1. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 1 Accounting for Management Decisions WEEK 8 MANAGEMENT OF WORKING CAPITAL READING: TEXT Ch 13

2. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 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. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 3 The Nature and Purpose of Working Capital minus (CA – CL) Working Capital is usually defined as current assets minus current liabilities (CA – CL) Represents a net investment in short-term assets The main elements of CA are: - Inventory receivable - Accounts receivable (trade debtors) - Cash - Cash (in hand and at bank) The main elements of CL are: payable - Accounts payable (trade creditors) overdrafts - Bank overdrafts

4. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 4 The Nature and Purpose of Working Capital cont’d Finished goods Finished goods Work in progress Work in progress Cash sales Trade receivables Trade receivables Cash/bank overdraft Cash/bank overdraft Raw materials inventories Raw materials inventories Trade creditors Trade creditors Figure 13.1 - The working capital cycle of a manufacturing business START

5. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 5 The Nature and Purpose of Working Capital cont’d essentialshort-term The management of working capital is an essential part of the short-term planning process too much too little There are costs incurred by holding too much and too little of each element opportunity Costs include opportunity cost of using these elements elsewhere change Needs are likely to change over time externally internal Change may be externally driven (economy) or result from changes to the internal environment (product mix)

6. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 6 The Management of Inventories customers Inventories are held mainly to meet the immediate requirements of customers and production high assets Manufacturing businesses tend to hold a high proportion of their assets as inventory: - Raw materials - Work-in-progress - Finished goods

7. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 7 The Management of Inventories cont’d Seasonality Seasonality may vary inventory holdings over a year minimise costs Retail businesses would try and minimise their inventories because of costs eg storage, financing, opportunity cost etc.

8. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 8 The Management of Inventories cont’d Forecasts of future demand: Accurate Accurate forecasts are important statisticaljudgement Can use statistical approaches or judgement of staff/managers monitor Financial ratios: can be used to monitor inventory levels Inventory Average inventory held x 365 turnover = Cost of sales period

9. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 9 The Management of Inventories cont’d Recording and re-ordering systems: Efficiency regularly Efficiency is key, needs to be monitored regularly authority senior Decision authority should be confined to a few senior staff members Lead-timesdemand Lead-times and likely demand should be determined Bufferuncertainty Buffer levels to deal with uncertainty should be determined

10. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 10 The Management of Inventories cont’d Stock/inventory management models: EOQ Economic order quantity (EOQ): holding ordering Recognises that total cost includes holding and ordering costs optimum Calculates the optimum size of the order, taking these two components into account Decreasing increase Decreasing inventory held means an increase in order costs as the number of orders rises in the period Increasing increase Increasing inventory held means an increase in holding & storage costs minimisetotal EOQ seeks to identify the size of the order that will minimise total costs

11. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 11 The Management of Inventories cont’d Figure 13.4 - Inventories holding and order costs

12. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 12 The Management of Inventories cont’d The EOQ model: where: demand D is the annual demand for the item of stock placing an order C is the cost of placing an order holding H is the cost of holding 1 unit of stock for 1 yr Some limiting assumptions apply to the model (next slide)

13. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 13 The Management of Inventories cont’d The EOQ model: assumptions Limiting assumptions of EOQ model: predicted That demand for the product can be predicted with accuracy even Demand is even over the period with no fluctuations buffer No ‘buffer’ inventory is required discounts There are no discounts for bulk purchasing

14. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 14 The Management of Inventories cont’d Just-in-time (JIT) inventory management: just in time Aims to have materials delivered to production ‘just in time’ for their required use holding Limits holding time and investment in raw materials Suppliers advance Suppliers are informed of production requirements in advance Some disadvantages: expensive May mean inventory is more expensive non-supply Risk of non-supply

15. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 15 The Management of Debtors incurs Selling goods or services on credit incurs costs Costs include administration, bad debts and opportunity costs policy When a business offers to sell on credit, it must have a clear policy (see next slide)

16. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 16 The Management of Debtors cont’d When a business offers to sell on credit, it must have a clear policy concerning: Which Which customers should receive credit much How much credit should be offered length What length of credit terms it can offer discounts Whether discounts will be offered for prompt payment collection What collection policies should be adopted reduced How the risk of non-payment can be reduced

17. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 17 The Management of Debtors cont’d Which customers should receive credit? 5 Cs The ‘5 Cs’ of credit: 1.Capital 1.Capital/Contribution - must appear to be financially sound (liquidity risk) before credit is offered 2.Capacity 2.Capacity - must seem able to pay amounts owing (examine payment record/history) 3.Collateral 3.Collateral - can the customer offer satisfactory security if required … cont’d over page

18. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 18 The Management of Debtors cont’d ‘5 Cs’ of credit ( cont’d) : 4.Conditions 4.Conditions - how the industry and general economic environment the customer operates in affects their ability to pay amounts owing 5.Character 5.Character - a subjective assessment made by the business of factors such as honesty, willingness to pay, integrity, reliability, etc.

19. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 19 The Management of Debtors cont’d Length of credit period: The length of credit offered varies and may be influenced by factors such as: industry Typical credit terms operating in the industry competition The degree of competition in the industry bargainingpower The bargaining power of particular customers risk The risk of non-payment capacity The capacity of the business to offer credit marketing The marketing strategy of the business

20. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 20 The Management of Debtors cont’d discounts Cash discounts (early settlement offers): costbenefits The cost must be weighed against benefits slow still Danger that customers will be slow to pay and still take the discount offered reduction The benefit represents a reduction in the cost of financing debtors and bad debts

21. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 21 The Management of Debtors cont’d Collection policies Steps to ensure amounts owing are paid promptly may include: relationships Develop customer relationships terms Publicise credit terms promptly Issue invoices promptly Monitor Monitor outstanding debts Produce a schedule of aged debtors Answer queries quickly slow Deal with slow payers Identify the monthly pattern of receipts from credit sales

22. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 22 The Management of Cash Why hold cash? varies Most businesses hold cash but the amount held varies considerably 3 There are 3 reasons for holding cash: Transactionary Transactionary – for day-to-day requirements (wages, overheads, etc) Precautionary Precautionary – is prudent for uncertain times (bad debts, poor economic cycle, etc) Speculative Speculative – for profitable opportunities (get bulk discounts, buy competitor, etc) … cont’d over

23. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 23 The Management of Cash cont’d Why hold cash cont’d …? much How much cash should be held? different different No set formula - different businesses will have different views/amounts lower quickly Amount held can be lower if funds can be raised quickly or assets held that can be converted to cash with ease such as shares or bonds

24. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 24 The Management of Cash cont’d Controlling the cash balance Upperlower Upper and lower control limits model: Assumes business can access cash as needed The model proposes the use of 2 upper and 2 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 judgement Model relies heavily on management judgement to determine where the control limits are set and what time limits for breaches are acceptable Fig 13.5 see Fig 13.5

25. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 25 The Management of Cash cont’d Cash flow statements and management of cash: budget It is useful for a business to a prepare cash flow statements and/or a cash budget Comparison variances Comparison of budgeted cash flows to cash flow statements will identify variances for action surplusesdeficits prior Expected cash surpluses and deficits can have a course of action decided upon by management prior to occurrence

26. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 26 The Management of Cash cont’d Operating cash cycle: between purchase sale Definition: The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash from the sale of goods awareness To effectively manage cash, there must be awareness of the operating cash cycle shorten cash Management seeks to shorten the time and reduce cash required in the cycle

27. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 27 Business Operating Cycle Source of diagram: Entrepreneurship and Small Business, 2ed, Wiley Cash Inventory Cash Inventory Accounts Receivable Accounts Receivable Purchase and Cash Cash Sale Purchase and Credit Credit Sale

28. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 28 The Management of Cash cont’d Cash transmission: Benefitimmediately Benefit is received immediately if payment is made in cash Cheques normally incur a delay of up to 10 working days to clear through the banking system (see next slide) Opportunity Opportunity cost of this delay can be significant minimise Alternatives to minimise delays can include:  Insist on payment in cash (not always practical)  Utilise direct debit facilities and card payments

29. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 29 Good A cheque ’ s path ( Good cheque) Source of diagram: Horngren, 5ed, Pearson Drawer writes cheque to payee.Drawer writes cheque to payee. Payee deposits cheque in own bank.Payee deposits cheque in own bank. Payee’s bank sends cheque to Drawer’s bank. Payee’s bank sends cheque to Drawer’s bank. Drawer’s bank pays pays the cheque. Drawer’s bank pays pays the cheque. Start:

30. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 30 Dishonoured after Cheque ’ s Path (a Dishonoured cheque) - after completing circuit in previous slide Source of diagram: Horngren, 5ed, Pearson Drawer’s bank not balance is not sufficient sufficient to pay the cheque. Drawer’s bank not balance is not sufficient sufficient to pay the cheque. Drawer’s bank sends worthless back cheque back to payee’s bank. Drawer’s bank sends worthless back cheque back to payee’s bank. Payee’s bank decreases decreases payee’s balance. Payee’s bank decreases decreases payee’s balance. Payee holdsworthless cheque. Payee holdsworthless cheque.

31. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 31 The Management of Cash cont’d overdrafts Bank overdrafts: loan Are simply a type of bank loan (short term – repayable usually within 1 year or even a few months) cash Can be useful for managing cash flow requirements

32. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 32 Creditors The Management of Trade Creditors source Trade credit is an important source of finance for many businesses sales Tends to increase in line with the increase in sales free costs Widely regarded as ‘free’ however, there can be costs associated with taking credit: rise  Cost of goods may rise as credit needs to be paid for lower priority  May be given lower priority in terms of delivery dates  Administration  Administration costs associated with dealing with invoices and confirming receipt of goods/service

33. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 33 The Management of Trade Creditors cont’d Controlling Controlling trade creditors Using the average settlement period method: Average Average trade creditors x 365 settlement = Credit purchases period Alternative approaches: -Ageing schedule -Pattern of credit payments