F9 Financial Management

2 Section C: Working capital management Designed to give you the knowledge and application of: C2. Management of inventories, accounts receivable, accounts payable and cash C3. Determining working capital needs and funding strategies

3  Calculate level of working capital investment in current assets & discuss key factors determining this level: i.the length of the working capital cycle and terms of trade ii.an organisation’s policy on the level of investment in current assets iii.the industry in which the organisation operates  Key factors in determining working capital funding strategies: i.distinction between permanent and fluctuating current assets ii.relative cost and risk of short-term and long-term finance iii.matching principle iv.relative costs and benefits of aggressive, conservative and matching funding policies v.management attitudes to risk, previous funding decisions and organisation size Learning Outcomes C3: Determining working capital needs and funding strategies

4 Level of working capital investment in current assets and the key factors determining this level The length of the working capital cycle and terms of trade Inventory conversion period and holding period Average collection period of receivables Average payment period of payables Raw material Work-in- progress Finished goods average time it remains in stock time taken to process the goods time it remains in stock after production is complete

5 Example A manufacturing process takes 4 weeks. 100% of material are input at the start. Labour costs and overheads are incurred uniformly over the period. At the end of the 4 week period work in progress which remains is 50% completed. The amount tied up in work in progress will include: 4 weeks equivalent of annual raw material consumption 2 weeks (4 weeks x 50%) equivalent of annual wages and overheads. Inventory conversion period and holding period  the period required to convert raw material into finished goods  amount of capital tied up in work in progress includes raw material, labour and overhead

6 Example Credit sales for Vish & Co are currently $1.25m. The credit control department is currently extending credit to customers of 30 days. As a result they anticipate average debtors to be $102,740 (30/365 x $1.25m). However, since customers are actually taking 40 days to pay, the company’s actual level of debtors is $136,986 (40/365 x 1.25m) It can be seen, therefore, that the longer the credit period, the higher the level of debtors. The collection period is 33% higher than anticipated, thus the debtors are also 33% higher. Average collection period of receivables  depends on terms and conditions of trade and the customers’ willingness and ability to comply with the terms  the longer the credit period allowed, higher the average level of debtors

7 Example of average payment period of payables Bda plc has been allowed 2 months credit from its supplier. In an attempt to shorten their cash conversion cycle Bda plc decides to pay after 3 months. When the debt is two weeks overdue the supplier sends a reminder notice which Bda plc ignores. When the debt is three weeks overdue Bda plc receives a phone call from the supplier informing them that if payment is not received within the next 24hrs interest will be charged on the amount outstanding. Bda plc quickly sends a cheque to the supplier before the trade relationship is strained. Average payment period of payables  Average payment period depends upon the credit terms agreed with the suppliers and the company’s ability to pay.  Liquidity position can be improved by requesting longer credit periods.  Trade relations should not be hampered by too much delay in payments. Refer to Test Yourself 1 (page 139)

8 Organisation’s policy on the level of investment in current assets Level of investment in working capital is affected by the following factors  The nature of the business: manufacturing organisations need more stock than service organisations.  Uncertainty in supplier deliveries: uncertainty would mean that extra stocks need to be held to cover fluctuations.  The level of activity: as output increases, debtors, inventory, cash balances etc tend to increase as well.  The organisation’s credit policy: this will determine the level of debtors.  The length of the operating cycle. Ratios indicating over-capitalisation  Sales/Working capital: if this ratio is compared to previous years or with similar companies, it indicates whether there is over capitalisation.  Liquidity ratio: current ratio greatly in excess of 2:1 may indicate overcapitalisation.  Turnover periods: excessive turnover periods for stocks and debtors, or a short period taken from suppliers may indicate over capitalisation. Over capitalisation takes place when the firm has excessive working capital for its needs.

9 Over trading the volume of activities is too large given the level of long-term capital at the company’s disposal Symptoms of over trading  rapid increase in turnover  rapid increase in the volume of current assets and sometimes fixed assets  no substantial increase in capital  significant reduction in liquidity ratios  increase in debt ratios  rapid increase in trade payables  rapid increase in bank overdraft Solutions to combat the problem of over trading  inject new capital from shareholders  ensure better management of stocks and debtors  postpone expansion plans until the business has built up a strong capital base Over Trading Industry in which the organisation operates Manufacturers Supermarkets and retailers Wholesalers Small companies

10 The key factors in determining working capital funding strategies Current assets assets which are held by the business for period of 12 months or less variations in current assets because of normal business activities certain minimum amount is tied up in individual current assets to sustain the normal level of operations Fluctuating current assets Permanent current assets Working Capital Funding

11 Distinction between fluctuating current assets, permanent current assets and non-current assets Fluctuating current asset Permanent current asset Non-current asset Relative cost and risk of short-term and long-term finance Short-term finance cheaper, more flexible, more risky e.g. trade credit, bank overdraft, credit card Long-term finance more expensive but more secure, likelihood of long-term finance being withdrawn is minimised e.g. debenture, long-term loan or lease Matching principle Matching short-term fund requirements with short-term sources and long-term fund requirements with long-term sources

12 Relative costs and benefits of matching funding policies Aggressive funding policy  rely heavily on short-term sources of finance  short-term funds used to finance fluctuating current assets as well as part of permanent current assets  enhances profitability but at the same time most risky policy Conservative funding policy  company uses long-term funds to finance non-current assets, permanent current assets and a part of fluctuating current assets  risk reduction, at the same time reduction in profitability Matching funding policy  maturity of funds matched by the maturity of assets  moderate level of risk

13 Management attitudes to risk, previous funding decisions and organisation size Previous funding decisions may restrict the freedom of management to take decisions large organisations may take higher risks Organisation’s size Factors influencing management’s view on risk Predecessor view on risk Shareholder attitude to risk General management culture Economic outlook Need to maximise returns

14 Recap  Calculate level of working capital investment in current assets & discuss key factors determining this level: i.the length of the working capital cycle and terms of trade ii.an organisation’s policy on the level of investment in current assets iii.the industry in which the organisation operates  Key factors in determining working capital funding strategies: i.distinction between permanent and fluctuating current assets ii.relative cost and risk of short-term and long-term finance iii.matching principle iv.relative costs and benefits of aggressive, conservative and matching funding policies v.management attitudes to risk, previous funding decisions and organisation size