1 EUE43E: ‘Trade & Commerce’ Understanding Working Capital & Cash Flow Robert J. Williams

This Lecture... Following this session you should understand: l What Working Capital is? l Factors that affect the requirements for Working Capital? l How to evaluate the requirement for Working Capital? l How evaluate a Cash Flow statement? l How to manage Working Capital? l How to prepare for Decisions 2 2

Team Questions? l What is the main cause of new businesses failing? l What do we mean by Capital? l What do we mean by Working Capital? l What do we mean by Fixed Capital? l What do we mean by Liquidity? l What is Liquidation and why are businesses liquidated? 3

4 Working capital… l The working capital cycle: buy raw materials pay labour pay overheads store finished goods store raw materials pay supervisors sell finished goods on credit debtors pay pay creditors

5 Working capital… The working capital cycle: l What can be done to reduce working capital required? delay start of the cycle bring forward completion of the cycle reduce scale of the cycle

6 Working capital Working capital can be estimated: 1. from the balance sheet: current assets - current liabilities eg stocks (raw materials, work-in-progress, finished goods) + debtors + cash less (minus) overdraft + creditors

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8 Adequacy of working capital? Adequacy can be estimated by: Looking at Balance Sheet Liquidity Ratios (%) (crude, at one point in time) 1. current ratio - Current assets > than 2 or 200% Current liabilities Current liabilities 2. acid test ratio - cash + debtors > than 1 or 100% Current liabilities Current liabilities

9 l What is the Current Ratio? 322,578 x 100% = 578% 55,861 l What is the ‘Acid Test’ 256,736 x 100% = 460% 55,861

10 Working capital Working capital over a production (accounting) period can be estimated: l by drawing up a cash flow budget l for the whole business the maximum anticipated overdraft is shown by the monthly cash flow forecast – 12 months forward – further forward for investment projects

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12 Working capital shortage? Scenario 1 - new business Scenario 2 - declining market Scenario 3 - overtrading/developing too fast

The Life-Cycle Model The Market Development Dilemma?

14 Working capital shortage l Generating working capital – There are only 4 options....? l increase liabilities l reduce assets l increase cash flow from trading l inject more equity capital

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16 Working capital shortage Best preventative measure: l Sound budgetary control using rolling annual cash flow forecasts.... l monitoring actual against budget and using variance analysis to understand major discrepancies... l If failure is predictable but unavoidable at least you may be able to withdraw from business in an organised way with some capital and good name intact

17 Cash Flow Budgeting & Variance Analysis

18 Can you answer this question : Why do women live longer than men?

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20 Three Main Financial Statements – Historic? l Cash Flow & Flow of Funds l Trading & Profit / Loss Account incorporating a Manufacturing Account l Balance Sheet/Statement of Assets & Liabilities l Why do we need them and what do they tell us?

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22 Cash Flow l measures money flows into & out of the business bank account over the accounting period and shows how the bank balance changes as a result l solvency/ feasibility l Cash Flow during accounting period: Cash Receipts - Cash Payments = Net Cash Flow Opening Bank Balance + Net Cash Flow = Closing Bank Balance

23 Net Cash Flow l Cash Receipts = £284,274 minus l Cash Payments = £283,118 = Net Cash Flow = £1,156 l Opening Bank Balance = (£44,418) (-) Plus l Net Cash Flow = £1,156 = Closing Bank Balance = (£43,262) (-)

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25 Minus Cost of Sales £193,552

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27 Minus Cost of Sales £193,552

28 Trading & Profit / Loss Account l Wealth/value creation (profit)/consumption (Loss) by the business over the accounting period l effectiveness of management l efficiency of use of resources especially capital l Revenue – matched Expenditure = Profit (Loss) Note: not Receipts & Payments (cash terminology)

29 Trading & Profit / Loss Account l Revenue – matched Expenditure = Profit (Loss) l Revenue = money received/owed to the business/increase in value of business stocks; for goods produced/sold during the period minus l Matched Expenditure incurred/owed / resources consumed during the period to achieve the Revenue Thus profit involves subjective judgement because not always based on money measurement. l Accounting Conventions to guide – see textbook

30 The BIG picture The Business Health Check To determine business viability evaluate the extent to which the Net Profit + Depreciation (added back) meets the needs for: 1.Private drawings (non-corporate) 2.Taxation commitments 3.Repayment of loans when due 4.Normalised business re-investment 5.Expansion to remain competitive or Surplus funds to invest in or outside the business

31 The BIG picture The Business Health Check 1.Strong Business – meets all 5 criteria. Looking for business development / investment opportunities. 2.Secure Business – meets first 3 criteria. Viable in short term. Needs to develop scope to invest in modest growth to survive in the long term. 3.Insecure Business – just falls short of meeting first 3 criteria. Not quite viable but looking for business turn around strategies

32 The BIG picture The Business Health Check 4. Serious Business Problem – falls well short meeting first 3 and debt is likely to increase. serious action required but possibly time to turn business around. A realistic appraisal and severe restructuring/asset sales are likely to be necessary to remedy the situation 5.Acute Business Problem – a very major shortfall in & weak balance sheet. Needs realistic appraisal of turn- around prospects & immediate & drastic action to avoid bankruptcy Likely that the business needs intensive care or winding up

33 What you need to do… Team Leader - responsibility for administration for your team: l Review budgeting spreadsheet and use as template for calculating decisions? l Put Results 1 onto Bosscat Business Management Simulation Trend Analysis Data Sheet Blank l post e-decision sheets on time - as attachments to (see timetable) l Ensure that you use new team number & give names of all team members

What you need to do… l Period 2 decisions by & Period 3 by l In ‘subject’ put new team number, team name and decision number (D2) l Results will be ed back to Team Leader l keep your own e-file of all Decisions (D) & Results (R) for your team l Put all Results onto Bosscat Business Management Simulation Trend Analysis Data Sheet Blank and try to understand what they tell you about your business? 34

35 Bosscat e-Decision Sheet – Periods 2+

36 EUE43E: ‘Trade & Commerce’ The End Robert Williams