1. ACCOUNTING FOR MANAGEMENT DECISIONS
WEEK 8
MANAGEMENT OF WORKING CAPITAL
READING:
TEXT CHAPTER 13

2. Learning Objectives List the items making up working capital
Discuss the nature and importance of working capital
Illustrate the working capital cycle
Demonstrate the importance of inventory and the techniques available to manage this asset efficiently
Discuss the provision of credit to customers and use various management tools to monitor and control this asset
Explain the reasons for holding cash, and the basis of management and control
Summarise the key aspects of creditor management

3. The Nature and Purpose of Working Capital
Working Capital is usually defined as current assets less current liabilities
The main elements of current assets are:
Inventory
Accounts receivable (trade debtors)
Cash (in hand and at bank)
The main elements of current liabilities are:
Accounts payable (trade creditors)
Bank overdrafts
Represents a net investment in short-term assets

4. The Nature and Purpose of Working Capital cont’d
Finished
goods
Work in
progress
Cash sales
Trade
receivables
Cash /
bank
overdraft
Raw
materials
inventories
creditors
Figure The working capital cycle of a manufacturing business

5. The Nature and Purpose of Working Capital cont’d
The management of working capital is an essential part of the short-term planning process
There are costs incurred by holding too much and too little of each element
Costs include opportunity cost of using these elements elsewhere
Needs are likely to change over time
Change may be externally driven or result from changes to the internal environment

6. The Management of Inventories
Inventories are held mainly to meet the immediate requirements of customers and production
Manufacturing businesses tend to hold a high proportion of their assets as inventory:
Raw materials
Work-in-progress
Finished goods
Seasonality may vary inventory holdings over a year
Retail businesses would try and minimise their inventories because of costs e.g. storage, financing, opportunity cost etc.

7. The Management of Inventories cont’d
Forecasts of future demand:
Accurate forecasts are key
Can use statistical approaches or judgment of staff / managers
Financial ratios: can be used to monitor inventory levels
Recording and re-ordering systems:
Efficiency is key, should be monitored regularly
Decision authority should be confined to a few senior staff
Lead-times and likely demand should be determined
Buffer levels to deal with uncertainty should be determined

8. The Management of Inventories cont’d
Stock / inventory management models:
Economic order quantity (EOQ):
Recognises that total cost includes holding and ordering costs
Calculates the optimum size of the order, taking these two components into account
Decreasing inventory held means an increase in order costs as the number of orders rises in the period
EOQ seeks to identify the size of the order that will minimise the total costs

9. The Management of Inventories cont’d
Figure Inventories holding and order costs

10. The Management of Inventories cont’d
The EOQ model:
where:
D is the annual demand for the item of stock
C is the cost of placing an order
H is the cot of holding one unit of stock for one year
Some limiting assumptions apply to the model:
That demand for the product can be predicted with accuracy
Demand is even over the period with no fluctuations
No ‘buffer’ inventory is required
There are no discounts for bulk purchasing

11. The Management of Inventories cont’d
Just-in-time (JIT) stock / inventory management:
Aims to have materials delivered to production ‘just in time’ for their required use
Limits holding time and investment in raw materials
Suppliers are informed of production requirements in advance
Some disadvantages:
May mean inventory is more expensive
Risk of non-supply

12. The Management of Debtors
Selling goods or services on credit incurs costs
Costs include administration, bad debts and opportunity costs
When a business offers to sell on credit, it must have clear policy concerning:
Which customers should receive credit
How much credit should be offered
What length of credit it is prepared to offer
Whether discounts will be offered for prompt payment
What collection policies should be adopted
How the risk of non-payment can be reduced

13. The Management of Debtors cont’d
Which customers should receive credit?
The ‘five Cs’ of credit:
Capital - must appear to be financially sound (liquidity risk) before credit is offered
Capacity - must seem able to pay amounts owing (examine payment record / history)
Collateral - can the customer offer satisfactory security if required
Conditions - how the industry and general economic environment the customer operates in affects their ability to pay amounts owing
Character - a subjective assessment made by the business of factors such as honesty, integrity etc.

14. The Management of Debtors cont’d
Length of credit period:
The length of credit offered varies and may be influenced by factors such as:
The typical credit terms operating in the industry
The degree of competition in the industry
The bargaining power of particular customers
The risk of non-payment
The capacity of the business to offer credit
The marketing strategy of the business

15. The Management of Debtors cont’d
Cash discounts (early settlement):
The cost must be weighed against the benefits
Danger that customers will be slow to pay and still take the discount offered
The benefit represents a reduction in the cost of financing debtors and bad debts

16. The Management of Debtors cont’d
Collection policies:
Steps to ensure amounts owing are paid promptly may include:
Develop customer relationships
Publicise credit terms
Issue invoices promptly
Monitor outstanding debts
Produce a schedule of aged debtors
Answer queries quickly
Deal with slow payers
Identify the monthly pattern of receipts from credit sales

17. The Management of Cash Why hold cash? How much cash should be held?
Most businesses hold cash but the amount held varies considerably
There are three reasons for holding cash:
Transactionary
Precautionary
Speculative
How much cash should be held?
No set formula - different businesses will have different views
Amount held can be reduced if funds can be raised quickly or assets held that can be converted to cash such as shares or bonds

18. The Management of Cash cont’d
Controlling the cash balance
Use of upper and lower control limits:
Assumes business can access cash as needed
The model proposes the use of two upper and two lower limits
If an outer limit is exceeded, managers must decide if the balance is likely to return over the next few days to within the inner limits, if not, cash must be bought or sold to restore the cash balance to within limits
Model relies heavily on management judgement to determine where the control limits are set and what time limits for breaches are acceptable

19. The Management of Cash cont’d
Cash flow statements and management of cash:
It is useful for a business to a prepare cash flow statements and / or a cash budget
Comparison of budgeted cash flows to cash flow statements will identify variances for action
Expected cash surpluses and deficits can have a course of action decided upon by management prior to them occurring

20. The Management of Cash cont’d
Operating cash cycle:
Definition: The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash from the sale of goods
To effectively manage cash, there must be awareness of the operating cash cycle
Management seeks to shorten the time and reduce cash required in the cycle

21. The Management of Cash cont’d
Cash transmission:
Benefit is received immediately when payment is made in cash
Cheques normally incur a delay of up to ten working days to clear through the banking system
Opportunity cost of this delay can be significant
Alternatives to minimise delays can include:
Insist on payment in cash (not always practical)
Utilise direct debit facilities and card payments
Bank overdrafts:
Are simply a type of bank loan
Can be useful for managing cash flow requirements

22. The Management of Trade Creditors
Trade credit is an important source of finance for many businesses
Tends to increase in line with the increase in sales
Widely regarded as ‘free’ however, there can be costs associated with taking credit:
Cost of goods may rise as credit needs to be paid for
May be given lower priority in terms of delivery dates
Administration costs associated with dealing with invoices and confirming receipt of goods / service

23. The Management of Trade Creditors cont’d
Controlling trade creditors:
Using the average settlement period method:
Alternative approaches:
Ageing schedule
Pattern of credit payments