SESSION 13 WORKING CAPITAL MANAGEMENT

1301
OVERVIEW
Objective
To appreciate the importance of working capital and therefore its effective management.








WORKING
CAPITAL
MANAGEMENT
ASSESSING THE
LIQUIDITY
POSITION
What is working capital?
Investment in working capital
Financing working capital
Ratios
Cash operating cycle
Calculating the cash operating cycle
Overtrading
Solutions to liquidity problems


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1 WORKING CAPITAL MANAGEMENT
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.


Net working capital is made up of
Accounts receivable + Inventory + Cash Accounts payable
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.
Working capital management is concerned with the liquidity position of the company,
so the main aim is to generate cash as quickly as possible.
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.
Two questions must be considered:
How much to invest in working capital?
How to finance it?
1.2 Investment in working capital
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

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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.
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:
1.3.1 Long-term
Equity new share issues
retained profits

Debt debentures
long-term bank loans
1.3.2 Short-term
Overdraft expensive as it is flexible
risky as repayable on demand

Accounts payable appears cheap but refusing quick settlement discounts can be
expensive

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2 ASSESSING THE LIQUIDITY POSITION
Liquidity is a companys ability to meet its financial obligations as they fall due.
A secure liquidity position is desirable. The firms liquidity position can be assessed in
two ways.
2.1 Ratios
2.1.1 Liquidity ratios
Current ratio =
s liabilitie Current
assets Current

Quick ratio =
s liabilitie Current
assets Quick
=
s liabilitie Current
inventory assets Current

2.1.2 Efficiency ratios
Inventory turnover =
stock Average
sold goods of Cost

shows how quickly inventory is sold
Accounts receivable turnover =
receivable accounts Average
sales Credit

shows how quickly debts are collected
Accounts payable turnover =
payable accounts Average
purchases Credit

shows how quickly accounts payable for supplies received on credit are paid.

2.1.3 Problems with ratios
(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.
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2.2 Cash operating cycle
The length of time between a firm paying out cash for raw materials and/or inputs and
receiving cash for goods sold
The number of days between paying suppliers and receiving cash from customers.
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

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.
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2.3 Calculating the cash operating cycle
days receivable Accounts
= 365
sales credit Annual
receivable accaounts Average
= x

days payable Accounts
= 365
purchases credit Annual
payable accounts Average
= (x)

days goods Finished
= 365
sales of cost Annual
goods finished of stock Average
= x
WIP holding period =
WIP of completion of
Degree sales of cost Annual
progress in work of stock Average

365 = x

days materials Raw
= 365
purchases Annual
materials raw of stock Average
= x

__

Length of cycle x

__


Commentary

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.


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Solution
Cost of sales =
WORKINGS Days



__





___

Number of days between payment and receipt

___


2.4 Overtrading
Overtrading occurs when a company tries to support a large volume of trade from a
small working capital base.
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.
The result can be a liquidity crisis.
This can often happen at the start of a new business, since
there is no reputation to attract customers, so a long credit period is likely to be
extended in order to break into the market;
if the business has found a niche market, rapid sales expansion may occur;
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.
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2.4.1 Indicators of overtrading
Decline in liquidity;
Rapid increase in turnover;
Increase in inventory days;
Increase in accounts receivable days;
Increase in short-term borrowing and a decline in cash holdings;
Large and rising overdraft
Reduction in profit margin;
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:
reducing the inventory-holding period for both finished goods and raw materials ;
reducing the production period not easy to do but it might be worth investigating
different machinery or working methods;
reducing the credit period extended to accounts receivable, and tightening up on cash
collection;
increasing the period of credit taken from suppliers;
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;
reducing the level of sales growth to a more sustainable level.
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Key points

The key issues are (i) what level of current assets should a business hold
and (ii) how should current assets be financed?
There 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
Good knowledge of ratio analysis is essential in many exam questions on
working capital management e.g. estimating the length of the operating
cycle.
There 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:

explain the nature and scope of working capital management;
calculate appropriate ratios to analyse the liquidity and working capital management of
a business;
calculate the length of the operating cycle of a business;
explain the relationship between working capital management and business solvency.
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EXAMPLE SOLUTION
Solution 1 Cash operating cycle
Cost of sales = 75% 3,600,000 = 2,700,000
WORKINGS Days
Raw materials days

60% 2,700,000
150,000

365
34
Credit taken from suppliers

60% 2,700,000
130,000

365
(29)

__
5
WIP days

80% 2,700,000
350,000

365
59
Finished goods days

2,700,000
200,000
365
27
Credit given to customers

3,600,000
306,000
365
31

___

Number of days between payment and receipt 122

___