GBS 520 :FINANCIAL AND MANAGEMENT ACCOUNTING BRYSON MUMBA

FINANCIAL AND MANAGEMENT ACCOUNTING UNIT 10 : WORKING CAPITAL MANAGEMENT

INTRODUCTION Learning objectives Appreciation of the importance of working capital in corporate finance Identify the types of working capital policy and their effects Discuss how to finance working capital Evaluate the problem of overtrading and its consequences Consider the approaches to managing stocks, debtors and cash

INTRODUCTION Definition of terms Working Capital Management Refers to the financing, investment and control of net current assets within policy guidelines Working Capital(WC) Gross working capital = current assets Net working capital = net current assets(Current Assets – Current Liabilities)

INTRODUCTION Why working capital matters Without working capital a business cannot operate WC is usually a significant part of the assets – in some companies WC > 50% of total assets WC involves key company activities such as purchasing, production, selling Uncertainties: Material delivery uncertainties Production uncertainties Sales uncertainties There is need to manage working capital to reduce liquidity risks

Cash Operating Cycle Cash operating cycle is the length of time between the company’s cash payment for purchases, labour and other production expenses and the cash receipts from sales. In other words - Cash operating cycle is the amount of time cash is tied up in WC Cash operating cycle = stock period + customer credit period – supplier credit period Stock period(days) = 365/stock turnover Stock turnover = cost of sales / average stock Customer credit period(days)= 365/debtors turnover Debtor turnover = sales / average debtors Suppliers credit period(days) = 365/creditors turnover Creditor turnover = cost of sales / average creditors

Cash Operating Cycle Example : Calculate the cash operating cycle for the following company Company X Statement of financial position Amounts in Kwacha 2013 2014 Current Assets Stock 5,500 6,500 Debtors 3,200 4,800 Current Liabilities Creditors 3,000 4,500 Net Working Capital 5,700 6,800 Credit Purchases K30,000 Credit sales for the year K50,000 Cost of sales for the year

Working Capital Policies Working capital policies relate to policies for the proper management of working capital Policy should cover: Level of cash, stock Credit terms for customers Credit terms for suppliers Benefits: Influences the expected future returns and associated risks Enhances shareholder value Effects of ineffective WC policy: Jeopardises long term growth Increases liquidity risk and profitability Overtrading problems

Working Capital Policies Issues to consider in developing a WC policy: Level of investment in total current assets Level of investment in each type of current asset How to Finance WC Factors influencing level of WC: Industry factors Product type Whether products are manufactured or bought in Level of sales Stock and credit policies Systems for managing WC Level of liquidity risk

Working Capital Policies WC strategies: Aggressive approach Operate with lower levels of WC Increases profitability Low cost of WC High risk Relaxed approach Operate with high levels of stock, extended credit terms and high cash and marketable securities that can be turned quickly into cash Low risk May attract more customers High cost of tying up WC

Working Capital Costs Managing working capital involves trade off between: Risk and required return on assets Carrying costs of WC and Shortage Costs

Working Capital Costs Carrying costs These are costs that increase with level of WC investment Such as: Opportunity costs of holding WC Storage costs for stock Handling costs for stock

Working Capital Costs Shortage costs These are costs that fall with level of WC investment Such as: Ordering costs – order regularly and in small amounts Lost business Reputation Costs of running out of stock Cost of running out of cash Going concern Disruption of production Time and cost of alternative sources of finance

Working Capital Relaxed Strategy – carrying costs v shortage costs trade-off Total cost of WC Carrying costs Shortage costs Optimal level of WC Investment in WC

Working Aggressive Strategy Capital – carrying costs v shortage costs trade-off Total cost of WC Carrying costs Shortage costs Optimal level of WC Investment in WC

Aggressive v Relaxed WC Policy More suited to companies with high carrying costs relative to shortage costs Relaxed More suited to low carrying costs relative to shortage costs

Financing Working Capital Types of finance for WC: Short term finance Long term finance Approaches to funding WC: Matching approach Long term finance used to finance: Fixed assets Permanent current assets Short term finance used to finance Fluctuating current assets Maturity of long term finance matches type of asset

Financing Working Capital Aggressive approach Long term finance used to finance: Fixed assets Part of Permanent current assets Short term finance used to finance Fluctuating current assets Part of permanent current assets More risky

Financing Working Capital Relaxed approach: Long term finance used to fund: Fixed assets Permanent current assets Fluctuating current assets Safer More expensive

Financing WC – Matching Strategy K Short-term borrowing Fluctuating current assets Capital Permanent current assets Long term borrowing + equity capital Fixed assets Time

Financing WC – Aggressive Strategy K Short-term borrowing Fluctuating current assets Capital Permanent current assets Long term borrowing + equity capital Fixed assets Time

Financing WC – Matching Strategy K Fluctuating current assets Capital Permanent current assets Long term borrowing + equity capital Fixed assets Time

Overtrading problems Overtrading is defined as carrying on a business with an inappropriate capital/financing structure Causes of overtrading: Initial under-capitalisation Inadequate initial share capital at company formation Over-expansion Expansion and financing needs exceed invested capital Poor utilisation of WC resources: Failure to achieve planned profit and cash flow levels Cost over-runs Higher dividend payments

Over-trading Consequences Remedies Liquidity crisis Decline in competitiveness Decline in profitability Remedies Reduce level of business activity Increase capital base Maintain tight control over WC

Inventory management Aim to reduce stock days to an optimal level Balance stock holding costs with shortage costs Costs of holding stock: Storing costs Insurance Pilferage Stock obsolescence Stock deterioration Stock management Models: Economic Order Quantity Model Just-In-Time model

Inventory management Stock management Models: Economic Order Quantity Model Economic Order Quantity(EOQ) = 2AC H Where A = annual usage of the stock in quantities C = cost of placing an order H = cost of holding a unit of stock for one year

Inventory management Stock management Models: EOQ Example A company uses 5,000 units of stock in a year. The costs of holding one stock is K10 per annum and the cost of placing an order is K90. What is the most economical order quantity for each order? Answer A = 5,000 C = K90 H = K10 EOQ = square root[ (2 x 5000 x 90)/10] = 300 units Each order will be for 300 units.

Inventory management Stock management Models: EOQ model Limitations Demand may be seasonal Constant usage rate for stock may be unrealistic Only certain costs are included in the model

Inventory management Stock management Models: JIT Aims at ‘ideal’ level of zero stocks but with no hold-ups due to stock shortages Materials are delivered from suppliers only just before they are needed Products are manufactured only just before they are needed by the customers Allows a company to operate with minimum level of WC

Managing trade credit Trade credit comprises: Suppliers credit Customers credit Extension of trade credit to customers: Need an effective debtor control policy Consider Credit period Credit standards Cost of cash discounts Collection policy Involves collaborative efforts between finance department and marketing department

Managing trade credit Main factors to consider: Credit period Normal terms of credit for industry Importance of trade credit as a marketing tool The individual credit ratings of customers Credit Standards; Procedures for credit assessment Prior experience with customer Analysis of payment history – Use of Credit reference bureau References Credit collection policy Clearly defined procedures Customers know the credit policies

Managing trade credit Case study Required The Director Marketing and Director Finance of Trades Ltd have been tasked by the Board of a company to develop a credit policy for the company. One key issues that they need to consider and agree upon is which department between marketing and finance should be responsible for debt collection. You have been approached by the Director Marketing to assist him decide. Required Prepare a report to the Director Marketing as to which department should be responsible for debt collection. Justify your answer.

Cash management Cash plays a pivotal role in WC management Corporate liquidity is essential for any company Cash management is usually centralised in companies Cash flow forecasting/budget is a vital tool in cash management

EXERCISES Q1  Discuss the most important factors which determine the optimum level of stockholding for a company Define overtrading and discuss its consequences What are the main elements of a company’s credit policy Cash is often considered the life-blood of a business. Discuss Q2 Sound working capital management and in particular credit management plays an important role in the financial success of a business. Required: Discuss the major elements of working capital Explain the role of the credit manager within a business Discuss the major factors a credit manager would consider when assessing the creditworthiness of a particular customer Identify and discuss the major sources of information that may be used to evaluate the creditworthiness of a company State the basis upon which any proposed changes in credit policy should be evaluated