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Understanding and Managing Finance 9

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1 Understanding and Managing Finance 9
This Presentation is in Self-Study Form To start the presentation: Press F5 (Top Row of Keyboard) Then use the navigation buttons at the foot of each page.

2 Managing Finance and Budgets
Lecture 9 Working Capital (2)

3 Session 3 - Financial Statements (2)
Learning outcomes: Understand how the Working Capital Cycle can be affected by management decisions. Specify changes in the management of stocks, creditors and debtors in order to achieve reductions or increases to Working Capital. Key concepts: Stock Control Debtor Management Credit Management

4 Structure of the Presentation
A : Working Capital Reviewed B : The Management of Stocks C: The Management of Debtors D: The Management of Creditors E: Seminar 9

5 Working Capital Reviewed
Section A: Working Capital Reviewed

6 SAQ 9.1 What exactly is Working Capital?
What are the major elements of it? Which type of industry would have greater requirements for working capital, manufacturing or retail? Solution

7 SAQ 9.1 Solution Working capital is defined as:
Current Assets - Current Liabilities Major elements are Stocks, Debtors, Cash, Creditors, Short-term loans (Overdraft), Tax payable Working capital requirements vary between different types of industry (e.g. high in manufacturing, low in retail) & according to the fluctuations in trading

8 The nature and purpose of working capital
Major elements Major element The summary diagram Stocks Trade debtors Cash (in hand and at bank) Trade creditors Working capital Current assets Current liabilities equals less

9 The working capital cycle
Each ‘pass’ through the Working Capital Cycle will generate profit. Cash sales Trade creditors Trade debtors Finished goods Cash/ bank overdraft Work-in-progress Raw materials

10 Calculating the Operating Cash Cycle
equals minus Operating cash cycle Average payment period for creditors Average settlement period for debtors plus Average stockholding period The Operating Cash Cycle is the time between outlay of funds, and money returning to the business on one circuit of the Working Capital Cycle Provided that we can maintain the same level of profit on each cycle, we can increase overall profitability by reducing the OCC to a minimum.

11 The Length of the Operating Cash Cycle
Suppose that in a business, each ‘turnover’ of the Working Capital Cycle generates £10,000 of profit: OCC 3 months 4 cycles per year, profit = £40,000 OCC 2 months 6 cycles per year, profit = £60,000 What happens though, if in shortening the cycle, we reduce our profit margins?

12 Optimising Working Capital
Even if we reduce profit margins at each pass, we may still be able to increase profitability overall. In the last example, suppose the effect of shortening the OCC was to reduce the profit at each pass through the cycle by 25% to £7,500, we would now generate profit of: 6 cycles x £7,500 = £45,000 compared to 4 cycles x £10,000 = £40,000 This is still £5,000 more profit per year than before.

13 Optimising Working Capital
As a ‘rule of thumb’, provided that the percentage of profit lost at each cycle is less than the percentage reduction in OCC, overall profitability will increase. So the problem becomes: “How can we reduce the Operating Cash Cycle without reducing profitability by same amount?”

14 Optimising Working Capital
This means that, whatever the business, Working Capital will be optimised by reducing the Operating Cash Cycle to the minimum possible level which will allow the maximum increase in profitability. This means: Reducing Stock Levels Reducing Trade Debtors Increasing Trade Creditors The rest of this session is concerned with methods which will allow each of these to occur., SAQ 9.2

15 Discuss the following:
SAQ 9.2 Discuss the following: Why is it important to keep careful track of working capital requirements? Solution

16 SAQ 9.2 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 customers defaulting on payments. Suppliers refusing credit, or even refusing to supply. Stock not being available for manufacturing and other processes. Payments to employees being delayed or impossible. Bankruptcy.

17 Section B: Management of Stocks

18 SAQ 9.3 In the previous section we identified the need to Reduce Stocks as one of the ways to shorten the Operation Cash Cycle. (a) Can you think of any other advantages to carrying low levels of stock? (b) Are there any disadvantages? Solution

19 SAQ 9.3 Solution Holding Low Stock Levels:
(a) Advantages – Low cost, low overheads in terms of storage space, fewer staff needed to secure and maintain, low depreciation costs. (b) Disadvantages – lack of flexibility, may run out, and therefore lose sales & long term custom

20 The management of stocks
Procedures and techniques Forecasts of future demand Monitoring Recording and reordering systems Levels of control Stock management models Materials requirements planning (MRP) systems Just-in-time (JIT) stock management This slide summarises important issues and techniques

21 Inventory Control Inventory = Stock
There are two driving forces behind inventory control systems to ensure that ‘stock-out’ time either does not occur, or is reduced to a minimum, so that there is continuity of supply, at both ends of the link in the supply chain. (goods or services IN and goods or services OUT) To ensure that stock levels are kept to the minimum possible while still satisfying (1)

22 Inventory Control There are two basic approaches: Inventory Modelling
Use an analysis of the existing business system to create models of the inventory which will allow predictions to be made or allow strategies to be developed Operations Management To redesign the business system so that more efficient ways of managing the flow of goods and services can be integrated.

23 Inventory Modelling We will briefly examine two different models:
Pareto Analysis This uses an analysis of stock values held to try to reduce the overall quantity held. Economic Order Quantity Model This creates a theoretic ‘perfect’ model, and derives mathematical solutions to a variety of problems. There are many other models that are used, which involve, for example queuing theory.

24 Inventory Models (1) Pareto Analysis
Pareto Analysis is sometimes called the method. It takes as its underlying principle the fact that a warehouse will contain different amounts of stock at different prices. If we put the goods in order, according to value, we often find that the first 20% of the items will be worth 80% of the total value. The method derived from this categorises the stocks into three bands A, B and C

25 ABC method of analysing and controlling stock
Cumulative value of stock items (%) Volume of stock items held (%) A B C

26 ABC method of analysing and controlling stock
Cumulative value of stock items (%) Volume of stock items held (%) A B C Category C: A lot of low valued items. Category B: mid- valued items. Category A: A few, high valued items.

27 ABC Method As a result of the Analysis we might do the following:
Category A: Attempt to severely reduce the numbers of stock held in this category. If this is not possible, ensure that we monitor carefully when orders are placed for these items. A manager may personally wish to sign the order form. Category B Make a small reduction in the numbers of these stocks. If this is not possible, monitor the stock levels & review regularly. Category C Do nothing.

28 ABC Method Example Ace Jewellers keep the following watches in Stock:
Type A: £4,000 each (£40,000) Type B: £180 each (£ 7,200) Type C: £14 each (£ 2,800) Analysis: Type A is 4% of the stock, but 80% of the total cost Type B is 16% of the stock, but 14.4% of the total cost Type C is 80% of the stock, but 5.6% of the total cost

29 ABC Method Example Solution
Ace Jewellers, depending upon the demand, might: Reduce Type A to a minimum (say 2 items) £4,000 each £8,000 Reduce Type B to half the quantity; £180 each £ 7,200 Keep Type C as it is £14 each £ 2,800 Total Stock: £18,000 Reduction in Stock: £32,000

30 Inventory Models (2) Economic Order Quantity
This model takes as its starting point the basic graph of stock movements over time. A real graph of stock quantities held may look something like this:

31 Stock Levels Deliveries of Stock Daily sales depleting stock levels
Out of Stock

32 Modelling stock movements over time:
The “Ideal” Situation Assumptions: 1. A steady demand pattern Fixed re-order quantity Fixed time between deliveries. Stock level Time The new stock arrives just at the point at which the previous stock runs out.

33 What are the problems with this?
When we place an order, it does not get delivered immediately. There is a delivery ‘lead-in’ time. The demand pattern may well be erratic, and will fluctuate on a day-to-day basis. Holding any amount of stock will cost money in lost sales, wastage, security etc. We will probably get charged for placing an order. This might be a delivery charge, or an administrative charge. Deliveries may not occur at regular intervals.

34 Stockholding and stock order costs
The Total Stock Cost comprises: Holding Costs ( value of the stock + loss of interest) plus Ordering Costs Ordering costs Annual costs (£) Total costs Holding costs E Stock level (units)

35 How do we achieve the ideal?
This model can be further developed to answer the following question: Suppose we know the Annual Demand for stock. The Annual cost of holding 1 item of stock The cost of an order. What quantity of goods should we order, and when should we so as to achieve the greatest profit?

36 Economic Order Quantity
We can calculate an Economic Order Quantity (EOQ): Square Root of: ( 2 x Annual Demand x Order Cost ) Yearly holding cost for 1 stock unit and Time Between Deliveries = EOQ x 365 days Annual Demand

37 Economic Order Quantity Example
John Jones Stationers sells 10,000 boxes of printer paper each year. It has been estimated that the cost of holding one box is £2.50. The cost of placing an order with the suppliers is £ What is the Economic Order Quantity, and how far apart should the deliveries be spaced? Economic Order Quantity = (2 x 10,000 x 10) (2.50) = boxes (nearest box) Time between deliveries = 283 x = 10 days 10000

38 Inventory Control Operations Management Approach
Stock is seen as just one element in the overall product cycle. The approach is to consider the problem as one of supply chain management. We can take two opposing viewpoints: A Push Approach A Pull Approach

39 A ‘Push’ Approach This approach assumes that the driving force in the supply chain comes from the beginning, and that goods & services must be managed to ensure that the next process in the chain can follow on effectively from the one before it Using this approach, we make decisions about where an when our stocks enter the system and we need to manage the process at each stage very carefully. PUSH Process 1 Process 2 Process 3

40 A ‘Pull’ Approach This approach assumes that the driving force in the supply chain comes from the end of the chain, the customer. This means that goods & services must be managed to ensure that the each process in the chain leading to the customer , in turn is serviced effectively by the process before it. Using this approach, the customer needs drive the process, and we the decisions about where and when our stocks enter the system are determined by the needs of each step in the process. PULL Process 1 Process 2 Process 3

41 Inventory Control Operations Management Methods
There is a wide variety of different Operations Management Methods. Here we look at two different approaches: Materials Requirement Planning Just-in-Time It is entirely possible to adopt methods which merge different elements from each of the techniques. SAQ 9.4

42 Example of a ‘Push’ Approach Materials Requirement Planning
Materials Requirement Planning (MRP) uses sales forecasts & production plans to schedule deliveries so that they occur at the correct times that the processes need them. This is ‘top-down’ planning. Only those items which are necessary for the flow of production are ordered and delivered. An important element in MRP is the Master Production Schedule. This forecasts when things will occur, and schedules events such as deliveries and prompts changes in practice.

43 Materials Requirement Planning Example of Master Production Schedule
We start with a predicted demand: The stock level to support this demand is then planned. This defines how the production should be managed to meet the required stock levels. This specifies the production quota. Orders for raw materials will now be placed. This will drive the process

44 Example of a ‘Pull’ Approach: Just-in-Time
There are several variations on this approach. The basic idea, is that deliveries (and each stage in the production process) should occur ‘just in time’ as the stock levels to support the process run out. In this way, the minimum amounts of stock are held. The net result of this technique is that it forces suppliers to hold onto stocks longer. These suppliers may then need to employ techniques of their own to minimise costs. (one of which is to increase prices!)

45 Just-in-Time Variation: KANBAN
Kanban is Japanese for ‘card’ , but has come to mean a whole way of working and organising production. The basic idea is that every part of a production process (whether manufacturing, retail or service) is delivered ‘just-in-time’ to enable the next stage to occur. The system uses a system of boxes and cards to signal when items should be produced. KanBan was developed by Toyota in the early 1970’s.

46 The KANBAN Approach Order received The production process is triggered by orders of specific items. Only one or two of these items is held in stock. As the order is delivered, this triggers production of the item backwards in the chain. Workers at delivery end package up item Workers at penultimate stage now caused to create a new item from parts available Causes Workers further down create new parts Causes Workers further down create new parts

47 Just-in-Time Variation: KANBAN
The claims of companies introducing JIT are well documented. Hewlett Packard claim to have reduced manufacturing time for the assembly of 31 circuit boards from 15 days to 11.3 hours. At the same time the value of inventory fell from $670,000 to $20,000 dollars. Traditional manufacturing systems are termed "Push systems“, because components are pushed through processes into finished stores, then directed on to individual orders. Components pass through the system in batches. Batch size is determined after considering the inventory cost, set up cost and demand. JIT/Kanban is a “Pull system”. Components are made to a specific order. As a component is finished a void is created which is filled by a component from further down the line.

48 Discuss the following:
SAQ 9.4 Discuss the following: What do you think might be the advantages and disadvantages of the JIT system of Stock Control? Solution

49 SAQ 9.4 Solution JIT system of Stock Control
Advantages – low overheads in terms of storage space, low depreciation costs. Disadvantages –difficult to maintain continuity of supply. Suppliers may increase prices

50 Section C: Management of Debtors

51 Managing Debtors Selling goods on credit means that there is a cost to the business. These costs can include: Administrative costs - due to the credit transactions Opportunity costs - incurred as a result of the money being unavailable for the business to uses Bad debts – money effectively lost because customers will not or cannot pay.

52 Debt Collection Policies & Methods
In order to manage debtors effectively a business should have clear policies developed in answer to the following questions: Which customers will be offered credit? What payment time is acceptable? What discounts will be offered? What collection policies will be in operation? Will external agencies be used? Again, it is possible to use a selection of different methods in order to achieve the maximum effect.

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

54 Offering Credit Capital: Is the customer financially sound?
Capacity: Does the customer have the capacity to pay the amounts owed? Collateral: Can the customer offer any security? Conditions: What is the current economic climate? Character: Does the customer appear to have integrity? Sources of information: Trade refs, Bank refs, Published accounts, Directors, employees, premises, credit agencies

55 What payment time is acceptable?
This is variable, but typical criteria will be: Local Conditions: Credit terms operating within the particular sector Degree of co-operation between companies in the sector Bargaining power of particular customers Risk of bad debt (either from particular customers or to the business as a whole) The financial position of the business – their ability to offer credit. The marketing strategy – is length of credit an important feature (e.g. as a ‘loss leader’)?

56 Cash Discounts for Early Payments
In order to encourage customers to pay early, we may offer a discount of say 5% for early payment (or alternatively impose a penalty for late payment – same effect.) We need to weigh the cost of this against the fact of having the money.

57 Cash Discounts Example
P & L has debtor period of around 80 days, but is attempting to reduce this to around 30 days, by offering 5% discount on all sales for payment within one month of delivery. Cost of discount is 5%, for 50 days cash gained. As an annual rate this is 365 x 5% = 36.5% approx 50 This is a very high rate of interest; we would need to be satisfied that the return on the money gained (using say the ROCE) was greater than 36.5% in order for this to be a sensible proposition.

58 Debt Collection Policies
The first principle of debt collection is that all current debts need to be recorded effectively, and payments monitored carefully, so that it is clear which debtors have paid which amounts. One way to do this is through an Ageing Schedule of Debtors Another way is to devise a predicted payment schedule, and to compare this with payments made.

59 Ageing Schedule of Debtors
The Schedule will record the amount and the length of debt. This will allow a business to monitor individual and total amount of debt, for example total debt which has remained unpaid for at least 3 weeks.

60 Comparison of actual and budgeted receipts over time
% Time 10 20 30 40 June July August September Actual Budgeted

61 Using External Agencies
There is a bewildering variety of services available in this industry, ranging from straightforward debt-collection companies working for a fee, to companies who will effectively buy your debts from you. We look at two such methods: Debt Factoring Invoice Discounting

62 Debt Factoring Debt Factoring is done by companies who specialise in the administration & collection of debts. Factors take over the debts of a business, and offer the business cash payments in advance of the actual collection of debts. Typically, a Factor will offer up to 80% of the face value of the debtors in advance, but will charge interest on the money advances, as well as a fee for the service.

63 Invoice Discounting This involves obtaining a loan from a third party based on the proportion (normally about 75%) of the face value of credit sales outstanding, while still retaining full control over the sales ledger. There is normally a service charge related to turnover (e.g. 0.2% ), and the loan is obtained for a short period , for example 60 or 90 days. The business gets the money immediately, and there is a much lower charge than with Factoring; however the business still has the responsibility of collecting the debts. Debt Factors often offer an Invoice Discounting service.

64 Bad debts At the end of the day there may still be companies who cannot or will not pay the money owed for goods delivered. This can happen where a customer is declared bankrupt; creditors are offered possibly a small proportion of the amount owed out of the sale of assets. In this case, the deficit must be borne entirely by the business, and the amount is ‘written off’ against profit. Most companies will include a provision for bad or doubtful debts in their balance sheet. SAQ 9.5

65 Discuss the following:
SAQ 9.5 Discuss the following: Why is there potential for conflict between the credit control department and the sales department of an organisation?

66 SAQ 9.5 Solution Potential conflict between credit control and sales.
Sales will wish to improve sales figures by making sales to anyone. It will not be in their remit to worry about when or if the customers actually pay. Sales defines a good customers as one who orders large amounts. Credit control will be keen to improve their performance by ensuring that customers pay, and pay promptly. CC defines a good customer as one who pays on time.

67 Management of Creditors
Section D: Management of Creditors

68 Management of Creditors
Trade credit may be regarded as a “free source of finance” However, exactly the same strategies that we may use to encourage early payment and discourage late payment may be used on us, but in reverse. In terms of Early Payment, discounts may be offered for paying early and these may be more valuable than the trade credit Paying late may have many disadvantages: We may be given lower priority, forced to pay higher prices, and in the extreme case there may even be a refusal to supply SAQ 9.6

69 Discuss the following:
SAQ 9.6 Discuss the following: A supplier’s normal credit terms are 70 days. They offer a 2% discount for payment in 30 days. What is the approximate annual percentage cost of not taking up the discount? Is it reasonable to compare the above figure directly to the cost of capital for the organisation when deciding to take up the offer or are there other factors which should be taken into account? Solution

70 SAQ 9.6 Solution A supplier’s normal credit terms are 90 days. They offer a 2.5% discount for payment within 60 days. What is the approximate annual percentage cost of not taking up the discount? The loss will be 30 days ‘free credit’. The annual percentage cost of this credit will be approximately 365 x 2.5% = 30.41% 30 This figure is very high; for a business not to pay within 60 days, they would need a very good reason, for example that they could earn more than 30.41% (if their ROCE was higher for example)

71 SAQ 9.6 Other factors to be considered:
Is it reasonable to compare the above figure directly to the cost of capital for the organisation when deciding to take up the offer or are there other factors which should be taken into account? Other factors to be considered: Is there cash currently available? Would the cash have been more profitably employed elsewhere? Is there a better offer on other goods purchased by the company? Is there somewhere that the cash can be invested which would give more than 2% over the 40 days?

72 Seminar Nine - Activities
Preparation: read all of Chapter 16 Working Capital Internet Links (Word Document) Use this document as a resource, and follow up some of the links to pursue your own ‘research’ into managing working capital. You should try to find a range of methods and examples of real businesses which have used these methods. M & A Exercise 16.3 You should use the Spreadsheet M&A 16.3 as a structure to answer the question; this asks you to calculate other ratios and amounts. Here the methods that you suggest in part (b) should be based on the research you have carried out using the internet.


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