Chapter 10 Managing working capital LEARNING OUTCOMES You should be able to: Discuss the purpose of working capital and the nature of the working capital cycle Identify the main elements of working capital Explain the factors that have to be taken into account when managing each element of the working capital Explain the importance of establishing policies for the control of working capital

The nature and purpose of working capital Major elements Major element Inventories Trade receivables Cash (in hand and at bank) Trade payables less equals Current liabilities Working capital Current assets

The working capital cycle Trade payables Trade receivables Finished goods Cash/ bank overdraft Work in progress Raw materials Cash sales Credit sales Cash Source: P. Atrill and E. McLaney, Acounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Excess working capital investment by large European businesses as a percentage of sales revenue 5 % 2005 2006 2007 2008 12.6 12.1 12.3 11.7 15 10 2009 12.7 Source: compiled from information in REL Consultancy 2010 Europe Working Capital Survey, www.relconsult.com.

Inventories financing cost Business Type of operations Cost of capital Average inventories held Cost of holding inventories Operating profit/ (loss) Cost as % of operating profit/(loss) (a) (b) (a) × (b) % £m Associated British Foods Food producer 9.5 1,152 109 625 17.4 British Airways Airline 8.9 120 11 (220) 5.0 Kingfisher Home improvement retailer 7.8 1,669 130 623 20.9 J. Sainsbury Supermarket 10.0 696 70 710 9.9 Source: Annual Reports for years ending in 2009 and 2010

Managing inventories Forecasts of future demands Financial ratios Recording and reordering systems Inventories management models Materials requirements planning (MRP) system Levels of control Just-in-time (JIT) stock management Procedures and techniques that can be used to ensure the proper management of inventories

ABC method of analysing and controlling inventories Cumulative value of inventories items (%) Volume of inventories items held (%) A B C 100 Source: P. Atrill and E. McLaney, Acounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Patterns of inventories movements over time Inventories level Time

Inventories holding and order costs Annual costs (£) Average inventories level (units) E Total costs Holding costs Ordering costs

The economic order quantity (EOQ) model where: D = the annual demand for the inventories item (expressed in units of the inventory item); C = the cost of placing an order; H = the cost of holding one unit of the inventories item for one year EOQ = 2DC H

Managing receivables Questions to ask Which customers should receive credit Questions to ask How much credit should be offered What length of credit it is prepared to offer Whether discounts will be offered for prompt payment What collection policies should be adopted How the risk of non-payment can be reduced

Which customers should receive credit? The five Cs of credit Capital Capacity Collateral Conditions Character

Collection policies Develop customer relationships Publicise credit terms Issue invoices promptly Develop customer relationships Produce an ageing schedule of receivables Answer queries quickly Monitor outstanding debts Deal with slow payers

Comparison of actual and expected (budgeted) receipts over time for Example 10.5 % Time 10 20 30 40 June July August September Actual Budgeted

Why hold cash? There are three reasons: To meet day-to-day commitments To deal with uncertain cash flows To exploit profitable opportunities

Managing cash Main techniques Preparing projected cash flow statements Controlling the cash balance (using control limits) Managing the operating cash cycle

Controlling the cash balance Inner limit Outer limit Target cash balance Cash balance (£) Time (days) 2 8 6 4 9 5 3 1 7 11 12 10 Source: P. Atrill and E. McLaney, Acounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

The operating cash cycle Purchase of goods on credit Payment for goods Sale of goods on credit Cash received from credit customer Inventories holding period Operating cash cycle Source: P. Atrill and E. McLaney, Acounting: An Introduction, 5th edn, Financial Times Prentice Hall, 2009.

Calculating the operating cash cycle equals minus plus Operating cash cycle Average payment period for payables Average settlement period for receivables Average inventories turnover period Source: P. Atrill and E. McLaney, Accounting and Finance for Non-Specialists, 7th edn, Financial Times Prentice Hall, 2010.

The average OCC of large European businesses 15 2005 2006 2007 2008 2009 Days 46.9 44.4 45.6 44.1 45 30 Source: compiled from information in REL Consultancy 2010 Europe Working Capital Survey, www.relconsult.com.