Financial Management II – DFA 4102

UNIT 1 PRINCIPLES OF WORKING CAPITAL

MANAGEMENT

Unit Structure

1.0 Overview
1.1 Learning Objectives
1.2 Working Capital and Working Capital Management
1.3 Operating and Cash Cycle
1.3.1 Calculation of Cash Cycle
1.4 Working Capital Ratios
1.5 Overtrading
1.5.1 Symptoms of Overtrading
1.6 Estimating Working Capital Needs
1.6.1 Example-Estimating Working Capital Needs
1.7 Summary
1.8 Activities

1.0 OVERVIEW

The management of working capital is of prime importance to the financial manager. Sufficient
liquid funds must be made available for the business to operate properly. An understanding of
the cash cycle and forecasting working capital needs are essential. These aspects are covered
thoroughly in this unit.

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1.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to do the following:

1. Calculate working capital.

2. Understand the importance of working capital management.
3. Calculate operating and cash cycles.
4. Calculate and interpret working capital ratios.
5. Discuss the reasons for overtrading.
6. Recognise the symptoms of overtrading.
7. Calculate working capital requirements.

1.2 WORKING CAPITAL AND WORKING CAPITAL MANAGEMENT

Net working capital is the difference between a firm’s current assets and current liabilities.
Current assets are assets which can be converted into cash within an accounting period. They
include: cash, short term securities, debtors (accounts receivable) and inventory (stock). Current
liabilities are claims of outsiders which fall due within an accounting period. Current liabilities
comprise trade creditors (accounts payable), short term borrowings and tax due.

Every business needs adequate liquid funds for its day-to-day operation like purchase of stock,
payment of wages and salaries and other business expenses, and financing of credit sales.
Ensuring that the business has sufficient liquid resources is a matter of working capital
management. This involves achieving a balance between maximising return on assets and
minimising the risk of insolvency.

An excessively conservative approach to working capital management will lead to excessive

stocks, debtors and cash coupled with low creditors. This is known as ‘overcapitalisation’; such
a situation will lead to lower return on investment and the use of long term funds for short term
assets.

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On the other hand, insufficient working capital will result in cash flow problems highlighted by
inability to pay suppliers when they fall due and failing to take advantage of early discounts
offered by them and overdraft exceeding its maximum limit.

Every firm has a minimum level of working capital which is fixed. All firms at all times usually
maintain a minimum level of stock, debtors and cash. This portion of working capital must be
financed by permanent sources such as equity share capital, loan notes, preference share capital
or retained earnings. Firms must therefore make a judicious use of long term and short term
sources when financing current assets.

1.3 OPERATING AND CASH CYCLE

As mentioned earlier, all firms require a minimum investment in working capital. Current assets
do not convert into cash immediately, there is always an operating cycle involved in the
conversion of sales into cash. The operating cycle is the time period between the acquisition of
inventory and the collection of cash from receivables. For a typical manufacturing business, the
operating cycle might consist of the following activities:

1. Buying raw materials

2. Paying cash
3. Manufacturing the product
4. Selling the product
5. Collecting cash

These activities create patterns of cash inflows and outflows, which are most of the time neither
synchronised nor certain. They are not synchronised because, for example, the payment of cash
for raw materials does not happen at the same time as the receipt of cash from selling the
product. They are uncertain because future sales and costs are difficult to forecast accurately.

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The operating cycle has two distinct components:

1. The time taken to acquire and sell inventory which is called the inventory period. The
inventory period includes the raw materials, conversion period, the work-in-progress
conversion period and finished goods conversion period.

2. The second part is the time taken to collect outstanding amounts from debtors. This is
known as the accounts receivable period.

Operating cash cycle = Inventory period + Accounts receivable period

In practice, a firm may acquire raw materials or goods on credit and temporarily postpone
payment of certain expenses. The time between receipt and payment for inventory is called the
‘accounts payable period’. The cash cycle is the number of days that pass until we collect the
cash from a sale, measured from when we actually pay for inventory.

Cash cycle = Inventory period + Accounts receivable period – Accounts payable period

The cash cycle also represents the time interval over which additional funds, called working
capital should be obtained in order to carry out the firm’s operations. The firm has to negotiate
working capital from sources such as commercial banks. The negotiated sources of working
capital financing are called non-spontaneous sources. If the cash cycle of a firm increases, it
means further need for negotiated working capital (Pandey, 2005:581).

1.3.1 Calculation of cash cycle

Preston Ltd has provided the following information based upon the year to 31 December 2009.

Credit sales Rs 1,400,000

Credit purchases Rs 650,000
Average stock Rs 90,000
Average debtors Rs 200,000
Average creditors Rs 54,000

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Calculate the length of Preston Ltd working capital cycle.

The average length of time that goods remain in stock can be calculated as follows:

Average stock *365 days = 90,000*365 = 51 days

   
Credit purchases 650,000

The average time taken to pay suppliers may be calculated as follows:

Average creditors *365 days = 54,000*365 = 31 days

   
Credit purchases 650,000

Whilst the average time taken for cash to be collected from a credit sale is calculated as:

Average debtors *365days = 200,000*365 = 52 days

   
Credit sales 1,400,000

The working capital cycle for Preston Ltd can be summarised as follows:

Stock received today is held for 51 days

Less:  
Credit period offered by suppliers 31 days
 
20 days
Add:  
Credit period offered to customers 52 days
Length of working capital cycle
72 days

1.4 WORKING CAPITAL RATIOS

Current Ratio = Current Assets/ Current Liabilities

The current ratio indicates the availability of current assets in rupees terms for every rupee of
current liability. In practice, a ratio in excess of one is expected for the firm to operate smoothly.

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However, this ratio is a measure of ‘quantity’ and not ‘quality’. Further analysis into the quality
of current assets is needed when investigating the current ratio. There is no universal rule of
thumb like 2:1for the current ratio, it varies from industry to industry.

Quick Ratio = Current Assets-Closing Inventory/ Current Liabilities

The quick or acid test ratio shows the relationship between liquid assets and current liabilities.
Inventories are considered to be less liquid as they usually require some more time to convert
into cash compared to other current assets. Logically a high quick ratio should be preferred than
a low one. We should however be cautious when interpreting the quick ratio as all debtors might
not be liquid while cash might be needed to pay operating expenses.

Debtors Collection Period = Trade Debtors /Credit Sales X 365

The debtors’ collection period is a rough measure of the average time period the business
collects money from debtors. The actual debtors’ collection period is compared with the stated
credit period allowed to debtors to judge the efficiency of the firm’s collection from debtors. An
excessively long collection period implies that the firm’s collection performance is too liberal.

Stock turnover period = Average inventory/ Cost of sales

This ratio shows the number of days stock is kept before being sold. A lengthening of the stock
turnover period indicates a slowdown in the firm’s trading activities or building up excessive
stock levels.

1.5 OVERTRADING

Overtrading happens when a firm tries to do too much too quickly with too little long term
capital. An increase in turnover is desirable for a business but this should be part of a planned
strategy by having an increase in permanent working capital financed by long term sources.
Overtrading is common in growing companies which overextend themselves by increasing sales
with insufficient working capital. Increasing turnover results in higher debtors and stocks which
have to be funded. Overtrading also occurs when a business repays a loan and has insufficient

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cash to fund its operating activities. An increase in trade credit will be helpful in the short term
to fill the gap caused by the repayment of the loan, but trade credit alone is not likely to be
sufficient to sustain growth in the long term.

1.5.1 Symptoms of Overtrading

Possible symptoms of overtrading are:

(a) There is a rapid increase in turnover.

(b) There is rapid increase in the volume of current assets and possibly non-current assets,
stock turnover and debtors turnover might slow down, in which case the rate of increase
in stock and debtors will be greater than the rate of increase in sales.
(c) There is only a small increase in proprietors’ capital. The major part of the increase in
assets is financed by credit, especially:
(i) The payment period to trade creditors is likely to lengthen;
(ii) A bank overdraft which often reaches or exceeds the limit set by the bank.
(d) Some debt ratios and liquidity ratios alter dramatically.
(i) The proportion of total assets financed by proprietors’ capital falls, and the
proportion financed by credit increases.
(ii) The current and quick ratio fall.
(iii) The business might have a liquid deficit, that is, an excess of current liabilities
over current assets.
(BPP, 2004:376)

1.6 ESTIMATING WORKING CAPITAL NEEDS

The operating cycle is quite useful in estimating working capital requirements. However, we
have other methods which can be used to determine working capital needs in practice. For
example, ratio of sales whereby working capital requirement is calculated as a ratio of sales
assuming that current assets change with sales. The ratio of fixed investment can also be used to

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calculate working capital needs. For the purpose of this unit we shall focus on the operating
cycle method for calculating working capital needs.

1.6.1 Exercise- Estimating working capital needs

The following data relate to PR Ltd, a manufacturing company.

Turnover for the year Rs2,000,000

Cost as a percentage of sales %

Direct materials 30
Direct labour 25
Variable overheads 10
Fixed overheads 15
Selling and distribution 5

On average:
(a) Debtors take 3 months before payment
(b) Raw materials are in stock for three months
(c) Work-in-progress represents three months’ worth of half produced goods
(d) Finished goods represents one month’s production
(e) Credit is taken as follows:
(i) Direct materials 2 months
(ii) Direct labour 2 weeks
(iii) Variable overheads 1 month
(iv) Fixed overheads 1 month
(v) Selling and distribution 0.5 month

Work-in-progress and finished goods are valued at material, labour and variable expenses cost.

Compute the working capital requirement of PR Ltd, assuming the labour force is paid for 50
working weeks a year.
Solution
Annual costs incurred will be as follows:
Rs
Direct materials 30% of Rs2,000,000 600,000
Direct labour 25% of Rs2,000,000 500,000
Variable overheads 10% of Rs2,000,000 200,000
Fixed overheads 15% of Rs2,000,000 300,000
Selling and distribution 5% of Rs2,000,000 100,000

The average value of current assets will be as follows:

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Raw materials 3/12 X 600,000 150,000

Work-in-progress
Materials(50% complete) 50% X 3/12 X 600,000 75,000
Direct labour (50% complete) 50% X 3/12 X 500,000 62,500
Variable overheads (50% complete) 50% X 3/12 X 200,000 25,000

Debtors 3/12 X 2,000,000 500,000

Finished goods
Direct materials 1/12 X 600,000 50,000
Direct labour 1/12 X 500,000 41,667
Variable overheads 1/12 X 200,000 16,667
920,834
Average value of current liabilities
Direct materials 2/12 X 600,000 100,000
Direct labour 2/50 X 500,000 20,000
Variable overheads 1/12 X 200,000 16,667
Fixed overheads 1/12 X 300,000 25,000
Selling and distribution 0.5/12 X 100,000 4,167
165,834

Working capital required (920,834-165,834) 755,000

1.7 SUMMARY

 Working capital is the difference between a firm’s current assets and current liabilities.
 Working capital management involves achieving a balance between maximising return
on assets and minimising the risk of insolvency.
 The cash cycle is the number of days that pass until we collect the cash from a sale,
measured from when we actually pay for inventory.
Cash cycle = Inventory period + Accounts receivable period – Accounts payable period
 Working capital ratios can help the financial manager to control the liquidity position of
the business.
 Overtrading occurs when a firm tries to do too much too quickly with too little long term
capital.

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1.8 ACTIVITIES

1. Northcote Ltd has provided the following information based upon the year to 31
December 2009.

Credit sales Rs2,800,000

Credit purchases Rs1,200,000
Average stock Rs150,000
Average debtors Rs400,000
Average creditors Rs105,000

(a) Calculate the length of Northcote Ltd. cash cycle.

(b) List the steps Northcote Ltd can take to reduce the length of the cash cycle.
(c) Calculate the reduction in working capital assuming that debtors collection period
and stock turnover period are reduced by five days each.

2. The following data relate to Pride Ltd, a manufacturing company.

Turnover for the year Rs3,000,000

Cost as a percentage of sales %

Direct materials 25
Direct labour 25
Variable overheads 15
Fixed overheads 10
Selling and distribution 5

On average:
(a) Debtors take 2.5 months before payment
(b) Raw materials are in stock for two months
(c) Work-in-progress represents two months’ worth of half produced goods
(d) Finished goods represents one month’s production
(e) Credit is taken as follows:
(i) Direct materials 1.5 months
(ii) Direct labour 1weeks
(iii) Variable overheads 1 month
(iv) Fixed overheads 1 month
(v) Selling and distribution 0.5 month

Work-in-progress and finished goods are valued at material, labour and variable expenses cost.

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Required: Compute the working capital requirement of Pride Ltd. assuming the labour force is
paid for 50 working weeks a year.

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