1. Working Capital Management

2. Working Capital
In this lecture we will look at
 short and medium term methods of financing
 short term financing concerns
 inventory levels, trade payables and receivables
 the cash conversion cycle
 why it is important to manage working capital
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3. Short and medium term financing
 SHORT (repayment in under 1 year?)
 Overdraft
 Trade credit
 Factoring
 MEDIUM (repayment in 1 to 7 years?)
 Term loan
 Hire purchase
 Leasing
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4. Overdraft facilities
 timescale of months
 interest charged on the daily outstanding balance
 flexible - no term structure
 available to smaller and riskier businesses
 lender can remove facility at short notice
 conditions:
 cash flow projections
 creditworthiness
 commitment from the borrower
 security in the form of assets
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5. Trade Credit
 company receives goods and services
 invoice paid at a later time
 some flexibility in credit terms
 vital source of finance for large as well as small
companies
 “Tesco and Asda typically have over twice as much
owing to suppliers at any one time as the value of all
the goods on their shelves – more than £2.2bn for
Tesco and £1.5bn for Asda.”
 5 Arnold, chapter 12, page 482

6. Factoring
 immediate transfer of cash to firms with outstanding
receivables
 when invoices are paid then factoring company
receives payment
 carried out by subsidiaries of major banks
 fee and interest charged on amount advanced
 comparable with overdraft interest rates
 transfer of risk to factoring company
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7. Hire purchasing
 company takes possession of the goods
 a series of regular payments are made until the
company owns the goods
 payments include principal repayment and interest
 no large payments up front
 plant and machinery; agricultural equipment; hotel
equipment; office equipment; commercial
vehicles
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8. Leasing
 lessor gives right to use equipment in return for
regular payments
 no transfer of legal ownership
 Operating lease
 short term contract
 asset then sold or leased to another client
 photocopiers
 Finance lease
 full cost of equipment recovered over the life of the lease
 risks borne by lessee
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9. Issues
Balance:
cash too little/
too much
payables risk
inventory
receivabl
es
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10. What is working capital?
 Current assets less current liabilities
 inventory
 cash
 receivables
 payables
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11. Working Capital Management
inventory Conversion Period Receivables
Conversion period
Fin.
Raw Mat WIP Goods £
Credit from Suppliers
Cash Conversion Cycle
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12. Cash conversion cycle
 Cash conversion cycle = inventory days +
receivables days – payables days
 For example:
 Buy raw materials on 33 days‟ credit
 Takes 50 days to turn raw materials into finished product
 Give 30 days‟ credit on finished product
CCC = 50 + 30 – 33
= 47 days
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13. Some ratios: LIQUIDITY
 Current ratio (working capital ratio)
= CA / CL
o a ratio of less than one might indicate liquid
resources not enough to meet short term payments
o a ratio of more than one might indicate high levels of
inventory and not enough cash
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14. Some ratios: EFFICIENCY
 receivables (days)
= (receivables/sales ) x 365
 payables (days)
= (payables/cost of sales ) x 365
 inventory turnover (days)
= (inventory / cost of sales ) x
365
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15. Example – 2007
Balance Sheet Sainsbury Rolls Royce
plc Group
£m
inventory 590 2,203
receivables 30 889
inventory + 620 3,092
receivables
payables 1,706 778
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16. Example – 2007
P&L Sainsbury Rolls Royce
plc Group
£m
Sales 17,151 7,435
Cost of Sales 15,979 6,003
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17. Example – 2007
Ratios Sainsbury plc Rolls Royce
Group
receivables days (30/17,151) x 365 (889/7,435) x 365
= 0.6 days = 44 days
payables days (1706/15,979) x 365 (778/6,003) x 365
= 39 days = 47 days
inventory (590/15,979) x 365 (2,203/6,003) x 365
turnover days = 13 days = 134 days
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18. Overtrading
 Not to be able to provide the level of working capital
required to sustain a particular level of trading is
known as overtrading
 Failure to meet increases in turnover with appropriate
increases in working capital requirement
 Possible for a firm to double its sales and profits and yet
become insolvent
 Too much money is tied up in inventory and trade
receivables?
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19. Managing working capital
 INVENTORY
 TRADE PAYABLES
 TRADE RECEIVABLES
 CASH
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20. Managing inventory
 Determined by what the firm does
 There will be large differences in inventory
levels between traders due to
 the nature of the goods
 the speed of the inventory turnover
 seasonal fluctuations
 Costs of holding inventory need to be balanced
against the opportunity costs
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21. Balance
 Risks of holding high  Risks of holding low
inventory inventory
 storage costs  loss of production
 handling costs  loss of sales
 money tied up  loss of customer
 obsolescence goodwill
 insurance costs
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22. Policy decisions
 Optimum reorder quantities need to be
established for each item of inventory
 Companies need to take into account how fast
inventory is used up and how long orders take to
be fulfilled
 Many firms like to hold a “buffer” of inventory to
meet unexpected changes in demand
 Other firms operate “just in time” policies
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23. Managing Trade payables
 „Free‟ source of finance
 No interest
 Costs
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24. Policy decisions
 Take into account
 discounts offered
 attitude of suppliers
 Exploit trade credit
 Manage exchange rate risk
 Use ratios for monitoring
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25.  Companies that take the longest to pay are in the
construction, manufacturing, pharmaceuticals and
retail sectors
 Large number of small suppliers
 Average payment time is
 44 days for all plcs
 34 days for 350 largest plcs
 Based on article by David Oakley, FT, March 2008
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26. Managing receivables
 Attitudes vary
 Credit sales = interest free loans
 A balance must be arrived at between the costs of
granting credit and those associated with denying or
restricting credit
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27. Balance
 granting credit  denying credit
 higher sales  loss of customers
 customer goodwill
 risk
 costs of administration
 costs of financing
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28. Policy decisions
 Establish a credit policy
 Assess credit worthiness of customers
 Establish a policy on bad debts
 Consider cash discounts and factoring/ invoice
discounting
 Manage exchange rate risk
 What are competitors offering?
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29. Managing Cash Balances
 Cash needs to be held
 to meet planned needs
 transaction motive
 to meet unplanned obligations
 precautionary motive
 to enable unexpected opportunities to be taken
 speculative motive
 Surplus cash should be invested
 Cash needed varies over time
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30. Balance
 Holding too much cash  Holding too little cash
 loss of interest  liquidity risk
 loss of goodwill
 inability to meet
emergency requirements
 missed opportunities
 borrowing costs
 deterioration in liquidity
measures
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31. Financing WC
 Firms need mixture of LT and ST funds
 Assets needing to be financed
 Fixed
 Permanent CA
 Fluctuating CA
 Policies
 Matching
 Conservative
 Aggressive
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32. Matching
Funds
Fluctuating CA
Short-term finance
Long-term
Permanent CA finance
Fixed Assets
Time
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33. Conservative
Funds
Fluctuating CA
Short-term finance
Long-term
Permanent CA finance
Fixed Assets
Time
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34. Aggressive
Funds
Fluctuating CA
Short-term finance
Permanent CA
Fixed Assets Long-term
finance
Time
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35. Summary
 Efficient management of working capital – key to
business success
 Relates to management of:
 inventory
 receivables
 payables
 Cash
 Poor working capital management one of the more
common reasons for corporate failure
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36. Further reading and prep for seminar
Watson, D. and Head, A. Corporate
Finance Principles and Practice, 5th edn
Chap 3.
Arnold, G. Corporate Financial
Management, Chapter 12, Chapter 13 (pp
529-550)
Self test questions page 91 of Watson and