Nursery Management Understanding and Managing Finance Session 8

What is Working Capital? Working Capital is usually defined as: Current Assets Less Current Liabilities The major elements are:  Stocks, Debtors, Cash (Assets)  Creditors, Tax payable, Overdraft (Liabilities)

For 2002, Current Assets Total = £574,300 For 2002, Current Assets Total = £574,300 For 2002, Current Liabilities Total = £233,360 For 2002, Current Liabilities Total = £233,360 Working Capital for 2002: £574,300 - £233,360 £340,940 Working Capital for 2002: £574,300 - £233,360 £340,940 Example

Why is Working Capital Important? Working Capital…  is money which is used to keep the organisation running on a day to day basis  represents a net investment in short term assets.  defines the Liquidity of the business (whether or not the business is solvent in the short term)  is directly related to the Cash Flow from Operating Activities.

Current Assets Total = £574,300 Current Liabilities Total = £233,360 Working Capital for 2002: £574,300 - £233,360 £340,940 Working Capital for 2002: £574,300 - £233,360 £340,940 Example Revisited Here we can see that although we have a large amount of Working Capital, it is all locked up in Stock and Debtors. The amount of actual cash (£33,500) is low in comparison; this may not be sufficient for needs.

Why do we need to Manage Working Capital?  A shortage of Working Capital may lead to operating difficulties - shortage of stock(food and art equipment), inability to offer credit to parent/guardians, slow payment to creditors, missed opportunities  An excess of Working Capital also represents money “locked up” in stocks and debtors(unpaid fess)  Working capital, therefore, needs careful management

For 2001, Current Assets Total = £175,750 For 2001, Current Assets Total = £175,750 For 2001, Current Liabilities Total = £225,900 For 2001, Current Liabilities Total = £225,900 Working Capital for 2001 is negative £175,750 - £225,900 - £50,150 Working Capital for 2001 is negative £175,750 - £225,900 - £50,150 Further Example Here we can see that the business has a deficit of Working Capital; it owes more money to creditors than it has in Stocks and Debtors. It might be Overtrading. Here we can see that the business has a deficit of Working Capital; it owes more money to creditors than it has in Stocks and Debtors. It might be Overtrading.

How exactly do we Manage Working Capital? In order to be able to Manage Working Capital effectively, we need to know:  The elements of Working Capital (stocks, debtors, creditors)  Detailed information about these elements; whether the levels are high or low, and whether we are are using them efficiently.  What actions can be taken to affect the situation. All of the above relies on an knowledge how each of these elements affects the Working Capital Cycle

Working Capital in Summary  Working Capital is the ‘lubricant’ which allows the business to run smoothly  Requirements vary between different types of industry (e.g. high in manufacturing, low in retail) and according to the fluctuations in the trading position  What about your sector of the early year’s market?  An increase in business may well require a parallel increase in working capital

Activity 1 a. Why would the requirements for a greengrocer’s working capital be very different from that of a nursery? b. What changes in the general business environment might lead a company to change the level of their Working Capital investment?

Activity 1 Solution a. Why would the requirements for a greengrocer’s working capital be very different from that of a builder?  Greengrocer: stock has very short shelf-life -often a matter of a day or two; Amount of stock is kept to the minimum possible, otherwise large wastage. In the retail trade, there are virtually no trade debtors, but may be some trade creditors. All this suggests very low levels of Working Capital: hundreds of pounds.  Nursery: Often needs to outlay lots of expense: specialist materials, hire of equipment etc. Often this is on credit. Stock here is not clear cut. Often people may pay monthly. All of this suggests that Working Capital will involve much larger sums of money – hundreds of pounds even for a small nursery.

Activity 1 Solution b. What changes in the general business environment might lead a company to change the level of their Working Capital investment? Some possibilities:  Interest Rate Change  Seasonal demand patterns  Economic climate  Changes in the Market  Competition

Key Elements of Working Capital There are three key elements to Working Capital:  Stock(absorbs working capital)  Trade Debtors(absorbs working capital)  Trade Creditors(releases working capital) Each one of these needs to be monitored effectively.

Activity 2 Discuss the following:  Why do you think it is important to keep careful track of working capital requirements?

Activity 2 solution The need to keep track of working capital requirements: Failure to do so could lead to:  Debts not being collected on time, possibly with parents etc defaulting on payments.  Suppliers refusing credit, or even refusing to supply.  Stock not being available for use with the children and other processes.  Payments to employees being delayed or impossible.  Possible Bankruptcy.

Key Elements of Working Capital: Stock  The higher the levels of stock, the more money the business has tied up in goods.  There may be very good reasons why some businesses need to carry high stock levels (Tesco, for example needs to carry a huge range of items; it will also need to have some basic items such as bread, milk and potatoes in large quantities)  Normally, holding large volumes of stock is not a good idea; if stock is held for long periods, the money is ‘dead’, and not being used effectively.  Typically, the highest profitability occurs when stock levels are at the minimum levels to supply customer needs.

Stock Control  One of the important issues here is how we can monitor and control stock levels.  There are several standard techniques for doing this.  Some require simple arithmetical calculations.  Others require a complete redesign of production processes or retail layout  We will explore some of these issues in the next session.

Key Elements of Working Capital: Trade Debtors  Carrying higher levels of Trade Debtors means that the business has a lot of money tied up, which it is not able to use to generate profit.  The businesses that owe us money, are effectively using it to invest in their business, and so create profits for them.  There may be good reasons why some businesses need to carry high levels of Trade debtors. (Builders, for example typically work on contracts for several months before getting paid.)  On the other hand parents /guardians may be delaying payment because they simply cannot pay.  In the normal ‘cut and thrust’ of trade, most businesses would typically expect payment within one calendar month.

Management of Debtors  Just as with stock, an important issue is how we can monitor and control the levels of trade debtors.  There are several standard techniques for doing this.  Organisational policies required regarding offering credit; credit terms etc.  Debt Collection Policies and their management.  Cash Discounts offered for early payment.  We will explore some of these issues next week.

Key Elements of Working Capital: Trade Creditors  Carrying high levels of Trade Creditors means that the business has access to a lot of resources (such as stock, rent, fuel etc.), but for which it has not paid.  This means that other businesses have effectively provided us (until we pay) with free resources, that we can use to create create profits for us.  Before we get carried away, there are good reasons why we should not carry high levels of Trade Credit.  In the normal ‘cut and thrust’ of trade, most businesses would typically expect payment within one calendar month; if this does not happen, we may incur penalties, and ultimately suppliers may refuse to trade with us.  You should have a strict policy on late pay and stick to it!

Key elements of working capital Remember from the last session: Average settlement period for Creditors: Creditors (days) = Trade Creditors x 365 Credit purchases This indicates how long, on average, the business takes to pay what it owes.

Average Settlement Period (Creditors) Example of Credit Settlement Period: A company’s accounts for 2003 shows that:  The amount currently owing is £43,500  The total amount of credit purchases is £198,000 Creditors (days) = x =80.19 days

Management of Creditors  Just as with stock and trade debtors, an important issue is how we can monitor and control the levels of trade creditors.  There are several issues here.  Discounts may be offered for paying early and may be more valuable than the trade credit  Paying late may have disadvantages: lower priority, higher prices, refusal to supply  We will explore some of these issues in the next session.

Activity 3 Tina’s Dressmaking Fabrics and Accessories Ltd. prides itself on stocking a wide range of fabrics in all colours, sizes and materials as well as a huge collection of trimmings, buttons, and ornamentations. It plies its business with specialist dressmakers, who buy mainly on credit, and takes its supplies directly from manufacturers, buying in bulk at a discount, on credit, but in order to qualify for the discount, payment must be made within seven days.  What level of working capital do you think Tina needs?  Do you think that this is an efficient way to run the business?

Activity 3  Tina carries very high levels of stock (probably in the hundreds of thousands of pounds); unless she has a credit policy, it is likely that there would be huge amounts of trade debtors, certainly in the tens of thousands  On the other hand, given the 7-day discount, it is likely that she will keep the amounts owed to trade creditors very low, certainly much lower than the trade debtors.  All this suggests that the Working Capital requirements would be enormous; a huge proportion of this being tied up in stock which may not actually be needed in the short term.  It might be more profitable to hold lower levels of the less popular stocks, and run the risk of running out. If suppliers require payment within 7 days, then it is likely that they offer delivery within that time; hence customer service would not be affected greatly.

The Working Capital Cycle - essential events The diagram below is an even more simplified version of the Working Capital Cycle: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit Assuming all trade is done on credit, this shows the four essential events, in the normal order in which things occur.

The Working Capital Cycle - essential events From the simplified diagram, purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit  We can see immediately:  The Debtor Period  The Creditor Period Debtor Period Creditor Period

The Working Capital Cycle - essential events There are two more important time periods: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit  The Stockholding Period (where is this?)  The Operating Cash Cycle (what is this?)

The Stockholding Period  The Stockholding period is the time from the purchase of goods to the sale of goods: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit

Controlling Working Capital through the Cash Balance  We have seen that three important elements of Working Capital are Stocks, Debtors and Creditors.  Another element is the Cash Balance at the Bank.  This is important because sooner or later, we need to get money from our Debtors, and pay our creditors.  In order to manage this process, we need to monitor our current cash flow situation, and our current bank balance.

Controlling the Cash Balance  The Cash element of Working Capital now becomes of crucial importance.  If we have too high a Bank Balance, then the money might be gaining interest, but hopefully, we would obtaining a better ROCE employing it in the business.  If we have too low a Bank Balance (or an overdraft), then we are in danger of incurring penalties in the form of overdraft interest payments

Controlling the Cash Balance There are many techniques for controlling the cash element of Working Capital: One model proposes:  A Target Balance  Inner Limits (+/-) (close to the target)  Outer Limits (+/- ) (further away)

Activity 5  Why might any business want to hold some of its assets in the form of cash?

Activity 5 Solution  Why might a business want to hold some of its assets in the form of cash?  For day-to-day trading purposes: Some of this may need to be in cash; we need to pay rent, rates, fuel bills, tax and interest.  As an ‘insurance’ against cash-flow problems: we may need a cash ‘buffer’ to ensure that we do not exceed our overdraft limit at particular times in the year.  To take advantage of opportunities that arise: there may be ‘bargains’ that we spot, or we may wish to secure short-term investments which offer high profitability.

Controlling the Cash Balance  The Cash element of Working Capital now becomes of crucial importance.  If we have too high a Bank Balance, then the money might be gaining interest, but hopefully, we would obtaining a better ROCE employing it in the business.  If we have too low a Bank Balance (or an overdraft), then we are in danger of incurring penalties in the form of overdraft interest payments

Controlling the Cash Balance There are many techniques for controlling the cash element of Working Capital: One model proposes:  A Target Balance  Inner Limits (+/-) (close to the target)  Outer Limits (+/- ) (further away)

Activity 6  When deciding what is a suitable ‘Target’ level of cash to hold, what factors would we need to take into consideration?

Activity 6  When deciding what is a suitable ‘Target’ level of cash to hold, what factors would we need to take into consideration?  The type of business : businesses such as gas/electricity suppliers have cash flows which are steady and predictable. Xmas tree producers have cash flows which are seasonal and unpredictable).  The cost of holding cash and borrowing: this includes factors such as the the current interest rate, overdraft conditions etc.  The general economic climate: Following 9/11 there was a downturn in many areas; some business responded by holding more cash, some less, depending upon the sector.