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MANAGEMENT OF WORKING CAPITAL
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Working capital - definition
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Working capital – the amount of capital that covers current assets Net working cap
ital – current assets minus current liabilities Current assets – circulating assets
as opposed to long-term (fixed) assets; the same true with current liabilities (
circulating sources of cash) Current liabilities are appropriate source of finan
ce for current assets. Total investment in the company then is divided into inve
stment in operations and investment in fixed assets.
Operating cycle
l l l l l l l
Interrelationship of the investment in operations may be represented in the oper
ating cycle that includes: acquisition of raw materials and packaging, use of ma
terials and packaging in manufacturing process to create work in progress (semi-
finished goods), use of materials, packaging and work in progress to complete fi
nished goods, despatch of finished goods from warehouses and delivery to custome
rs, recording as sales by the company its deliveries to customers, use of cash r
esources to pay overheads, salaries, use of cash resources to pay trade creditor
s and other expenses.
Current assets
l Current assets –
part of assets that have the form of cash or that convert into cash within one y
ear (see the structure of the assets side of the balance sheet!) l Characteristi
cs of current assets: - short-term character, - rather high liquidity
Functions of current assets
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Internal function – to secure uninterrupted circulation of assets and capital Liqu
idity function – to secure solvency Reserve function – some current assets are a res
erve against different risks Security function – some assets can be collateral to
be pledged when applying for loans External function – entering economical and fin
ancial relations with business environment by means of current assets
Working capital requirements
l
l
l
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Important – to determine the entire working capital requirement (i.e. the entire r
equirement of current assets); the main purpose – to determine the optimal amount
of sources employed in current assets Current assets – do not bring any financial
benefits, therefore good management of the working capital requirement is of vit
al importance for the sustained success of any business Managing the short-term
resources – major impact on the relationship between risk and return, riskiness he
re attributed to its impact on liquidity The size and composition of working cap
ital varies between industries and businesses.
Composition of working capital
l l
Permanent working capital Temporary current assets
Groups of current assets (depending on form) l stock (production stock, work-in-
process, finished goods) l trade debtors (accounts receivable), l cash (cash, cu
rrent bank accounts, short-term securities) → working capital management consists
of management of stock, management of receivables, cash management
MANAGEMENT OF STOCK
stock management – important to the financial health of the firm – WHY? l Stock – diff
icult to manage because it crosses so many lines of responsibility – WHICH ONES? l
There are significant costs associated with holding stock as well as with holdi
ng too low level of stock – WHAT COSTS?
l Proper
Types of stock
materials) – the initial input into the production process l Work-in-process (semi
-finished goods) – items beyond the raw material stage but not yet at the complete
d product stage l Finished goods – completed goods
l Production supply (raw
Procedures and techniques of stock management
1.Determining the average stock value (the average production supply value, the
average work-in-process value, the average finished goods value) 2.Stock managem
ent models (EOQ) 3.Complex systems of stock management 4.Stock ratios
1. Determining the average stock value
l Simply
method (determining stock standards) that enables to quantify the average capita
l need to be tied in stock. The average stock value depends on: - the average da
ily consumption of each type of stock given in monetary units, - the average day
s in stock for each type of stock in days.
The average production supply value
l
The average production supply (raw materials) value
Zv=S*Dv Dv=DC/2 + P + T
Zv ... S ... Dv ... DC... P ... T ... the average production supply value in Sk
the average daily consumption of raw materials in Sk the average days in raw mat
erials the length of delivery cycle in days the safety stock the technological s
tock
The average work-in-process value
l
The average work-in-process value
ZNV = Nd * DNV DNV = VC * k
ZNV ... Nd ... DNV... VC ... k ... the average work-in-process value in Sk the a
verage daily production costs in Sk the average days in work-in-process the leng
th of production cycle in days the cost increase coefficient
The average finished goods value
l
The average finished goods value
ZHV = NHV * DHV DHV = OC/2 + E + P
ZHV ... NHV ... DHV ... OC ... E ... P ... the average finished goods value the
average daily costs of sold products the average days in the finished goods the
length of sales cycle in days despatch in days the safety supply of finished goo
ds if any
2. Stock management models (EOQ)
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Economic Order Quantity (EOQ) – minimizes the total cost of managing stock (orderi
ng and holding costs assumed as key costs) The cost of holding stock can be subs
tantial – managers try to minimise the average amount of stock held. However, redu
cing the level of stock held increases a need to increase a number of orders dur
ing the period, so ordering costs will rise. Question: How much stock should be
ordered?
EOQ - continued
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The EOQ level can be derived by differentiating the total cost equation f(Q) = N
= (No*S)/Q + (Ns*Q)/2 Qopt =
2 * No * S Ns
Then:
vopt = S/Qopt DCopt = Qopt/(S:360) Nopt = 2 * S * No * Ns
EOQ - continued
Qopt ... No ... S ... Ns ... economic order quantity the cost of placing an orde
r the annual demand for the item of stock the cost of holding one unit of stock
for one year
EOQ - continued
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EOQ – that quantity of stock items that should be ordered each time an order is pl
aced. It is the order quantity which minimizes the total cost of managing the fi
rm´s stock Limiting assumptions of basic EOQ model: demand of the product can be p
redicted with accuracy and is even over the period; no safety stock is required;
the amount can be purchased in single units that correspond exactly to the EOQ –
for ex. 158 units and not in multiples of 50 or 100; no discounts are available
for bulk purchases
3. Complex systems of stock management
l
Complex systems of stock management represent integrated management of wide area
s of activities: - stock records keeping, - predictions of stock needs, - order
calculations, - monitoring of orders, - system of control over stock values etc.
They are associated with utilizing PCs and different types of software, mainly
used in large and mediumsized enterprises (Material Requirement Planning – MRP, Op
timised Production Technology – OPT,etc).
4. Stock ratios
l Stock
turnover ratio
R = sales (or costs of goods sold)/average stock held
l Stock
operating ratio
K = average stock held/sales (or costs of goods sold)
l Average
stock days
D = average stock held/daily sales (or costs of goods sold)
MANAGEMENT OF RECEIVABLES
l l
In literature also referred to as credit management, management of debtors CF is
greatly affected by the policies established by a company with regard to: - the
choice of customers, - the way in which sales are made, - the sales invoicing s
ystem, - the speedy correction of errors and resolution of disputes, - the means
of settlement, - the monitoring of customer settlement performance, - the overd
ue accounts collection system.
Policies of trade credit
l • • • • • •
When offering to sell on credit, the business must have policies concerning: whi
ch customers should receive credit, how much credit should be offered, what leng
th of credit it is prepared to offer, whether discounts will be offered for prom
pt payment, what collection policies should be adopted, how the risk of non-paym
ent can be reduced.
Phases of decision-making in management of receivables
1. Decision on offering trade credit – initial phase of management of receivables
(who to grant credit to, how much, for how long) – establishing credit policy cont
aining general guidelines then used by various managers 2. Management and monito
ring the receivables balance – phase containing methods, procedures, steps to ensu
re that amounts owing are collected as quickly as possible
1. Decision on offering trade credit
l Establishing
credit policy and procedures (basic strategy establishing framework or guideline
s) l The credit-granting decision (whether to grant a credit – credit analysis; if
yes, character and credit terms must be determined – type, advance payments, leng
th of credit period, cash discount, credit limits)
2. Management and monitoring of the receivables
Methods, procedures and steps to achieve that amounts owing are collected as qui
ckly as possible: Publicise credit terms Issue invoices promptly Monitor outstan
ding debts Produce an ageing schedule of debtors Identify the pattern of receipt
s Answer queries quickly Deal with slow payers
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Reducing the risk of non-payment
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advance payments, the offset amounts owed against amounts due, requiring a third
-party guarantee, legal title of the goods is not passed to the customer until t
hey are paid for, insurance to cover the costs of any legal expenses incurred in
recovering debt, insurance against the risk of non-payment
MANAGEMENT OF CASH
Motives for holding cash according to economic theory: transactionary motive – to
meet day-to-day commitments precautionary motive – holding a balance of cash as fu
ture cash flows may be uncertain for any reason speculative motive – holding cash
in order to be in a position to exploit profitable opportunities as and when the
y arise
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Controlling the cash balance
l If
a business is able to borrow quickly at a favourable rate, the amount of held ca
sh can be reduced. l Several models have been proposed (Baumol model, Miller-Orr
model) l It is useful to prepare a projected CF statement identifying periods w
hen cash surpluses and deficits are expected

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