Sunday, 26 August 2012

Lecture Notes -Working Capital Management


Working capital management

Working capital

Working capital is the capital available for conducting the day to day operations of an organisation, represented by its current assets. Working capital is the money used to produce goods and attract sales. In short working capital refers to short term assets such as stock, debtors and cash minus short term creditors. (FTC Foulks Lynch- 2005)

Working capital is an investment which affects cash flows.
·         For example when stocks are purchased, cash is paid for them.
·         Debtors represented the cost of selling goods or services to customers including the costs of the materials and labour incurred.
Investing in working capital has a cost which can be expressed as either as:
·         The cost of funding it or
·         The lost investment opportunities because cash tied up and unavailable for other uses (FTC Foulks Lynch- 2005)

Working capital management

Working capital management is the management of all aspects of both current assets and current liabilities to minimise the risk of going bankrupt and at the same time increasing returns on assets. (FTC Foulks Lynch- 2005)
Current assets represent more than half the assets of companies and they tend to be of a particular to small firms. Most often small businesses fail because they failed to control working capital investment and business liquidity
For most companies good working capital management is the fastest and most cost effective means of creating shareholder value. The following mechanism can be used to manage working capital effectively
·         Stretch out payments( creditors) as long as possible for example by negotiating longer terms with suppliers
·         Collect your debt as quickly as possible by making it easy for customers to pay( offer them discounts for early payment)
·         Avoid holding too much stock by using Just-in-time (JIT) inventory method since holding stock will tie up cash which earn no interest.
The cost of holding stock includes the following
·         Interest on capital
·         Storage space and equipment
·         Administrative and staff costs
·         leases

Financing working capital

Current assets have to be financed with either short term or long term sources of finance.
For example suppose a company has $200,000 of stocks and debtors. It can finance these assets in the following ways
·         With long term funding of $2000,000
·         With short term credit of $2000, 000. If the credit is provided by trade creditors there would be no cost. If it is provided by a bank overdraft, there is an interest cost on the overdraft balance.
·         With the combination of long term and short finance

If the increase in assets is financed largely by short term credit, the risk of liquidity shortages will grow. Financing asset growth with short term credit is called overtrading (FTC Foulks Lynch- 2005)

Cash operating cycle

Cash operating cycle is the length of time between paying trade creditors and receiving cash from debtors. It can be calculated by adding the average stock holding period and the average time for debtors to pay and then subtracting the average time taken to pay creditors. The average stock period may be subdivided into the holding periods for raw materials, work-in-progress and finished goods.
Using accounting ratios the cash operating cycle can be approximated by adding stock days and debtors days(debtors’ ratio) and subtracting creditors day(creditors’ ratio).
If creditors are paid before cash is receive from debtors the cash operating cycle is positive; if debtors pay before trade creditors are paid the cycle is negative. (FTC Foulks Lynch- 2005)

                                        Cash
                                      Equity/loan
                                                                  
                                                                  
Goods Sold                                     Payments (to suppliers)                                                 
                                     

Goods Produced

Calculating the cash operating cycle

For a manufacturing business the cash operating cycle will be measured by:
Cash operating cycle= raw materials holding period + WIP holding period + finished goods holding period + debtors’ collecting period- creditors’ payment period

For a wholesale or retail business, there will be no raw materials or WIP holding periods and the cycle is:
Cash operating cycle = stock holding period + debtors’ collecting period – creditors’ payment period. (FTC Foulks Lynch- 2005)
The cash operating cycle is measureable in days as:

Stock turn over period + Debtor days – Creditor days

Example
Tuber Ltd
                                                             GHc
Credit sale                                         1,200,000
Credit purchases                                  650,000
Average stock                                          80,000
Average debtors                                    200,000
Average creditors                                    54,000           

Calculate the length of cash operating cycle for the following

Stock turnover
Creditors
Debtors

State the length of cash operating cycle Dublin Ltd

Solution

·         Average length of time that goods remain in stock
Average stock/Credit purchases x 365 days
= 80,000/650,000 x 365 days = 45 days

·         The Average time taken to pay supplies
Average creditors/credit purchases x 365 days
54,000/650,000x 365 days = 30 days

·         Average time taken for cash to be taken from a credit sale
Average debtors/ Credit sales x 365 days
200,000 / 1,200,000x 365 days = 61 days

 The company’s working capital cycle is:
45 + 61 – 30 = 76 days

Example 2
Extracts from the profit and loss account for the year and the balance sheet as at the end of the year for a company show the following

                                                          GHC
Credit Sales                                                250,000
Credit Purchases                               140,000
Debtors                                               31,250
Creditors                                             21,000
Stock                                                   92,000
Note: All sales and purchases are on credit


(a)  Calculate the length of cash operating cycle for the following

(i)           Creditors
(ii)          Debtors
(iii)        Stock turnover

State the length of cash operating cycle for the company
Solution
(i)           Creditors
Average payment collection period
Creditors / purchases x 365
21,000/ 140,000 x 365                                        = 55 days

(ii)          Debtors 
Average collection period
= debtors/Credit sales x 365
31,250 / 250,000 x 365                                  = 46 days

(iii)        Stock Turner over
= stock / Credit Purchases x 365
92,000/250,000 x 365                                    = 134 days

Length of cash operating cycle           
 134 + 46 – 55 = 125 days

The longer the cycle the greater the level of resources tied up in working capital.

Variation in industries

The length of cash operating cycles varies between businesses. For some businesses products are produced and sold quickly and so working capital is quickly restored for some businesses money had to be tied up for a long time
1.   For example a service organisation will have no stock holding period
2.   A retail organisation will have a stock holding period based mostly on finished goods and very low level of debtors
.
3.   A manufacturing organisation will have a stock holding period based on raw materials, work-in-progress and finished goods.
The level of investment in working capital will therefore depend on the nature of business operations.

The cash operating cycle and the resultant level of investment in working capital does not depend on the nature of business however.
Companies within the same business sector may have different levels of investment in working capital, measured for example by the accounting ratio of sales/ net working capital as a result of adopting different working capital policies.
A good policy on the level of investment in working capital is marked by lower level of stocks and debtors. This lower level of investment increases profitability but also increases the risk of running out of stock, or losing potential customer due to better credit terms offered by competitors.

A conservative policy on the level of investment in working capital has higher levels of investment in stock and debtors. Profitability is therefore reduced, but the risk of stock –outs is lower and new credit customers may be attracted by more generous terms.

Reduction in working capital

It is possible to reduce the level of investment in working capital by reducing the length of cash operating cycle by adopting the following strategies.
1.   By reducing the stock holding period (for example by using JIT methods).
2.   By reducing the average time taken by debtors to pay (for example by improving debt management)
3.   By increasing the length of credit period taken from suppliers( for example by settling invoices as late as possible)


Reasons for holding cash
(i)           Transaction motive: cash would be required for the day to day operations of the business e.g. To pay creditors, to buy stock, to pay dividend

(ii)          Speculative motive:  the company would need cash to finance risky business ventures e.g. the purchase of machine to carry out a speculative project

(iii)        Precautionary motive: contingent losses may materialise e.g. legal claims against the company. Cash will need to be held to satisfy such contingencies as they arise
The company must maintain a sufficient level of cash to satisfy the above three requirements.

Any cash in excess of this level will result in lower profits. It is true that surplus cash can be invested in the short term to earn interest and in this respect cash is different from other assets but such returns will nearly always be less than the return which can be earned on the business other assets
Surplus cash which is lying idly is not being properly utilised and would result in the decrease of profitability.
On the other hand if the company is holding too little cash it may encounter liquidity problems. Such shortage of cash may mean the company is forced to reject certain very good investment opportunities due to lack of funds. May profitable companies have been forced into liquidation or sale due to cash flow problems?
A proper cash budgeting and planning procedures should ensure that a company does not fall into the trap of holding too little or too much cash

Advantages of holding cash and near cash assets

In addition to the four motives just discussed, sound working capital management requires that an ample supply of cash and near-cash assets be maintained for several specific reasons:

1. It is essential that the firm have sufficient cash and near-cash assets to take trade discounts. Suppliers frequently offer customers discounts for early payment of bills. As we will see later in this chapter, the cost of not taking discounts is very high, so firms should have enough cash to permit payment of bills in time to take discounts. (Brigham and Houston 2003)

2. Adequate holdings of cash and near-cash assets can help the firm maintain its credit rating by keeping its current and acid test ratios in line with those of other firms in its industry. A strong credit rating enables the firm both to purchase goods from suppliers on favourable terms and to maintain an ample line of low-cost credit with its bank. (Brigham and Houston 2003)

3. Cash and near-cash assets are useful for taking advantage of favourable business opportunities, such as special offers from suppliers or the chance to acquire another firm. (Brigham and Houston 2003)

4. The firm should have sufficient cash and near-cash assets to meet such emergencies as strikes, fires, or competitors’ marketing campaigns, and to weather seasonal and cyclical downturns. (Brigham and Houston 2003)



Reference

Brealey, R., Myers S. and Marcus, Fundamentals of Corporate Finance, McGraw-Hill Irwin, New York
Brigham and Houston, Fundamentals of Financial Management: 2003
FTC Foulks Lynch, Financial Management and Control 2005


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