1. Chapter 12
MANAGING WORKING
CAPITAL

2. Identify the main elements of working capital
LEARNING OUTCOMES
You should be able to:
Discuss the purpose of working capital and the nature of the working capital cycle
Identify the main elements of working capital
Explain the factors that have to be taken into account when managing each element of working capital
Explain the importance of establishing policies for the control of working capital

3. The nature and purpose of working capital
Major elements
Major element
Inventories
Trade receivables
Cash (in hand and at bank)
Trade payables
less
equals
Current liabilities
Working capital
Current assets

4. The working capital cycle
Trade payables
Trade receivables
Finished goods
Cash/ bank overdraft
Work in progress
Raw materials
Cash sales
Credit sales
Cash
Figure The working capital cycle

5. Working capital opportunity assessment
€800B
Total working capital opportunity
€700B
€600B
€500B
€400B
€300B
€200B
€100B
Trade receivables opportunity
Inventories opportunity
Trade payables opportunity
€890B
€293B
€296B
€900B
Figure Working capital opportunity assessment

6. Inventories financing cost
Business
Type of operations
Cost of capital
Average inventories held
Financing cost of holding inventories
Operating profit/ (loss)
Financing cost as % of operating profit/(loss)
(a)
(b)
(a) × (b) %
Associated British Foods
Food producer
11.4
£1,540m
£176m
£1,093m
16.1
SIG Group
Builders
merchants
8.2
£224m
£18m
£58m
31.0
J Sainsbury
Supermarket
10.0
£962m
£96m
£887m
10.8
Babcock Int.
Engineering
7.5
£78m
£6m
£235m
2.6
Source: Annual Reports for years ending in 2012 and 2013

7. Managing inventories
Budgeting future demand
Financial ratios
Recording and reordering systems
Inventory management models
Materials requirements planning (MRP) system
Levels of control
Just-in-time (JIT) stock management
Procedures and techniques that can be used to ensure the proper management of inventories

8. Average inventories turnover period
Financial ratios
Average inventories turnover period
Average inventories held × Cost of sales =

9. ABC method of analysing and controlling inventories
Cumulative value of inventories items (%)
Volume of inventories items held (%) A B C
100
Figure ABC method of analysing and controlling inventories

10. Patterns of inventories movements over time
Inventories level
Time
Figure Patterns of inventories movements over time

11. Average inventories level (units)
Annual costs (£)
Average inventories level (units) E
Total costs
Holding costs
Ordering costs
Inventories holding and order costs
Figure Inventories holding and order costs

12. The economic order quantity (EOQ) model
Where:
D = the annual demand for the inventories item (expressed in units of the inventory item);
C = the cost of placing an order;
H = the cost of holding one unit of the inventories item for one year.
EOQ =
2DC H

13. Just-in-time inventories management
May result in hidden costs (taking advantage of cheap sources of supply)
Requires close relationship with suppliers
May require re-engineering production process
Can be seen as part of TQM approach

14. Managing trade receivables
Which customers should receive credit
Questions to ask
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

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

16. Sources of credit information
Bank references
Published financial statements
Trade references
Credit agencies
Register of County Court Judgements
The customer

17. Length of credit period
The typical credit terms operating within the industry
The degree of competition within 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
May be influenced by:

18. Ageing schedule of trade receivables at 31 December
Customer
Days
outstanding
Total
1 to 30 days
31 to 60 days
61 to 90 days
More than 90 days
A Ltd
12,000
13,000
14,000
18,000
57,000
B Ltd
20,000
10,000 –
30,000
C Ltd
24,000
32,000
47,000
111,000

19. Collection policies Develop customer relationships
Publicise credit terms
Issue invoices promptly
Develop customer relationships
Produce an ageing schedule of receivables
Answer queries quickly
Monitor outstanding debts
Deal with slow payers

20. Comparison of actual and expected (budgeted) receipts over time%
Time 10 20 30 40
June
July
August
September
Actual
Budgeted
Figure Comparison of actual and expected (target) receipts over time for
Example 12.5

21. Why hold cash? There are three reasons: To meet day-to-day commitments
To deal with uncertain cash flows
To exploit profitable opportunities

22. Factors influencing the amount of cash held
The opportunity cost of holding cash
The level of inflation
The nature of the business
The cost of borrowing
Economic conditions
The availability of near-liquid assets
Relationships with suppliers
Possible factors may include:

23. Managing cash Main techniques Controlling the cash balance
Preparing cash budgets
Controlling the cash balance
Managing the operating cash cycle

24. The operating cash cycle
Purchase of goods on credit
Payment for goods
Sale of goods on credit
Cash received from credit customer
Inventories holding period
Operating cash cycle
Figure The operating cash cycle

25. Calculating the operating cash cycle
equals
minus
plus
Operating cash cycle
Average settlement period for payables
Average settlement period for receivables
Average inventories holding period
Figure Calculating the operating cash cycle

26. Working capital performance for the US and Europe 2002-2012
2005
2004
2003
2006 36 38 40 42 44 46 48 50
2002
2007
2008
2009
2010
2012
2011 US
Europe
OCC
Figure Working capital performance of large European and US businesses
over time Source: All Tied Up: Working Capital Management Survey 2013, Ernst and Young, p. 6 ,