BAF 813:

WORKING CAPITAL MANAGEMENT

Working capital has two concepts:-

a) The gross working capital which means total current assets

b) The net working capital concept which means current assets-current liabilities.

Working capital management involves the administration and policy guidelines of current assets and current
liabilities. It is therefore involves decisions such as:-

- The target level of current assets

- How these assets are financed.

The importance of working capital management:-

i) Finance mangers devote most of their time to routine decisions. Research has shown that the time
spent on routine decisions or working capital management approximately 60% of the finance
managers’ time while only 40% is spent on strategic decision making.
ii) Working capital items represent the largest proportion of the total investment of the company unlike
fixed assets are very liquid and subject to frequent changes
iii) Current assets are exposed to the risk of fraud and theft.
iv) Because long term conditions normally set by creditors demand that a company should maintain a
certain minimum level of net working capital in order to solve their agency problem.
v) The need for working capital is directly related to the company sales growth. i.e. in order to increase
the company sales all the components of the working capital may be increased at some predominant
rates.
vi) The working capital item has a great significance to small companies because they have got
problems in raising funds from long term sources and because small companies concentrate in
business where large investment in current assets is required.

WORKING CAPITAL FINANCING POLICIES.

There are basically 3 types of financing policies.
a) The Aggressive Financing Policy.
Under this policy a company finances most of its investments using short term sources of finance. This is
because short term source of finance are normally cheaper and by so doing the company will minimize its cost
of financing hence increasing its profitability. However, the companies will decrease because it will be required
to repay the borrowed amount within a short period of time. The assets of the company can be classified into 3
categories.
- Fixed assets
- Permanent current assets
- Temporary current assets
Under the aggressive financing policy a company can finance a 5 yr project with a 2 yr loan. Under this policy
therefore all the working capital items permanent current and temporary current assets will be financed using
short term sources of finance.
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 b) Conservative financing policy.
A company is said to be traditionally conservative when at least 90% of its total investments are financed using
long term sources of finance, this is because long term sources of finance can be turned over several times
before the maturity date for loan repayment hence giving a company time to prepare for the repayment of the
loan. Under this financing policy a 5 year loan can be used to finance a 2 year project and a 3 year project in
succession before the maturity date for the loan repayment.
The major aim of the conservative financing policy is to improve the company’s liquidity position but at a
reduced profitability level. This is because long term sources of finance are usually expensive and when used to
finance short term project whose return is relatively low then company’s profitability will be reduced. Under
this financing policy therefore the company’s current assets will be financed using long term sources of finance.

c) Moderate/Matching/Hedging Financing Policy:-

This policy tends to much the life of the investment with the maturity date for the loan repayment. In this case,
long term investment will be financed using long term sources of finance while short term investment will be
financed using short term sources of finance. Therefore according to this financing policy all the working
capital items will be financed using short term sources of finance. This policy aims on striking a balance
between moderate liquidity & moderate profitability.

Risk Return Trade Off.

The financing policies above the return trade off. The Aggressive financing policy is a high risk, high return
approach because it uses short term sources of finance while conservative financing policy is low risk low
return approach. The moderate hedging financing policy is a compromise between the aggressive financing
policy and conservative financing policy.
Note:- A company cannot adopt a particular financing policy and use it throughout its life because the selection
of a particular policy its affected by the following factors:-
a) Management attitude towards risks:- the managers who are risk averse may use the conservative
financing policy while those who are risk takers may use the aggressive financing policy. The managers
are agent of shareholders and keep on changing from one period to another hence the financing policy
will be expected to change as per the changes of management.
b) Availability of the funds at time of investment:- funds may not be available from all the 3 sources of
finance (long term, short term and medium term) at the same time because of this the management may
be forced to use the available funds to undertake the investment.
c) The terms and conditions of obtaining the funds:- creditors normally sets the minimum requirements
which the company most comply with before raising funds from a given source of finance.
d) The borrowing capacity of the company: - different sources of finance require security or collateral
before obtaining funds from those sources of finance. If the company does not be able to borrow funds a
given source.
e) Cost:-cost of funds differs from one source of finance to another. In order to minimize the cost of
borrowing the company may be forced to raise funds from a particular source of finance which is
considered to be less costly.

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Debtors/Accounts Receivable Management.

Debtors or account receivable results from sales on Credit Company normally sell on credit due to the following
reasons.
a) In order to increase its sales volume.
b) In order to avoid stock from been outdated
c) In order to maintain the existing customers and acquire other new customers
d) In order to avoid the fluctuation in prices.
The amount of receivable outstanding at the end of any particular period will be given by
a. The volume of credit sales
b. The average collection period
Recall from ratio analysis the debtor’s collection period in days was calculated as:

Average debtors/credit sales*no of days in a year.

The average collection period will depend on:-

a. The credit stand out i.e. the maximum risk acceptable from credit sales
b. The credit period i.e. the length of time for which credit is granted.
c. The discount given for earlier payments
d. The company’s collection policy.
The credit stand out policy:-
A company can adopt either alienate or stringent credit policy. Alienate credit policy is one in which liberal
terms are granted for longer period while stringent policy a company will sell on credit but on highly selective
basis to the customers who approve to be credit worth and are financially stable.

Alienate credit policy will result in an increase in sales, increase in contribution margin that is will later on lead
increase in marginal cost e.g. bad debts expenses the cost of credit analysis increase in collection cost increase
the opportunity cost for the funds tied up in all receivable therefore the main objective of accounts receivable
management is to reduce total relevant cost of maintaining accounts receivable. This is obtained by operating
optimal credit policy.
CREDIT RISK MANAGEMENT:
This refers to the procedure and control that a company has put in place to ensure efficient correction of
customers payments to minimize risk of non-payment. Credit risk management forms the major part of
company overall risk management. The management of accounts receivable normally begins with the decision
on whether to grant credit to the customers and if so on what term and conditions and how much credit. This is

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normally referred to as company’s credit policy, which involves all systems and procedures governing the
company.

a) Credit selection: i.e. the process of selecting customer who will be granted credit and determining
individual credit terms.
b) Credit standards: i.e. the minimum credit standard and financial viability and credit worthiness that
customers must portray before credit is granted.
c) Credit terms: this involves setting out the credit period around and end discount offered four early
selection e.g. X+ 10 net 30 where X-discount rate, 10 Discount period, 30 credit period.
Collection policy this is company’s system and procedures of collecting payment from customers when it
becomes due. The credit policy of the company should be balanced because if a company operates in a lenient
credit policy then the risk of bad debts will increase.

Credit Selection/screening

In the initial stages of operation an efficient credit system requires a sound screening credit procedure because
this will help reduce bad debts risk or risk of default by eliminating unsuitable applicant and therefore avoiding
the cost of bad debts the traditional method of customer selection and analysis involves the use of 5C’s this
include
a) Capacity:- this is the assessment of customer ability to repay debts. This assessment includes financial
analyst of customer accounts with emphasis on liquidity gearing and profitability position of customers.
b) Capital: - this involves assessment of customer’s capital by analyzing the capital structure of the
company.
c) Collateral: - this involves evaluation of assets customers has available as a security for the credit to e
granted.
d) Character: - this is assessment of personal character integrity of the customer and his willingness to
repay the credit terms.
e) Conditions:- the decision to grant credit to customers. It may be influenced by existing conditions of the
time the credit was to be offered.
If the company is finding it difficult to selling a given product then the company may adopt a lenient credit
policy.

Sources of information for credit assessment.

Credit information is available from various sources both internal &external sources. Some of the sources
include:- trade partners, bank references, financial accounts of the customer, business contacts and associates,
credit remitting agencies, etc

Credit Analysis.
Once information has been obtained about a given customer the information will be analyzed in order to
determine whether to grant credit or not to the customers. There are normally two methods.

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 a) Discriminant Analysis: - this is an actuarial analysis used to determine the credit worthiness of
customers. It involves combination of various ratios to determine the score of customers. Under this
analysis various liquidity ratios profitability ratio, gearing ratio investors ratio are combined to obtain,
Z- Score. Research has shown that a customer with Z-Score greater that 1.8 is credit is credit Worth Z-
Score<1.8 not credit worth, Z- Score=1.8.
b) Credit Scoring Technique:- This technique operates as follows:
 The company identifies the range of key financial and financial factors which are given ranking
e.g. Salary/income of individual preferences, age brackets etc.
 A customer is then required to complete a detailed application form which is assessed by
members of credit staff.
 The customer will be awarded initial Score of each variable( with a maximum score being 100)
 The minimum score is then set which the customer must obtain before obtaining credit.
 Each factor is weighted to obtain the weighted average of the customer. The weight given to
each Score. It will represent importance of factor awarding credit.
The collection policy may affect the accounts receivable. This is because the higher the collection cost the lower
the bad debts up to a given minimum point. This point is referred as saturation point. After the saturation
increase expenditure on collection cost will not result in decrease in bad debt expenses.
The company should therefore not spend more on collection costs after saturation point. Usually an ageing
schedule or analysis on account receivable can be undertaken by the company so as to determine the action to
be taken an account receivable.

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