Managing Working Capital Week 9

1
Managing Working CapitalWeek 9

• ACF108
• Sharon Loane

2
Nature and Purpose..CA less CL (creditors lt 1
year)

• Current assets
• Stocks
• Trade debtors
• Cash (in hand at bank)

• Current Liabilities
• Trade creditors
• Bank overdrafts

3
Size composition varies by industry

• Manufacturers invest heavily in raw materials,
  work in progress, and have finished goods stocks.
  They may sell on credit generating trade debtors.
• Retailers, may only hold finished goods stock,
  and usually sell for cash.
• Working capital a net investment in short-term
  assets, which flow in and out of the enterprise.

4
The working capital cycle These elements are
interrelated and are part of a short-term cycle.
5
Management of working capital essential

• Part of short-term planning process
• Managers decide how much of each element to hold
• There are cost associated with holding too much
  and also too little
• Need to be aware that there may be more
  profitable opportunities for the tied up in
  stocks etc
• Things change with time, seasonality, constant
  revue required
• What kind of environmental changes may drive
  change in the level of investment in working
  capital??

6
External drivers of investment level in working
capital

• Changes in interest rates
• Changes in market demand
• Changes in supply (like bank for hols)
• Change in seasons
• Change in state of the economy (Tayto)
• Internally,
• Changes in business process
• Production process changes
• Changes in levels of risk managers wish to take

7
Scale of working capital

• Tempting when say compared to FA, that investment
  in working capital is trivial!!!
• False, the scale for most businesses is vast.
• For 2000, (As a , of the total net investment of
  these firms see pg, 511, fig 16.1)
• Anglia Water 1, Boots plc, 16, Rolls Royce 27,
  Fuller Smith and Turner 4

8
Managing Stocks

• Held to meet day to day requirements of clients,
• Try to minimise because of costs
• Storage, handling, financing costs, risk of
  pilferage obsolesence, also forgo other
  opportunities
• What costs might be associated with stock being
  too low???

9
Too low stock levels cause

• Loss of sales revenues
• Loss of goodwill from customers
• High transport costs to ensure that stocks are
  replenished quickly
• Lost production due to shortage of raw materials
• Associated inefficient production scheduling
• Buying stocks at inflated prices to replenish

10
Procedures and techniques

• Budgets of future demand for each product, these
  determine ordering and production levels,
  accuracy vital
• Financial Ratios, aid in monitoring stock levels,
  
• Stock Turnover period ave. stock held X
  365days
• 
  cost of sales
• Gives picture of the average length of time stock
  is held, but need for each product line.

11
Re-ordering systems..

• Good procedures should be in place
• Sound system for recording both sales and
  purchases (GRN)
• Periodic stock checks, book stock actual
• Re-order procedures
• Authorisation procedures re ordering
• Costs of controlling stocks have to weighed
  against the benefits

12
(No Transcript)
13
ABC method of analysing and controlling stock A,
B, C goods, greatest control over A
etc Categorising stock ensures that management
effort is directed to the most important areas,
control costs are appropriate to their importance
14
Stock management models

• EOQ
• Economic Order Quantity
• MRP
• Materials requirements planning
• JIT
• Just in Time

15
Patterns of stock movements over time EOQ assumes
that demand is constant, and that stock will be
replenished just at the point when it runs out
16
EOQ

• Assumes key costs are holding ordering costs
• Use to calculate the optimal size of purchase
  order
• Formula is 2DC
• H
• D annual demand
• H cost of holding 1 unit for one year
• C cost of placing an order
• Sell 2000 units per year of X. The cost of
  holding one unit for a year is 4. The cost of
  placing an order is 25. Calculate the EOQ.

17
EOQ cont

• Limitations
• Assumes demand can be predicted evenly
• Assumes demand is even
• Assumes that no bulk discounts are available
• Also that the order quantity will be readily
  available

18
MRP

• Use sales forecasts as the starting point
• Computer aided schedules are developed to
  coincide with production requirements
• Links materials and components to their scheduled
  input in the production process
• By just ordering enough to sustain flow of
  production, stock levels are minimised.
• Now developed into a fully integrated approach to
  production planning

19
JIT

• Attempt to eliminate the need to hold stocks
• First used by US army WW2
• Widely used by Japanese industries
• Stockholding problem rests with suppliers rather
  than the firm
• Can however, drive raw materials prices up
• More than stock control, it is a philosophy
  concerned with eliminating waste
• Onus on supplier to always supply, first grade
  items, no strikes, road closures, bad weather etc
• But does create a management culture dedicated to
  quality

20
Management of debtors

• Selling goods /services on credit creates costs
• Administration
• Bad debts
• Opportunity cost
• But weigh these against benefits of increased
  sales re ability to delay payment
• But need clear policies regarding
• Which customers will get credit
• What length of credit will be offered
• Discounts for prompt payment
• Collection policies?

21
Which customers should get credit

• 5 Cs of credit management
• Capital, must appear financially sound, ratios,
  accounts etc
• Capacity, Appear to have capacity to pay. Check
  payment records where possible
• Collateral, on occasions ask for some form of
  security
• Conditions, What is the state of the industry?
• Character, Willingness to pay depends on
  integrity and honesty
• Trade references, bank references, published
  accounts, credit agencies

22
Length of credit period

• Varies between firms, impacted by
• Typical terms in industry
• Degree of competition
• Bargaining power of customers
• Risk of non-payment
• Capacity of the business to offer credit
• Marketing strategy of the business- for example,
  if they want to increase market share they may
  liberalise credit terms

23
Cash Discounts

• May encourage prompt payment
• Weigh cost against benefit
• Customer may take the discount anyway, if they
  are important to the business, what do you do?
• Small businesses have a greater proportion of
  overdue debt than large business
• Law now permits interest chargeable on overdue
  accounts
• Large companies have to disclose payment policies
  towardssuppliers

24
Collection Policies..

• Have to get s owed in as quickly as possible
• Prompt invoicing
• Regular statements , monthly
• Agreed procedures when customer does not pay,
  legal action?
• Try to take in account cost bad debt in pricing
  products
• Ave settlement period for debtors
• trade creditors/credit sales x 365 days
• But this is only an average figure
• More innovative to produce an ageing schedule of
  debtors (see pg, 524, fi 16.2)

25
Cont..

• Pattern of trade debtors
• Work out patterns, for example, how the sales
  made in June were actually received
• Small firm
• May have no separate credit control function
• May lack good procedures
• Excessive concern for growth can cause bother
• Lack of market power

26
Comparison of actual and budgeted receipts over
time for Example 16.3
27
Management of cash

• Why hold cash?
• Transactionary motive, day to day expenses
• Precautionary motive, ensures ability to meet
  obligations
• Speculative motive, Can exploit profitable
  opportunities quickly
• But not always necessary, some businesses can
  borrow quickly, or CA can be turned into cash
  quickly
• Varying views

28
Controlling the cash balance

• Several models, one is the upper and lower
  control limit model,
• If they hit an outer limit, then managers have to
  decide if this will rectify in a matter of days,
  if not take action.
• Breach of the higher limit may mean too much
  cash, use it say for marketable securities
• Lower limits sell these to meet obligations

29
Controlling the cash balance
30
Cash budgets

• Good for both planning and control purposes
• Can see the expected outcome of planned events,
  cash swings up/down
• Decide best use surplus funds
• Plan for deficits
• Cash transmission
• Benefit from receipts at the earliest opportunity
• Methods of transferring cash, cheque, standing
  order, electronic

31
Management of trade creditors

• Can be an important source of finance
• Cost associated with availing, not always a free
  source of credit
• Opposite of halo effect!
• Extra admin etc to support using credit
• Balance whether or not taking early settlement
  discounts is beneficial
• Real benefits, if not abused, it is really an
  interest free loan, good when inflation high
• Trade creditors/credit purchases x 365 days
  average settlement period for trade creditors

32
Finally, Bank overdrafts

• Flexible form of borrowing
• Therefore widely used.
• Theoretically short-term finance, but can be
  extended and become long term in nature.
• But bank has the right to demand payment at short
  notice
• Consider the purpose for which overdraft is
  required.
• Good for covering short term cash flow problems
• Borrowings in excess incur high charges
• Therefore cash budgets will really help