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WORKING CAPITAL MANAGEMENT
ARIZONA STATE UNIVERSITY
FIN 540 - ADVANCED FINANCIAL MANAGEMENT
WEEK 10
13.1 INTRODUCTION
Working capital requirements:
When businesses make investment decisions, they not only have to consider the
financial outlay required to acquire new machinery, new buildings or whatever, but also take
into account the additional current assets that are usually required for the expansion of
activities. Increased output tends to create the need to hold additional inventories of raw
materials and work-in-progress. Increased sales revenue usually means that the level of trade
receivables will increase. An increase in the scale of operations in general tends to imply the
need for larger amounts of cash. As with any investment, working capital exposes the
business to risk.
Working capital financing:
Current assets (inventories, trade receivables, and cash) tend not to be financed
entirely from long-term sources of financing. Most businesses also have access to two main
sources of short-term. The first is trade credit, which arises from the fact that purchases of
goods and services are usually made on credit; in other words, the buyer does not have to pay
immediately on delivery but may be allowed to defer payment for a certain period of time, say
30 days. The second source is one that many of us are familiar with in our personal lives,
namely bank overdrafts.
Since the relationship between short-term sources of finance (or current liabilities) and
current assets tends to be very close, it makes sense to discuss both in the same chapter,
although there is logic in dealing with short-term sources of funding, in addition to long-term
sources of funding, in Chapter 8.
Specific features of working capital management:
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Just as it is unreasonable to discuss short-term finance separately from long-term
financing, it can also be argued that it is wrong to separate the discussion of current assets
from the discussion of investment decisions in general. The reason for taking this approach is
that there are features of managing current assets and current liabilities that make it
appropriate to deal with them together, but separately from long-term investment and
financing decisions. These features include the systematic nature of managing working capital
elements and the frequency of decision-making with respect to most of them.
Perhaps another reason for discussing current assets and current liabilities together is
that financial managers need to be careful to maintain a reasonable balance between the two,
so it is important not to lose sight of the interrelationships both. In fact, they are so closely
related that they are often combined with each other and considered as one factor, i.e. working
capital (current assets minus current liabilities).
The objective of working capital management is the same as that of non-current assets
and long-term financing decisions. This is usually the maximization, or at least increase, of
shareholder wealth. This can be achieved by optimizing positive cash flows through an
appropriate balance between costs and revenues, on the one hand, and risks, on the other.
13.2 WORKING CAPITAL DYNAMICS
Working capital cycle:
The top part of Figure 13.1 illustrates, in a very simplified form, the chain of events in
a manufacturing business with respect to working capital. The chain begins with the purchase
of raw material inventory on credit. Later the inventory will be used in production, work will
be done on the inventory and it becomes work in process (WIP). Work on WIP will continue
until it eventually becomes a finished product. As production progresses, labor and overhea d
costs must be met. Of course, at some stage, accounts payable need to be paid. When finished
goods are sold on credit, trade receivables increase. Customers will eventually pay them off,
so cash will flow into the business.
Each of these areas - inventories (raw materials, WIP, and finished goods), accounts
receivable, cash (positive or negative) and accounts payable - can be viewed as tanks into
which funds enter and leave. A large part of this chapter will address the question of why
these 'tanks' need to exist and, if required, what attitude managers should take towards the
amount that should be kept in each tank at any given time. Here managers need to attempt to
balance the costs associated with maintaining the funds in the tanks, with the risks of the tanks
being too full or too empty. Note that the top part of Figure 13.1, with minor changes, would
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also apply to non-manufacturing businesses. For example, a retailer has no raw material or
WIP inventory. Service businesses have neither raw material nor finished goods inventory, but
may have WIP. The figure takes the example of manufacturers because manufacturers tend to
own all elements of working capital.
Relationship between working capital and investment and long-term financing:
Working capital is definitely not the only aspect of business that impacts cash.
Companies have to pay taxes to the government, both central and local. Non-current (fixed)
assets will be bought and sold. Tenants of non-current assets will receive their lease payments.
Shareholders (old or new) may provide new funds in the form of cash, some shares may be
exchanged for cash and usually dividends will be paid. Similarly, long-term lenders (old or
new) may provide debt financing, loans must be repaid over time and interest obligations must
be met. Unlike the movement of working capital items, most of these 'non-working capital'
cash transactions are not everyday occurrences. Some of them may be annual events (for
example, lease payments, dividends, interest, and possibly purchases and disposals of non-
current assets).
Other events (such as new equity and debt financings and redemption of old equity and
debt financings) are usually less frequent events. One factor that most of these non-capital
work transactions have in common is their size: they are likely to involve individually large
amounts of cash.
It is evident that the management of working capital, particularly cash, is closely
linked to funding decisions and decisions involving investments in non-current assets. These
linkages involve the amount of cash, the timing of cash flows, and the level of risk involved.
For example, if certain long-term loans are to be redeemed under contractual obligations, the
question of the source of that cash must be considered. If cash has not been generated through
the working capital cycle (which is essentially through profitable trading), other sources (for
example, new equity or debt financing) need to be considered. These themes will be
developed later in this chapter.
Measuring the operating cash cycle:
The working capital cycle, depicted descriptively at the top of Figure 13.1, can also be
expressed quantitatively, as shown in Figure 13.2. It shows the length of time each element of
working capital takes to cycle. Figure 13.2 also refers to a manufacturing business, but can
easily be altered to suit nonmanufacturers.
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In Figure 13.2, raw material inventory (RM) is held for a period of time before being
put into production: it is now part of WIP, along with other elements (labor, overhead costs,
and so on) until it is completed and is part of finished goods inventory (FG). The finished
inventory is held until it is sold and becomes accounts receivable, which in turn is repaid by
the customer; thus the cycle is completed. The amount of time it takes from payment for the
purchase of raw material inventory to receipt of cash from customers is known as the
operating cash cycle. This cycle must be financed by the business. In general, the shorter the
operating cash cycle, the less funding is required. One of the objectives of working capital
management is to keep this cycle to a minimum. By doing this, shareholder wealth will tend to
increase, all things being equal.
Notes for the solution:
It should be noted that the days in the above solution are not equally important in
economic terms. For example, reducing the accounts receivable settlement period by one day
would save Rp. 685 Trillion in funding (i.e. Rp. 250 Billion/365). Reducing the settlement
period of accounts payable by one day would result in a funding loss of only Rp. 184,000,000
(i.e. Rp. 67 Billion/365). So while these two actions do not change the length of the operating
cash cycle, they will result in a reduction in working capital investment of Rp. 501,000,000
(i.e. Rp. 685,000,000 - Rp. 184,000,000).
13.3 THE IMPORTANCE OF WORKING CAPITAL MANAGEMENT
Working capital scale
It is tempting to believe that with working capital we are dealing with relatively small
amounts. Such a view is in stark contrast to the typical UK business; the sums involved tend
to be large. Table 13.1 provides an overview of investment working capital for five companies
in the UK whose names are very well known, or whose products are everyday commodities
for most of us. These businesses were chosen at random, except that each is well-known and
comes from a different industry. For each business, the main items that appear on the
statement of financial position are expressed as a percentage of the long-term financial
provider's total investment (equity and non-current liabilities).
The table shows considerable differences in the composition of the statement of
financial position between one business and another, including the working capital element.
Although total current assets are quite large when compared to total long-term investments,
the percentage varies greatly between businesses. When looking at the mix of current assets,
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we can see that only Next, Babcock and Tesco, which manufacture and/or sell goods, hold
large amounts of inventory. The other two businesses are service providers so inventory is not
a significant item. We can also see that very few of Tesco, Ryanair and Severn Trent's sales
are on credit, as they invest relatively little in trade receivables.
Next plc is a large retail and home shopping business. Ryanair Holdings plc is a
leading airline. Babcock International Group plc is a large engineering and support business.
Tesco plc is one of the UK's leading supermarkets. Severn Trent plc is an important supplier
of water, sewage services, and waste management, especially in the UK. Source: Table
compiled from information appearing in the financial statements for the year ended 2015 for
each of the five related businesses.
Note that Tesco's trade payables are much higher than its trade receivables. The
amount is also very high compared to its inventory. Since its trade payables are mainly
amounts payable to inventory suppliers, this means that Tesco receives cash from the grocery
trolley long before it pays for it. The relatively large figures for 'Other current assets' and
'Other current liabilities' for Tesco come from customer advances and deposits respectively,
which is due to the business' involvement in banking. The magnitude of working capital
investments made by companies in general has led to working capital management
increasingly being regarded as fundamental to the well-being of the company and its ability to
survive and prosper.
Working capital financing costs:
Although, as we will see when we consider each type of current asset in more detail,
funding is not the only cost of owning such assets, it is still a considerable cost. To illustrate
this point, let's consider Associated British Foods plc (ABF), using information provided in
the business's 2015 annual report. ABF operates in a range of food-related activities, including
food manufacturing (e.g., Ovaltine, Ryvita, and Kingsmill brands), which accounts for about
60 percent of its revenue, and retail (including Primark, Fortnum, and Mason) providing the
rest. The company operates worldwide, with a total turnover of nearly IDR 13 trillion.
Applying ABF's cost of capital rate, which is revealed in its annual reports (an average
of 12.2 percent), its cost of funding current assets, after taking into account the benefits of
'free' trade debt financing provided by its suppliers, was IDR 198 billion in 2015. This amount
represented 21 percent of the business's operating profit and 1.5 percent of its revenue that
year. These are big numbers. This example should not be used to suggest that ABF is
mismanaging its working capital. This level of financing costs is common for businesses
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operating in ABF's area of activity. We will refer to the cost of financing each element of
ABF's working capital at several points in this chapter.
Nature of working capital decisions:
We have just seen that the difference between working capital decisions and decisions
involving non-current assets and long-term funding does not seem to lie in the amount of
funding involved. The difference lies in the tendency for working capital decisions to be
short-term, changeable in a relatively short period of time, and made more frequently.
While these decisions are made more frequently, many working capital decisions are
straightforward as they tend to be repetitive. There will (or should) be a policy that creates a
set of rules that must be followed. For example, every time a customer wants to buy an item
on credit, a decision is needed on whether to grant credit or, if so, in what amount. Most
businesses will decide on some formulas that can be applied to help them make decisions. The
existence of such formulas has the advantage that many decisions can be made by employees
low level in the management hierarchy so that it can be taken fairly quickly and cheaply.
In establishing a formula or set of rules for working capital management
day-to-day, care must be taken to assess which approach best advances the business
objectives. When a set of rules has been established, they should be considered as the
framework within which all working capital decisions should be made. The rules established
at one time are unlikely to continue to represent the most favorable approach over a long
period of time. Circumstances, including the competitive position of businesses, interest rates,
and the general economic environment, change over time. Therefore, policies should be
reviewed periodically and, if necessary, revised.
Budget utilization:
Controlling working capital through the use of detailed plans in the form of budgets
can be very useful. The ability to assess in advance the needs that will be made of the various
elements of working capital allows managers to ensure that the 'tank' is always adequately
filled. Few businesses have stable and regular working capital requirements from week to
week throughout the year. This is partly due to seasonal factors. Prior knowledge of what the
demands are likely to be at various times is invaluable.
General attitude towards working capital:
In general, businesses should seek to minimize the level of each type of current asset
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they hold and maximize the benefits of cheap short-term financing. This of course depends on
the risks and costs involved in doing so. For example, extending credit to customers is costly
(due to the loss of interest on the funds, if nothing else), so ideally credit should not be
extended. However, failure to offer credit is likely to mean that the business will not be able to
make sales (perhaps because competitors do offer credit). Clearly, credit policy should
attempt to strike a balance between the costs and risks arising from taking one extreme view
and the other extreme view.
Since the elements of working capital tend to have a high financial value, striking a
balance between the extremes tends to be a costly problem. Indeed, as we will soon see, this
can even be fatal.
13.4 WORKING CAPITAL AND LIQUIDITY
The need for liquidity:
Not only do companies need to strike a sensible balance between the extremes in terms
of each element of working capital, they also need to strike the right balance between
exploiting 'cheap' sources of short-term finance (current liabilities) to the maximum extent
possible and the risks and costs that may arise from heavy reliance on financing suppliers who
can demand repayment at short notice. This means that businesses need to maintain sufficient
current assets to enable them to meet short-term claims as they fall due. They need to be able
to do this as failure to meet the claims will entitle the short-term claimants (or current
liabilities) to take steps to liquidate the business. This usually involves a forced sale of some
or all of the business' assets, including non-current assets.
If bankruptcy costs are insignificant and if real asset markets are efficient, from a
shareholder wealth maximization perspective, then the threat of liquidation will not be
important. This is because shareholders can expect, upon liquidation of the business, to
receive an amount equal to the capital market price of the shares immediately before
liquidation. In other words, liquidation will not affect shareholder wealth. Of course, in
reality, since bankruptcy costs are likely to be high and real asset markets are likely to be
inefficient, liquidation is usually expected to have an adverse impact on shareholder wealth.
Means residual fluid:
One way to avoid the risk of liquidation is to keep large amounts of cash in short-term
interest-bearing deposits. In this way, if the need for cash to meet current liabilities suddenly
arises, cash can be made available quickly. Of course, there is no point in taking such an
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approach unless the funds used to form short-term deposits are provided from long-term
sources. Otherwise, the policy will have the effect of solving the original problem by creating
another group of short-term claimants who may cause the same difficulties.
The approach of using long-term funding to create short-term funds would offer a
perfect solution to the liquidity problem but is incompatible with the nature of capital markets.
This tends to mean, among other things, that businesses are usually unable to lend at the high
interest rates that they have to pay to borrow. In addition, long-term interest rates are usually
higher than short-term interest rates. So, for the average firm, long-term borrowing and short-
term borrowing, in an effort to maintain good liquidity and avoid the risk of liquidation, are
likely to be expensive solutions to the problem.
In practice, businesses seem to try to strike a balance between their level of current
assets and current liabilities, i.e. a balance between the utilization of cheap short-term funding
sources and the risks inherent in doing so.
It is probably fair to say that, regardless of the root cause (e.g., lack of profitability),
most business failures result directly from a lack of working capital.
Working capital financing:
The amount of funds tied up in working capital is usually not constant throughout the
year. Businesses that require constant working capital funding may be a minority group. For
most businesses, there will be weekly fluctuations. Many of the Those operating in industries
that have largely seasonal demand patterns. This means that sales revenue, inventories,
accounts receivable, and so on will be at higher levels at certain predictable times of the year
than at other times.
In principle, working capital requirements can be divided into two parts, namely a
fixed part and a fluctuating part. The fixed part may be defined in terms of an amount as the
minimum working capital requirement for the year.
It is widely recommended that the business be funded in the manner depicted in Figure
13.3. More permanent needs (non-current assets and elements of fixed working capital) should
be financed from fairly permanent sources (equity and long-term loans, or equivalent);
fluctuating elements should be financed from short-term sources (such as bank overdrafts),
which can be drawn down and repaid easily and at short notice.
Figure 13.3 assumes no fundamental changes to any asset levels, except for fluctuating
working capital. In practice, any expansion, contraction or structural change in its operations
is also likely to affect the pattern of funding required by the business.
Fluctuating elements of working
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Use of accounting ratios in working capital management
Accounting ratios are widely used in working capital management. Some of the ratios
used are:
•
current ratio (current assets/current liabilities);
•
acid test (quick assets) ratio (liquid assets/current liabilities); and
•
without credit period (liquid assets/average daily cash operating cost).
You may want to refer back to Chapter 3 for more details on this ratio. Perhaps,
managers can make good use of this ratio to monitor the actual liquidity position and compare
it on an ongoing basis with a standard or target figure, taking steps to correct significant
deviations. Such standards may arise from within the business, or industry averages, or
perhaps a combination of both. One way or another, businesses should actively seek to
maintain liquidity and confidence that short-term trade payables will be paid.
13.5 OVER-TRADING
Problem:
A particular business, under certain circumstances, will have a particular working
capital requirement, although this actually depends on managerial judgment. For example, the
management of a retailer, with a certain level of demand for its merchandise, will decide on
the level of inventory requirements. If demand changes, a different level of inventory holding
is usually required. A doubling of the level of demand does not necessarily mean the need to
double the level of inventory, but it usually means the need for a significant increase in the
amount of inventory available to customers. The same applies generally to all businesses with
respect to all aspects of working capital. It is obviously important for managers to not only
decide on the level of working capital that will be required, but also ensure that the business
can finance that amount. Not being able to provide the level of working capital required to
maintain a certain level of activity is called overtrading.
Excessive expansion and trade:
In practice, problems arise for businesses that experience an expansion of trade activity
due to increased demand, especially when the increase in demand is rapid and unexpected.
The temptation to exploit new profitable trading opportunities is often great. But increased
activity without increased working capital to sustain it can lead to serious overtrading
problems, possibly culminating in the complete financial failure of the business. At first
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glance, this problem appears to be self-resolving, as increased profits from additional
activities will provide the necessary funds to expand working capital. However, this view is
usually misleading, as working capital requirements (additional inventory, additional cash for
labor, and other costs) generally precede the additional cash flow from increased activity. This
arises from the fact that a business, regardless of the type of activity, must pay cash to meet
most of the costs of certain sales, before cash is received from customers. The extent of this
problem varies from one type of business to another. Obviously, this problem is greater for
manufacturing companies that sell on credit, with relatively large levels of inventory and
accounts receivable, compared to companies that provide cash settlement services in the near
future, such as hairdressing businesses. In fact, for a hairdressing business, rapid expansion of
trade may not pose a problem overtrading at all. In other words, manufacturers tend to have
long cash cycles whereas hairdressers do not.
13.6 INVENTORY (INVENTORY IN TRADE):
As we see in Figure 13.1, manufacturing businesses usually keep inventory at various
stages of completion, from raw materials to finished goods. Trading businesses (wholesalers,
retailers and so on) keep inventory in one state only. Broadly speaking, the level of inventory
investment by manufacturers tends to be relatively large compared to the level of investment
by traders.
Even with traders, there can be a big difference. A jeweler usually has a much higher
level of inventory (in terms of value) than a greengrocer with the same annual turnover rate.
The perishable nature of a greengrocer's inventory also contributes to this, as does the high
value of individual items in a jeweler's inventory. Another factor may be that when we buy
jewelry, we usually ask for a choice, which is not the case when we buy potatoes.
In many businesses, inventory requirements vary according to the time of year.
Fireworks manufacturers in the UK, who experience high sales volumes in the period leading
up to November 5, may find it necessary to hold large amounts of inventory each summer as
they stock up for the upcoming period of high demand.
Regardless of the nature of the trade, all businesses must seek to balance the costs and
risks of holding inventory with the risks of not holding or having low inventory levels. While
the costs of holding inventory tend to be fairly certain, if difficult to quantify, the costs arising
from failing to hold sufficient inventory may or may not occur: in other words, there is risk.
So the cost is an expected value, where the cost is combined with the probability of
occurrence.
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Cost and risk of holding inventory:
Some of the costs and risks of holding inventory are:
Financing costs:
There are financial costs tied to inventory. For example, for Associated British Foods
plc in 2015, the cost of holding inventory was IDR 207 Billion, an amount equivalent to 22
percent of the operating profit of the business in that year. In other words, had the business
been able to trade without the need to hold inventory, shareholders would have been richer, by
at least IDR 207 Billion. (See above for an explanation of how ABF's working capital
financing costs were derived.) Inventory financing costs are not the only costs, as we will
soon see. Other costs can be as large or larger than the financing cost. We have calculated the
financing costs because they are the only costs that can be assessed based on publicly
available information. Given the nature of ABF's business, it is not possible to to avoid
inventory at a certain level, but this is costly.
The cost of funding the inventory is partially reduced by a certain amount of free credit
that is
provided by the inventory supplier, which will only be available if the inventory is purchased.
The existence of this aspect is very important in some businesses. Food supermarkets, due to
their fast inventory turnover, usually have their entire inventory financed by their inventory
suppliers (see, for example, the position of Tesco plc as shown in Table 13.1 above).
Storage cost:
Storage costs include the rent of the space occupied by the inventory and the cost of
hiring people to maintain and manage it. For some types of inventory, the cost may include
the cost of storing them in a specific environment necessary for their preservation. This is
especially true for perishable items such as food.
Insurance costs:
Storing valuable inventory exposes businesses to the risk of fire, theft, and so on.
Companies usually insure these risks for a fee.
Easily damaged and worn out:
Certain types of inventory, such as food, can lose value due to perishability.
Inventories can also become obsolete, for example, because they become outdated or lose
their value due to changes in the design of the products whose production they are intended to
be used for. Therefore, inventory that appears to be fine, when viewed from its physical
condition, will only become scrap. Businesses that do not have inventory are obviously not
exposed to this cost risk.
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Costs and risks of insufficient inventory:
The costs and risks of having little (or no) inventory can also be substantial. The more
common ones are:
Loss of customer goodwill:
Failure to be able to supply a customer due to insufficient inventory could mean the
loss of not only a particular order, but also subsequent orders. The extent to which this is a
significant risk depends largely on the nature of the trade and the relative market power
between the supplier and the customer.
Production dislocation:
Running out of raw materials, when other production facilities (plant, machinery,
labor) are available, can be very costly. How costly it is depends on how flexible the business
is in responding to stock-outs, which in turn may depend on the nature of the inventory in
question. For example, a car manufacturer that runs out of a major body part may have no
choice but to stop production. If the company runs out of interior mirrors, it may be feasible to
add them at the end of the production cycle rather than at a scheduled stage, without having to
perform costly dislocations.
Loss of flexibility:
Businesses that have little or no inventory will inevitably lead a 'hand-to-mouth' life,
where purchasing and manufacturing must be closely linked to sales. This may get in the way
of maximizing the efficiency of the production process or buying materials in batches of
optimal economic size. This kind of existence also means that, if things don't go to plan, the
business will face the risk of costly problems. There is also the risk that even the slightest
increase in sales demand cannot be met.
Buffer stock, although costly, creates a 'margin of safety' that can reduce risk, so that
errors of any description can occur without major adverse impact. We will consider situations
where no buffer stock is available in the near future.
Reorder cost:
Any business that has little or no inventory will be forced to place small orders with
short time intervals between each order. Each order incurs costs, including physical placement
of the order (buyer's time, telephone, postage, and so on) and receipt of goods (store staff
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time, invoice and payment processing costs).
Inventory management model
Models have been developed to assist managers in their task of balancing costs. Each
of these models appears to have advantages and limitations.
One such model can be used to identify the optimal order size to be placed for the
purchase of new raw materials, taking into account specific inventory utilization levels and
other relevant factors. The model is based on the assumption that the level of each inventory
item will be as shown in Figure 13.4. This shows the inventory level falling evenly over time
until the inventory is completely depleted and replaced by quantity E. Since the inventory
level falls evenly from E to zero, the average inventory holding rate is E/2. The model
attempts to balance the inventory holding cost with the ordering cost.
If C is the cost of placing each order, A is the annual demand for (i.e., usage of) the
inventory item and H is the cost of storing one unit of the inventory item for one year, then the
annual cost of placing an order is (A/E*C) and the cost of storing inventory is (E/2*H). The
total cost associated with order placement and inventory holding is the sum of the two. (Note
that we are not interested in the purchase price of the inventory itself as this is determined by
the annual usage and price per unit and is independent of, except for the question of possible
discounts for bulk orders, the size of each order and the average inventory level.)
This amount continues to be used until the level drops to the reorder level, at which
point a new shipment will be ordered. The reorder level should be set such that there is
sufficient inventory to sustain operations until the new shipment arrives and to provide a
margin of safety. The size of the margin of safety will probably depend on the supplier's
reliability in making deliveries within the expected timeframe. It will also depend on the
predictability of inventory utilization levels during lead times. Lead time is the period
between ordering and receiving the inventory. We need to pay attention to the weaknesses of
this model, the most glaring of which are:
•
Demand for supplies may fluctuate based on the season, so the diagonals in Figure
13.4 may not all be parallel, or even straight.
•
Annual demand may (almost certainly) be impossible to predict with certainty,
although statistical probabilities may be derived from the likely level of demand.
•
This model ignores many of the costs associated with holding and failing to hold
inventory. This is especially true for some of the costs incurred due to low-quantity
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inventory, such as loss of customer goodwill, production dislocation, and loss of
flexibility.
In fact, all of these shortcomings can be accommodated by increasing the sophistication of the
model. For example, the loss of customer goodwill and the problem of production dislocation
can to some extent be overcome by revising the model to include a margin of safety that
reflects the pattern of inventory levels over time, following more closely what is depicted in
Figure 13.6 than what is shown in Figure 13.4. How The size of this margin of safety should
be determined by managerial judgment. Some estimate of the cost of holding additional
inventory, the cost of running out of inventory and the likelihood of such occurrences, should
provide some guidance in the exercise of judgment.
It should be noted that the application of the safety buffer means that the average
inventory holding level is no longer E/2 so the basic model is not completely valid; however,
the model can be easily adjusted to address this.
Let us be clear that the model we have obtained is a very simple, even simplistic,
attempt to balance both types of costs. However, as we have seen, this model can be extended
to handle most of the factors ignored by the simpler version. The model can also be used with
little adaptation for WIP and finished inventory as well as for purchased raw materials.
Some practical points on inventory management
Optimal order quantity
This should be established for each inventory item, either by using the model we derived
(above) or a more sophisticated version. These quantities should be revised periodically, but
between revisions should be considered the standard size of orders to be placed. Only in
exceptional circumstances can orders other than the standard size be placed. Inventory reorder
rate
The inventory level at which subsequent orders should be placed must also be
established and adhered to. The actual level for a particular inventory item depends largely on
the lead time (i.e., how long it takes between ordering and the inventory actually arriving at
the business premises) and the utilization rate of the inventory. One way or another, the order
must be placed early enough for the inventory to arrive just as the security level is expected to
be reached. This is depicted in Figure 13.6. To illustrate this point, let us assume that, in the
economic order quantity example (Example 13.2), the lead time is three weeks. Since the
weekly usage is about 20 units (i.e., 1,000/52), if the order is placed when the inventory level
drops to about 60 units and everything goes according to plan, then the new inventory will
arrive exactly when the depleted inventory does. . This of course does not provide a margin of
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safety, but as we have seen, such devices can be easily combined. That margin of safety is
represented by the 'buffer' - the level at which inventory does not normally drop.
Most computer packages dealing with inventory recording have the facility to
incorporate reorder levels for each inventory item so that the computer output will draw
attention to the need to place the next order.
Budgeting and planning
A large part of successful inventory management has to do with knowing what to expect in
terms of demand levels and the costs associated with inventory. In terms of cost and risk
reduction, the importance of forward planning and budgeting may not be overestimated.
Reliable inventory records:
Unless companies know what they have in inventory, managing it becomes very
difficult. In practice, it is rare to obtain sufficient information about inventory from physical
observation.
Ratio:
Ratios can be useful in managing inventory, particularly the inventory holding period
ratio (average inventory * 3 6 5 / annual inventory utilization), which shows the average
period, in days, that inventory is held. The input to calculate the ratio can be expressed in
physical units of inventory or in monetary units. Both inputs should be expressed in the same
terms; usually cost is used.
This ratio can be calculated for the entire inventory of a business (in which case the
input needs to be expressed in monetary units), for a part of the inventory (for example, the
inventory of tires for a car manufacturer), or for a specific inventory item (such as the
inventory of a specific size and quality of tires). The figures can be used as evidence that the
set policy is actually being followed.
Security and authorization
Routine systems should be established in an effort to ensure that inventory can only be
ordered (or produced) and used under the authority of sufficiently senior employees. This
involves determining which employees are authorized to place orders and ensuring that
inventory is stored in an enclosed area, only to be released on the authority of certain other
employees. Obviously, management needs to use common sense in this regard so that
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purchasing and issuing inventory does not become a major bottleneck to business activities.
However, a system where anyone can order inventory and use it without authorization is
likely to cause chaos and losses. In short, these practical points really pertain to establishing a
routine to be implemented systematically. Inventory management should not be done
haphazardly.
13.7 TIMELY INVENTORY MANAGEMENT
Just in time philosophy:
There is a trend, which seems to have originated in the United States, but later
developed in Japan, where manufacturing companies operate a system where there is a fairly
continuous flow of raw material inventory into the factory, work in process (WIP) through the
factory and finished inventory to the customer. (WIP) through the factory and finished
inventory to customers. In such a system, large amounts of inventory (raw materials, WIP,
and finished products) would never accumulate. Finished goods will be produced as needed
for supply to customers. Inputs of internally produced components and sub-assemblies will be
produced, and passed on to the next stage of production, just when they are required for use.
Shipments of raw materials will arrive from suppliers just as they are needed in production. In
essence, the Just-in-time (JIT) means that production and purchasing are closely linked to
sales demand on a daily, even hourly basis, thus avoiding the need to keep buffer inventory to
see the business through unexpected peaks in demand.
Although at first glance JIT appears to be an inventory and production control
technique, its effective implementation requires the acceptance of a certain philosophy and
culture. An effective JIT system requires a flexible attitude on the part of both suppliers and
the internal workforce, to expand and contract output at short notice. It also requires careful
attention to the quality of output at every stage, both by suppliers and by the internal
workforce. If raw material supplies are to arrive just in time for immediate production, then
they must be quality assured and do not need to be tested or inspected before being put into
production. The same general point about quality follows every stage of production and sales.
Practicality of JIT:
A JIT system can only be built reliably if there is a very close relationship between the
user and the supplier. This requires that the user be prepared to guarantee to purchase from
only one supplier with respect to a particular inventory item and give the supplier access to the
user's production/sales plan. This allows the supplier to tailor its production to the user's needs
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in the same way that a user business department supplies components or sub-assemblies to
other internal departments. To work well, this system may require the supplier and user to be
geographically close enough to each other so that deliveries can be made frequently and, when
necessary, at short notice. Achieving low inventory levels on internally produced components,
sub-assemblies, and finished inventory usually requires short production runs. This means that
each production batch of a particular product or component is fairly small in size. To be
economical, this usually means that the setup cost of each production run is quite low. High-
tech production methods (robot- and computer-controlled manufacturing) usually have low
setup costs and great flexibility. This makes an effective JIT system more achievable than in
the past when
production technology is still more basic.
An effective JIT system also requires a workforce that is willing to increase and
decrease its working hours from one period to another. This can pose a serious problem in the
implementation of JIT systems, particularly in some western countries where regular weekly
working hours are a common feature of industrial work. Having a number of workers
available at short notice to supplement the 'core' workforce during peak production periods
can provide a solution in some cases.
Clearly, a JIT policy will tend to lower inventory levels from the user's point of view
and, therefore, save on inventory holding costs. The attention paid to quality control and
assurance is also likely to result in net financial benefits. On the other hand, there may be
additional opportunity costs arising from the fact that users cannot, at least in the short term,
justify the cost of JIT policies short, buying from different suppliers based on price. In
addition, maintaining a flexible workforce may be quite costly. However, the growing
popularity of the JIT approach implies that many companies consider the policy to have net
benefits for them.
JIT in practice:
JIT seems to be used quite widely in practice.
A few years ago, Alliance Boots (Boots the Chemist), the largest healthcare retailer in
the UK, improved inventory management in its stores. The business uses a JIT system where
there are daily inventory deliveries from one central warehouse in Nottingham to each retail
branch. Almost all inventory lines are placed directly on the sales shelves, rather than in the
branch store area. The business says that this expands the selling space in each store, saves
store staff time significantly, and lowers the level of inventory held significantly, without
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reducing the service offered to customers.
Honda Motor Europe Limited, the manufacturing arm of Japan's car business in the
UK, has a factory in Swindon in southwest England. Here it operates a well-developed JIT
system. For example, engines made by Honda in Japan arrive by truck every two minutes and
only two hours before they are used in production. This is typical of the 200 suppliers of
components and materials to the Swindon plant.
Nissan Motor Manufacturing UK Ltd, a Japanese car manufacturer in the UK, has a
plant in Sunderland in the northeast of England. Here the company used to operate a well-
developed JIT system for almost all its inventory items. However, by using only local
suppliers, it missed opportunities to exploit low-cost suppliers, particularly those from China.
Recently the company has withdrawn its total adherence to JIT, but this has led to the
company feeling that it now needs to hold buffer stocks to prevent supply disruptions arising
from transportation problems in sourcing parts from the Far East.
13.8 ACCOUNTS RECEIVABLE (TRADE DEBTORS OR ACCOUNTS
RECEIVABLE):
With the exception of retail trade, which is dominated by direct cash settlement, most
commercial sales are made on credit. When goods or services move to a customer's business,
the business becomes one of the supplier's accounts receivable until the supplier settles its
obligation by paying cash.
It seems that attitudes towards extending credit vary from trade to trade, with credit
policies having been in place for so long due to the fact that each company finds it difficult to
break the pattern that their competitors want to continue.
In determining credit policy, financial managers should seek to strike a balance
between the costs and risks of extending credit and the risks associated with denying or
restricting credit.
Costs and risks of lending:
The costs and risks of lending are:
Financing costs:
Providing credit is the same as providing an interest-free loan. As trade receivables are
usually unsecured, they tend to be quite risky loans. Thus the interest lost is at a fairly high
level.
For Associated British Foods plc in 2015, the cost of funding trade receivables was
€143 billion, an amount equivalent to about 15 percent of the business's operating profit for
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the year. In other words, if the business had been able to trade without the need to offer trade
credit, then shareholders would have benefited by at least IDR 143 billion. As with
inventories, ABF, in practice, is unlikely to avoid financing some trade receivables, but this is
costly.
Loss of purchasing power:
When there is price inflation, which occurred in the UK (and most developed
countries) for most of the 20th century and, so far, in the 21st century, including every year
since 1945, there is a transfer of value from lenders to borrowers. This is because the
borrower (the credit customer in this context) pays Rp.s at a lower value than the value
borrowed. To some extent, this point has already been covered in the previous point, but
recent experience of very high inflation rates shows that, at such times, interest rates do not
necessarily increase fully to compensate lenders for the erosion of the purchasing power of
their money. Those providing trade credit should be aware that they may lose more than just
the basic cost of finance in times of inflation.
Assess the creditworthiness of prospective customers:
Usually before extending credit to a new customer, or perhaps when increasing the
credit limit of an existing customer, to assess creditworthiness. This is usually done by
seeking references from the customer's bank and from other merchants who have extended
credit to the customer. The assessment may include examining the customer's published
financial statements, looking for clues as to liquidity and financial probity, and paying credit
rating agencies for reports on the customer.
Implementing these procedures will reduce the risk of bad debts, but they come at a
cost, although most of these costs, once incurred, are unlikely to recur. Typically, a business,
after extending credit to a particular customer, reassesses that customer based on its own
experience of the customer's payment record.
Administration and record-keeping costs:
Most companies that grant credit find it necessary to employ people to act as credit
controllers, i.e. devote themselves to the administration and collection of accounts receivable.
Extending credit usually involves an increased volume of accounting transactions.
Bad debt:
Unless the company applies a very prudent credit granting policy, it is almost
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inevitable that some trade receivables will never be paid, for example due to the financial
collapse of a customer in default. This risk can be insured, although it is usually borne by the
supplier; either way, there is a cost.
Discount:
It is very common for businesses to offer discounts to their credit customers if they
settle quickly. For example, a 2.5 percent discount may be offered if the customer pays within
30 days of receipt of the goods or services. How cost effective the policy is depends on how
long customers who pay quickly and claim the discount would be required to pay if there was
no discount. If, say, in the example above, they take 40 days on average but the discount
causes them to pay on day 30, then the effective cost of the discount is 2.5 percent per 10
days, or about 100 percent per year. (pounded). Of course, giving discounts for prompt
payment can be costly, so they should be used with caution. However, we should keep in
mind that prompt payment triggered by discounts may reduce some of the costs we have
discussed, particularly the costs associated with bad debt risk and accounts receivable
administration.
Exchange rate fee:
Any business that makes credit sales in foreign currencies will face greater risks and
costs as a result. The risks can be effectively managed, but this entails further costs. This topic
will be covered in Chapter 15.
Cost and risk of credit denial:
There are various costs and risks associated with credit denial. These are:
Loss of customer goodwill:
If its competitors are extending credit, it will be difficult for the company to refuse
credit, unless it offers special incentives (such as discounts), which may be as costly as
extending credit. If the supplier is in a monopolistic, or near-monopolistic position, it may be
able to sell as much as it wants without offering credit. However, in a competitive market,
credit may be used as a basis for competition, so it may be necessary to offer an unusual
amount of credit to attract large, repeat orders.
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Inconvenience and loss of security in collecting cash:
Administratively, supplying goods or services on credit can be very convenient. Cash
is usually not paid until the customer is satisfied that the goods are as ordered, thus avoiding
the need for refunds in connection with defective goods. Cash is collected centrally, usually
via direct bank credit. Delivery drivers do not need to collect the cash: thus delays and
potential administrative and security issues that may arise from decentralized cash collection
can be avoided. The existence of trade credit tends to allow for specialization and separation
of duties; delivery drivers deliver goods and credit controllers collect cash.
Some practical points in managing accounts receivable
Establish a credit policy:
Companies should consider whether they consider it appropriate to offer trade credit
and, if so, in what amount, to whom and under what circumstances. For example, the
institution may decide in general that trade credit is not a good idea, but still identify certain
circumstances in which they are prepared to offer it. For example, a retailer may be willing to
offer credit only for orders over IDR 100,000.
One way or another, every company has to set a policy, not just accept that credit is
inevitable.
Assessing customer creditworthiness:
Even if the company has decided in principle that extending credit is in its best
interest, it should not offer unlimited credit to potential customers who seek it. Those seeking
credit are actually asking for an unsecured loan. The supplying company should assess the
matter in light of these provisions.
The company should establish a policy for investigating creditworthiness and should
not be prepared to extend credit until it has satisfied itself that the risk of doing so to any
customer is acceptable. It is not simply a question of extending credit or not. Credit limits
must be set. This will almost certainly vary from customer to customer depending on the
supplier company's confidence in each customer's creditworthiness. Once established, each
customer's credit limit should be strictly enforced until there is a fundamental review by
senior employees.
Supplier businesses should try to implement routines that are 'ear to the ground' so that
signs that a particular credit customer is experiencing liquidity problems can be quickly
recognized and action taken. Such routines might include regular monitoring of customer
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financial statements (in annual reports). Another approach is to look out for customers who
are taking longer than usual to pay; this may indicate a weakening liquidity position.
Establish effective accounts receivable administration:
Systems should be put in place to ensure that:
•
No goods are shipped or services rendered until it is confirmed that the current order
will not put the customer over the credit limit that has been set for that customer;
•
Invoices for goods or services supplied on credit are provided to customers as soon as
possible after the sale, thereby encouraging customers to start the payment routine
sooner rather than later; and
•
Existing accounts receivable are systematically reviewed and reminders are sent to
those who pay late.
Most computer packages for handling accounts receivable can generate lists,
with the amount owed by each customer analyzed based on its payment term. This tool
(known as an 'aging summary') and similar tools can be used usefully by credit controllers in
pursuing accounts receivable.
Establish a policy on bad debts:
At some stage, chasing reluctant payers will usually become more expensive compared
to the value of their debt. Businesses must decide on a policy for writing off bad debts. Once
established, the policy should be followed except in unusual circumstances.
Bad debt write-offs should be made only if all the steps identified in the policy have
been followed. It is also important that bad debt write-offs can only be done with the
permission of a senior employee.
Consider offering discounts for fast payments:
A discount for prompt payment (or cash discount) is a reduction allowed on trade
receivables that are paid within a certain period of time, such as one month from the
transaction in question.
The costs and benefits of providing discounts should be assessed. If the business sets a
specific policy that allows discounts, care should be taken to ensure that customers are
allowed to deduct discounts only if they have actually paid within the specified timeframe.
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Consider factoring trade receivables:
It is possible to enter into an agreement with an accounts receivable factor (many are
subsidiaries of commercial banks). Here the factor collects the debt amount on behalf of the
supplier's business. The exact arrangements can vary widely but, typically, payment (at a
discounted rate) is made by the factor, immediately after the sale. The factor then collects the
money and manages all the accounting and administrative matters associated with it. This
relieves the supplier of the administrative and financial burden of providing trade credit, but
there is a cost. 'Invoice discounting' is a very similar arrangement.
Ratio:
This can be useful in the management of accounts receivable. Perhaps the most widely
used is the accounts receivable settlement period ratio (average accounts receivable * 3 6 5
/annual credit sales revenue) which shows the average time taken between sales being made
and cash being received. This gives an overall picture of what is actually happening with the
accounts receivable, which can be compared to the business settlement policy to provide a
control device. If the settlement period is found to exceed the period specified in the policy,
steps can be taken to try and improve the situation.
In conclusion, the management of accounts receivable must be thought out in advance
and carried out systematically. Events, whether accidental or intentional, Deviations from the
established credit policy should be considered exceptional.
13.9 CASH (INCLUDING OVERDRAFTS AND SHORT-TERM DEPOSITS):
If we look back at Figure 13.1, we see that sooner or later, money is involved in
everything a typical business does. Some businesses may not have inventory (perhaps because
they sell services rather than goods), others may not have accounts receivable or accounts
payable (because they don't give or receive credit), but all of them have cash. It's true, some
businesses have negative cash balances (overdrafts), but a business that has no cash balance at
any given time will be rare.
Cash tends to be held back for three reasons:
•
to meet planned needs to pay suppliers and labor;
•
as funds to meet unexpected obligations: for example, short-term lenders requesting
earlier-than-expected payments; and
•
to take advantage of unforeseen opportunities: for example, placing a larger than planned
inventory order to take advantage of a temporary price advantage.
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As we saw in our discussion in Figure 13.1, cash is more than just one element of working
capital. As a medium of exchange and store of value, it provides a link between all financial
aspects of the business. More specifically, it links short-term and long-term funding decisions
to each other. It also links funding decisions with decisions involving investments in both
non-current assets and working capital.
Clearly, cash management is one of the key roles in any organization of any size and
description. Treasury Management, as the role is called, requires specialized skills, knowledge
and experience. This has led to a tendency for treasury managers in larger organizations to
become specialists whose career path lies solely in that functional area. Not surprisingly, in
smaller organizations the treasury manager role is likely to be filled by an accountant.
We will first look at the costs incurred from keeping and not keeping cash, before we
move on to the closely related topics of using bank overdrafts to address temporary cash
shortages and how temporary cash surpluses can be utilized.
Costs and risks of holding cash:
The costs and risks associated with holding cash are:
Financing costs:
If cash is kept in its most liquid form (notes and coins), it will earn no interest at all.
Even if it is in a current account at a bank, it will not generate very high income. It is possible
that a The company has some, perhaps most, of its cash in short-term deposits that can be
withdrawn at short notice if needed. Even if this is done, it comes at a cost, as short-term
interest rates tend to be lower than long-term rates. One way or another, cash is usually not an
asset that can be self-financed; businesses usually have to bear most of the finance costs.
For Associated British Foods plc in 2015, the cost of funding its cash balances,
assuming none of them earned interest, was £86 million, an amount equivalent to around 9
percent of the business's operating profit in the year. This means that if the business could
trade without the need to maintain a positive cash balance, then shareholders would benefit by
£86 million. As with inventories and trade receivables, in practice ABF requires access to
cash, but such facilities are costly. (See above (page 361) for an explanation of how ABF's
working capital financing costs were obtained.)
Loss of purchasing power:
As with trade receivables, in times of inflation the value of money erodes. This is not
necessarily offset by interest rates, although it is possible to earn some interest on cash.
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Exchange rate fee:
Businesses that hold cash in foreign currencies will incur costs if those currencies
weaken against the domestic currency. This will be discussed at length in Chapter 15.
Costs and risks of holding little or no cash
The costs and risks of having little or no cash are:
Loss of employee and supplier goodwill
Failure to meet financial obligations on time, due to lack of cash, can mean further loss
of supply from aggrieved parties. This can be very costly, especially if the particular
commodity is one that is critical to the continuity of operations, such as labor. Failure to meet
financial obligations to lenders puts those lenders in a position where they may take steps to
trigger liquidation of the defaulting business. Given the costs of bankruptcy and inefficient
real asset markets, the possibility of such an occurrence should be of great concern to
shareholders who wish to increase or at least preserve their wealth. A shortage of cash can put
a business at risk of liquidation.
Missed opportunities
A shortage of cash tends to mean that it is impossible to react quickly to an
opportunity. For example, if a company is offered a contract that must be fulfilled at short
notice through overtime work, it may have to decline if cash is not available to meet the
additional labor costs. Therefore, a shortage of cash exposes the business to the risk of
incurring opportunity costs. Inability to claim discounts
Discounts for prompt payment are usually very favorable, in percentage terms, to the
purchasing business. Lack of cash may preclude claiming such discounts. Loan fees
Lack of cash will put the business at risk of having to borrow in the short term to be
able to meet unexpected obligations. Interest costs for the loan. This can be costly, especially
if the funds have to be raised at very short notice and under pressure. As always, optimally
balancing these two types of costs and risks is the finance (treasury) manager's goal. There are
several models that can help in this task.
Cash management model
Several cash management models have been developed. The simplest model is
basically the same as the economic inventory order quantity model we obtained above (on
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page 367-8). This cash model assumes that the business keeps all its cash in an interest-
earning deposit account from which the business can make withdrawals as needed.
Bank overdraft:
A bank overdraft is a facility allowed by commercial banks that allows customers to
have a negative balance on their current account. A bank overdraft is therefore a form of loan
on which the bank will charge interest, usually at 1 or 2 percent above the relevant base
lending rate. Banks usually also charge a fixed fee for the establishment of the facility.
Once the facility is established, the customer can continue to run the bank account as
normal, except it can now have a negative balance up to a set limit. This tends to be a cheap
form of financing, as the customer only has to pay for the funds that have been used while
they are still in use. In fact, overdrafts are essentially short-term loans of fluctuating amounts,
with fluctuating interest rates.
As discussed above, businesses seem to use overdrafts primarily to address temporary
cash shortages that may be caused by seasonal fluctuations. For example, a retail business
whose main trading period is during the summer vacation season will tend to stock up in late
spring. This will put a temporary strain on its financial resources, which will gradually ease as
the summer progresses. The only alternative to overdraft financing may be long-term sources.
If the business borrows through a term loan, it will be saddled with interest payments
throughout the year on funds that are only needed for a month or two. Of course, this could
put the remaining cash on deposit for the next 10 or 11 months, but the nature of the financing
market tends to mean that the interest received will not match the interest paid on the funds.
Bank overdrafts have a major drawback compared to long-term loans: they are usually
repayable when needed (i.e., immediately) as a condition of granting the facility. When an
overdraft is used, as in our example, to address a temporary shortage of cash, this may not be
a problem as 'immediate', in practice, may mean within the previous few months. However,
for businesses looking to use a bank overdraft as a more permanent source of finance, this can
be a serious issue.
Despite this problem, many businesses are partially financed through overdrafts,
permanently. The overdraft remains, but is not repaid. For businesses like these, overdrafts are
a relatively cheap but risky source of funding.
Short-term cash surplus:
If a company experiences a cash surplus, which is usually characterized by an
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accumulation of cash in its checking account, it is necessary to determine whether the cash is
a permanent surplus or a temporary surplus. If it is permanent, then it is necessary to
considered using it in a 'long-term' way. This should involve further investment, if a positive
NPV project can be found, or repayment of some long-term financing, if none can be found.
If the cash surplus appears to be temporary, for example due to the trading season of a
business, then steps need to be taken to utilize it in the most effective way. Possible options
are as follows:
•
Put cash on deposit that earns interest. Generally, higher returns are obtained from
deposits that require a withdrawal notice period, perhaps 30 days. Therefore, care should
be taken in assessing how long the reserve funds will be available and how likely they are
to be needed unexpectedly.
•
Buying marketable investments. These should be easy to liquidate, so those listed on a
stock exchange or similar liquid and efficient market are likely to be the most appropriate
choice. Equities may be seen as too risky a prospect in this context; their prices can easily
fall. It may be possible to use financial derivatives, such as put options (see Chapter 9) to
cover this risk, but at a cost. Some loan notes, perhaps government loan notes (gilts) may
be suitable. These tend to have less risk, although shareholders are exposed to interest rate
risk (see Chapter 8). Again, financial derivatives can be used to hedge against this risk.
Transaction costs are likely to be associated with buying and selling both types of securities,
which tends to mean that such investments are not suitable when small amounts and/or short
investment horizons are involved.
As with the treatment of permanent cash surplus, the decision in this regard should be
based on which action will result in the greatest increase in shareholder wealth.
Some Practical Points in Cash and Overdraft
Management Set a policy:
Companies should, with the help of models and other means, establish a policy
regarding cash. This policy should be adhered to, except in the most unusual circumstances,
until the policy is formally reviewed.
Notes for the solution:
1. This statement reflects the timing and amount of cash payments and receipts and the
resulting balances. It is not and is not intended to be a profit and loss statement (profit and
loss account). The profit or loss for the months is almost certainly different from the cash
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surplus or deficit.
2. Knowledge of the projected cumulative cash balance allows plans to be made to utilize the
surplus; even if the most effective prospect is to put it on short-term deposit, it is better
than nothing.
Utilize overdraft accounts and bank deposits wisely:
Bank overdrafts should be avoided where possible, by scheduling payments and
receipts with a view to staying within credit. Temporary cash surpluses should be held or
invested in securities. When cash surpluses look more permanent, it is worth thinking about
whether they will be used in real investments or paid back to suppliers of long-term funds,
thus saving the cost of providing those funds.
Bank often:
The company should encourage credit customers to pay by direct bank credit, thus
limiting the minimum time before such receipts reach the bank. Any checks received should
be paid to the bank immediately. Businesses with large receipts of notes and coins (for
example, retailers) should consider banking several times each day, even if only for security
reasons.
Time transactions to get the best cash flow effect:
There are some matters, particularly with regard to the payment of taxes, where with a
little forethought, the payment can be postponed or its receipt can be accelerated.
For example, corporation tax is based on the reporting period of individual businesses
and the timing of capital allowances depends on the date of acquisition of non-current assets.
If a new factory is purchased at the end of the reporting period, the tax relief will first
materialize in the form of cash flow a year earlier than if the acquisition is postponed for a
short period to the beginning of the new accounting year.
13.10 ACCOUNTS PAYABLE (BUSINESS CREDITORS):
Accounts payable represents money owed for goods and services purchased on credit
by a business. This is the other side of the coin from accounts receivable; one company's
accounts receivable is another company's accounts payable. Around the world it is true that
the total of all accounts receivable equals the total of all accounts payable.
Table 13.1 shows that trade credit was a significant source of funding for the five
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highlighted businesses. The table also shows how the use of trade credit differs from business
to business. Trade credit is therefore an important source of 'free' funding and should be taken
seriously.
That trade credit is truly free is doubtful, as suppliers will incorporate the cost of
extending credit into their pricing policies. However, unless suppliers are willing to
discriminate in pricing between those who settle their invoices promptly and those who do
not, there will be no clear cost differential in taking credit. There may be less obvious costs so,
as always, a balance must be sought between these costs and the costs of not taking trade
credit.
Costs and risks of taking out credit:
The costs and risks of taking out credit are:
Price:
Some suppliers may offer cheaper prices for settlement immediately - which is essentially a
discount for immediate payment. Cash and carry wholesalers in the grocery trade are examples of
businesses that are prepared to offer lower prices because they do not offer credit (or delivery).
Small retailers have the option of dealing with wholesalers who offer credit (and delivery) but
usually also charge higher prices.
Possible loss of supplier goodwill:
If credit is overextended, suppliers may discriminate against delinquent customers if
supplies are reduced. As with the impact of loss of goodwill, this depends largely on the
relative market power of the parties involved.
Administration and accounting
Taking credit almost inevitably incurs administrative and accounting costs that would
not be incurred otherwise.
Restrictions
Many suppliers insist that, in order to get credit, orders must be sized and/or regular.
Exchange rate fee:
Businesses that buy on credit with settlement in a foreign currency will face risks and
potential costs. Typically, buyers expect to be invoiced in their home currency, which means
that customers do not face this issue, but there are exceptions to this. This will be discussed at
length in Chapter 15.
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Costs and risks of not taking credit:
The costs and risks of not taking credit are:
Financing costs:
Trade credit is essentially an interest-free loan, so failure to exploit it will incur
funding costs. It may be worth incurring some of the costs of taking out credit, particularly
when funding costs are high. With Associated British Foods plc, the financing cost savings in
2015 from utilizing free trade credit offered by suppliers was IDR 272 billion, an amount
equivalent to about 29 percent of the business's operating profit in that year. If the company
had not taken advantage of this, shareholders would have been 272 Billion poorer. For an
explanation of how ABF's working capital financing costs were obtained).
Inflation:
In inflationary periods, borrowers are favored over lenders as interest rates do not seem to
fully correct the equilibrium.
Inconvenience:
It may be inconvenient, for reasons discussed in the context of trade receivables, to
pay upon delivery of goods or performance of services. It may also be inconvenient for the
supplier. Indeed, the insistence on paying delivery costs may even be a cause of loss of
supplier goodwill. If the supplier's system is geared towards deferred payment, customers who
insist on immediate settlement may not be welcome.
Some practical points in managing business debt Set
a policy:
After considering both types of costs, a policy should be established and followed. It is
possible that suppliers are treated differently based on:
•
discounts offered for fast payments;
•
attitude towards credit taken by each supplier; and/or
•
the weight of any impact that may arise from the supplier's loss of good faith.
Utilize trade credit to the extent reasonable:
For a typical business, it is unlikely that the cost of claiming credit outweighs the benefits
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of doing so.
Ratio
The most useful ratio in monitoring trade payables is the trade payables settlement
period ratio (average trade payables * 3 6 5 / annual credit purchases). This gives an idea of
how long on average it takes the company to pay its suppliers, which can be compared with
the planned period.
13.11 LEVEL OF WORKING CAPITAL IN PRACTICE
In general, businesses are not managing their working capital as efficiently as they
could, according to a survey conducted by Ernst and Young (2015a). For example, comparing
the working practices of various top-performing businesses shows that the 1,000 largest
businesses in Europe and 1,000 businesses in the US spent a total of about IDR 0.9 trillion on,
but did not need, working capital. This amount represents about 7 percent of total sales
revenue
2,000 such businesses. In other words, on average, for every Rp. 1 of revenue, every business
has the capacity to save 7 pence in its working capital investment. This shows the excess
funds tied up in working capital for businesses in general. Table 13.2 shows the average size
of working capital for European and American businesses in the survey.
The table shows that companies in the US are more efficient in working capital
management than companies in Europe. The OCC is 1.3 days shorter and the inventory
turnover period is 3.3 days shorter. Both of these are important. The accounts payable period
is much shorter in the US, but European companies compensate by having a longer accounts
payable period. It seems that businesses in Europe have a slower creditor repayment culture
compared to businesses in the US. These figures, which refer to 2014, generally show
improvement in recent years.
