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

2. 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

3. 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

4. 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.

5. 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?

6. 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.

7. 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.,

8. 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

9. Pareto Analysis Pareto Analysis is sometimes called the 80-20 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

10. 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:

11. 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)

12. 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

13. 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.

14. 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!)

15. 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.
Therefore the business should have clear policies on:
Which customers will be offered credit
What payment time is acceptable
Whether discounts are offered
What collection policies will be in operation

16. 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

17. 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’)?

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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

24. 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.