Working Capital Management-1

WORKING CAPITAL MANAGEMENT This is the difference between current assets and current liabilities. Working capital management refers to the administration of working capital so that the firm is liquid enough to meet its financial obligations. It therefore involves the administration and policy guidelines of current assets and current liabilities. Objectives of working capital management

i.
ii.

iii.

To determine the optimal mix of the various components of working capital to be employed by the firm To reduce the costs associated with working capital management To ensure that the liquidity of the firm enables it to meet its short-term maturity obligations as and when they fall due To maximize the shareholders wealth by maximizing the market value of the firm

iv. 1. 2. 3. 4. 5. 6.

Factors influencing the amount of working capital Size of the firm- The larger the firm and its operations the higher the amount of working capital Nature and type of business- Trading firms dealing with fast moving goods such as supermarkets require more working capital compared with firms in areas such as construction industry Business fluctuations- There are businesses whose goods and services experience erratic demand in the course of the year. During peak periods when demand is high, the firm will need more working capital and vice versa. Production and operating efficiency- If the firm is utilizing its assets efficiently to generate sales revenue at minimal costs, this level of efficiency will require a lower level of working capital and vice versa. Price level changes- If the firm speculates that the purchase price of inventory will increase in the near future, the firm may hold more inventory now when prices are low so as to eliminate the need to buy stock at higher prices in the future. The firms credit policy- The higher the amount of credit sales, the longer the credit period granted to customers and hence the higher the amount of debtors.

Importance of working capital management i. Time devoted to working capital management. Finance managers devote most of their time to routine decisions. Research has shown that the time spent on routine decisions on working capital management is approximately 60% of the finance managers time while only 40% is spent on strategic decision making. ii. iii. iv. v. Working capital items represent the largest proportion of the total investment of the company unlike fixed assets. Current assets are very liquid and are subject to frequent changes. Because current assets are exposed, to the risk of fraud and theft Because long-term conditions normally set by the creditors demand that a company should maintain a certain minimum level of net working capital. Because working capital items have a great significance to small companies since small companies encounter problems in raising funds from long-term sources and therefore they invest in large volumes of current assets.

Components of Working Capital The components of working capital include: Inventories Accounts receivables Cash Management of Inventories Investment in stocks represents a major asset of most companies and its essential that stocks be managed efficiently so that such investments do not become unnecessarily large. A firm should determine its optimum levels of investment in stock and to do this two conflicting requirements must be met: It must ensure that stocks are sufficient to meet the requirements of production and sales. It must avoid holding surplus stocks that are unnecessary and that increase the risk of obsolescence. Firms hold stocks for the following reasons: Transactions motive which refers to holding stocks for meeting the productions requirements. Precautionary motive which refers to holding stocks due to future uncertainty.

Working Capital Management-2

Speculative motive which refers to holding stocks due expectations in future change in prices.

Relevant costs in conditions of uncertainty The relevant costs that should be considered when determining optimal stock levels include: Holding or carrying cost. Ordering or set up cost. Shortage or stock out costs. Purchase cost. Holding costs- this consists of the following items: Opportunity cost for investment in stocks Incremental insurance costs Warehousing and storage costs Materials handling costs Costs of obsolescence and deterioration costs Stores operation and running costs Ordering/ set up costs- this comprise of the following items: Clerical costs of preparing a purchase order. Delivery costs Remuneration of purchase department personnel Clearing charges Inspection for quality costs Shortage/stock out costs- this is the cost that is associated with either a delay in meeting the demand or liability for not meeting the demand at all. These include: Back-order costs i.e. the cost of dealing with disappointed customers Loss of goodwill and loss of customers Cost of idle staff Cost of having to speed up orders and deliveries Purchase cost- this is the amount that is paid to suppliers for supplying the stock item. It is relevant for inventory policy decisions if there is a provision for quantity discounts. Total inventory cost = holding cost + ordering cost + shortage cost + purchase cost Inventory control decision models Deterministic or EOQ model Probabilistic or stochastic model Simulation model Deterministic model EOQ Model EOQ is the order size that minimizes the total ordering and holding costs. Basic assumptions of the EOQ model i. Holding cost per unit remains constant ii. Average balance in stock is equal to one-half of the order quantity iii. Demand is constant and is known with certainty iv. Lead time is constant and is known with certainty v. Replenishments of stock is in equal batches vi. Ordering costs per order is fixed irrespective of the order size vii. Purchase cost is constant. viii. There is no safety stock

EOQ = EOQ =

2DT H

Where: D- Annual demand T- Cost per order H- Holding or storage cost (usually expressed as % of purchase price per unit) Total ordering cost = no. of orders x cost per order Holding cost = average stock x stock holding cost per unit

Working Capital Management-3

Average stock = Order Quantity 2 No. of orders = Annual Demand Order Quantity Calculus determination of the EOQ model: Total Cost = Total Ordering Cost + Total Holding Cost TC = D x T + Q x H Q 2 TC = DTQ-1 + QH 2 Differentiating TC with respect to Q gives: TC = -DTQ-2 + H Q 2 Equating the above F.O.C to zero gives H DT = 0 2 Q2 Making Q the subject gives an EOQ as follows:

EOQ =

2DT H

Illustration 1: A company has an annual demand for material X of 25000 tons. The cost price per ton is ksh. 2 000 and the stock holding cost is 25% p.a of stock value. Delivery cost is ksh. 400 per order. Required: Calculate: i. The ii. The iii. The iv. The

EOQ total ordering cost total holding cost total relevant cost

Graphically the model is represented as follows:

Costs

TRC Holdin g Cost

Total ordering Cost EOQ Quantity

Quantity Discounts: Circumstances frequently occur where firms are able to obtain quantity discounts for large purchase orders. Buying in large quantities so as to take advantage of quantity discount will lead to the following cost savings:

Working Capital Management-4

A saving in the purchase price which consists of the total amount of the discount for the period i.e. the discount itself. A reduction in the total ordering cost because fewer orders are placed.

Note: The cost savings must however be balanced against the increased storage cost arising from higher stock levels when higher quantities are purchased. To determine whether or not the discount is worthwhile, the cost savings must be compared with the additional storage cost. Illustration 2: A company purchases a raw material from an outside supplier at a cost of shs 7 per unit. The total annual demand for this item is 9000 units. Holding cost for this item is shs 4 per unit and the ordering cost is shs 5 per order. A quantity discount of 3% of purchase price is available for orders in excess of 1000 units. Required: Should the company order in quantities of 1000 units and take advantage of the discount? Illustration 3: A company is revising its stock policy and has the following alternatives available for the valuation of stock: Purchase stock twice monthly 100 units Purchase stock monthly 200 units Purchase every three months 600 units Purchase every six months 1 200 units Purchase annually 2 400 units It is ascertained that the purchase price per unit is shs 0.80 for deliveries up to 500 units. A 5% discount is offered by the supplier on orders where deliveries are 501 1000 units, and 10% discount on total orders for deliveries in excess of 1000 units. Each purchase order incurs administration cost of shs 5 and storage cost of shs 0.25 per unit of average stock held. Required: Advise the management on the optimum order size. Management of Cash This involves measures taken to ensure that the firm has an optimal amount of cash balance. Too much cash is costly to the firm since there are costs associated with having too much cash such as the possibility of theft and the opportunity cost of not investing the cash in profitable investment opportunities. Too little cash, on the other hand, is expensive to the firm since the firm may not be able to meet its financial obligations as and when they fall due. Organizations hold cash for the following motives: Transaction motive This is to finance the day to day transactions, including purchases and payment of operating expenses. Precautionary motive To cushion the company in times of emergencies thus ensuring that operations run smoothly. Speculative purposes To enable the company to take advantage of temporary and short-term profitable opportunities There are two common models of cash management:

i.
ii.

Baumols cash management model Miller and Orrs cash management model

Baumols cash management model This model attempts to determine the cash flow which would minimize the total cost of holding funds by identifying the optimal amount of cash input and the total number of cash inputs (deliveries) over a period of time. This model was developed out of the EOQ model.

C=

2 FT i

Where: C = optimum cash balance to be raised by selling marketable securities

Working Capital Management-5

F = fixed transaction cost per security T = Total cash required for entire period i = interest or opportunity cost of holding cash This model operates under the following assumptions: i. That the companys periodic cash expenditure is known in advance and is constant. ii. That there are investment opportunities in which short-term funds can be invested and that it is possible to convert such investments into cash within a short period. Advantages of the model Can be useful where cash flows are certain and constant over time Disadvantages Makes simplistic assumptions (such as a periodic inflows) so can be unrealistic There may be costs associated with running out of cash (e.g. overdraft costs). The model does not work well where there are exceptionally large or small inflows or outflows of cash.

Easy to understand and use

The model assumes a constant disbursement rate The model doesnt allow for safety cash reserves It ignores cash receipts during the period.

Illustration 1 XYZ Ltd makes a payment of ksh16,000 per week. The applicable interest rate on marketable securities is 12% p.a. Every security costs ksh 30. Required: a) Determine the optimal amount of the securities to be converted into cash.

b)
c)

Determine the number of transfers required per year Determine the total cost of maintaining the cash balances per year (Assume a 50-week year)