1Working

Capital Management

Learning outcomes Students should be able to: define working capital and explain the working capital cycle for a typical business; calculate and discuss the cash operating cycle; explain the main issues in the financing of working capital management; explain the cause and effect of overtrading; explain how the management of the working capital elements is a question of striking a balance of costs and risks; outline the main approaches to the management of each element of working capital, Working Capital Net working capital (often referred to as just working capital) is Debtors + Stock + Cash Short term Creditors Working capital equates to net current assets (i.e. current assets less current liabilities). The management of working capital is concerned both with the overall liquidity position of the company and controlling the individual elements. The aim of working capital policy is to balance having too little working capital, which can lead to an inability to pay debts as they fall due or the need for expensive short term borrowings, and too much which is wasteful in terms of lost opportunities for the funds tied up. The crucial role of working capital is that it finances the goods inwards, production and sales activities. The trade off of risk and return can be ascertained for each element: Cash: access to funds in cash or an overdraft facility is necessary to pay debts when they fall due and take advantage of discounts for prompt payment but the opportunity cost of holding cash is the loss of interest or other employment of the funds. Debtors: credit terms for customers is an integral part of the product offering in many sectors and reduction in credit terms may well reduce sales Stock: high stock levels of finished goods facilitate meeting customer demands and stocks of components and raw materials must be high enough to fulfill production needs but again there is an opportunity cost in lost to set against these benefits. Creditors: increasing payment terms not only loses discounts but alienates suppliers and may result in a move to cash only trading. Working capital policies There are three possible approaches: Aggressive Cash Minimum holding

Moderate Prepared to hold some precautionary balances Moderate levels

Conservative Prepared to hold idle cash balances High stock and debtor levels to maximize sales Low level seeking discounts and reputation for good payment Unpredictable Rejecting

Debtors and stock

Minimum consistent with business needs Maximum available without compromising business needs Predictable Accepting

Creditors

Moderate level

Future cash flows Attitude to Risk

Reasonably predictable Neutral

For most companies some proportion of current assets will be permanent. The policies derive from the position that at any point in time: Total assets = fixed assets + permanent current assets + fluctuating current assets The three methods of financing positions relating to the working capital policies are given in Handout The moderate approach follows the principle of maturity matching which holds that the net cash flows from the asset should be used to repay the debt and therefore the life of the asset and the debt financing it should be matched. This suggests a policy of fixed assets and permanent current assets being funded by medium and longer-term debt, while fluctuating assets should be funded by short-term debt (15.3a). An aggressive strategy (1.3b) has an increased use of shortterm debt, which is more volatile and a conservative approach has considerably more long-term where only peaks are met by short-term funding and in troughs surplus funds are invested. Short-term funds are seen as being advantageous as typically long-term debt is more expensive than short-term debt. This is largely due to the lower risk taken by creditors. For example, if a bank were considering two loan applications, one for one year and the other for ten years, all other things being equal it would demand a higher interest rate on the longer year loan. This is because there is a longer exposure to interest rate change and default. On occasions this may not be true if interest rates are currently high and expected to fall. There are also no early repayment penalties on short-term finance. Finally, short-term finance also includes items such as trade creditors, which do not charge interest and only cost the sacrifice of discounts for early payment. 10.5 Overtrading Business growth has a direct effect on working capital requirements and may put pressure on the ability of the business to generate internal funds to finance this. Rising sales cause increases in stocks and debtors even if no further capital expenditure is required to achieve the growth. A failure to properly fund working capital growth is known as OVERTRADING. The best way appreciate this is by considering the cash conversion cycle: Cash conversion = inventory conversion + debtor conversion creditor conversion cycle period period period Suppose a company with annual sales of 1,200,000 has an inventory conversion period of one and a half months, a debtors conversion period of two months, a debtors deferral period of one month and input costs are 50% of sales value. What would working capital be? Inventory 50% x 1,200,000 x 1.5/12 75,000 Debtors 1,200,000 x 2/12 200,000 Creditors 50% x 1,200,000 x 1/12 (50,000) Working capital 225,000 Suppose sales increase 50% then we have: Inventory 50% x 1,800,000 x 1.5/12 112,500 Debtors 1,800,000 x 2/12 300,000 Creditors 50% x 1,800,000 x 1/12 (75,000) Working capital 337,500 Which is an increase of 50% in funding requirements but, if to generate the extra sales, the inventory conversion period rose to two months and debtors to two and a half months, we get:

Inventory 50% x 1,800,000 x 2/12 Debtors 1,800,000 x 2.5/12 Creditors 50% x 1,800,000 x 1/12 Working capital

150,500 375,000 (75,000) 450,000

Which is a 78% increase in working capital requirements. Therefore businesses need to be very careful to ensure that the working capital necessary for increased sales volumes is available so that overtrading can be avoided. The initial response to problems will be to reduce the length of the cash conversion cycle. This can be achieved by: reducing the stock-holding period for both finished goods and raw materials through better stock control; reducing the production period through different machinery or different working methods; reducing the credit period extended to debtors and tightening up on cash collection; extending the period of credit taken from suppliers 10.11 Stock Given that stock is an idle resource costing the business money, there must be good reasons for holding stock. The decision reflects a trade off between profitability and liquidity as higher stocks may give higher sales but require more finance which imposes costs. Basically, firms hold stocks for the following reasons: to act as a buffer in times of unusually high demand to ensure continuity of production avoid high costs of emergency orders to take advantage of quantity discounts by ordering more at a time to reduce ordering costs by ordering more items on fewer as part of the production process e.g. maturing whisky or keeping oil in pipelines seasonality of demand (e.g. firework) or supplies suppliers insist on minimum order quantities Against this must be set: Costs associated with stock the opportunity cost of capital tied up holding cost including: insurance, losses from deterioration, obsolescence and pilferage warehousing costs 10.15 Trade Debtors The management of trade debtors involves the firm in trading-off the following factors: the costs of extending credit these include finance costs, bad debt losses and administrative costs of the credit control department. the benefits of granting credit increased sales generated because of the credit terms offered. 10.17 Credit Management Credit control and collection policies should be set by a senior financial manager. The scope of any policy will include: Granting of credit - rating customers and setting credit limits Credit terms and early prompt payment discounts reflects competitive pressures, costs and benefits and also custom and practice in the industry Communication of terms invoices, statements etc. Enforcement strategy taking of discounts not earned, breaches of credit limits and slow payers

The sorts of cost and benefit decisions are illustrated by the following situation: The Marketing Director believes that increasing the credit period from 30 to 60 days will have the following effect on revenues and costs. On the assumption that finance for increased debtors will cost 10% per annum and that the gross profit margin on sales is 20%, should the company go ahead with this strategy? Existing Credit period Average collection period Sales Credit management costs Bad debts Debtors 30 days 35 days 150,000 12,000 1% of sales 150,000 X (35/365) = 14,384 Proposed 60 days 65 days 200,000 15,000 1.2% of sales 170,000 X (65/365) = 30,274

SOLUTION Extra net revenue Extra costs Credit management Bad debts (2,400 1,500) Finance cost (30,274 14,384) X 0.1 Net benefit

10,000 3,000 900 1,589 5,489 4,511

Trade Creditors Creditors are a short-term source of finance that needs to be managed. The trade off is between the benefits of free finance and the costs in terms of lost discounts, the worsening of the relationship with the creditor and the impact on the firms creditworthiness more generally. In particular, creditors may retaliate by giving low priority to the future orders, raise prices in order to compensate for the free finance taken, or seek credit blacklisting of the firm. Cash management A business has the following motives for holding cash: Transactional - to meet day to day financial obligations Financial to cover major items such as the repayment of loans and investments Precautionary cushion against unplanned Cash management involves a trade-off between the cost of holding cash and the cost of running out of cash.

Cash management balances the holding cost (opportunity cost of the money) and the costs of running out of cash(vary from the loss creditor goodwill, lost discounts and foregone investment opportunities to insolvency). Cash management needs: accurate cash flow budgeting/forecasting, so that shortfalls and surpluses can be anticipated planning of and access to short-term borrowing planning for the investments of surpluses Investing surplus funds If a firm has a short-term surplus of funds it should aim to invest them to earn a

Return, if the surplus is long-term it should be invested in projects to increase shareholder wealth or paid out as dividends. Possible investments Surplus funds can be invested in: Treasury bills, which have a minimum investment which last three months and are highly secure and liquid Deposits with Banks, Building Societies and other financial institutions from overnight to several years Bonds, debentures and loans of firms quoted on stock market 10.27 In deciding, consider amount available, duration, ease of obtaining funds early, and return.