1. WORKING-CAPITAL MANAGEMENT
CHAPTER 14
WORKING-CAPITAL MANAGEMENT

2. Chapter outline Introduction What is working capital?
Why is it important to manage working capital?
The cash conversion cycle
Managing cash
Managing inventory
Managing accounts receivable (debtors)
Managing accounts payable (creditors)
Conclusion

3. Learning outcomes By the end of this chapter, you should be able to:
Explain working capital
Calculate and interpret the cash conversion cycle
Prepare a cash budget and comment on it
Calculate measures to manage inventory
Explain what a credit policy is
Calculate the effect of a change in credit policy
Evaluate whether a discount for early payment of debt should be accepted or not.

4. Introduction Three financial management decisions
Capital budgeting
Capital structure
Working-capital management
Short-term capital management
Management of short-term assets and liabilities
All assets to be sold or liabilities paid in 12 month period
Entity needs to establish and maintain optimal level of short-term capital to result in highest possible level of profitability while reducing risk

5. What is working capital?
Short-term assets and liabilities that a business uses to conduct its day-to-day operations
Assets and liabilities are continually transformed
Management of these assets and liabilities called short-term capital management

6. Current assets and liabilities
Short-term assets (current assets):
Cash
Accounts receivable (debtors)
Inventory
Short-term liabilities (current liabilities):
Accounts payable (creditors)

7. Examples of current assets and current liabilities
Cash and cash equivalents
Creditors/accounts payable
Inventory
Short-term portion of a long-term loan
Short-term investments
Short-term loans (overdrafts)
Debtors/accounts receivable
Income received in advance
Prepaid expenses
Accrued expenses
Accrued income
Dividends payable
Notes receivable
Tax payable

8. Net working capital
Difference between total current assets and total current liabilities
Positive value shows entity has more current assets than current liabilities – company is able to pay back its current liabilities as they become due
Too low a level of working capital means entity cannot pay current liabilities
Too high a level of working capital means cash is tied up in debtors and inventory instead of being available for cash

9. Why is it important to manage working capital?
Profits and shareholder wealth maximisation is only possible if a business is able to conduct its day-to-day operations successfully
To operate on a daily basis, working capital needs to be available and ready for use
A shortage of working capital means that the level of customer service can be affected negatively e.g. inventory shortages
An oversupply of working capital can also have a negative effect e.g. spoilage

10. Why is it important to manage working capital?
Elements of working capital needed to conduct daily business
Inventory – ready for manufacturing or resale
Cash – to pay creditors and expenses
Debtors – customers can purchase on credit which is convenient for them
Creditors – entity can purchase on credit which is convenient

11. Liquidity Ability of an entity to pay its short-term liabilities
Evaluated by means of current ratio
Fine balance to be maintained to ensure:
Expenses and liabilities paid
Investment in current assets is not too high
Risks include fraud and theft

12. The elements of the cash conversion cycle
Cash conversion cycle (CCC) way to assess business’s liquidity
CCC calculated from inventory, accounts receivable (debtor) and accounts payable (creditor) figures
Result is the number of days that cash is invested in assets other than cash
Important because while cash is invested in other assets it is not available for day-to-day activities and transactions

13. Calculating the CCC Combined total of the following: Formula:
Average age of inventory
Average collection period
Average payment period
Formula:
Where:
AAI = Average age of inventory
ACP = Average collection period
APP = Average payment period
CCC = AAI+ACP-APP

14. Operating cycle and cash conversion cycle
Purchase inventory
Sell inventory
Collect debtors
20 days
30 days
Pay creditors
40 days

15. Example 14.2
RET Ltd has an inventory turnover of 5, an average collection period of 35 days and an average payment period of 60 days. You are required to calculate the cash conversion cycle (CCC) and the investment in the CCC.
Credit sales are on average R2 500 000 per year and cost of sales are 70% of sales. Assume that there is no opening or closing balances for inventory, debtors or creditors and that there are 365 days per year.
An inventory turnover of 5 means inventory is used up 5 times per financial period.

16. Example 14.2 The average age of inventory is: AAI = 365/5 = 73 days
Inventory needs to be replenished every 73 days
Possible to calculate:
CCC = = 48 days
In other words, RET Ltd has to wait average 48 days from when inventory is purchased on credit to receive the cash from debtors

17. Example 14.2
Based on average sales, the investment in the CCC can be calculated as follows:
Inventory = 73/365 x (R x 0.70) = R
+Debtors = 35/365 x (R ) = R
-Creditors = 60/365 x (R x 0.70) = R
The total amount of resources invested are: R

18. Example 14.2
If only the average sales figure is available an approximate investment in the CCC can be calculated:
Approximate investment in the CCC:
R x 48/365 = R
Different from answer on previous slide, but still gives an idea of the investment of resources and the availability of cash

19. Managing cash Business needs cash for transactions
Giving customers change
Buying supplies
Paying creditors
Paying other expenses
Cash for contingencies

20. Cash budgeting Cash is most liquid of all current assets
Cash inflow
Cash outflow
Careful planning to ensure sufficient cash on hand for daily transactions and operations
Cash budget prepared before a financial period
Based on estimated figures rather than actual amounts – company can plan its expenditure and avoid cash deficit

21. Cash budgeting
Cash inflows – all the cash expected to come into a company
Cash sales
Receipts from debtors
Interest received
Cash outflows – all the cash expected to go out a company
Purchases of inventory
Salaries and wages
Purchases of assets

22. Cash budgeting
From the cash budget it is possible to see if a company will end a given period with a cash surplus or a cash deficit
Cash surplus results from spending less cash than is available
Cash deficit results from spending more cash than is available

23. Example 14.3
Retail Ltd is a company that supplies a variety of grocery items in bulk to small supermarkets. The accountant of the company has prepared estimations for three months following April.
Feb
Mar
Apr
May
Jun
Jul
Sales
1 100’
1 200’
1 400’
1 500’
1 250’
1 300’
Purchases
500’
600’
850’
800’
750’
900’

24. Example 14.3
The cash balance of the company on 30 April is R11 500. It is company policy to keep a minimum cash balance of R10 000.
50% of all sales are cash. Credit sales are collected as follows:
20% in the month of sale
60% in the month following sale
10% in the second month after sale
the remainder is expected to be uncollectible

25. Example 14.3
All purchases are on credit and paid for in the month after purchase
Water and electricity of R15 600 in May, expected to increase with 10% per month as winter approaches
Salaries and wages are expected to be R150 000 per month
Warehouse rent amounts to R7 000 per month and is not expected to change in the foreseeable future

26. Example 14.3
Office expenses (all cash) are expected to cost approximately R per month
Depreciation is written off using the straight-line method, R5 000 per month
A new delivery vehicle of R520 000 will be purchased in June
An extension of R200 000 will be built in June to enlarge the current warehouse
Interest of R2 500 on an investment will be received in July

27. Example 14.3 The expected cash collections from debtors: May Jun Jul
Total sales (given)
1200’
1400’
1 500’
1 250’
1 300’
Credit sales (50%)
600’
700’
750’
625’
650’
Collected in month of sale (20%)
120’
140’
150’
125’
130’
Collected one month after sale (60%)
360’
420’
450’
375’
Collected two months after sale (10%)
60’
70’
75’
630’
645’
580’

28. May
June
July
Opening balance
11 500
10 000
Total receipts
Cash sales
Receipts from debtors
Interest
 2 500
Total payments
Creditor payments
Water and electricity
15 600
17 160
18 876
Salaries and wages
Warehouse rent
7 000
Office expenses
12 000
Vehicle purchase
Building extension
Net cash flow
( )
Minimum closing balance
Cash surplus/(deficit)
( )

29. Example 14.3
It is clear from the cash budget that the company in the example will experience cash flow problems in June if they continue to operate according to their original plan and estimates.
The example illustrates how useful a cash budget can be for planning purposes by showing in which month problems in cash flow may arise and gives the company the opportunity to make adjusting changes beforehand to avoid a deficit from arising or arrange for short-term credit such as a bank overdraft.

30. Managing inventory
Inventory management is important for a number of reasons:
Too little
It can be harmful to the image of a company if they do not have enough goods to sell to customers
Too much
Perishable inventory items can spoil
All types of inventory can be destroyed in a disaster
Where there is a lot of development, like technology, inventory can become obsolete so that customers won’t want to buy it anymore

31. Managing inventory
Inventory causes a number of different costs to a company:
Carrying costs
Costs that a company incurs to keep inventory, like storage and insurance. The more inventories a company holds, the higher this cost will be
Ordering costs
Costs of placing and receiving an order for inventory, for example, clerical costs, handling and transport
Cost of not carrying enough inventory
Opportunity cost that occurs when a customer cannot be helped due to a lack of inventory. The lost sale is then a cost to the company

32. Methods to manage inventory
The Economic Order Quantity (EOQ) can be used to evaluate the best quantity of inventory to purchase at a time that will reduce the costs of inventory
The EOQ calculates the optimal number of units of inventory that needs to be ordered so that costs are kept to a minimum

33. Methods to manage inventory
The EOQ is calculated by using the following formula:
Where:
O = Cost of placing an order
D = Annual demand
C = Annual cost of carrying one unit

34. Methods to manage inventory
Another useful concept that helps to ensure a company has the right amount of inventory at the right time is the reorder point
It is calculated by using the following equation:
Reorder point = lead time x daily usage

35. Example 14.4
The logistics manager of Manufacture Ltd provides the following information:
The company uses 15 000 units of Ingredient X in the product they manufacture
The cost to place an order for Ingredient X is R150 per order. Storage and insurance costs amount to R19 per unit
The lead time for delivery of an order is 5 days
Assume the factory operates for 240 days per year
Calculate the EOQ and the reorder point.

36. Example 14.4

37. Example 14.4

38. Accounts receivable management
Debtors not as liquid as cash – company has to wait before they receive the cash
Debtors more liquid than inventory, because having a debtor means that the inventory has already been sold
Debtors need to be managed – too many debtors cause company to not have enough cash to meet short-term commitments
Bad debt is when a debtor cannot pay his debt
Bad debt is written off as an expense, so it needs to be avoided as far as possible

39. Accounts receivable management
Debtors can be monitored by a debtors’ age analysis
It helps to see how much debt is outstanding and for how long debt has been outstanding
Example of an age analysis:
0 – 10 days
R 82,967.00
24%
11 – 30 days
R 154,175.00
44%
31 – 60 days
R 66,375.00
19%
61 – 90 days
R 31,809.00 9%
91 + days
R 11,646.00 3%
 Total
R 346,972.00
100%

40. Establishing a credit policy
To avoid too much cash invested in debtors and increased bad debt, most companies set a credit policy that states what is acceptable when it comes to debtors
Credit standards put a limit on the amount of credit allowed to customers
Credit terms is the period for which credit is allowed
Credit terms written as: 5/10 net 30
Debtor receives a 5% discount if the debt is paid within 10 days
If debtor does not take discount, debt needs to be paid in 30 days

41. Establishing a credit policy
5 C’s of creditworthiness to evaluate whether a customer should be granted credit:
Character refers to a customer’s reputation for paying back debt
Capacity is the customer’s ability to pay its debt from available funds
Capital considers any capital the customer can put toward an investment, which will lessen the chance for default
Collateral refers to property or large assets that can act as security for a loan
Conditions are the details stating the credit agreement and are covered in the credit policy

42. Establishing a credit policy
A company may change its credit policy
The table below illustrates the effects of relaxing credit standards. The opposite will happen if stricter credit standards are implemented.
Variable
Change that
will happen
Effect on
profits
Sales volume
Increase
Accounts receivable/debtors
Decrease
Bad debts

43. Example 14.5
ABC Office Furniture sells their main product, a basic office chair, at R150 per unit. Total credit sales for the previous financial year was 4 000 units. The variable cost to manufacture a chair is R60 and total fixed costs for the year are R80 000.

44. Example 14.5
The company’s credit terms are 2/10 net 45 and wants to tighten it to 3/7 net 30
This will result in a 5% decrease in sales
Bad debt will reduce from 2% of credit sales to 1% of credit sales
The average collection period will reduce from 45 days to 30 days
20% of debtors will accept the discount
The company’s return on risk-free assets is 14%
Assume 365 days per year

45. Example 14.5
To calculate the effect of the tightening of standards, the company needs to calculate:
Profit loss/gain from decrease/increase in sales
Cost of the marginal investment in accounts receivable
Cost of marginal bad debts
Cost of the discount

46. Example 14.5 Profit loss/gain from decrease/increase in sales:
Fixed costs are not included in the calculation, as it is not affected by a change in credit standards
Sales will decrease by 5%, which will result in a decrease of 200 units (4000 x 0.05)
Profit lost is R18 000 (200 x (150-60))

47. Example 14.5 Cost of the marginal investment in accounts receivable:
Calculated by multiplying daily sales with the average collection period
Daily sales will be R1 644 per day
((4000xR150)/365)
The average investment in accounts receivable would be R73 980 (R1644 x 45 days)
For the new credit policy daily sales will be R1 562
This will lead to an average investment in accounts receivable of R46 860

48. Example 14.5
Cost of the marginal investment in accounts receivable (continued):
The marginal investment in accounts receivable is the difference between the investment under present and investment under proposed plans. The difference is R27 120
Reducing accounts receivable means the company will have more cash available for daily transactions instead of having to borrow the money
The effect is the marginal investment in accounts receivable multiplied with the rate of return on risk- free assets of 14%. This leads to a cost saving of R3 797

49. Example 14.5 Cost of marginal bad debts:
The amount of expected bad debt under the present policy is R12 000
Under the proposed policy, bad debt is expected to be R5 700
The difference is R6 300. This is a benefit to the company since the cost of bad debt is reduced

50. Example 14.5 Cost of the discount:
Under the present plan, the expected cost that arises as a result of the discount is R2 400
Under the proposed plan, the cost of the discount is expected to increase to R3 420
The difference is a cost increase of R1 020

51. Example 14.5
The total effect of the tightening of credit standards is:
Profit loss/gain from change in sales (R18 000)
Marginal investment in acc rec R3 797
Cost of marginal bad debts R6 300
Cost of the discount (R1 020)
Total effect (R8 923)
The proposed tightening of credit standards will result in a reduction of R8 923 in profits

52. Managing accounts payable
Accounts payable or creditors are short-term – more cash on hand for everyday transactions
Inventory is often purchased on credit – favourable impact on the cash conversion cycle
Accounts payable or creditors must be managed to ensure company does not have too much debt
In the same way that a company gives credit terms to its debtors, creditors also give credit terms to a company. It is expressed in the same way, e.g. 2/15 net 60

53. Managing accounts payable
A simple calculation makes it possible for a company to determine if it is better for them to buy on credit or not
It determines whether it is cheaper to borrow from the bank and pay the supplier immediately or to “borrow” from the supplier by buying on credit

54. Managing accounts payable
The calculation to determine whether it is better to buy on credit or to borrow from the bank and pay immediately is:
Where:
CD = The discount in percentage terms
N = The number of days that payment can be delayed by giving up the cash discount

55. Example 14.6

56. Conclusion
Short-term capital management is important to ensure that an entity is able to conduct its daily business successfully.
Working capital consists of cash, debtors, inventory and creditors.
In order to maintain liquidity, an entity needs to manage and limit its investment in those current assets that are not as liquid as cash. Having too large an investment in current assets that are not as liquid as cash means that cash is not immediately available when it is needed for day-to-day transactions.

57. Conclusion (cont.)
The most important areas of working capital are the cash conversion cycle, inventory, accounts receivable and accounts payable. Through the individual and combined management of each of these areas of working capital, it is possible to avoid liquidity problems.
All companies need working capital to conduct their day- to-day operations and provide services to their customers.
Short-term liabilities like creditors give the company the opportunity to delay payment.