Financial Decision Making-5

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MN7029 – Financial Decision Making

2.3 Working Capital Management

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Identify the main elements of working capital

Discuss the purpose of working capital and the nature of the working capital cycle

Explain the importance of establishing policies for the control of working capital

Explain the factors that have to be taken into account when managing each element of working capital

What are the components of working capital?

The nature and purpose of working capital

Major elements

Inventories

Trade receivables

Cash (in hand and at bank)

Trade payables

less

equals

Current liabilities

Working capital

Current assets

Bank overdrafts

Figure 10.1 The working capital cycle

Cash is used to pay trade payables for raw materials, or raw materials are bought for immediate cash settlement. Cash is also spent on labour and other items that turn raw materials into work in progress and, finally, into finished goods. The finished goods are sold to customers either for cash or on credit. In the case of credit customers, there will be a delay before the cash is received from the sales. Receipt of cash completes the cycle.

What can change amount or split of working capital?

Seasonality of business

Market demand

External economic factors

Changes in manufacturing technique

Interest rates

Change in attitude towards risk

Figure 10.2 Average investment (in days) for the main working capital elements

Trade receivables settlement period

Inventories turnover period

Trade payables settlement period

Days

47.9

48.1

41.0

51.9

2013

2014

2015

2016

2017

51.8

54.0

56.4

58.9

53.1

2013

2014

2015

2016

2017

58.2

58.8

60.4

62.9

68.0

2013

2014

2015

2016

2017

67.7

Source: Compiled from information in ‘Navigating uncertainty: PwC's annual global working capital study’, 2018/19, www.pwc.com.

Inventories

Opportunity cost

Finance cost

Storage and handling

Order costs

Obsolescence

Lost sales

Goodwill

Lost production

Inventories financing cost


Business	Type of operations	Cost of capital	Average inventories held	Financing cost of holding inventories	Operating profit/ (loss)	Financing cost as % of operating profit/(loss)
		(a)	(b)	(a) × (b)
		%				%

Associated British Foods	Food producer	14.2	£2,144m	£304.4m	£1,404m	21.7
BT Group	Telecoms	8.4	£233m	£19.5m	£20,342m	0.1
Go-Ahead	Transport	5.2	£17m	£0.9m	£161m	0.6
Kingfisher	DIY	10.1	£2,437m	£246.1m	£685m	35.9
Tesco	Supermarket	9.5	£2,282m	£216.8m	£1,837m	11.8

Source: Annual reports of the businesses for the years ended during 2018.

Managing inventories

Forecasting future demand

Financial ratios

Recording and reordering systems

Inventories management models

Enterprise resource planning (ERP) system

Levels of control

Just-in-time (JIT) inventories management

Procedures and techniques that can be used to ensure the proper management of inventories

1. Forecasting future demand

2. Financial ratios

Average inventories turnover period

Average inventories held Cost of sales

× 365

3. Recording and reordering systems

Checks and procedures

Authorisation

Buffers

Lead time

4. Levels of Control

Figure 10.4 ABC method of analysing and controlling inventories

Category A contains inventories that, though relatively few in quantity, account for a large proportion of the total value. Category B inventories consist of those items that are less valuable but more numerous. Category C comprises those inventories items that are very numerous but relatively low in value. Different inventories’ control rules would be applied to each category. For example, only Category A inventories would attract the more expensive and sophisticated

controls.

5. Inventories Management Models

Figure 10.5 Patterns of inventories movements over time

Here, we assume that there is a constant rate of usage of the inventories item and that inventories are reduced to 0 just as new inventories arrive. At time 0, there is a full level of inventories. This is steadily used as time passes and just as it falls to 0 it is replaced. This pattern is then repeated.

5. Inventories Management Models

Figure 10.6 Inventories holding and order costs

Small inventories levels imply frequent reordering and high annual ordering costs. Small inventories levels also imply relatively low inventories holding costs. High inventories levels imply exactly the opposite. There is, in theory, an optimum order size that will lead to the sum of ordering and holding costs (total costs) being at a minimum.

The economic order quantity (EOQ) model

Where:

D = the annual demand for the inventories item (expressed in units of the inventory item);

C = the cost of placing an order;

H = the cost of holding one unit of the inventories item for one year

EOQ

2DC

6. Enterprise Resource Planning Systems

Integrated software systems

Can manage inventory, logistics, pricing

Can be very expensive

7. Just-in-time inventories management

May result in hidden costs (taking advantage of cheap sources of supply)

Requires close relationship with suppliers

May require re-engineering production process

Can be seen as part of TQM approach

Toyota Production System ( https://www.youtube.com/watch?v=nFu4FFgbMY4&t=1s)

Demand (units)

Jan

Feb

Mar

Apr

May

June

July

Aug

Sept

Oct

Nov

Dec

Category Z

Category Y

Category X

Figure 10.7 Patterns of inventories demand

Managing trade receivables

Which customers should receive credit

Questions to ask

How much credit should be offered

What length of credit it is prepared to offer

Whether discounts will be offered for prompt payment

What collection policies should be adopted

How the risk of non-payment can be reduced

What might you look at to determine whether you will offer credit to a particular customer?

Managing trade receivables

Which customers should receive credit

Questions to ask

How much credit should be offered

What length of credit it is prepared to offer

Whether discounts will be offered for prompt payment

What collection policies should be adopted

How the risk of non-payment can be reduced

The five Cs of credit

Capital

Capacity

Collateral

Conditions

Character

Which customers should receive credit?

Sources of credit information

Bank references

Published financial statements

Trade references

Credit agencies

The customer

Other suppliers

Length of credit period

The typical credit terms operating within the industry

The degree of competition within the industry

The bargaining power of particular customers

The risk of non-payment

The capacity of the business to offer credit

The marketing strategy of the business

May be influenced by:

Collection policies

Publicise credit terms

Issue invoices promptly

Develop customer relationships

Produce an ageing schedule of receivables

Answer queries quickly

Monitor outstanding debts

Deal with slow payers

Financial ratios

Average settlement period for trade receivables

Average trade receivables Credit sales

× 365

Financial ratios (Continued)

Trade receivables to sales

Trade receivables outstanding Sales revenue for period

× 365

Ageing schedule of trade receivables at 31 December

Customer		Days	outstanding		Total
	1 to 30 days	31 to 60 days	61 to 90 days	More than 90 days
	£	£	£	£	£
A Ltd	12,000	13,000	14,000	18,000	57,000
B Ltd	20,000	10,000	-	-	30,000
C Ltd	-	24,000	-	-	24,000
Total	32,000	47,000	14,000	18,000	111,000

Figure 10.9 Comparison of actual and expected (target) receipts over time for Example 10.5

It can be seen that 30 per cent of the sales income for June is received in that month; the remainder is received in the following three months. The expected (target) pattern of cash receipts for June sales, which has been assumed, is also depicted. By comparing the actual and expected pattern of receipts, it is possible to see whether credit sales are being properly controlled and to decide whether corrective action is required.

Why does a business hold cash?

Should it hold as much cash as possible?

Why hold cash?

There are three reasons:

To meet day-to-day commitments

To deal with uncertain cash flows

To exploit profitable opportunities

Factors influencing the amount of cash held

The opportunity cost of holding cash

The level of inflation

The nature of the business

The cost of borrowing

Economic conditions

The availability of near-liquid assets

Relationships with suppliers

The availability of borrowing

Possible factors may include:

Managing cash

Main techniques

Preparing projected cash flow statements

Controlling the cash balance (using control limits)

Managing the operating cash cycle

Figure 10.10 Controlling the cash balance

Management sets the upper and lower limits for the business’s cash balance. When the balance goes beyond either of these limits, unless it is clear that the balance will return fairly quickly to within the limit, action will need to be taken. If the upper limit is breached, some cash will be placed on deposit or used to buy some marketable securities. If the lower limit is breached, the business will need to borrow some cash or sell some securities.

Figure 10.11 The operating cash cycle

The OCC is the time lapse between paying for goods and receiving the cash from the sale of those goods. The length of the OCC has a significant impact on the amount of funds that the business needs to apply to working capital.

Figure 10.12 Calculating the operating cash cycle

For businesses that buy and sell on credit, three ratios are required to calculate the OCC.

Figure 10.13 The average OCC of businesses categorised according to size

Revenues <€500m

Revenues between €500m and €1bn

Revenues >€1bn

Net working capital days

2013

2015

2016

2014

100

2017

Source: Compiled from information in ‘Navigating uncertainty: PwC's annual global working capital study’, 2018/19, www.wpc.com, p. 17.

Managing Trade Payables

Remember – one business’s trade receivable is another business’s trade payable…

Admin expenses of tracking payables dates;

Goodwill;

Prompt payments discounts – the other side;

Monitor through average settlement period for trade payables.

Discussion question

How might each of these affect levels of inventory held by a business?

Increase in number of production bottlenecks

Rise in business cost of capital

Decision to offer a narrower range of products

A switch of suppliers from overseas to local

Deterioration in quality and reliability of bought in components.

What’s Next…

7.30pm 8.30pm – Business Simulation Round 3

8.30pm – Finish!

For next time:

Business Simulation round 3 submitted by 3pm Friday 16th December

Business Simulation round 4 submitted by 3pm Sunday 8th January 2023

Assessment 1 – Thursday 12th January 2022

Review Weblearn for extended learning questions

Read Atrill Ch 4&5

Consider: In respect of a business you have worked in or know well, can you think of significant capital investment decisions that company has had to make?

Financial Decision Making-5

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