The nature, elements and importance of working capital

Learning Outcomes

 The nature of working capital

 Objectives of working capital management in terms of liquidity and
profitability
 Central role of working capital management in financial management.

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Managing and measuring Liquidity
• Working capital management ensures that company has
enough funds to manage day to day operational expenses,
inventories, accounts receivable and payable and cash.
• It involves a relationship between company’s short term
assets and its short term liabilities.
• Liquidity management refers to the ability of an organization
to generate cash so as to meet its financial obligations.

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The nature of working capital and its elements

Net Working Capital

(Net WC) The amount of current assets minus the current liabilities of a business

Current Current
assets - liabilities = Net WC

Current assets

Cash and Marketable Other assets

Trade Advances to
bank Inventories financial realisable within
receivables suppliers
balances assets 12 months

Current liabilities

Long-term loans i.e. Other liabilities

Trade Current tax Dividends Short-term
the part maturing payable within 12
payables liability payable loans
within 12 months months

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 Objectives of working capital management in terms of liquidity and
profitability

Objectives of WC
Liquidity Profitability
management
describes how easily an investor can access refers to the return earned on surplus
the cash he has put in an investment funds deployed in investments.

 invest minimum possible amount

 liquidity is required for payment of trade in WC so as to free the funds for
payables and other expenses more profitable uses
 if liquidity is absent company will find itself  proper balance between liquid
in cash flow difficulties assets to cover current liabilities
 liquid assets should be at least equal to the and the short-term securities
current liabilities
 overdrafts with banks prove effective in
ensuring liquidity
 current assets other than inventory are Conflict between liquidity and profitability
considered to be liquid

 cash in hand, which is an absolutely liquid asset, earns

no returns
 as the term of deposits or time to maturity on
investments increases, the rate of return also increases
 profitability and liquidity are inversely-related

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 Example

Trecon Co has earned profits of $25m in the year 20X6 and its accumulated earnings are $35m.
The details of its current assets and liabilities are as follows:

$’m
Cash and bank 4 ($16m worth are slow-moving)
Inventories 30 ($8m are o/s for > 1 year)
Trade receivables 20
Trade payables 45

That leaves $14m of inventories and $12m of receivables.

Further, inventories are not liquid assets. So, the actual liquid assets are only $16m (cash 4 +
receivables 12).
This condition is precarious.

No sufficient liquidity to pay trade payables of $45 m, in spite of having profits – current
as well as accumulated.

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The central role of working capital management in financial
management

 finance to a business is like blood to a human body

Day-to-day  efficiency is required in cash collections and
functioning disbursements
 not possible to exploit non-current assets without WC

 appropriate liquidity to be maintained

Survival  mismanagement of working capital can endanger the
survival of the company

 for assets with a physical existence

Profitability  for liquid assets, monetary investment is needed
 opportunity costs

Cash  efficient WC management helps to earn higher profits

generation which generate funds for the growth of the business
organisation

Appropriate  the level of WC should be neither too low (overtrading) nor

level of WC too high (over-capitalisation)

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Cash operating cycle & the role of accounts payable and accounts
receivable

Cash operating time period between the payment for raw materials and receipt
cycle of cash from sales

Raw
material
and service
Work in
Payables
progress

Cash operating cycle /

WC cycle / Cash Finished
Cash
conversion cycle goods

Receivable
Sales
s

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Working Capital Cycle

Working Capital Cycle

=
Average time raw
materials remain in
stock

+
Time taken to produce
the goods
+
Time for which finished
goods remain in stock
+
Time taken by
customers to pay for
the goods
-
Period of credit taken
from suppliers

Cash operating cycle depends directly on the credit period of accounts payable and
accounts receivable, production time and inventory holding period.
The longer the cash conversion cycle, the higher the investment in working capital will be.
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Martin and Sons decides to increase the credit period offered to its
customers from 30 days to 45 days while the supplier wants the payment to
be made in 60 days. The company buys inventory on 10 March and its
holding period is 1 month. The WIP holding period is 1.5 months. The
finished goods remain in inventory for a period of 15 days.

Days
Average time raw material remains in inventory 30
Add: Time taken to produce the goods 45
Add: Holding period of finished goods 15
Add: Credit period for the customers 45
Less: Period of credit in the case of suppliers (60)
Working capital cycle 75

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Sanderling Ltd buys raw materials from suppliers on six weeks’ credit, which
are delivered immediately. The raw materials are held in inventory for four
weeks before being issued to production. The production process takes three
weeks and the finished goods are held in inventory for two weeks before being
sold on credit. Customers are allowed eight weeks’ credit and pay promptly at
the end of the period.

What is the length of the operating cash cycle of the business?

A 9 weeks
B 11 weeks
C 17 weeks
D 23 weeks.

The correct option is B

Operating cash cycle
(8 + 2 + 3 + 4 – 6) 11 weeks

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 The following is the balance sheet and the profit / loss statement (with estimated figures for the
coming year) of Ciasco Ltd, a food processing company.
Extracts from Balance sheet as on 31 March 2010

$
Accounts receivable 2,89,000
Stock of materials
Raw materials 1,20,000
Finished goods 3,35,000
W-I-P (68% complete) 4,12,000

Accounts payable 2,20,000

Extracts from Income Statement as on 31 March 2010

$
Sales 3,000,000
Materials purchased 1,800,000
Wages 1,800,000
Production overheads 900,000

Sales overheads 300,000

Net Profit margin 25%

Note: 70% of the sales and purchases are on credit

Required:

Calculate the cash operating cycle.

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 Particulars Days
Raw material stock period 24
WIP period 49
Finished goods holding period 27
Inventory holding period 100
Credit period of suppliers 64
Credit period allocated to debtors 53

Length of cash operating cycle = Inventory holding period + Receivables collection

period – Payables payment period

Length of cash operating cycle = 100 days + 53 days – 64 days = 89 days

Workings

W1 Cost of sales

= Materials + Wages + Production overheads

= $(1800000 + 1800000 + 900000)
= $4,500,000

W2 Cost on credit

Sales overheads = $300,000

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W3 Inventory holding period
Raw materials holding period = RM x 365/Pur
24 days
i.e. 120000/1800,000
WIP holding period = WIP/COGS (degree of
49 days
completion) i.e. 412,000 / 4500000 x 68%
Finished goods holding period = FG/COGS
27 days
i.e. 335000/4500000
100 days

W4 Receivables collection period

= Receivables/Credit sales x 365

= $289000/$2100000 x 365
= 50 days

W5 Payables payment period

= Payables/Credit purchases x 365

= $220000/$1260000 x 365
= 64 days

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14
Techniques in managing inventory, Economic Order Quantity model
and Just-in-time techniques

Major costs associated with inventory

Holding cost Ordering cost

Average inventory x cost of holding No. of orders x cost per

one unit order

Warehousing + Handling + Cost of

Holding cost = costs costs + Insurance + Deterioration + Theft
capital

inversely related to

Ordering cost = Ordering costs + Delivery costs

Total annual cost

Total annual costs (TAC) = annual cost of (purchasing + holding + ordering)

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Inventory Management Techniques

Inventory management techniques

Economic order Maintaining appropriate

quantity Just in time
stock levels

Reorder Minimum Maximum Average Stock

level level level level outs

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Economic Order Quantity

 developed by F. W. Harris in 1915

Economic Order Quantity (EOQ)  an order quantity that will minimise the
total holding an ordering cost of inventory
D = Annual consumption for one period
C0 = Cost per order 2 Co D
EOQ =
Ch = Annual cost of holding one unit Ch
Bulk discounts and EOQ
 Bulk discounts encourage the purchase of larger quantities at a cheaper price.
 The quantity ordered through bulk discount may not be the same as EOQ.
 Ordering according to EOQ may not necessary be the most economical ordering policy.
 Total annual cost associated with adhering to the EOQ and to bulk discount needs to be
compared.
Steps in selecting the best ordering policy

calculate EOQ and the total annual costs with that

Step - 1
order size

calculate total annual costs for the minimum order

Step - 2
size to earn the discount

compare the alternatives and choose the quantity

Step - 3
which produces the lower total annual cost
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Just-in-time (JIT) Techniques

Just-in-time (JIT) techniques

 reliable suppliers
 accurate production planning
 no defects or wastage
 minimum movement and handling of
material
 minimum stock of finished goods held
 production by order
 May not be suitable to satisfy high
demand

With the help of internet, suppliers can keep track of

External extended the company’s demands and have material delivered
just-in-time just in time for production which reduces holding and
handling costs.

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Example

Uses JIT
techniques

Manufactures Flow process for JIT

Automobiles Meco informed of inventory
requirements of Belco
through server
Belco

Supplies goods to Belco

Meco plans production
Both connected through
server and common
software Meco formally confirms
material requirement from
Belco

Meco commences
Meco production

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The use of relevant techniques in managing accounts receivable

Assessing credit worthiness

Methods of assessing credit worthiness

Publicly
Bank Trade Financial
Credit rating available
reference references information
information

Managing accounts receivable

Managing accounts receivable is also known as credit control

establishing credit limits and terms of payment

Managing
account monitoring outstanding debts
receivables
chasing slow payers

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Credit limit and terms of payment

A company will have to match the terms of trade prevalent in the industry if it wants
to remain competitive.

Example
A company’s competitors sell DVD player at $100 with a credit period of 2 months.
The company cannot increase the price of its DVD player above $100 unless there is some
value addition.
Similarly, it cannot insist on a shorter credit period unless it correspondingly reduces the price
below $100.
Failure to do so may result in loss of sales as customers switch to suppliers offering more
favourable terms.

Factors to be taken in to consideration while extending credit terms

 volume of extra sales that will be generated due to allowing extra credit
 increase in the length of the average credit period
 profitability of the additional sales
 the rate of return required

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Importance of monitoring outstanding debts

Customers do not pay their dues on time

Liquidity of the organisation is affected

Company has to raise funds from other short-

term sources which may be expensive

Profitability is affected

Thus monitoring outstanding debts is important

Systems to monitor outstanding debts

 Maintaining accurate and up to date records

Unless records are updated and accurate, there is no way of knowing for certain
the amounts due for collection.
 Aged debtor analysis
It is a report showing the total amount of debts owed to the business, analysed
between debts that are not yet due for payment and payments that are overdue.
This gives information about the exact age of each invoice.

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Collecting amounts receivable

Collection of receivables

 aged debtor analysis gives exact age of each invoice

 reminders to customers
 visits
 recourse to legal proceedings
 charging interest on delayed payment

Offering early settlement discounts

Two variables to be considered while offering early settlement discounts

 amount of discount
 interest saved due to lower investment in receivables

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Using factoring and invoice discounting

Factoring is selling of accounts receivable to a factor at a discount.

Factor is a financial institution which is used to accelerate the cash conversion cycle.

Services provided by a factor

 finance provision
 administration of the sales ledger and debt collection
 credit protection / insurance
 invoice discounting

Credit protection / insurance

With recourse Without recourse

The factor provides

The client must bear the
protection against bad
loss of any bad debts thus
debts. If a customer
must reimburse the factor
defaults, the factor bears
for all bad debts
the loss
Continued …
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Continued …

Benefits of factoring

 Managers need not spend time chasing up defaulting customers.

 Company does not have to incur the cost of running a receivables section.
 Company can better manage its payables, and improve its cash operating
cycle and cash position.
 It helps the company to grow.
 It provides an alternative source of finance.

Disadvantages of factoring

 Interests charged on advances may be higher than that charged on

alternative finance sources.
 Customer may become annoyed by factors ‘pushing’ them for payment.
 Use of a factor may suggest that the company is experiencing liquidity
problems.
 Once a company starts factoring it is difficult to revert to an internal system.

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Invoice discounting

Invoice discounting is selling invoices but retaining control over the sales ledger.

Characteristics of Invoice discounting:

 Credit worthy invoices are sold to the factor / bank at a discount.
 Responsibility for debt collection is not passed to the factor / bank.
 When the debts are eventually paid by the customers, the factor / bank is paid off.
 Money is borrowed by the firm from the factor/ bank using outstanding debts as
security.
 Customer is unaware of the service provided.
 Control of credit is not passed to the factor / bank.

Steps of invoice discounting The company pays the factor / bank 100% 4
of the invoice value plus any fees

The company receives payment from the

customer after 30 days 3

The company borrows up to 80% of the

value of the debt from the factor / bank 2
The company sells the goods to the
customer payable in 30 days
1
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Reasons for holding cash and use of relevant techniques in
managing cash
Reasons for holding cash

Transactions motive Precautionary motive Speculative motive Finance motive

projection of expected
Cash flow forecasts cash outflows and
inflows

Operating cash flows Investing cash flows Financing cash flows

E.g. interest payments,

based on the budgets of based on the strategic
loan re-payments,
other departments planning of management
dividend payments

the times when the

sales receipts and cash assets are to be acquired
payments to suppliers or sold are known
can be deduced
converted into cash flows on the
basis of payment or receipt terms

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Reasons for holding cash and use of relevant techniques in
managing cash
Reasons for holding cash

Transactions motive Precautionary motive Speculative motive Finance motive

projection of expected
Cash flow forecasts cash outflows and
inflows

Operating cash flows Investing cash flows Financing cash flows

E.g. interest payments,

based on the budgets of based on the strategic
loan re-payments,
other departments planning of management
dividend payments

the times when the

sales receipts and cash assets are to be acquired
payments to suppliers or sold are known
can be deduced
converted into cash flows on the
basis of payment or receipt terms

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Treasury Management

set of policies, that a to manage to handle

Treasury
transactions company its cash relationships with
management and strategies puts in place resources financial stakeholders

Benefits of centralised treasury management

avoid need lower lower foreign precautionary

Profit
for external bank interest currency risk cash balance
centre
finance charges rates management can be lowered

Benefits of decentralised treasury management

responsive autonomy for sources of

to local the divisions and finance match
needs subsidiaries the local assets

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Cash Management Models

Baumol Miller-Orr cash

model
Cash management models projection model
Baumol model

 developed by Baumol
 similar to EOQ model
 treatment of cash as inventory, costs of arranging funds as ordering costs
and interest lost as the cost of holding cash
 assumed that financial manager can predict requirements with certainty and
cash used at a steady and predictable rate
 assumption of predictable cash requirement itself is the drawback as cash
flows fluctuate tremendously

2NF
Z=
i

Where:
Z = the amount to be transferred out of investments
N = the annual cash requirement
F = the fixed cost of arranging funds (the order cost, O)
i = the annual interest rate (for interest lost)
30 Continued …
Ways to solve cash shortage

 accelerating cash inflows

 postponing or reversing capital investment decisions
 longer credit from suppliers
 rescheduling of loans
 deferral of corporate tax payment within the permissible limits
 reduction in dividends

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Organisation’s policy on the level of investment in current assets

Level of investment in working capital is affected by

the following factors
 The nature of the business: manufacturing
organisations need more stock than service
organisations.
 Uncertainty in supplier deliveries: uncertainty would
mean that extra stocks need to be held to cover
fluctuations.
 The level of activity: as output increases, debtors,
inventory, cash balances etc tend to increase as well.
 The organisation’s credit policy: this will determine
the level of debtors.
 The length of the operating cycle.

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