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Working capital comprises a number of different items and its management is difficult
since these are often linked. Hence altering one item may impact adversely upon other
areas of the business. For example, a reduction in the level of stock will see a fall in
storage costs and reduce the danger of goods becoming obsolete. It will also reduce
the level of resources that an organisation has tied up in stock. However, such an
action may damage an organisation’s relationship with its customers as they are forced
to wait for new stock to be delivered, or worse still may result in lost sales as
customers go elsewhere.
Extending the credit period might attract new customers and lead Extending the credit
period might attract new customers and lead to an increase in turnover. However, in
order to finance this new credit facility an organisation might require a bank
overdraft. This might result in the profit arising from additional sales actually being
less than the cost of the overdraft.
Management must ensure that a business has sufficient working capital. Too little will
result in cash flow problems highlighted by an organisation exceeding its agreed
overdraft limit, failing to pay suppliers on time, and being unable to claim discounts
for prompt payment. In the long run, a business with insufficient working capital will
be unable to meet its current obligations and will be forced to cease trading even if it
remains profitable on paper.
On the other hand, if an organisation ties up too much of its resources in working
capital it will earn a lower than expected rate of return on capital employed. Again
this is not a desirable situation.
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OBJECTIVES OF WORKING CAPITAL MANAGEMENT
Working capital management aims at finding out the optimum:
Working capital investment.
Working capital financing combination.
Many companies finance the working capital with the combination of short-term and
long-term so as to reap the advantages inherent in both financing vehicles and to
minimise the disadvantages associated with them.
Short-term financing has the advantage of being cheap and matching the current
assets with current liabilities. However the risk associated with short-term financing
tend to outweigh the advantage of cheap cost. Below are the renowned risks
associated with short-term financing:
1) Renewal Problem
Short-term finance may need to be continually negotiated as various
facilities expire (e.g. bank overdraft, bank loan, creditors period etc)
Sometimes it may be difficult to renew the short-term finance due to
bad economic conditions or worsening company’s financial situation.
2) Negotiation cost
Because every time the credit facilities expire they need to be renewed,
management time spent on negotiation is enormous. Management time is
costly if translated in monetary terms.
3) Interest rate stability: As the Company is continuously renewing its funding
arrangements, it is likely that it will be facing fluctuation in short-term interest.
Example below will be used to discuss total working capital management concepts:
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Lecture example1
The balance sheets of Bryan Ltd at 30 April 20X0 and 30 April 20X1 are given
below:
20X0 20X1
£'000 £'000
Assets
Tangible
Cost or valuation 51,000 63,000
Accumulated depreciation (12,500) (16,300)
38,500 46,700
Current assets
Stock 16,400 18,400
Trade debtors 19,100 20,600
Sundry debtors and prepayments 3,100 4,000
38,600 43,000
Less current liabilities
Trade creditors (11,400) (18,400)
Accruals (3,400) (4,200)
Bank overdraft (13,700) (4,800)
Net currect assets 28,500 27,400
10,100 25,600
Total assets less current liabilities 48,600 72,300
Less: 7% Debebtures (£20m issued 1 May 20X0) (20,000) (40,000)
28,600 32,300
The summarised profit and loss accounts of Bryan for the year ended 30 April 20X0 and
20X1 are:
20X0 20X1
£'000 £'000
Sales 58,000 66,000
Cost of Sales (43,000) (49,000)
Gross Profit 15,000 17,000
Operating expenses (10,000) (10,500)
Profit from operations 5,000 6,500
Interest payable (1,400) (2,800)
Net profit fot the year 3,600 3,700
Dividend (450) (300)
3,150 3,400
Additional information
1. The opening stock for the year ended 20X0 was £ 14,000.
2. Purchases amounted to £45,400 and £51,000 for 20X0 and 20X1 respectively.
Required:
a. Calculate the necessary working capital ratios from the data above.
b. Comment briefly on the movements of these ratios between the two years.
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The levels of current assets required to be maintained by the company depend much
on the size of the respective company. Therefore, there is no one level that is
considered to be suitable to all companies. A use of ratio analysis helps to identify the
levels at which a company maintains its current assets. Below is a discussion on
common working capital ratios, illustrated by the use of the above example.
1. Current Ratio
Is a ratio between current assets and current liabilities. It indicates the ability of
the Company to pay its short-term financial obligations out of its current assets.
It is calculated as:
Current ratio = Current assets
Current liabilities
For Bryan:
20X0 20X1
Current ratio 36,800 1.35:1 43,000 1.57:1
28,500 27,400
2. Quick Ratio
Gives the same indication as the current ratio. But this ratio excludes stock, as
stocks often can not be converted into cash in a short notice.
It is calculated as:
Quick ratio = Current assets – stocks
Current liabilities
For Brian
20X0 20X1
Quick ratio 38,600 - 16,400 0.78:1 43,000 - 18,400 0.9:1
28,500 27,400
An ideal quick ratio is at least 1. Depending on the industry, a quick ratio from
0.8 is considered acceptable.
- The current and quick ratios have improved significantly. The major
noticeable changes with working capital are the overdraft, which is assumed to
have been reduced by the debenture loan, and trade creditors.
It is calculated as:
Stock holding period = Average stock x 365 days
Cost of sales
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For Bryan:
20X0 20X1
Stock holding period 1/2 (14,000 + 16,400) x365 Days 1/2 (16,400 + 18,400) x365 Days
43,000 129 49,000 130
The days the company holds stock has not changed to signify any concern.
This ratio should be kept at minimum in order to boost the company’s cash
flow. Therefore, the lower the better.
It is calculated as:
Debtors’ collection days = Closing debtors x 365 days
Credit sales
For Bryan:
20X0 20X1
Debtors' collection period 19,100 x 365 Days 20,600 x 365 Days
58,000 120 66,000 114
Average collection days have improved from 20X0 to 20X1. However, it seems
the company’s credit policy is very loose.
NB: Only trade debtors have been considered in our calculations. A question
might ask for total debtors’ collection days. This will include the sundry
debtors.
It is calculated as:
Creditor’s payment period = Closing creditors x 365
Credit purchases
For Bryan:
20X0 20X1
Creditors' payment period 11,400 x 365 Days 18,400 x 365 Days
45,400 92 51,000 132
The creditors’ payment days show a significant improvement over the two
years.
CASH OPERATING CYCLE
Cash operating cycle, also known as working capital cycle is the length of time
between a business paying for its raw materials and receiving cash from its customers.
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The efficiency of the cash operating cycle depends on how faster a firm can push
working capital items around the cycle.
The length of the operating cycle needs to be maintained at a lower level to minimize
the investment in working capital, but without affecting the liquidity.
If the company is involved with manufacturing as well, the cash operating cycle will
be lengthened by the periods of raw materials holding and work in progress holding.
Cash operating cycle has improve over the two years. However, the information is not
sufficient to allow us to comment whether this cycle is good or bad. The operating
cycle could be compared with other companies in the industry or with an overall
industrial expected operating cycle.
On the other hand, keeping too much of working capital results into tying up the
organisation’s cash. This cash could have been used in other profit generating
projects. A Company maintaining excessive working capital than its operational needs
is said to be over capitalized.
The symptoms of over capitalisation can be identified through poor accounting ratios
i.e. liquidity ratios being too high, or stock turnover periods being too long.
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OVER TRADING
An over trading organisation is characterized with rapid increase in turnover without
having sufficient working capital to match the capacity expansion.
Over trading organizations are often not able or not willing to raise long-term capital
and thus tend to rely heavily on short-term sources of finance such as overdraft and
trade creditors.
It follows that the solution to over trading is a change of mode of financing from
short-term to long-term finance such as loan or equity funds.
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Use of Just In Time (J.I.T) system
A well-established link in the supply chain is needed. Any slight delay in supplies
may result in loss of customers, or high costs to meet emergency demand.
i- Purchase cost:
Is the cost of acquiring materials. This cost varies with the number of units
purchased. Often a unit price is reduced when large quantities are bought.
Hence a business can strive to reduce the total purchase cost by purchasing in
large quantities.
From the above analysis of stock related costs, we find that by aiming at reducing one
type of cost we might find ourselves in danger of increasing another type of cost. It is
this conflict of cost minimisation that calls for a mechanism necessary to establish
stock levels that can minimise the overall costs, and act as control measures and
warning signs for stock replacement purposes.
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A good stock control system is the one that will manage to keep all, holding costs,
ordering costs and stock out costs, at the minimum.
Is the quantity of stock ordered each time, which minimises the annual costs of stock
ordering and stock holding.
Figure 1
The way in which this EOQ is calculated is based on certain assumptions, including:
o constant purchase price
o constant demand and constant lead-time
o holding-cost dependent on average stock
o order costs independent of order quantity.
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Figure 2
The Formula
Using the standard ACCA notation in which:
CH = cost of holding a unit of stock for a year
CO = cost of placing an order
D = annual demand
also:
TOC = total annual re-ordering cost
THC = total annual holding cost
x = order quantity
then:
average stock = x/2
THC = x/2 × CH
and:
number of orders in a year = D/x
TOC = D/x × CO
The total annual cost (affected by order quantity) is:
C = THC + TOC = x/2 × CH + D/x × CO
This formula is not supplied in exams – it needs to be understood (and remembered).
The value of x, order quantity, that minimises this total cost is the EOQ, given by an
easily remembered formula:
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b) Consistent units – ensure that figures inserted have consistent units. Annual
demand and cost of holding a unit for a year. Both holding costs and re-
ordering costs should be in £, or both in pence.
Bulk Discounts
A common twist to exam questions is to ask students to evaluate whether bulk
discounts are worth taking. While prices reduce, total annual holding costs will
increase if more stock is ordered at a time, so the matter needs a little thought. The
common approach is one of trial and error. This involves finding the total annual cost
(holding cost, re-ordering cost and purchasing cost) at the level indicated by the EOQ
and at the level(s) where discount first becomes available.
Figure 3 shows total costs (now including cost of purchasing the stock) plotted against
order quantity with discount incorporated.
Figure 3
Point A represents the cost at the order quantity indicated by the EOQ. If stock is
ordered in larger quantities, total costs will increase to point B1, at which stage bulk
discounts are available, bringing the costs down to point B. Any calculations will
involve finding which cost out of A, B or C is the lowest, as Example 1 will show.
Example 1
Moore Limited uses 5,000 units of its main raw material per month. The material
costs £4 per unit to buy, supplier’s delivery costs are £25 per order and internal
ordering costs are £2 per order. Total annual holding costs are £1 per unit. The
supplier has offered a discount of 1% if 4,000 units of the material are bought at a
time.
Required:
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Example 1 solutions
Re-order levels
As important as how much to order at a time is the question of when to order more
stock. If an order is placed too late, when stocks have been allowed to run too low, a
‘stock-out’ will occur, resulting in either a loss of production or loss of sales, or
possibly both.
If orders are placed too soon, when there are still substantial supplies in stock, then
stock levels and holding costs will be unnecessarily high. The re-order level as
explained below should not be confused with the stock control levels referred to in
textbooks – this article ignores these. When it comes to calculating re-order levels,
three sets of circumstances can be envisaged.
Lead-time is zero
‘Lead-time’ is the interval between placing an order with a supplier and that order
arriving. It is unlikely that this could be reduced to zero – it would require
astonishingly co-operative and efficient suppliers. If it were possible, a re-order level
of zero could be adopted. An organisation could simply wait until it ran out of stock,
click its corporate fingers, and stock would arrive instantaneously.
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Figure 4
If the lead-time is, say, 5 days, an order has to be placed before stocks have been
exhausted. Specifically, the order should be placed when there is still sufficient stock
to last 5 days, i.e:
So, if lead-time for a particular stock item is 5 days and daily demand is 30 units, the
re-order level would be 5 days at 30 units per day, 150 units.
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1) A tabular approach – Calculate, for each possible ROL (each level of buffer
stock) the cost of holding different levels of buffer stock and the cost incurred
if the buffer is inadequate (‘stock-out’ costs). The optimal re-order level is that
level at which the total of holding and stock-out costs are a minimum.
2) A ‘service level’ approach – An organisation has to determine a suitable level
of service (an acceptably small probability that it would run out of stock), and
would need to know the nature of the probability distribution for lead-time
demand. These two would be used to find a suitable ROL.
Formulae:
Q= 2CoD
CH
Where:
Q = Economic order quantity.
Co= Cost of placing one order
D = Periodic demand.
CH= Holding cost for one unit of stock for a period.
Solution: EOQ
Q= 2CoD = (2x£32x25,000)/£6.40)
Ch
= 500 units.
The basic EOQ theorem assumes that materials are purchased at a constant cost per
unit. In real life, discounts are offered for purchasing in large quantities. If discounts
are available, there is a possibility of minimising the total costs at a minimum order
level to qualify for the discount. The total cost to be minimised include:
- Total material cost.
- Ordering cost, and
- Stock holding cost.
Steps
1. Calculate the total cost at the EOQ.
2. Calculate the total cost at different discount levels.
3. Compare and choose the level with a minimum total cost.
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Lecture Example: Bulky discounts
An item of stock costs £96 per unit with annual demand of 4,000 units and ordering
cost of £300 per order. Holding costs are 10% of purchases price. A supplier offers a
discount of 8% if orders are placed in 1,000 units.
Require:
Determine whether the discount is worth to take.
Costs analysis £
Purchase cost (4,000 x £96) 384,000
Ordering costs (£300 x (4,000/500)) 2,400
Holding costs £96 x 10% x (500/2) 2,400
Total cost 388,800
Costs analysis £
Purchase cost (4,000 x £96 x 92%) 353,280
Ordering costs (£300 x (4,000/1,000)) 1,200
Holding costs £96 x 10% x 92% x (1,000/2) 4,416
Total cost 358,896
A Company will choose to order 1,000 units because this proves to be cheaper in total
cost. As a result, a saving of £29,904 (£388800 - £ 358,896) can be made if the
discount is taken.
MANAGEMENT OF DEBTORS
Debtors’ management involves all activities necessary to ensure that cash is collected
from credit customers within reasonable time.
Extending credit period might attract new customers and lead to an increase in
turnover. However, in order to finance this new credit facility, an organisation might
require a bank overdraft. A care needs to be taken, therefore, by the management to
strike a balance between the benefits of extending credit period and the costs arising
therefrom.
Therefore, the optimum level of trade credit extended represent a balance between:
a) Profit improvement from sale obtained by allowing credit; and
b) The cost of credit allowed.
i- Financing costs.
ii- Bad debts possibility.
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CREDIT POLICY
Management of debtors requires a credit policy be established, properly implemented
and continually monitored.
Management may resort to either of the following methods to manage its debtors:
Strengthening business’s own credit control system.
Debt factoring.
Invoice discounting.
Credit insurance.
The sources of credit reference will include: trade reference from existing
suppliers, bank reference, credit agencies, the press, court records, the DTI,
customer’s financial accounts and a personal customer visit.
Setting credit limits, which should not be exceeded, except with a prior
authorisation from senior management.
Clear communication to customers on their respective credit limits and credit
period.
Offering a reasonable level of settlement discounts to encourage early payment.
Keeping accurate records detailing all transactions with customers and the
amounts owing. This is normally executed by the use of aged debtors’ list, which
lists individual debtors’ balances with their respective length of time since they
became due. This list is useful to focus management’s focus on those balances that
are overdue.
Issuing regular statements.
Collection of overdue debts. This will include all steps taken to make sure that the
balances, which have not been after the expiry of the credit period, are collected to
minimize the rate of bad debts. Actions take will include; reminder letters,
telephone calls, withholding supplies, personal approach, using debt collection
agencies and trade association and legal action.
DEBT FACTORING
Debt factoring involves turning over the responsibility for collecting the company’s
debts to a specialist institution.
Depending on the debt financing deal agreed upon, a company can get up to three
services with the debt factor. These include:
1. Financing:
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A factor normally provides a company with short-term finance based on the value
of its unpaid invoices. A factor will pay an agreed proportion of the value of new
invoices as soon as they are sent out to customers. The balance of the invoice
value, less factoring service charge, is repaid to the company when the debt is
eventually collected.
3. Credit protection
A factor might also agree to insure the debts of a company against bad debts risk.
On this arrangement, if the customer defaults payment, the factor takes the loss.
This is called ‘non-recourse’ factoring, whereby a factor can not turn to the
company for any bad debts arising. Otherwise, if no insurance against bad debt is
agreed by the factor, the arrangement is called ‘recourse’ or ‘with recourse’
whereby a company bears any bad debt arising.
Advantages of factoring
Gives the company immediate access to cash, which help the company to pay for
its stocks and pay its supplies on time and hence take advantage of cash discounts.
The company managers are relieved of the duty of keeping the sales ledger and
chasing for slow paying debtors, and instead concentrate their time on generation
of revenue.
A factor also saves the administration costs of keeping the sales ledger and the
costs of debt collection.
Growth can be financed through sales rather than injecting fresh external capital.
Bad debts are minimised to a certain level or completely eliminated. Depending
on whether a ‘recourse’ or ‘non-recourse’ factoring is in place.
The finance is secured by the debtors’ balance, hence leaving other assets such as
land and buildings for further debt finance.
Disadvantages of factoring
Danger of loss of customers due to intervention of factor.
Customers might doubt about the company’s liquidity and credibility because of
the use of factoring agencies.
Loss of control. The company looses the decision power on its own customers.
Costs. A factoring institution charge commission and finance charge on advance
which may prove to be expensive compared to other forms of shot-term financing.
Therefore, the decision to factor debts should be taken on cost benefit basis. This can
be demonstrated by the example below.
Cannors plc is a small engineering company with annual credit sales of £2m.
Recently, the company has witnessed increasing problem in its credit control
department. The average collection period for debtors has risen to 55 days, even
though the stated policy of the business is for payment within 30 days. Moreover, 1%
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of debtors are annually written off as bad debts. Connors plc has entered into
negotiations with a factor who is prepared to make an advance to the company
equivalent to 80% of trade debtors, based on the assumption that in the future,
customers will adhere to 30 day payment period. The interest rate for the advance will
be 11% per annum. Trade debtors are currently financed at 12%, through a bank
overdraft. The factor will take over the credit control procedure of the company. This
will not only lead to an annual saving of £15,000, but will also eliminate all bad debts.
The factor will, however, make a 2% charge of sales revenue for the provision of this
service.
Should Connors plc take advantage of the opportunity to factor its debts?
∴ Connors Plc will benefit from entering into an agreement to factor its debts with the
agent.
INVOICE DISCOUNTING
Involves the company raising the money from specialized institution, and using its
invoices as security.
In invoice discounting, a company does not hand over administration of its credit
management procedures to invoice discounting institution.
The arrangement is, therefore, purely for cash. The discounting organisation advances
a certain proportion of invoice value (e.g. 75%), controls receipts of cash settling
those invoices and passes on the remaining 25% back to the company.
Under this arrangement, a risk on bad debts is also not passed over to the discounting
institution in anyway.
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