Working Capital Management

Working Capital Management

Working Capital Management involves the determination of:

The optimal investment in current assets – that is, the level of current assets that maximises the overall profitability of the firm; and

The appropriate mix of long term and short term capital – that is, the combination of long and short term debt that minimises the company's cost of capital.

The Operating Cycle

Financial manager must be aware of the relationship between different current assets and current liabilities. The concept of the ‘operating cycle’ explains these relationships.

Operating cycle refers to the time that elapses between the purchase of new materials and the payment of suppliers of those materials.

Operating cycle usually consists of five steps: The purchase of raw materials on credit; The conversion of those materials into finished goods; The sale of those finished goods; The collection of accounts receivable; and The payment of accounts payable.

The Operating Cycle

Table 6.1 on page 129 of your text book summarises the effect on the business of the operating cycle

A business should reduce its operating cycle to the point where the marginal savings obtained are equal to the marginal cost of implementation.

The Matching Principle

One of the most important principles of financial management is that of matching the repayment term of borrowings with the life of the asset acquired with those borrowings.

This is so that cash flow generated through the use of the asset will provide the necessary funds required to repay the loan.

The Matching Principle and Current Assets

Current assets have both temporary and permanent components.

Some current assets never fall below a certain minimum level and these assets are therefore a permanent investment in the business.

Many businesses have peak periods of manufacturing and sales, resulting in increased levels of inventory, accounts receivable and cash in those times.

Have to finance large inventories until the selling season; when those inventories are sold, accounts receivable will peak and then decrease as they are collected.

The matching principle requires that the maturity of all assets – fixed, permanent current and temporary current – be matched with the maturity of liabilities.

Figure 6.1 on pg 130 illustrates this concept.

Inventory Management

As inventory is an important segment of most businesses, an efficient inventory management is necessary.

There are three categories of inventory: raw materials, work in process, and finished goods.

Aim to have sufficient to meet normal operating requirements, plus a quantity, known as safety stocks, to meet unforeseen contingencies.

‘Stockout costs’.

Inventory-associated Costs. There are two types of costs associated with

inventories: carrying and order costs. Carrying costs are:

The cost of funds invested in inventory; Storage costs; Insurance costs; and Deterioration and obsolescence.

Order costs are: The costs of placing and order; The costs of receiving an order.

As size of orders increase, so does the average level of inventories, resulting in higher carrying costs. If larger quantities are ordered, fewer orders will have to be placed and so order costs will be reduced.

Economic Order Quantity

The total cost of inventory consists of carrying costs plus ordering costs.

Figure 6.2 on pg 132 Review the figure The total cost curve begins to rise after point EOQ

because the rate of increase in carrying costs exceeds the decrease in ordering costs.

The EOQ represents the order size which results in the minimum total inventory costs. For this reason it is referred to as the economic order quantity.

Economic Order Quantity

A formula has been developed which enables economic order quantity to be calculated:

EOQ = 2UO C

Where:U = unit usage per period , O = cost per orderC = carrying cost per unit per periodSee Figure 6.2. Page 132 and Example 6.1 p133Complete STQ 6.1 page 134

Stock Reorder Points

When reordering inventories ensure that there are sufficient stocks on hand to allow for usage which will occur between the raising of the order and the receipt of the goods.

That stock level is known as the reorder point and each time inventory falls to that level a new order is raised.

Reorder point = Daily usage x Delivery lead time

Review Example 6.2 and Complete STQ 6.2

Safety Stocks

There is often some uncertainty as to the usage rates and/or delivery lead times.

Additional safety stocks can me carried to the level at which the additional costs incurred are equal to the savings from avoiding stockout costs.

See figures 6.5 and 6.6 on pp 136 of your text book.

See Example 6.3. Page 136 Complete STQ 6.3

Quantity Discounts

Quantity discounts are often offered by suppliers as an inducement to purchasers to place larger orders.

In order to decide whether it is economical to claim a quantity discount, it is necessary to compare the discounts that will be derived per period with the net costs involved increasing order size above economic order quantity.

See Example 6.4 Page 137 Complete STQ 6.4 Complete Ex 6.17, 18, 19, 20, 21, 22FPM Chapter 6 Sol 617 onwards.doc