OVERVIEW
Objective
¾
To appreciate the importance of working capital and therefore its effective management.WORKING CAPITAL MANAGEMENT
ASSESSING THE LIQUIDITY
POSITION
¾ What is “working capital”?
¾ Investment in working capital
¾ Financing working capital
¾ Ratios
¾ Cash operating cycle
¾ Calculating the cash operating cycle
¾ Overtrading
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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.
¾
Net working capital is made up ofAccounts receivable + Inventory + Cash – Accounts payable
¾
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.¾
Working capital management is concerned with the liquidity position of the company, so the main aim is to generate cash as quickly as possible.¾
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.
¾
Two questions must be considered: How much to invest in working capital? How to finance it?
1.2
Investment in working capital
¾
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
¾
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.¾
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
¾
Equity – new share issues – retained profits¾
Debt – debentures– long-term bank loans
1.3.2
Short-term
¾
Overdraft – expensive as it is flexible – risky as repayable on demand1304
2
ASSESSING THE LIQUIDITY POSITION
¾
Liquidity is a company’s ability to meet its financial obligations as they fall due.¾
A secure liquidity position is desirable. The firm’s liquidity position can be assessed in two ways.2.1
Ratios
2.1.1
Liquidity ratios
Current ratio =
2.1.2
Efficiency ratios
Inventory turnover =
stock
¾
shows how quickly inventory is soldAccounts receivable’ turnover =
receivable
Accounts payable’ turnover =
payable
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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
2.2
Cash operating cycle
¾
The length of time between a firm paying out cash for raw materials and/or inputs and receiving cash for goods sold¾
The number of days between paying suppliers and receiving cash from customers.¾
Can also be referred to as the working capital cycle or the cash conversion cycleCASH
CUSTOMER
SUPPLIERS
RAW MATERIALS
WORK-IN-PROGRESS FINISHED GOODS
Cash collection
Sales
Production
Production Purchases Cash payment
THE CASH OPERATING CYCLE
¾
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;
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2.3
Calculating the cash operating cycle
days
Annualstock ofwork in progress Average
¾
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:
Solution
Cost of sales =
WORKINGS Days
__
___ Number of days between payment and receipt
___
2.4
Overtrading
¾
Overtrading occurs when a company tries to support a large volume of trade from a small working capital base.¾
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.¾
The result can be a liquidity crisis.This can often happen at the start of a new business, since
¾
there is no reputation to attract customers, so a long credit period is likely to be extended in order to break into the market;¾
if the business has found a “niche market”, rapid sales expansion may occur;1308
2.4.1
Indicators of overtrading
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Decline in liquidity;¾
Rapid increase in turnover;¾
Increase in inventory days;¾
Increase in accounts receivable days;¾
Increase in short-term borrowing and a decline in cash holdings;¾
Large and rising overdraft¾
Reduction in profit margin;¾
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:
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reducing the inventory-holding period for both finished goods and raw materials ;¾
reducing the production period – not easy to do but it might be worth investigatingdifferent machinery or working methods;
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reducing the credit period extended to accounts receivable, and tightening up on cash collection;¾
increasing the period of credit taken from suppliers;¾
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;Key points
³
The key issues are (i) what level of current assets should a business hold and (ii) how should current assets be financed?³
There are not always unique answers to these questions; it is a matter of opinion. Therefore you need (i) an appreciation of theadvantages/disadvantages of holding cash, inventory and receivables (ii) the relative advantages of using short vs. long-term finance
³
Good knowledge of ratio analysis is essential in many exam questions on working capital management e.g. estimating the length of the operating cycle.³
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:
¾
explain the nature and scope of working capital management;¾
calculate appropriate ratios to analyse the liquidity and working capital management of a business;¾
calculate the length of the operating cycle of a business;1310
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
