul><li>Precautionary motive </li></ul><ul><li>Speculative motive </li></ul><ul><li>(John Maynard Keynes) </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    48. 48. <ul><li>Simple and Effective Cash Management tool </li></ul><ul><li>Objective is to estimate future </li></ul><ul><li>cash shortages </li></ul><ul><li>cash surpluses </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    49. 49. <ul><li>Temporary Surpluses </li></ul><ul><li>Benefit from early settlement discounts </li></ul><ul><li>Increase current assets </li></ul><ul><li>Make short-term investments </li></ul><ul><li>Temporary Deficits </li></ul><ul><li>Arrange for short-term funding </li></ul><ul><li>Give early settlement discounts </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    50. 50. <ul><li>Permanent Deficits </li></ul><ul><li>Raise long-term finance </li></ul><ul><li>Permanent Surpluses </li></ul><ul><li>Look for feasible long-term projects </li></ul><ul><li>Reduce gearing </li></ul><ul><li>Expand/Diversify </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    51. 51. <ul><li>Cash management in large organizations tends to be more complex </li></ul><ul><li>Most organizations have centralized treasuries and apply more sophisticated models to manage cash </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    52. 52. <ul><li>The Baumol model is the same one which is used to estimate EOQ </li></ul><ul><li>Cash is considered as inventory and two related costs are: </li></ul><ul><li>Money Procurement costs </li></ul><ul><li>Opportunity cost </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    53. 53. <ul><li></li></ul>Treasury Division A Division D Division C Division B Cash flows Cash flows Cash flows Cash flows <ul><li>Maroof Hussain Sabri </li></ul>
    54. 54. <ul><li>According to the cash flow forecast, Division B’s annual cash requirement is $ 1 million </li></ul><ul><li>Procurement Costs - $ 700 </li></ul><ul><li>Opportunity Cost - 3.5% </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    55. 55. <ul><li></li></ul>Using the same formula for inventories, the optimal amount to be raised and transferred is U$ 200,000. <ul><li>Maroof Hussain Sabri </li></ul>
    56. 56. <ul><li>Current Assets are essential in sustaining the operations of a business. </li></ul><ul><li>Working Capital Management deals with how current assets are managed and financed. </li></ul><ul><li>The objective of working capital management is to maximize profitability without jeopardizing liquidity. </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>
    57. 57. <ul><li>QUESTION TIME </li></ul><ul><li></li></ul><ul><li>Maroof Hussain Sabri </li></ul>