1. U3.3 Working Capital

2. About Cash
Current asset
In hand or At bank
Liquidity

3. Cash Problems
Lack of cash or working capital more often than lack of profit lead to:
Insolvency
Liquidation

4. Working Capital = Current Assets – Current Liabilities
Money available for daily business operation
Also known as Net Current Assets
Shows available funds to pay immediate expenses
Working Capital = Current Assets – Current Liabilities

5. Current Assets
Cash
Debtors
Stocks

6. Current Liabilities
Overdrafts
Creditors
Tax

7. Working Capital Cycle
Production Costs
Sales
Cash

8. Working Capital Cycle
Hold enough cash to cover production costs i.e. stock, wages, debt collection
Without being wasteful by holding too much i.e. cash could be more profitably invested elsewhere

9. Current Ratio Desired ratio is 1:1
CA significantly higher indicates wastefulness
CA significantly lower indicates liquidity problem

10. Cash vs. Profit Simply put Profit = Revenues – Costs
Revenues are not always cash!
There are sources of cash outside of revenues.
Profitable companies can be cash poor.
Unprofitable companies can be cash rich.

11. Cash Flow Forecasts
Expected movement of cash in and out of a business:
Cash Inflows receipts
Cash Outflows payments, expenses, outgoings
Net Cash Flow cash inflows – cash outflows

12. Cash Flow Statements
Depicts the actual flow of cash in and out of a business over a given period of time.

13. Reasons for Cash Flow Forecasts
Persuade banks and other lenders when seeking external finance.
Aid in the anticipation and preparation for periods of time where cash flow shortages or surpluses may occur.
Assists in business and strategic planning.

14. Constructing Cash Flow Forecasts
Jul
Aug
Sept
Oct
Nov
Dec
Opening Balance
5,000
3,000
300
(1,400)
(2,600)
600
Inflows
Cash sales revenue
6,000
6,500
6,800
7,500
9,500
Other income
4,000
Total cash inflows
11,500
Outflows
Stocks
2,500
2,200
2,700
3,300
Labor costs
3,500
Other costs
2,000
1,800
Total cash outflows
8,000
7,700
8,200
8,00
8,300
9,000
Net cash flow
(2,000)
(2,700)
(1,700)
(1,200)
3,200
500
Closing balance
1,100

15. Cash Flow Forecast Practice
Jan ($)
Feb ($)
Mar ($)
Apr ($)
Cash sales
2,000
4,000
Stock purchases
600
900
1,200
Rent
1,000
Other costs
800
Opening cash balance
1,600
1,900
Net cash flow
300
1,800
Closing balance

16. Causes of Cash Flow Problems
Overtrading: quick expansion
Over borrowing: high geared
Overstocking: poor inventory control
Poor credit control: lenient credit policies
Unforeseen changes: demand shifts

17. Managing Working Capital
Dealing with liquidity problems:
Seek alternative sources of finance
Improve cash inflows
Reduce cash outflows

18. Seeking Alternative Sources of Finance
Overdrafts
Sale and leaseback
Selling off fixed assets
Debt factoring
Government assistance
Growth strategies

19. Improving Cash Inflows
Tighter credit control
Cash payments only
Change pricing policy
Improved product portfolio
Improved marketing planning

20. Reducing Cash Outflows
Seek preferential credit terms
Seek alternative suppliers
Better stock control
Reduce expenses

21. Combining Strategies Pareto principle Contingency fund 80/20 rule
80% time and resources boosting cash inflow
20% on cost cutting
Contingency fund
Cash set aside for unexpected, emergency use

22. Alternatives to Dealing with Cash Flow Problems
Spread risks with wider customer base
Require partial payments over time from customers of large or lengthy projects/services
Establish systems to pay bills in regular installments
Establish quality management systems

23. Limitations of Cash Flow Forecasting
Marketing
Human resources
Operations management
Competitors
Changing fashion and tastes
Economic changes
External shocks

24. Working Capital and Business Strategy
“More often than not, businesses fail because of cash flow problems rather than profitability problems.”
Cash flow “forecasts and calculations are static, i.e. they only represent the cash flow situation of a firm at one point in time”.
“Managers face a dilemma in balancing the conflict between the desire for sufficient working capital and the desire for profits.”
“Working capital is regarded as being more important than profit in the short run.”

25. 3.3.1 What is meant by working capital?
Working capital (or net current assets) refers to the money available for the daily running of a business, i.e. it is used to pay for everyday costs such as wages, utility bills, and payment so suppliers. Working capital is mainly generated from the sale of goods and services.

26. 3.3.2 explain the working capital cycle
The working capital cycle refers to the interval between cash paid by a business for the costs of production and receiving the cash from customers. For example, if the customers pay by credit then payment is not received until a later date, although costs are incurred for the transaction. Due to its revamped menu, McDonald’s was able to entice more customers thereby helping to boost its sales by 6 per cent. However, cash is not the same as profit. The costs of product research and development for its new menu, for example, would contribute to higher operation costs and hence lower profits. It is likely that there is a significant time lag between investment expenditure (R&D and marketing costs for its revamped menu) and receiving sufficient sales revenue to recoup the costs. Hence, it is probably that overall profits declined despite sales revenue being slightly higher.

27. Explain the use of cash cards
Credit cards allow customers to ‘buy now and pay later’ through a third party, i.e. a financial lender. The finance company pays the retailer (and charges the retailer a small fee for the service) and charges the customer at a later date. Since credit improves flexibility (customers do not need to carry so much cash with them) and allows customers to buy now but to postpone payment, it can attract a large number of customers to businesses, including McDonald’s. Hence, sales revenues may increase since customers have a greater choice of payment systems. However, retailers and restaurants such as McDonald’s will not receive their payment instantaneously, i.e. there is a (relatively short) delay in payment from the credit card company. This therefore extends the working capital cycle of the business that offers credit to its customers. In addition, the amount received from the finance company will be slightly lower since a fee will be charged by the creditor.

28. A firm faces a liquidity problem ;explain
Definition of liquidity problem, i.e. the extent to which the firm can meet its short term debts. The firm seems to be suffering from worsening liquidity as seen by the closing balance figures. The net cash flow for the first four months of trading is also negative suggesting the firm has insufficient working capital.

29. 3.3.5 Answer Key
Profitable firms can experience cash flow problems for a number of reasons, such as:
Overtrading
Long working capital cycle
Poor credit control
Long credit periods