Finance explained for non-Finance Managers

1. Prof. Parag Tikekar
Whatsapp/ Cell: +97150- 5785927
E-mail: ParagTikekar@yahoo.com
Finance for Strategic Managers
(Part 2 of 4)

2. About Parag Tikekar
 BE Electronics & Communication from DIT, India.
 MBA Finance & Marketing from IIM, India.
 Keynote Speaker on Segmentation at SMI Branch Banking
Conferences at London – June ‘07, ‘08, ‘09; Uniglobal
Conference Barcelona – Oct ‘08; EFMA Conference Paris –
June ‘09; Coreventus Conference KL – Sep ‘10.
 Sharia’ah Certified; Project Management; Credit Policy; Cash
Management; Omega Credit Skills Program & Trade Finance;
Quality Team Building; Customer Care – In-house courses.
 CRM Conferences at USA – NW University, Chicago – Oct ’99;
Florida – Jan ‘01 & Dallas – June ‘02.
 Gulf Marketing Review Conference on Increasing Marketing
Effectiveness at Bahrain – Oct ‘01.

3. Agenda- Day 1(continued…)
 Introduction
 Managing Cash & Working Capital
 Cash
 Capital
 WC Cycle
 Current & Quick Ratios
 Stock
 Debtors
 Creditors
 Activities

4. Managing Cash &
Working Capital

5. Introduction
 To be able to operate in any way, all businesses rely on the
availability of cash to fund their operations & activities.
 Without the necessary flow of cash, it would be impossible
to procure the materials necessary to support production,
which in turn would not enable the business to hold
appropriate stock levels to satisfy Customer demand.
 Furthermore, without available cash it would not be
possible to settle the accounts of suppliers, causing the
stream of raw materials to dry up & thus ceasing the
production of future goods.
 All in all, a very gloomy prospect! 

6. Introduction (continued…)
 However, this need not be the case if appropriate steps are
taken to ensure that sufficient cash is available to deal with
the day-to-day demands placed on the finances of the
business.
 Working capital provides the buffer necessary to maintain
the steady operation for a business.

7. Cash (!)
 Cash is king!
 It is the life-blood of any business.
 Having sufficient available funds to run a
business on a day-to-day basis is undeniably the
most important factor for successful financial
management.
 It is essential for a business to be able to manage
its financial affairs so that funds are available to
support both capital investment projects (usually
LT & high single cost) & routine cash flows (ST to
MT & repeated lower costs).
 Both of these have an important role to play

8. Cash (continued…)
 There are 3 main reasons why businesses hold some of
their assets in the form of cash:
1. Transactionary – cash is needed to meet everyday
commitments, such as payment of wages, overheads &
goods purchased. If these commitments are not met, the
business is likely to be placed at risk. A business must be
able to pay its debts when they fall due, not just consider
profitability.
2. Precautionary – holding cash now ensures that it will be
available for a later date. ‘Saving for a rainy day’ is a
sound financial maxim for business working capital as it
acts as a buffer against unexpected fluctuations in
financial demands.
3. Speculative– holding cash enables a business to be able
to make investments or acquisitions when opportunities
arise, thus increasing market placement. However,
holding cash does have an opportunity cost which must
be considered.

9. Capital
 The capital of a business consists of the funds
invested in it.
 The term capital covers LT liabilities, reserves &
debentures, as well as share capital.
 It can be used in 2 ways:
1. Permanent capital: employed in fixed assets,
such as buildings, plant and vehicles.
2. Working capital: used for paying for goods &
services before the recovery of money from
Customers.

10. Working Capital
 Working capital refers to the levels of cash that a business will
need to make available with some degree of regularity in order to
maintain an adequate cash flow.
 It can be described as the lifeblood of a business because it
needs to keep circulating for the business to operate & thrive.
 In simplistic terms, the nature of the circulation will be as follows:
 Creditors supply a stock of goods
 The stock is sold as cash sales or to debtors
 The debtors make the necessary payments in the form of cash
or through a bank
 Appropriate payment is made to creditors in the form of cash
or through a bank

11. Working Capital Flow

12. Working Capital (continued…)
 Working capital is defined as the excess of current assets
over current liabilities.
 Therefore, Working capital = Current assets – Current
liabilities
 2 other important relationships are:
1. Total liabilities = Current liabilities + Long term liabilities +
Share capital + Reserves
2. Fixed assets + Current assets = Total liabilities

13. Working Capital (continued…)
 Total liabilities are composed of:
 The current liabilities that are always deducted from
current assets in the balance sheet
 Long term liabilities, such as long term loans &
debentures
 Owners’ equity, which includes share capital share
premium accounts & reserves

14. Activity

15. Activity
 Here is an example of a simple balance sheet:
Fixed Asset 1,450 (+)
Current Asset 8,400
Less Liabilities 3,400 5,000 (+)
Total Asset 6,450
Long term Liabilities 3,100 (-)
3,350
Share Capital 1,000
Reserves 2,350
3,350

16. Activity / Feedback
Equation 1
Fixed assets + Current assets = Total liabilities
£1,450 + £8,400 = £9,850
Of these total liabilities, it can be said that long term liabilities
& the owners’ equity represent capital.
Equation 2
Fixed assets + Current assets = Current liabilities + Long
term liabilities + Share capital + Reserves
£1,450 + £8,400 = £3,400 + £3,100 + £1,000 + £235 =
£9,850

17. Activity / Feedback
Equation 3
Fixed assets + Current assets - Current liabilities = Long term
liabilities + Share capital + Reserves
£1,450 + £8,400 - £3,400 = £3,100 + £1,000 + £235
Equation 4
Fixed assets + working capital = Total capital employed
£1,450 + £5,000 = £6,450

18. Working Capital (continued…)
 These equations enable us to see how the capital of a
business can be represented, in terms of:
 Fixed assets that enable trading to take place & thus generate
profit
 Working capital
 Working capital, representing the excess of current
assets over current liabilities or net current assets, is
the amount invested in assets that can be realistically
expected to be realised within a period of 1 year.

19. Working Capital (continued…)
 The name indicates that it is not permanent; rather it
will be turned over many times within the year.
 Its primary purpose is to finance production, invest in
stock & provide credit for Customers.
 Working capital is financed by current liabilities or
long term capital, such as shares & debentures.

20. Working Capital (continued…)
 Fixed assets are acquired by a business to enable it
to trade, whilst current assets are generally temporary
by nature.
 Cash is used to pay current liabilities or creditors.
 The variation in the nature of current assets is
constant during the routine running of the business, &
it is the management accountant’s responsibility to
ensure that this change in flow happens in a
consistent fashion.
 The flow change can be considered as the working
capital cycle.

21. Working Capital Cycle

22. Working Capital Cycle
(continued…)
 The working capital cycle for a business that typically
sells goods on credit, & it illustrates the key issues
that influence the cycle.
 Using stock as the starting point, the cycle progresses
in the following way:
 Stock is held by the company to be sold on credit to
Debtors, who after an agreed period of time will pay
Cash which will remain in the bank until it is used to
pay Creditors, who are owed sums of money for the
Stock which they have supplied to the business on
credit, … etc.

23. Activity

24. Activity
 Think about a business that holds:
 stock (often derived from cash) to the value of £11,000,
 is owed £5,000 by its debtors,
 has £9,000 cash in the bank, &
 itself owes £25,000 to creditors.
The working capital cycle will look like this:

25. Activity / Feedback

26. Activity / Feedback
 If the firm now pays all its creditors in full, we get

27. Working Capital Cycle
(continued…)
 Finally, if the money held in the bank is now used to
pay the creditors of the business, there will be no
further working capital cycle.
 This example is, of course, simply a theoretically
ideal situation & would only be likely to occur if a
business decided to cease trading.
 Only in this event would stock be sold, debts collected
& creditors paid without any further attempt to trade.

28. Working Capital Cycle
(continued…)
 Successful management of working capital relies
upon balancing the liquidity of a business with
profitable trading.
 There will be a need for sufficient cash to pay wages,
creditors for supplies, & enough stock to provide a
smooth uninterrupted flow of production that is able to
satisfy the needs of the Customers.

29. Working Capital Cycle
(continued…)
 If a business had unlimited working capital (i.e. it had
plenty of stock to meet production needs, finished goods to
meet customer demand & cash to pay creditors), there
would be an impact on its financial position.
 By paying creditors promptly it loses potential bank interest
& through giving discounts for prompt payment to
encourage debtors, it is reducing its profitability.
 The key issue is to determine how much working capital a
business needs.

30. Working Capital Cycle
(continued…)
 This is not a straightforward calculation, & will depend on
the nature of the business & the way in which it is run, as
well as its financial position at the particular moment in
time.
 A simple way of assessing how much is required at a
specific time uses the ratio of annual sales to the amount
of working capital.

31. Activity

32. Activity
 For ABC Ltd with:
 stocks of £60,000,
 debtors of £50,000,
 cash to the value of £10,000, &
 creditors owed £40,000
We can determine the working capital

33. Activity / Feedback
Working capital = Stocks + Debtors + Cash –
Creditors
= £60,000 + £50,000 + £10,000 - £40,000
= £80,000
If the P&L account for the year records a turnover
of £400,000, then we can see that the working
capital is circulated:
 400,000 / 80,000 = 5 times
To put it another way, working capital accounts for
20% of turnover.

34. Activity / Feedback

35. Ratio Analysis

36. Current Ratio
 The current ratio is defined as the ratio of current assets to current
liabilities.
 In our previous example, this would be calculated as:
Current ratio = Current assets / Current liabilities
= (£11,000 + £5,000 + £9,000) / £25,000 = 1.0
 A current ratio value of 1.0 or higher shows that if the business ceases
to trade, it will be in a position in which it would be able to honour its
current liabilities from its current asset value.
 However, if the ratio value falls below 1, current liabilities will not easily
be met.
 Thus, if the current liabilities had risen to £30,000, the current ratio
would be reduced to 0.83, indicating that the business would be unable
to repay all its creditors.

37. Acid Test Ratio
 The acid test ratio is simply defined as:
(Current assets – Stock) / Current liabilities
 In reality, many financial experts view a current
ratio of up to 2.0 as acceptable, indicating that up
to half of the current assets could be held as
stocks & not turned rapidly into cash.
 This would leave an acid test ratio value equal to
1.0.
 Both the current ratio & acid test ratio described
here are directly concerned with determining the
liquidity of a business from financial information.

38. Current v/s Acid Test Ratio
 As guidance, an organisation with a large
proportion of sales on credit & large stock
holdings may have current ratios above 1.5: 1 &
quick ratios higher than 1.0:1.
 However, if an organisation makes most of its
sales for cash & shows a very high rate of stock
turnover, the current ratio may fall below 1.0:1 &
the quick ratio be as low as 0.2: 1.

39. Activity

40. Activity
Wiggins & Co had:
 total current assets of £155,000, including stock
of £65,000, &
 current liabilities of £120,000
at 31st December 2015.
Calculate:
 Net Current Assets
 Current Ratio
 Acid Test Ratio

41. Activity / Feedback
Net current Assets = 155,000 – 65,000 = £90,000
Current Ratio = Current assets / Current liabilities
= 155,000 / 120,000 = 1.29:1
Acid Test Ratio = (Current assets – Stock) / Current
liabilities = 90,000 / 120,000 = 0.75:1

42. Working Capital Cycle
 Working capital cycle = Period goods held in
stock + Debtors payment period – Creditors
payment period
 This becomes particularly relevant if the company
is involved in manufacturing, where the period of
time related to goods held in stock needs to
include the following:
 Length of time raw materials are held
 Production time
 Length of time finished goods are held prior to sale

43. Working Capital Management
 This becomes very complicated, so it is necessary to make some
compromises between the financial theory & practice.
 Thus, although low amounts of stock should be held, this is not
always a practical solution.
 Debtors are required to pay on time but there may be some
delays, while creditors may charge interest on late payments to
them.
 If there is insufficient cash available to pay creditors, it may be
necessary to use an overdraft facility.
 Therefore, the key essential problem with working capital
management is ensuring that there is sufficient money available
to pay creditors from current assets (liquidity) without affecting
profitability.

44. Working Capital Elements
 Each of the elements of the working capital cycle is likely to have some
level of additional costs involved which will have an impact on the
overall profitability of the business.
 Stock – costs of storage & risk of short shelf life of some items, but
sales will be lost if inadequate stock levels are maintained.
 Debtors – delays in payment may result in loss or bank interest but
penalty charges may be claimed.
 Cash - interest will be charged by the bank if account becomes
overdrawn but interest can be earned if debtors pay promptly, although
it is likely to be insignificant.
 Creditors – interest charged by creditors can become expensive but
discounts may be available for payments ahead of schedule.

45. Financial Management Dilemmas
(!)
 If the business invests in stock, it is likely to have to face
charges for storage but this will avoid the risk of losing
business through being unable to fulfil customer orders.
 If debtors are offered credit terms that are over-generous,
there is the possibility of forming good Customer relations
&, thus, future business but there will be longer delays
before payment.
 If the business pays its creditors promptly, it may gain
continuity of supplies but its cash levels will be reduced.
 If it delays its payments to creditors, cash levels will
increase but the reputation of the business may be
damaged, reducing the likelihood of future discounts.

46. Working Capital Components &
Ratios

47. Stock
 For a firm to be efficient, it needs to use its stock
effectively.
 This means that the stock levels achieve a sound
balance between: enough to cope with
unexpected demand & over-stocking.
 The stock turnover ratio can be calculated thus:
Stock turnover ratio = Costs of goods sold /
Average stock
(where average stock is the average of the opening
& closing stock levels)

48. Activity

49. Activity
During 1 particular month, a manufacturer sold
goods to the value of £80,000.
The opening stock was £18,000, &
The closing stock was £22,000.
Calculate:
 Stock Turnover Ratio

50. Activity / Feedback
 Stock turnover ratio = 80,000 / 20,000 = 4
 From this figure, we can see that the company turned
over its stock 4 times during the month, so that at any
time it holds 1 week’s worth of stock.
 This might be acceptable for a manufacturing
company but would be expected to be significantly
higher for a food retail outlet, for example.
(Note that cost of goods is used rather than sales
figures as the latter includes a profit element from
trading & would, therefore, be inconsistent with stock
values.)

51. Just In Time (JIT)
 JIT approach has been widely adopted in many
manufacturing industries.
 It is best suited to ‘production’ rather than ‘project’
situations.
 The overall aim of JIT is to keep inventory costs to a
minimum.
 This reduces costs, reduces the need for storage space, &
reduces the risks of loss & damage during storage.

52. JIT: Key Characteristics
 Demand call: The whole process is set into action
when a Customer places an order. Only then are
materials & components ordered. The supplier is
expected to supply the items quickly so that
production can start immediately.
 Reduced set up times & small batches: This approach
allows, for example, the car industry to produce small
numbers of slightly different model. The manufacturer
can order the exact numbers of each component to
satisfy specific Customer requirements.

53. JIT: Key Characteristics
(continued…)
 Efficient flow: The efficient flow of materials &
components is essential if production is to run
smoothly. Every component needs to be available in
the right place at exactly the right time.
 Employee involvement: Since the work is no longer
repetitive, employees need to be involved in their
work, & good communication is essential.
 Kanban & Visibility: All involved must be able to easily
identify each item, & that the flow, use & availability of
every item must be accurately recorded & visible to
everyone involved.

54. Debtors
 For almost all areas of commercial & industrial business, sales
are still made on credit, & hence there is a need for the
management of working capital to play a significant part.
 When using the acid test ratio, debtors are not excluded as they
are more easily converted to cash than stock.
 However, the most important risk of selling goods on credit is
that of late payment & its disruption to the working capital cycle.
 The debtors ratio provides an indication of how well credit control
is taking place for a business.
 The debt collection is calculated:
Debt collection period (in days) = (Average trade debtors / Total
credit sales) x 365
 The average age of the debts: (Average trade debtors / Credit
sales per period)

55. Activity

56. Activity
DEF Ltd has sales of £300,000 (of which £20,000
was in cash) for last year,
with opening debtors of £33,000 &
closing debtors of £27,000
Calculate:
 Average trade debtors
 Debt collection period (days)

57. Activity / Feedback
The average trade debtors = (£33,000 + £27,000) /
2 = £30,000
Therefore, the debt collection period (in days) =
(£30,000 / £280,000) x 365 = 39 days
The average age of debtors using the concept of
average credit sales per month, found using
£280,000 / 12 = £23,333
Thus the average age of debtors = £30,000 /
£23,333 = 1.3 months

58. Debtors Management
1. Giving Credit
 Before giving credit to a business, we would want to have
answers to a number of key questions:
 How long has the business been operating?
 How profitable is the business?
 How much is currently owed to creditors, including the bank?
 Does it pay its other creditors promptly?
 Such information can be obtained by asking the business
for trade or bank references, & by using credit agencies to
produce a credit report.
 Once satisfied, it will normally be possible to grant a period
of credit, which may be standard within particular
industries to avoid business gaining advantage, of typically
30 days.

59. Debtors Management (continued…)
2. Collecting Debts
 Collecting debts is an essential part of managing the working
capital of a business.
 Without this, it would not be possible to maximise the value of
working capital & it is highly likely that cash flow problems would
arise.
 Debts can be collected through persuasion by offering attractive
terms for prompt payment.
 Alternatively, passing the collection of debts on to another
specialist company (known as factoring) is a common practice
that ensures that funds are instantly available.
 Offering generous discounts can be expensive for a business &,
as it is generally charged to the P&L account, often results in a
reduction in profitability.
 It is important to compare the costs of offering such discounts
with the cost of financing a bank overdraft that may become
necessary if payments are late.

60. Cash
 An essential component of the working capital cycle, as without it, serious
problems will arise with the financial position of the business.
 It is needed to pay creditors & any expenses that need to be paid immediately,
such as wages.
 It also provides a safety net, guarding against the effects of bad debts or
unfavourable economic conditions.
 However, the key decision for any business is how much cash to hold at any
time:
 The costs in holding cash in a bank account, which may earn interest, compared
with the investment opportunities lost as a result
 The speed with which other current assets can be converted into cash. Some
sectors, such a food & drink, turn stock round more regularly than others. Where
turn round is rapid, it will be possible to hold less cash than when there is a slow
movement of stock
 The costs for failing to meet creditor demands for payments (& any interest
charges) may result in the loss of future transactions with that supplier
 The state of the economy during times of recession or inflation
 The interest rates charged by banks in the event of a business having to borrow
funds

61. Creditors
 A company will have developed its own policy for the handling of
creditors, normally covering 4 specific factors:
1. Purchasing objectives will need to be worked out for each supplier.
The priority is usually placed on reliability, followed by quality, price &
then credit terms. It is good practice to find good suppliers who are
prepared to extend credit periods in order to retain business.
2. Agreement should be made with all suppliers with regard to payment
terms, e.g. within 30 days of receipt of invoice. If a business
generates cash, as most retailers do, it should be possible to pay
quickly in return for price or settlement discounts.
3. Flexibility is important. It may be necessary to trade off credit in return
for other concessions from suppliers, as some will operate on a cash-
on-delivery basis or seek a deposit before delivery.
4. By paying promptly, many suppliers will be prepared to react
favourably to future requests or negotiations.

62. Any questions?

63. Thank you!