LONDON SCHOOL OF BUSINESS AND FINANCE

Accounting and Finance

Working capital appraisal
Saphie Alim, A4032674
01/09/2011

Accounting and Finance Content

2011

Introduction............................................................................................................................................. 2 1. 2. 3. Importance of working capital ........................................................................................................ 2 Determining the level of working capital to be maintained ........................................................... 3 Example of Premier Food Plc........................................................................................................... 5

Conclusion ............................................................................................................................................... 7 Annexe 1 .................................................................................................................................................. 8

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Accounting and Finance Introduction

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Working capital measures how much in liquid asset a company has to run its day-to-day operations. The rationale behind this is to appraise both the net investment in short-term assets of a company and its efficiency. Working capital ratio (efficiency ratios) is commonly defined as the difference between current assets and current liabilities. Current assets include inventories, trade receivables and cash while current liabilities is composed of trade payables and bank overdrafts. However, the composition of working capital depends on the nature and size of the business. For instance, manufacturing companies will significantly invest in finished goods, work in progress and raw materials selling their goods on credit and increasing subsequently trade receivables. Retail companies, on the other hand, will typically sell their goods for cash holding a single form of inventories. Many service businesses like airline companies (EasyJet, Ryanair) operate without inventories. Working capital can be positive or negative depending on how much debt the company is holding. If the companys assets are more than its liabilities, then working capital is positive. That means that the company is able to pay off its short-term loans, it has the potential for growth and can improve operations (Atrill and McLaney, 2011). This is good for stakeholders (investors and suppliers) as it is a key indicator of the companys underlying operational efficiency, whether it worth investing in or not. But if current liabilities exceed current assets, then working capital is negative and it is not good for investors. This may be due to a insufficient funds (cash) resulted in mismanagement of credit or a decrease in sales volumes. A lack of capital resources might hamper companys expansion and development leading it to bankruptcy. Therefore, it is vital for companies to manage their working capital properly as it is a key driver of growth and success. Demonstrating the importance of working capital management and determination is the purpose of this essay. An example of a company (Premier Food Plc) will be further taken to illustrate our argumentation.

1. Importance of working capital

In todays business world, managing working capital is crucial as working capital help the firm measure financial health of its business: the liquidity, asset utilisation and capital structure of a company. An inefficiency of working capital could lead to business failure affecting dramatically financial health of the firm. Mismanagement of working capital can also result in liquidation of a business unit and technical insolvency. This is likely to create excessive or insufficient working capital that includes negative consequences for the firm. First of all, it may become harder for the company to undertake large-scale projects due to insufficient funds or a lack of liquidity. This may hamper growth and attractive credit opportunities in the firm. Implementation of operating plans as well as day-to-day commitments may also be compromised and subsequently the business profit goals may not be met (Atrill and McLaney, 2011). A lack of working funds may also result in inefficiency and misuse of fixed assets reducing the rate of return on investments in the process. Finally, the businesss reputation and credibility may be dramatically affected as it will no longer be
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able to honour its short-term obligations. As a result, the business will be likely to face tight credit terms.

2. Determining the level of working capital to be maintained

Establishing working capital policy enables companies to determine the magnitude of working capital needed to maintain the existing level of activity. This amount fo working capital depends not only on the business itself but also on the macroenvironement (economic, monetary and the whole market environment). There are three different working capital policies: Matching working capital policy

This policy matches assets and liabilities to maturities. The risk is medium here. The company may or may not keep the cash on hands. Aggressive working capital policy

This policy is based on risk and return: the higher the risk, the higher the return. The business aims to take high risk where short-term liquidity are used in the fully extent to finance current and fixed assets (eventually). This policy involves a very low amount of current assets in the company. The focus here is on collecting payments on time and paying creditors as late as possible. Conservative working capital policy

In this case, the business is more concerned about having enough cash on hands. Conservative working capital policy is said to be the lowest risk working capital policy. It anticipates uncertainty and thereby ensures safety for the firm.

The level of working capital is determined according to the following factors that are essential for controlling working capital policy.

Size and nature of the business The size of the firm may affect its level of working capital required. Size can be measured in terms of the scale of operations. The higher the scale of operations, the more important is the need in working capital. In contrast, a small business will need less working capital as its scale of operation is likely to be less high. Drury (2008) also supports this point when he argues that a firm with larger scale of operations will need more working capital than a small
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firm. Additionally, internal issues in a business may have an impact on deciding the amount of working capital needed. The type of the company may also have a significant impact on the level of working capital needed. For instance, working capital is usually higher in manufacturing, financial and trading companies unlike service businesses. A prime example of this is M&S Metalcraft that requires a huge investment in working capital and a low investment in fixed assets. In contrast, public utilities do not need a large investment in working capital but a huge investment in fixed assets. Their need in working capital is not important as they have cash sales only and they supply services, not goods. Hence, the liquidity resources tied up with debtors or in stock are extremely low (Drury, 20088). Manufacturing cycle Manufacturing cycle starts with the placement of orders (raw materials) and is completed with the manufactured goods. The longer the manufacturing cycle, the higher is the need for working capital as an extended manufacturing cycle involves a higher tie-up of funds in inventories. Such delays may dramatically affect the inventory of work-in-process and finished goods increasing the need of working capital. It is widely believed that companies with long manufacturing cycles lower their investment in inventories (and subsequently in working capital) by seeking advance or periodic payments from consumers. Seasonality, production policy and business fluctuation Seasonal and cyclical fluctuations in demand for a product may have a significant impact on the need of working capital, particularly short-term working capital of the company. An upward trend in a high-pressure economy may also increase sales and thereby enhance the investment in inventories and receivables. In contrast, an economic downturn is likely to result in a large decrease in sales and subsequently a depletion of inventories and book debts. Furthermore, seasonal fluctuations may have a negative influence on production. Rise in production level may be twice as expensive as usual during inflationary pressure and peak seasons. Therefore, higher level of working capital will be required during peak seasons (Christmas, Easter). A policy of steady production permanently could be implemented to help the business exploit its resources to the fullest extent. This may include accumulation of stocks in offseason and their rapid and continuous depletion during peak periods. Therefore, seasonal working capital need should be anticipated. It is to be appraised very earlier through financial adjustments in order to ensure the successful implementation of the policy and thereby the good financial health of the firm. Atrill and McLaney (2011) also supports this point when they assert that those financial arrangements should be adequate and flexible enough to face any seasonal fluctuations. A policy of steady production may mean higher inventory costs and the higher the costs, the higher the risk. Thus, the company may implement the policy of diversifying its production schedule according to demand fluctuations as suggested by Drury (2008). Finally, most companies tend to manufacture their key products during peak seasons and others during off-seasons. This means that production policies of each company may vary from each other depending on circumstances. Accordingly, the working capital requirement will also change.
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Accounting and Finance

Other factors

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The need in working capital may also be affected by turnover of circulating capital (physical capital and operating expenses). If the operating cycle completes its round raw materials and turn account receivables steadily into cash, the magnitude of working capital needed may be much lower. Credit terms granted by creditors can also affect the need in working capital of a company. Each company has its own credit terms policy. Long-term credits generally increase the working capital requirement while short-term credits limit the level of working capital needed (Drury, 2008). Furthermore, operating efficiency refers to optimisation of resources utilized. An efficient control of operating costs may help the firm minimise its working capital requirement. Another point worth mentioning here is price fluctuations. Increasing prices usually involves a higher investment in working capital. For instance, during inflation, companies that manage to control prices of their products upwards may not face adverse effects of working capital. The effects of rising price levels, hence, differ from one company to another: they may not have an impact on certain companies while others may dramatically be affected. Finally, a high net profit margin is a source of working capital that contributes to its improvement. The ability of a company to retain profits may have a bearing on working capital determination. If the profits are well managed in the firm, the working capital will be strengthened. The volume of sales can also have an influence: as sales increase, so does the level of working capital that is needed to sustain the business.

3. Example of Premier Foods Plc

To illustrate our essay, we will calculate the efficiency ratios of Premier Foods Plc company that will be compared with The Real Good Food Companys working capital (annexe 1). The figures will be multiplied by (*1000) and are taken from financial statements of 2010.

The collection period of Premier Foods Plc is 53.34 days which indicates the average number of days receivables turns to cash while it takes averagely 44.46 days for The Real Good Food Company Plc. This can be an explanatory factor for Premier Foods having a negative cashflow of 28.7 million while The Real Good Food Company Plc has a positive cash-flow of 3.187 million for the same period. Cash which did not generate any interest if kept at the company or in the companies current account usually constitutes a greater proportion of working capital used to refinance the business. A company that has negative cash at fear end does not indicate very good working capital policy. Hence, this is a bad performance for Premier Food Plc and this can have a dramatic impact on its investors. The sales to inventory level for the Premier Foods is 18.03 days while for The Real Good Food Company Plc is 26.96 days. This shows the rate at which inventory turns to sales for the two firms and indicates the strict credit policy of The Real Good Food Company Plc. As we
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can see through the shorter receivables days, customers may not be able to comply and this leads to a fall in sales. Sales in The Real Good Food Company Plc stands at 200.104 million Premier Foods Plc stands at 2. 438 million. Most of sales for Premier Food Plc are on a credit basis whereas those for The Real Good Food Company Plc are on a cash basis. The asset to sales ratio of Premier Food Plc is 1.44 against 0.61 for The Real Good Food Company Plc. This rate indicates the aggressive nature of a business towards its sales efforts. The Real Good Food Company Plc has a lower rate that shows more aggressive nature towards sales as against Premier Foods Plc. However, sales of Premier Foods Plc are relatively higher than those of The Real Good Food Company Plc which may correspond to its relatively strict sales policy or credit policy. The working capital for Premier Foods Plc excluding financial liabilities and short-term borrowing is 201.9 million while for The Real Good Food Company Plc is - 43 000. Premier Foods actually is a very large company, hence, positive working capital may indicate that after setting current liabilities there is no capital available for expansion. This can be an explanatory factor for the high sales of Premier Foods Plc as oppose to those of The Real Good Food Company Plc. On the other hand, expansion opportunities may be limited when working capital is zero or negative, hence, this is bad for The Real Good Food Company Plc. This negative ratio also indicates that the business is unable to manage its current affairs efficiently due to its insufficient funds. The sales to working capital ratio for Premier Food Plc is 12.1; that means that working capital generates 12.1 pounds for each pound of working capital. However, it is difficult to calculate this ratio for The Real Good Food Company Plc because of the negative working capital. Further research into the financial position and performance of the company may be able to generate this information but due to time constraints and word limitation, further explanation would be hard to come by. The 12.1 for Premier Foods Plc shows the rate of expansion created by working capital. For Premier Foods Plc, account payables generate 4.9 time sales or better still for every pound of sales 4.9 pence in account payables. This is quite lower than 10.1 for The Real Good Food Company Plc. This can go further to explain the positive working capital for Premier Foods as oppose to the negative working capital for The Real Good Food Company Plc. While it takes an average of 4.9 days to pay payables as oppose to 53.34 days to collect receivables for Premier Food Plc, it is an average of 10.1 to pay payable as oppose to 44.46 days to collect receivables. Both companies have very low working capital. This may hamper their future large-projects thereby their growth.

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Conclusion

This analysis of Premier Food Plc and The Real Good Food Company Plcs working capital indicates the extent to which volume of sales, capital, cash, inventories, receivables and account payables have a bearing on the level of working capital required for both companies. As stated before, those factors are essential for measuring the working capital efficiency. It has been clearly seen that The Real Good Food Company Plc has a conservative working capital policy as its working capital is negative and inadequate working capital due to a poor management of receivables. This also indicates that the firm is unable to immediately convert its current assets into cash. But despite its negative working capital manages to pay its payables quicker than Premier Foods Company Plc. This company maximises its efficiency through right timed transactions. Its working capital indicates a managerial efficiency in a firm where inventory and account receivables are low. It also shows that it operates on a strictly cash and sales basis and is unable to convert account receivables and inventory into cash. Premier Foods on its part achieves a slightly better performance (higher sales and positive working capital) as oppose to its competitor. It has an aggressive working policy that may enable its business to grow as it has sufficient funds to expand its activity. Its working capital is quite good since even though it is positive, it is still low. It is to be hoped that working capital policy of both firms will be improved by a better management of credit, payables and trade receivables.

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Accounting and Finance Annexe 1 Premier Food Company

Collection period Account receivables/sales * 365 days = 356/2438*365 = 54.54 days Sales to inventory days = Annual sales/Inventory = 2438/135.2 = 18.03 Assets to sales ratio =Total assets/Net sales = 3499.5/2438 = 1.44 Working capital = Current assets Current liabilities = 901.1 699.2 (excluding financial liabilities but short-term borrowings) = 201.9 Sales to net working capital ratio = Sales/ Net working capital = 2438/201.99 = 12.1 Sales to account payables = Account payables/Sales = 2438/496.2 = 4.9

2011

Real Good Food Company

Collection period Account receivables/sales * 365 days = 24373/200.104 = 44.46 days Sales to inventory days = Annual sales/Inventory = 200.104/9545 = 20.96 Assets to sales ratio =Total assets/Net sales = 1294481/200.104 = 0.61
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Accounting and Finance

Net Working capital = Current assets Current liabilities = 37106 37149 (excluding financial liabilities but short-term borrowings) = - 43 Sales to net working capital ratio = Sales/ Net working capital = 200.104/ - 43 = 12.1 Sales to account payables = Account payables/Sales = 200.104/19891 = 10.1

2011

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Accounting and Finance

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Sources

Books Atrill, P., McLaney E., 2011, Accounting and Finance for Non-Specialists, 7th edition. Pearson Education Limited, pp. 170-455. Drury, C., 2008, Management and cost accounting. 7th editition. Italy: Pearson, pp. 50-189. Koller, T., Goedhart M. and Wassels D., 2010, Valuation: Measuring and managing the value of companies, 5th edition. U.S: John Wiley & Sons, pp. 49-96. Websites Kulkarni, A., 2010, Working capital policy. [online] (11th May 2010) Available at: http://www.buzzle.com/articles/working-capital-policy.html [Accessed 18 August 2010]. Mc Call, C., 2010, Effect of working capital on company groowth. [online] (28th September 2010) Available at : http://www.equitydealingguide.com/effect-of-working-capital-on-company-

growth.html
[Accessed 19 August 2011]. Premier Foods Plc. [online] Available at: http://www.premierfoods.co.uk/careers/the-people-behind-ourproducts/index.cfm?profile=AC186F98-1851-505D-DFE3-7FF8742C4AA4 [Accessed 18 August 2010]. The Real Good Food Plc. [online] Available at: http://www.realgoodfoodplc.com/ [Accessed 18 August 2010].

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