Working Capital Management

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Working CapitalIn this lecture we will look at

short and medium term methods of financing short term financing concerns inventory levels, trade payables and

receivables the cash conversion cycle why it is important to manage working capital

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Short and medium term financing SHORT (repayment in under 1 year?) Overdraft Trade credit Factoring

MEDIUM (repayment in 1 to 7 years?) Term loan Hire purchase Leasing

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Overdraft facilities timescale of months interest charged on the daily outstanding balance

flexible - no term structure available to smaller and riskier businesses

lender can remove facility at short notice

conditions: cash flow projections creditworthiness commitment from the borrower security in the form of assets

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Trade Credit company receives goods and services invoice paid at a later time some flexibility in credit terms

vital source of finance for large as well as small companies

“Tesco and Asda typically have over twice as much owing to suppliers at any one time as the value of all the goods on their shelves – more than £2.2bn for Tesco and £1.5bn for Asda.”

Arnold, chapter 12, page 482

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Factoring immediate transfer of cash to firms with

outstanding receivables when invoices are paid then factoring

company receives payment carried out by subsidiaries of major banks fee and interest charged on amount advanced comparable with overdraft interest rates transfer of risk to factoring company

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Hire purchasing company takes possession of the goods a series of regular payments are made until

the company owns the goods payments include principal repayment and

interest

no large payments up front

plant and machinery; agricultural equipment; hotel equipment; office equipment; commercial vehicles

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Leasing lessor gives right to use equipment in return

for regular payments no transfer of legal ownership

Operating lease short term contract asset then sold or leased to another client

photocopiers

Finance lease full cost of equipment recovered over the life of

the lease risks borne by lessee

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Issues

Balance:cash

inventory

receivables

payables risk

too little/too much

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What is working capital? Current assets less current liabilities

inventory cash receivables

payables

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Working Capital Management

inventory Conversion Period

Cash Conversion Cycle

Credit from Suppliers

Raw Mat

WIPFin. Goods

£

Receivables

Conversion period

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Cash conversion cycle

Cash conversion cycle = inventory days + receivables days – payables days

For example: Buy raw materials on 33 days’ credit Takes 50 days to turn raw materials into finished

product Give 30 days’ credit on finished product

CCC = 50 + 30 – 33 = 47 days

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Some ratios: LIQUIDITY

Current ratio (working capital ratio)= CA / CL

o a ratio of less than one might indicate liquid resources not enough to meet short term payments

o a ratio of more than one might indicate high levels of inventory and not enough cash

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Some ratios: EFFICIENCY receivables (days)

= (receivables/sales ) x 365

payables (days) = (payables/cost of sales )

x 365 inventory turnover (days)

= (inventory / cost of sales ) x 365

Example – 2007

Balance Sheet

Sainsbury plc

Rolls Royce Group

£m

inventory 590 2,203

receivables 30 889

inventory + receivables

620 3,092

payables 1,706 778

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Example – 2007

P&L Sainsbury plc

Rolls Royce Group

£m

Sales 17,151 7,435

Cost of Sales

15,979 6,003

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Example – 2007

Ratios Sainsbury plc Rolls Royce Group

receivables days (30/17,151) x 365= 0.6 days

(889/7,435) x 365= 44 days

payables days (1706/15,979) x 365= 39 days

(778/6,003) x 365= 47 days

inventory turnover days

(590/15,979) x 365= 13 days

(2,203/6,003) x 365= 134 days

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Overtrading Not to be able to provide the level of working

capital required to sustain a particular level of trading is known as overtrading Failure to meet increases in turnover with

appropriate increases in working capital requirement

Possible for a firm to double its sales and profits and yet become insolvent

Too much money is tied up in inventory and trade receivables?

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Managing working capital INVENTORY TRADE PAYABLES TRADE RECEIVABLES CASH

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Managing inventory

Determined by what the firm does There will be large differences in inventory

levels between traders due to the nature of the goods the speed of the inventory turnover seasonal fluctuations

Costs of holding inventory need to be balanced against the opportunity costs

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Balance Risks of holding high inventory storage costs handling costs money tied up obsolescence insurance costs

Risks of holding low inventory loss of production loss of sales loss of customer goodwill

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Policy decisions Optimum reorder quantities need to be

established for each item of inventory Companies need to take into account how

fast inventory is used up and how long orders take to be fulfilled

Many firms like to hold a “buffer” of inventory to meet unexpected changes in demand

Other firms operate “just in time” policies

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Managing Trade payables ‘Free’ source of finance No interest Costs

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Policy decisions Take into account

discounts offered attitude of suppliers

Exploit trade credit Manage exchange rate risk Use ratios for monitoring

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Companies that take the longest to pay are in the construction, manufacturing, pharmaceuticals and retail sectors

Large number of small suppliers Average payment time is

44 days for all plcs 34 days for 350 largest plcs

Based on article by David Oakley, FT, March 2008

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Managing receivables Attitudes vary Credit sales = interest free loans A balance must be arrived at between the

costs of granting credit and those associated with denying or restricting credit

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Balance granting credit

higher sales customer goodwill

risk costs of administration costs of financing

denying credit loss of customers

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Policy decisions Establish a credit policy Assess credit worthiness of customers Establish a policy on bad debts Consider cash discounts and factoring/ invoice

discounting Manage exchange rate risk What are competitors offering?

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Managing Cash Balances Cash needs to be held

to meet planned needs transaction motive

to meet unplanned obligations precautionary motive

to enable unexpected opportunities to be taken speculative motive

Surplus cash should be invested Cash needed varies over time

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Balance

Holding too much cash loss of interest

Holding too little cash liquidity risk loss of goodwill inability to meet

emergency requirements

missed opportunities borrowing costs deterioration in

liquidity measures

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Financing WC Firms need mixture of LT and ST funds Assets needing to be financed

Fixed Permanent CA Fluctuating CA

Policies Matching Conservative Aggressive

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Matching

Funds

Fixed Assets

Permanent CA

Fluctuating CA

Time

Short-term finance

Long-term finance

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Conservative

Funds

Fixed Assets

Permanent CA

Fluctuating CA

Time

Short-term finance

Long-term finance

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Aggressive

Funds

Fixed Assets

Permanent CA

Fluctuating CA

Time

Short-term finance

Long-term finance

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Summary Efficient management of working capital – key

to business success Relates to management of:

inventory receivables payables Cash

Poor working capital management one of the more common reasons for corporate failure

Further reading and prep for seminar

Watson, D. and Head, A. Corporate Finance Principles and Practice, 5th edn Chap 3.

Arnold, G. Corporate Financial Management, Chapter 12, Chapter 13 (pp 529-550)

Self test questions page 91 of Watson and Head