1

Working Capital Management

Introduction to Business Accounting

Week 8

2

Format of Exam 2 hours duration Answer Question 1 (compulsory) Represents 40% and is Accounts Preparation Trial Balance, Transactions, draw up P&L and Balance

Sheet Then Answer 3 out of 5 Likely topics

Ratios Cash flow statements Costing products Taxation Standard Costs Working Capital Management

You will need to remember formulae

3

Working Capital

You will recall the elements of Working Capital Stock Debtors Cash Creditors

The liquidity ratios examine the elements of working capital

4

Significance of working capital management

In a typical manufacturing firm, current assets exceed one-half of total assets

Excessive levels can result in a substandard Return on Investment (ROI)

Current liabilities are the principal source of external financing for small firms

Requires continuous, day-to-day managerial supervision

Working capital management affects the company’s risk, return, and share price

5

Key elements of Working Capital Invest in current assets, so long as

the return from such investment exceeds the cost of the capital used to fund them

Make use of short term funding, so long as it has a lower cost than other sources of funding and can be used to make profitable investments, after allowing for the cost of the funding

6

The Working Capital Cycle

Cash Conversion Period = Inventory Transformation Period + Debtor Collection Period – Creditor Deferral Period Eg the quicker you turnover stock

and collect debtors and the longer you leave creditors, the better

7

Stock

Stock is the least liquid of current assets

Companies will often hold more stock than they need and

This can be costly in terms of Capital tied up Costs of holding stock

8

So why hold stock, then? Transactions Motive

to meet anticipated production/sales and service delivery requirements

Precautionary Motive to maintain a cushion or buffer so that they

can cope with any underestimates of demand that may have been made

Speculative Motive to take advantage of temporary opportunities

to buy items of stock at less expensive purchase prices

9

The two elements of stock

The more stock held the greater the holding (storage) costs BUT

The less the order costs And vice versa The art is to balance the two for

optimal cost effectiveness

10

Economic Order Quantity (EOQ)

EOQ represents the minimum point in total stock costs.

Carrying Costs

Ordering Costs

Order Size (Q)

Co

sts

Total stock costs

EOQ

11

Formula for EOQ

O = Cost of placing an order S = Annual demand C = Holding cost of one unit

EOQ =2 (O) (S)

C

12

An Example Assume a company has an annual

demand for a stock item of 150,000 The cost of placing an order is £40 per

order It is calculated that the cost of holding 1

unit of the stock item is £2 The item can only be ordered in batches

of 1,500, 2,500, 3,500 or 4,500 Which batch size (all other things being

equal) would optimise costs?

13

By tabulation BatchNo. of Av holding Order Size Orders Costs Costs Total

1,500100 1,500 4,000 5,500 2,50060 2,500 2,400 4,900 3,50043 3,500 1,720 5,220 4,50033 4,500 1,320 5,820

14

By formula

EOQ = 2,449 Therefore, 2,500 is

optimum batch size

EOQ =2 (40) (150,000)

2

15

Pros & Cons of EOQ

It is quite effective in situations of regular demand

It can focus management thinking on cost reduction

BUT it is inflexible It assumes zero lead time in

ordering (Sawtooth pattern)

16

Zero lead time with EOQ

17

Materials Requirement Planning (MRP)

The system starts by seeing what production is planned and then develops a timetable for orders so the materials arrive in time for their use. 

Thus the resulting stock of materials depends directly on the known demand.

  Advantages of MRP

Reduced stock levels. Stock is related to demand, therefore there should be

fewer shortages of materials and consumer satisfaction should be higher.

The stock turnover will be higher, which should have positive implications for the quality of the materials present in the final product.

Delivery of finished goods should be more reliable. There will be improved plant efficiency, because facilities

will be utilised when required, as the materials will be ready for immediate use.  

18

Disadvantages of MRP The successful implementation of MRP requires the

construction of a detailed master schedule of all the parts that will be required in the production process.  If this master schedule has not been drawn up, the system can't operate.

Even if there is a master schedule, it may not be accurate and hence there may be shortages or surpluses of stock.

Plans are frequently changed and/or not made far enough in advance causing problems in accurate scheduling.

If the master schedule is to be accurate, information about current stocks, orders outstanding and the reliability of stock surpluses will be required.

It will be necessary to have information on the length of time it takes to acquire deliveries of stock in time for use.

19

Just in Time Stock Control Instead of holding stock at the factory only order stock

on a Just in Time basis (raw materials are ordered only as they are needed).

Advantages of Just in Time There is less stock in the factory, so costs are lower. This results in a lower unit cost.

Disadvantages of Just in Time If supplies are disrupted for some reason, the business

will have no stock to fall back on. This will affect their production rates very quickly.

20

Control of Debtors Key aspects of debtor management

A clear statement of the general terms on which it is prepared to grant credit to customers

Credit rating procedures A credit management system

Terms of credit - need to consider Custom and practice in the relevant

industrial/commercial sector Cash settlement discounts The likely/acceptable level of bad debts

21

Control of Debtors Costs of relaxing credit standards

A larger credit department Additional clerical work Servicing additional accounts Bad-debt losses Opportunity costs

Analysing the credit applicant Obtaining information on the credit applicant Analysing this information to determine the

applicant’s creditworthiness Making the credit decision

22

Encouragement to pay

Offering Discounts Everything costs so if you have

debtors there will be a cost attached to that income deferred

Either through loss of alternate use Or by having an overdraft because

you haven’t got the money

23

Offering Discounts – An example – Vole Ltd

Vole Ltd has an overdraft and pays 17% p.a. on it

Annual sales are £365,000 and debtors run at present at £90,000

If a 2.5% discount for settlement in 10 days was taken up by 1/3rd of customers

What would the saving be, if any? What is the maximum discount that

could be given and not dent profit?

24

Vole Ltd - 1 Annual cost of debtors = £90,000 X 17% = £15,300 Annual sales are £365,000 (ie £1,000 per day) Existing debtors = £90,000 (ie 90 days) Expected reduction = 1/3rd (ie £30,000) A reduction from 90 to 10 days = 8/9 8/9 X £30,000 = £26,667 Annual interest saved = 17% X £26,667 = £4,533 Annual cost of discount on 1/3rd of annual sales = £121,667 X 2.5% = £3,042 Therefore, there would be a saving

25

Vole Ltd - 2

If 2.5% wasn’t enough to tempt customers

Then maximum discount without affecting profits would be up to interest saved (ie £4,533)

Therefore, interest saved as a percentage of 1/3rd annual sales = 3.726%

26

Managing Creditors The basic rule is… Defer as long as possible Remember the cash conversion period is

reduced the longer the creditor deferral period

The downside is potential harm to supplier relations

Not good if say operating Just in Time system

27

You say creditor, I say debtor

To all of your creditors You are a debtor, so They will be trying to get you

to pay promptly If they offer discounts is it

worth taking them?

28

Calculation of “annualised interest rate”

Most small companies, because of cashflow considerations, cannot take advantage of discounts.

But “annualising” the effective interest rate shows the true cost of ignoring discounts

29

Formula to calculate “annualised” interest rate

Cost = Discount% X 365 (100-discount%) (Final due date –

discount period)

Assume a company is offered 2.5% to pay within 10 days on 28

day invoice Effective interest rate is 2.5/97.5 X 365/(28-10) = 46.15 %

30

Maintaining control of creditors Keep records of what is owed and how long you

have to pay Train whoever pays invoices to pay these when

it suits your cashflow Agree clear terms of payment with all your

suppliers Consider paying for non-current assets over a

longer period Decide whether or not you need to always pay

on delivery Pay as late as possible – without incurring

penalties or losing goodwill.

31

Management of Cash Balances

The financial manager wants to keep cash balances to a minimum

The goal is to speed up the inflow of cash and slow down the outflow of cash

32

Management of Cash Balances

Speeding Up Cash Inflow Expedite preparing and mailing invoices Accelerate mailing of payments from

customers Reduce the time during which payments

received by the firm remain uncollected Use Electronic Funds Transfer

Slowing Down Cash Payouts Control of disbursements

33

Management of Cash Balances

Source of short-term finance available to commercial entities: Trade credit. Bank borrowing Instalment credit Financial instruments Factoring