F9-chapter 4

47Chapter 44. Working capitalChapter GuideC1. The nature, elements and importance of working capital a) Describe the nature of working capital and identify its elements.b) Identify the objectives of working capital management in terms of liquidityand profitability, and discuss the conflict between them.c) Discuss the central role of working capital management in financialmanagement.C2. Management of inventories, accounts receivable, accounts payable and casha) Explain the cash operating cycle and the role of accounts payable &accounts receivableb) Explain and apply relevant accounting ratios including i. Current ratio, quick ratio,ii. Inventory turnover ratio, average collection period, average payablesperiod,iii. Sales revenue /net working capital ratio.48Chapter Overview49The two main objectives of working capital management are:✓ To increase the profits of a business✓ To provide sufficient liquidity to meet short term obligations as they fall dueThere is often a conflict between the two main objectives of working capital management; i.e. management need to carefully consider the level of investment in working capital and to consider the impact that this is having on a company’s liquidity position; an overview of this is given by the cash operating cycle.Working capital management is a key factor in an organization’s long-term success. A business must therefore have clear policies for the management of each component of working capital, management of short-term financing is the direct responsibility of the financial managers, and requires continuous day-to-day supervision.1 Elements of Working Capital2. Objectives of working capital management3. Role of working capital managementDifference50Lecture example 1RequiredHow can investment in higher levels of inventory or receivables will affect 1. Profitability? 2. Liquidity?The cash operating cycle (also known as the working capital or the cash conversion cycle) is the period of time which elapses between the point at which cash begins to be expected on the production of a product and the collection of cash from a purchaser.4.1 For manufacture businessRaw materials holding period X Less: payables’ payment period (X) WIP holding periodX Finished goods holding period X Receivables’ collection period X Cash operating cycleX4.Cash Operating CyclePurchase materialProductionGoods sold to customerMaterial daysWIP daysFinished Goods days Receivable daysCash operatingcycleCustomer paidPurchase paidPayable daysFinished goodsCustomer paidCredit purchase514.2 For retail/ wholesale businessInventory holding periodX Less: payables’ payment period (X) Receivables’ collection period X Cash operating cycleXLecture example 2Wines Co buys raw materials from suppliers that allow Wines 2.5 months credit. The raw materials remain in inventory for 1 month, and it takes wines 2 months to produce the goods. The goods are sold within a couple of days of production being completed and customers take on average 1.5 months to payRequiredCalculate wine’s cash operating cycle.Goods sold to customerInventory days Cash operatingcycleCustomer paidPurchase paidPayable daysReceivable daysCustomer paidCredit purchasePurchase material52Working capital ratios may help to indicate whether a company is over-capitalised, with excessive working capital, or if a business is likely to fail. A business which is trying to do too much too quickly with too little long-term capital is overtrading .✓ Current ratio ✓ Quick ratio✓ Accounts receivable payment period ✓ Inventory turnover period ✓ Accounts payable period✓ Sales revenue: net working capital5.1 Current RatiosCurrent Ratio = Current AssetQuick Ratio = Current Asset −InventoryCurrent Liability5.1.1 Average collection period5.2 Calculating the cash operating cycleAverage collection period =Receivables(Credit )Sales×365 days5.1.2 Inventory daysFinished goods days =Finished GoodsCost of Sales×365 daysWorking in progress days =WIPCost of Production×365 days5. Liquidity ratios53Raw material days =Raw Material×365 days5.1.3 Average payables periodAverage payables period =Payables(credit ) Purchases×365 daysCash operating cycle = Av. Collection period + Inventory days – Av. Payable periodLecture example 3The table below gives information extracted from the annual accounts of Management plc for the past year.Year 1$ InventoryRaw materials 108,000Work in progress 75,600Finished goods 86,400 Purchase of raw materials518,400 Cost of production675,000 Cost of goods sold756,000 Sales864,000 Receivables172,800 Payables86,400RequiredCalculate the length of the working capital cycle (assuming 365 days in the year).545.2 Forecasting cash flow needsThe cash operating cycle can be used to determine the amount of cash needed at any sales level, and to identify the possibility of a cash shortfall if sales rise too rapidly.We can identify a relationship between sales and cash required by using the sales / net working capital ratio.Ratio of Sales = Sales revenueThis ratio shows the level of working capital supporting sales. Working capital must increase in line with sales to avoid liquidity problems and this ratio can be used to forecast the level of working capital needed for a projected level of salesLecture example 4Refer to the company in example 3RequiredWhat level of net working capital (i.e. cash) is needed to support sales, if sales rise by 30% over the next year?55Overtrading is where a business has inadequate cash to support its level of sales. To deal with thisrisk a business must either:✓ There is a rapid increase in turnover6.1 Symptoms of overtrading✓ There is a rapid increase in the volume of current assets✓ There is only a small increase in proprietor’s capital. Most of the increasein assets is financed by credit, especially: a) Trade accounts payable b) A bank overdraft✓ Debt ratios and liquidity ratios alter dramatically.✓ Inject new long-term capital from shareholders 6.2 Solution to overtrading✓ Better control over working capitals ✓ Reduce trading level6. Overtrading56Chapter summary57Answer to lecture example 1(a) ProfitsHigher inventory means greater stock availability & possibly more choice to the customer ofdifferent variants of the product and therefore higher sales and higher profits. Higherreceivables may mean better payment terms, which may lead to higher sales and this again maylead to higher profits.(b) LiquidityHigher inventory & higher receivables mean more cash tied up in the short term which maylead to cash flow problems.There is sometimes a conflict between these 2 objectives.Answer to lecture example 2● Raw material days = 1 months ● WIP period= 2 months ● Receivable days = 1.5 months ● Payable days= (2.5) months Cash operating cycle= 1 + 2 + 1.5 – 2.5= 2 monthsAnswer to lecture examples58Answer to lecture example 3 ● Av. collection period = 73.0 days ● Inventory daysFinished goods = 41.7 days W.I.P = 40.9 daysRaw material = 76.0 days ● Av. payables period = (60.8) days Cash operating cycle= Inventory days + Payables period- collection period = 73+41.7+40.9+76-60.8 = 170.8 daysAnswer to lecture example 4Year 1 Inventory Raw materials 108,000 Work in progress 75,600Finished goods 86,400 Receivables172,800Payables(86,400) Net working capital 356,400 Sales 864,000 Sales/ Net working capital ratio= = 864/356.4 2.42Sales of next year = £864,000 x 1.3 = £1,123,200Net working capital needed = £1,123,200 / 2.42 = £464,132£464,132 of net working capital is needed to support 30% sales increase.59Chapter 55. Managing working capitalChapter GuideC2. Management of inventories, accounts receivable, accounts payable and casha) Discuss, apply and evaluate the use of relevant techniques in managinginventory, including the Economic Order Quantity model and Just-in-Time techniques.b) Discuss and evaluate the use of relevant techniques in managing accountsreceivable, including:i. Assessing creditworthiness ii. Managing accounts receivable iii. Collecting amounts owingiv. Offering early settlement discounts v. Using factoring and invoice discounting vi. Managing foreign accounts receivablec) Discuss and apply the use of relevant techniques in managing accountspayable, including:i. Using credit effectivelyii. Evaluating the benefits of discounts for early settlement and bulkdiscountsiii. Managing foreign accounts payable60Chapter Overview61The balancing act between liquidity and profitability, which might also be considered to be a trade-off between holding costs and stock out /re-order costs, is key to any discussion on inventory management.The objective of good inventory management is therefore to determine:✓ The optimum re-order level – how many items are left in inventory whenthe next order is placed, and✓ The optimum re-order quantity – how many items should be ordered whenthe order is placed✓ High value stock items, requiring careful stock control using sophisticatedmethods such asthe EOQ method discussed below with regular review and control1.1 Practical approach✓ Medium value stock items, as above but with less frequent review ✓ Low value stock items, aim to keep a continuous availability✓ Warehousing and handling cost 1.2 Basiceconomic order quantity (EOQ) modelThe order quantity affects a firm’s total inventory costs, these are:Holding costs✓ Insurance ✓ Obsolescence✓ Opportunity cost of capitalOrdering costs✓ Admin &delivery costs.Shortage costs✓ Contribution from lost sales✓ Extra cost of emergency inventory✓ Cost of lost production and sales in a stock-out.1. Managing inventory62The model uses the following terms: ✓ D = Annual demands in units ✓ C o = Cost of placing one order✓ C h = Annual cost of holding one unit in stock ✓ P = Purchase price per unit ✓ Q = Re-Order QuantityHolding Cost = (C h x Q)/2 (average inventory) Ordering Cost = C o x D/Q (number of orders) Total inventory cost = Holding cost + Ordering costTotal costs will always be minimised at the point where the total holding costs equals the total ordering costs. This point will be the economic order quantity.RRRREE =�2CoDChLecture example 1Firm X faces regular demand of 150 units per month, it orders from its supplier at a purchase cost per unit of £25. Each order costs £32, and holding cost is £4.5 p.a. and remains at this level.Requireda) Calculate the economic order quantity, and the average inventory level. b) Calculate total inventory related cost at this economic order quantity.Annual costRe-order quantityEOQ63Lecture example 2Monthly demand for a product is 10,000 units. The purchase price is $10/unit and the company’s cost of finance is 15% pa. Warehouse storage costs per unit pa are $2/unit. The supplier charges $200 per order for delivery. RequiredCalculate the EOQ, and the total inventory cost.i. Calculate EOQ in normal way1.3 Effect of discountsDiscounts may be available if the order quantity is above a certain size. Thus this needs to be considered in determining the best order quantity. The following 4 step approach should be used: ii. Calculate annual costs using EOQiii. Calculate annual costs at the lower boundary of each discount above the EOQiv.Select order quantity which minimises costs.Lecture example 3The annual demand for an item of inventory is 125 units. The item costs $200 a unit to purchase, the holding cost for one unit for one year is $30 and ordering costs are $300 per order. The supplier offers :1) 3% discount for orders of 60 units or more, and 2) Discount of 5% for orders of 90 units or more.RequiredCalculate the optimum ordering size64Lecture example 4Firm X faces regular demand of 150 units per month, it orders from its supplier at a purchase cost per unit of £25. Each order costs £32, and holding cost is $4.5 p.a. per unit.RequiredCalculates the minimum total cost assuming the following discount applies:1. Discount of 1% given on orders of 150 and over2. Discount of 2% given on orders of 300 and over3. Discount of 4% given on orders of 800 and over.✓ Assumes 0 lead times, and 0 bulk purchase discounts – although thesecan be adjusted for as shown above1.4Drawbacks of EOQ✓ Ignores the possibility of supplier shortages or price rises ✓ Ignores fluctuations in demand✓ Ignores the benefit of holding stock to customers (choice, short lead times) ✓ Ignores the hidden costs of holding stock651.5Uncertainties in demand and lead timeUncertainties in demand and lead time taken to fulfill orders mean that inventory will be ordered once it reaches a re-order levelRe-order level = maximum usage x maximum lead timeAverage Inventory= Q/2Average Inventory = B +Q/2TimeTimeQuantityQuantityB1.6Maximum and buffer safety inventory levelMaximum inventory level = re-order level + re-order quantity –(minimum usage x minimum lead time)Buffer safety inventory = re-order level – (average usage x average lead time)The expected usage during the lead time requires buffer stock (B) to be held, and the average stock level becomes B + Q/2.Average inventory = buffer safety inventory + re-order amount/2Lecture example5A company has an inventory management policy which involves ordering 50,000 units when the inventory level falls to 15,000 units. Forecast demand to meet production requirement during the next year is 310,000 units. You should assume a 50 week year and that demand is constant throughout the year. Orders are received two weeks after being placed with the supplier. What is the average inventory level?661.7.1 Benefit of JIT1.7 JIT (just-in-time) systemJIT is a term which describes a policy of obtaining goods from suppliers at the latest possible time and so avoiding the need to carry any materials or components inventory.Reduced inventory levels mean that a lower level of investment in working capital will be required. And lead to following benefits:a) Reduction in inventory holding costs b) Reduced manufacturing lead times c) Improved labour productivityd) Quick response to customer requirementse) Great production flexibility(adapt to customer needs) f) Faster / high quality suppliersg) More motivated staff who care about quality h) Faster delivery of high quality products i) Cost savings from carrying lower stock1.7.2 Limitations of JITa) Not suitable for business operate under volatile environment. b) Success largely depend on the reliability of suppliers c) Costly2.1 Policy formulationThe decision to offer credit can be viewed as an investment decision, resulting in higher profits. For many businesses offering generous payment terms to customers is essential in order to be competitive.2. Managing receivables (debtors)67Lecture example 6Greedy Ltd is considering a proposal to change its credit policy from allowing debtors credit of 2 months to credit of 3 months. Sales are currently £600,000 p.a. and as a result of the proposed change will increase by 15%. The contribution/ sales ratio is 20% and the cost of capital is 10%.RequiredShould the proposed change be made?a) Credit analysis system 2.2 Framework for managing receivablesTo keep control over the level of the level of debtors it is important to have an effective debtors policy which include:b) Credit control system c) Debt collection system2.2.1 Credit analysis systemBefore offering credit to particular customer, it is important to analyse the risk of trading with that customer by asking for bank references and trade references. A credit rating agency will also provide details on a customer’s trading history, debt levels and payment performance.a) New customers should give two good references,b) Credit ratings might be checked through a credit rating agency.c) A new customer's credit limit should be fixed at a low level and onlyincreased if his payment record subsequently warrants it/d) For large value customers, a file should be maintained of any availablefinancial information about the customer. This file should be reviewed regularly. Information is available form:e) The Department of Trade and Industry and the Export Credit GuaranteeDepartment will both be able to advice on overseas companies. f) Press commentsg) Send a member of staff to visit the company concerned,682.2.2 Credit control systemAfter credit analysis, a decision will be taken on the credit limit to be offered. It is important that this is not exceeded without senior management approval. Credit limits should also be regularly reviewed.2.2.3 Debt collection systemOn a regular basis a company should: ✓ Prepare an aged listing of debtors✓ Issue regular statements and reminders✓ Have clear procedures for taking legal action or charging interest ✓ Consider the use of a debt factor (considered later)✓ Analyse whether to use cash discounts to encourage early paymentIllustrationLet us assume that the Zygo Company sells widget for $1,000, which enables it to earn a profit, after all other expenses except interest, of $100 (i.e. a 10% margin).a) Aibee buys a widget for $1,000 on 1 January 20×1, but does not pay until31 December 20×1.Zygo relies on overdraft finance, which costs it 10% pa. The effect is:$ Net profit on sale of widget 100Overdraft cost $1,000×10% pa-100 Actual profit after 12 months credit Nil In other words, the entire profit margin has been wiped out in 12 months.b) If Aibee had paid after six months, the effect would be:$ Net profit 100months126 pa 10% $1,000cost Overdraft ×× -5050 Half the profit has been wiped out.69Lecture example 7Russian Beard Co is considering a change of credit policy which will result in an increase in the average collection period from one to two months. The relaxation in credit is expected to produce an increase in sales in each year amounting to 25% of the current sale volume.Selling price per unit $10 Variable cost per unit $8.50 Current annual sales$2,400,000The required rate of return on investments is 20%. Assume that the 25% increase in sales would result in additional inventories of $100,000 and additional accounts payable of $20,000.Advise the company on whether or not to extend the credit period offered to customers, if:a) All customers take the longer credit of two monthsb) Existing customers do not change their payment habits, andonly the newcustomers take a full two months credit2.3 Early settle payment discountEarly settlement discounts may be employed to shorten average credit periods, and to reduce the investment in accounts receivable and therefore interest costs. The benefit in interest cost saved should exceed the cost of the discounts allowed.To see whether the offer of a settlement discount (for early payment) is financially worthwhile we must compare the cost of the discount with the benefit of a reduced investment in accounts receivable .Varying the discount allowed for early payment of debts affects the average collection period and affects the volume of demand (and possibly, therefore, indirectly affects bad debt losses). We shall begin with examples where the offer of a discount for early payment does not affect the volume of demand.70Lecture example 8Lowe and Price Co has annual credit sales of $12,000,000, and three months are allowed for payment. The company decides to offer a 2% discount for payment made within ten days of the invoice being sent, and to reduce the maximum time allowed for payment to two months. It is estimated that 50% of customers will take the discount.If the company requires a 20% return on investments, what will be the effect of the discount? Assume that the volume of sales will be unaffected by the discount.712.4 Bad debt risk Lecture example 9Grabbit Quick Co achieves current annual sales of $1,800,000. The cost of sales is 80% of this amount, but bad debts average 1% of total sales, and the annual profit is as follows.The current debt collection period is one month, and the management consider that if credit terms were eased (option A), the effects would be as follows. Present policy Option A Additional sales (%) － 25% Average collection period 1 month 2 months Bad debts (% of sales) 1% 3%The company require a 20% return o its investments. The costs of sales are 75% variable and 25% fixed. Assume there would be no increase in fixed costs from the extra turnover, and that there would be no increase in average inventories or accounts payable. Which is the preferable policy, Option A or the present one?722.5.1 Types of factoring2.5 FactoringFactoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money it is due to collect.There are two types of factoringRecourse service✓ Factors do not take over firm’s administration of invoicing and debtcollection✓ Factors do not take over the default risk from clients ✓ This service is similar to a secured loan. Non-recourse service✓ Factor take over the administration of the client's invoicing, salesaccounting and debt collection service.✓ Credit protection for the client's debts, the factor takes over the risk ofloss from bad debts. This is known as a non-recourse service . However, if a non-recourse service is provided the factor, not the firm, will decide what action to take against non-payers.✓ Making payments to the client in advance of collecting the debts.2.5.2 Benefits of factoring73Lecture example 10A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt administration has been poor and the average collection period has been 45 days 0.5% of sales resulting in bad debts which are written off.A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of credit sales. The company would save $30,000 a year in administration costs. The payment period would be 30 days.The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current base rate). The company can obtain an overdraft to finance its accounts receivable at a rate of 2.5% over base rate. Should the factor's services be accepted? Assume a constant monthly turnover.✓ Invoice discounting is related to factoring and many factors will providediscounting service. It is the purchase of a selection of invoices, at a discount.2.6 Invoice discounting✓ The invoice discontent does not take over the administration of the client'ssales ledger.(a) Letters of credit2.7Managing foreign accounts receivableExporting carries a high risk of slow or nonpayment by customers, and requires closercontrol, this can involve:The customer’s bank guarantees it will pay the invoice after delivery of the goods.(b) Bills of exchangeAn IOU signed by the customer. Until it is paid, shipping documents that transferownership to the customer are withheld; it can also be sold to raise finance(c) Invoice discountingSale of selected invoices to a debt factor, the firm keeps control of its sales ledger.(d) Export factoring✓ invoicing & debt collection✓ cash advances in advance of the debtor paying74✓ Optional bad debt insurance (if used this is non-recourse factoring ).Lecture example 11A company with export sales of $480m pa has an average collection period of 3 months, bad debts are 2%. A factoring company will provide non-recourse factoring for a fee of 5% of revenue. As a result of this, administration savings will be made of £8m p.a. and the credit period will fall to 2 months.The company has a cost of capital of 10%, and the exchange rate is currently: 2 $/£. RequiredAssess, in £s, whether the factor should be used.✓ It is important that when suppliers offer credit, invoices are not paid early;an exception to this is when early payment discounts are offered.3.1 Importance of managing trade payables✓ It is also important to be careful that when suppliers offer credit, invoicesare not paid so late that this endangers the firm’s long term relationship with the supplier. The benefits of a long term relationship include: a. Better quality b. Lower stockc. Lower switching costsLecture example 12Pips Limited has been offered a discount of 2.5% for an early settlement by a major supplier from which it purchases goods worth £1,000,000 each year. Pip’s normal payment terms are 30 days, early settlement requires the payment to be made within 10 days.Currently Pips has an overdraft on which it is paying 10% interest.RequiredAssess whether Pips should take the discount and settle the invoice after 10 days.3.Managing trade payables75Lecture example 13X Co has been offered credit terms form its major supplier of 2/10, net 45. That is, a cash discount of 2% will be given if payment is made within ten days of the invoice, and payments must be made within 45 days of the invoice. The company has the choice of paying 98c per $1 on day 10(to pay before day 10 would be unnecessary), or to invest the 98c for an additional 35 days and eventually pay the supplier $1 per $1. The decision as to whether the discount should be accepted depends on the opportunity cost of investing 98c for 35 days. What should the company do? (Assume that investment can generate a return at 25% p.a)3.2Managing foreign accounts payableTo avoid the risk of the £ weakening by the time an invoice is due to be paid, companies sometimes pay into an overseas bank account today and then let the cash earn some interest so that they can pay off the invoice in the future.76Chapter summary77Answer to lecture examples 1 a. Calculate EOQ using formula RRRREE =�2×1,800×324.5=160 unitsb. Total cost= Purchasing cost + Ch x Q/2 + Co x D/Q = 1,800 x 25 + 4.5 x 160/2 + 32 x 1800/160 = 45,720Answer to lecture examples 2 Co= 200D = 10,000 x 12 = 120,000 Ch = (10 x 15%) + 2 = 3.5RRRREE =�2×200×120,0003.5=3,703 unitsAnswer to lecture examples 3 Step 1 Calculate EOQ ignoring discount RRRREE =�2×300×125=50 unitsStep 2 Calculate annual costs using EOQ, and at the lower boundary of each discount above the EOQOrdering 90 units a time have the lowest inventory cost.Answer to lecture examples78Answer to lecture examples 4Step 1 Calculate EOQ (already qualify for 1% discount condition) RRRREE =�2×1,800×324.5=160 unitsStep 2 Calculate annual costs using EOQ, and at the lower boundary of each discount above the EOQOrdering 300 units a time have the lowest inventory cost.Answer to lecture example5Average usage per week = 310,000 units / 50 weeks = 6,200 units Average lead time = 2 weeks Re-order level = 15,000 units Buffer safety inventory = inventory level – (average usage x average lead time)= 15,000 – (6,200 x 2 ) = 2,600 unitsAverage inventory = buffer safety inventory + re-order amount / 2 = 2,600 + 50,000/2 = 27,600 unitsAnswer to lecture example 6CostFinance cost of new receivables= (600,000 x 1.15 x 3/12) – (600,000 x 2/12) x 10%= (7,250)BenefitAdditional contribution= £600,000 × 15% × 20% = £18,000。