1. GBS 520 :FINANCIAL AND MANAGEMENT ACCOUNTING
BRYSON MUMBA

2. FINANCIAL AND MANAGEMENT ACCOUNTING
UNIT 10 : WORKING CAPITAL MANAGEMENT

3. 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

4. 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)

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

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

20. Financing WC – Matching StrategyK
Short-term borrowing
Fluctuating current assets
Capital
Permanent current assets
Long term borrowing + equity capital
Fixed assets
Time

21. Financing WC – Aggressive StrategyK
Short-term borrowing
Fluctuating current assets
Capital
Permanent current assets
Long term borrowing + equity capital
Fixed assets
Time

22. Financing WC – Matching StrategyK
Fluctuating current assets
Capital
Permanent current assets
Long term borrowing + equity capital
Fixed assets
Time

23. 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

24. 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

25. 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

26. Inventory management Stock management Models:
Economic Order Quantity Model
Economic Order Quantity(EOQ) = AC 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

27. 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.

28. 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

29. 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

30. 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

31. 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

32. 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.

33. 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

34. 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