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:
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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