Ü Investment in working capital Ü Financing working capital Ü Ratios Ü Cash operating cycle Ü Calculating the cash operating cycle Ü Overtrading Ü Solutions to liquidity problems..
Trang 1OVERVIEW
Objective
Ü To appreciate the importance of working capital and therefore its effective management
WORKING CAPITAL MANAGEMENT
ASSESSING THE LIQUIDITY POSITION
Ü What is “working capital”?
Ü Investment in working capital
Ü Financing working capital
Ü Ratios
Ü Cash operating cycle
Ü Calculating the cash operating cycle
Ü Overtrading
Ü Solutions to liquidity problems
Trang 21302
1.1 What is “working capital”?
Definition
The capital represented by net current assets which is available for day-to-day
operating activities It normally includes inventories, trade receivables, cash
and cash equivalents, less trade payables
Ü Net working capital is made up of
Accounts receivable + Inventory + Cash – Accounts payable
Ü Each of these components needs a control system, but it is also essential to consider working capital as a whole and how these components fit together
Ü Working capital management is concerned with the liquidity position of the company,
so the main aim is to generate cash as quickly as possible
Ü Working capital management is crucial to the effective management of a business because:
(i) Current assets comprise over half the assets of some companies
(ii) A failure to control working capital, and therefore liquidity, is a major
cause of business failure
Ü Two questions must be considered:
̌ How much to invest in working capital?
̌ How to finance it?
1.2 Investment in working capital
Ü The firm faces a trade-off
⇒ Is there an OPTIMAL level of working capital?
LIQUIDITY v PROFITABILITY
High investment
in working
capital
⇒ more liquid
But may not be using
working capital efficently
⇒ less profitable
Low investment
in working capital
⇒ less liquid But may be using working capital efficiently
⇒ more profitable
Trang 3Ü For each company there will be an optimal level of working capital However this can
only be found by trial and error, and in any case it is constantly changing
Ü Businesses must avoid the extremes:
̌ overtrading – an insufficient working capital base to support the level of activity This can also be described as under-capitalisation
̌ over-capitalisation – too much working capital, leading to inefficiency
1.3 Financing working capital
Whatever level of current assts the business decides to hold, they must be matched by
liabilities i.e current assets must be financed
The business must decide whether to use short-term or long-term finance
It is generally true that short-term interest rates are lower than long-term rates as short-term finance is less risky for the provider/lender
However short-term finance is not always cheaper and must be renegotiated when it expires.
The four principal sources of finance for current assets are:
Ü Equity – new share issues
– retained profits
– long-term bank loans
Ü Overdraft – expensive as it is flexible
– risky as repayable on demand
Ü Accounts payable – appears cheap but refusing quick settlement discounts can be
expensive
Trang 41304
Ü Liquidity is a company’s ability to meet its financial obligations as they fall due
Ü A secure liquidity position is desirable The firm’s liquidity position can be assessed in
two ways
2.1 Ratios
Current ratio =
s liabilitie Current
assets
Quick ratio =
s liabilitie
Current
assets
s liabilitie Current
inventory assets
Inventory turnover =
stock Average
sold goods of Cost
Ü shows how quickly inventory is sold
Accounts receivable’ turnover =
receivable accounts
Average
sales
Ü shows how quickly debts are collected
Accounts payable’ turnover =
payable accounts
Average
purchases
Ü shows how quickly accounts payable for supplies received on credit are paid
(i) Seasonal and other factors may mean that statement of financial position values may not be typical
(ii) There may be “window-dressing” e.g the finance director may make a large payment to suppliers at the year-end in order to reduce the reported payables days
(iii) Concern the past and not the future
(iv) They are of little value unless used in comparison to industry average data
Trang 52.2 Cash operating cycle
Ü The length of time between a firm paying out cash for raw materials and/or inputs and receiving cash for goods sold
Ü The number of days between paying suppliers and receiving cash from customers
Ü Can also be referred to as the working capital cycle or the cash conversion cycle
CASH
CUSTOMER
SUPPLIERS
RAW MATERIALS
WORK-IN-PROGRESS FINISHED GOODS
Cash
collection
Sales
Production
Production
Purchases
Cash payment THE CASH OPERATING CYCLE
Ü The length of the operating cycle is affected by various factors e.g
̌ type of industry, e.g retailing v house building;
̌ liquidity v profitability trade-off;
̌ efficiency of management e.g accounts receivable and accounts payable control Whilst it is desirable to have as short a cycle as possible, it is often difficult to differ significantly from competitors in the same trade
Trang 61306
2.3 Calculating the cash operating cycle
days receivable
Accounts
sales credit Annual
receivable accaounts
= x
days payable
Accounts
purchases credit
Annual
payable accounts
days goods
Finished
sales of cost Annual
goods finished of
stock
= x
WIP holding period =
WIP of completion of
Degree sales
of cost Annualstock ofwork in progress
Average
days materials
Raw
purchases Annual
materials raw
of stock
Commentary
Ü Use year-end figures if averages not available
Example 1
Tipple plc has the following estimated figures for the coming year:
Sales $3,600,000
Accounts receivable $306,000
Gross profit margin 25%
Finished goods inventory $200,000
Work in Progress Inventory $350,000
Raw Materials Inventory $150,000
Accounts payable $130,000
WIP is 80% complete Purchases represent 60% of production cost
Required:
Calculate the length of the cash operating cycle
Trang 7Solution
Cost of sales =
_
Number of days between payment and receipt
_
2.4 Overtrading
Ü Overtrading occurs when a company tries to support a large volume of trade from a small working capital base
Ü It can also be referred to as under-capitalisation and often occurs when a business grows very rapidly without increasing its level of long-term finance
Ü The result can be a liquidity crisis
This can often happen at the start of a new business, since
Ü there is no reputation to attract customers, so a long credit period is likely to be
extended in order to break into the market;
Ü if the business has found a “niche market”, rapid sales expansion may occur;
Ü smaller companies which are growing quickly will often lack the management skills to maintain adequate control of the debt collection period and the production period For the above reasons the amount of cash required will increase However, companies in this position will often find it hard to raise long-term finance and hence overtrading and business failure may result
Trang 81308
Ü Decline in liquidity;
Ü Rapid increase in turnover;
Ü Increase in inventory days;
Ü Increase in accounts receivable days;
Ü Increase in short-term borrowing and a decline in cash holdings;
Ü Large and rising overdraft
Ü Reduction in profit margin;
Ü Increase in ratio of sales to fixed assets
2.5 Solutions to liquidity problems
If a business is suffering from liquidity problems, then the aim will be to reduce the length
of the cash operating cycle Possibilities to consider include:
Ü reducing the inventory-holding period for both finished goods and raw materials ;
Ü reducing the production period – not easy to do but it might be worth investigating different machinery or working methods;
Ü reducing the credit period extended to accounts receivable, and tightening up on cash collection;
Ü increasing the period of credit taken from suppliers;
Ü an increase in the level of long-term finance i.e an equity or debt issue A new share issue is probably preferable to increasing debts in a risky company;
Ü reducing the level of sales growth to a more sustainable level
Trang 9Key points
ÐThe key issues are (i) what level of current assets should a business hold
and (ii) how should current assets be financed?
ÐThere are not always unique answers to these questions; it is a matter of
opinion Therefore you need (i) an appreciation of the
advantages/disadvantages of holding cash, inventory and receivables (ii)
the relative advantages of using short vs long-term finance
ÐGood knowledge of ratio analysis is essential in many exam questions on
working capital management e.g estimating the length of the operating
cycle
ÐThere is no official definition of overtrading but it refers to a situation
where a business is growing at an unsustainable rate compared to its level
of long-term finance It is also associated with poor working capital
management
FOCUS
You should now be able to:
Ü explain the nature and scope of working capital management;
Ü calculate appropriate ratios to analyse the liquidity and working capital management of
a business;
Ü calculate the length of the operating cycle of a business;
Ü explain the relationship between working capital management and business solvency
Trang 101310
EXAMPLE SOLUTION
Solution 1 — Cash operating cycle
Cost of sales = 75% × 3,600,000 = 2,700,000
Raw materials days
60%
2,700,000
150,000
Credit taken from suppliers
60%
2,700,000
130,000
5 WIP days
80%
2,700,000
350,000
Finished goods days
2,700,000
Credit given to customers
3,600,000
_ Number of days between payment and receipt 122
_