Working Capital Management
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Working Capital Management
- 2. PROGRAMME ï± The nature of working capital ï± The cash operating cycle ï± Funding the cash operating cycle ï± The objectives of working capital ï± Inventory management ï± Managing trade receivables ï± Relationship with suppliers ï± Managing Cash 2
- 3. The Nature of Working Capital 3
- 4. Definition of Working Capital Current Assets less Current Liabilities Current Assets Current Liabilities Inventories Trade Payables Raw Materials Accruals Work-in-Progress Taxation/Dividends Finished Goods Short-Term Borrowings Trade Receivables Prepayments Bank/Cash 4
- 5. Why Invest in Current Assets 5
- 6. Example: Raw Materials Despite running at full capacity, steel suppliers in Japan and elsewhere in Asia struggled to satisfy Japanâs booming exporters Nissan had to cut down its production by an estimated 40,000 vehicles to meet demand in March (March is the month where demand for cars in Japan hits a peak) Source FT Dec 2004 6
- 7. Funding Current Assets The Cheapest way to finance current assets is to use free credit from suppliers This may lead to LIQUIDITY PROBLEMS. This risk can be illustrated using a Cash Operating Cycle 7
- 9. Cash Operating Cycle Inventory Turnover Period Raw Materials Avg Raw Materials x 365 holding period Credit Purchases Production Average Work-in-Progress x 365 Period Cost of Production Finished Average Inventory x 365 Goods holding Cost of Sales period 9
- 10. Cash Operating Cycle cont. The accounts receivable payment period How long our customers take, Average Trade Receivables x 365 on average, to settle their bills Credit Sales 10
- 11. Cash Operating Cycle cont. Accounts payable payment period How long, on average, we Average Trade Payables x 365 take to pay our Credit Purchases customers FREE CREDIT DAYS!! 11
- 12. Ratios are not perfect Ratios have limitations particularly when comparing P/L items with Balance Sheet Figures Example: In December retailers normally have below average stock levels and therefore an average based on December figures may not reflect the annual average 12
- 13. Beware Averages If you are 6 feet tall and you donât know how to swim, would you wade across a pool with an average depth of 3 feet? 13
- 14. Cash Operating Cycle Financing current assets entirely from trade payables will keep the cost of interest down Raw Materials W-I-P Finished Goods Debtors Cash Inflow Trade Payables Cash Outflow BUT this may lead to liquidity problems 14
- 15. Liquidity Risk? Deferral of Cash Inflows Stock becoming obsolete or out-of-fashion Disruptions in production processes Debtors failing to meet credit deadlines Foregone Cash Inflows Bad Debts Other Cash Outflows - Overheads 15
- 16. The need for working capital The duration of the trade payables period is normally dictated by suppliers or the market in general. Therefore it may not match the current asset turnover period In addition the conversion of current assets into cash may be deferred or at worse foregone (Bad Debts) 16
- 17. Cash Operating Cycle Raw Materials W-I-P Finished Goods Debtors Trade Payables Funding the cash operating cycle 17
- 18. Funding the Cash Operating Cycle 18
- 19. Funding the Cash Operating Cycle Short-Term Borrowings ï± Bank Overdraft ï± Commercial Paper ï± Invoice or Bills of Exchange Discounting Long-Term Capital Employed ï± Debt / Equity 19
- 20. Funding the Cash Operating Cycle AGRESSIVE CONSERVATIVE SHORT-TERM FUNDING LONG-TERM FUNDING 20
- 21. Funding the Cash Operating Cycle MATCHING Current assets are assets which are either cash or expected to be converted into cash with one year For funding purposes these can be classified into: Permanent Fluctuating 21
- 22. Funding the Cash Operating Cycle Example: Toy Shop Permanent Inventory Inventory required to stock the shops plus to keep some buffer stock in warehouse/s Fluctuating Inventory levels before the Easter, Summer and Christmas holidays will normally be above average 22
- 23. Funding the Cash Operating Cycle 18 16 Fluctuating 14 Current Assets 12 financed by 10 Short-Term 8 Funding 6 Permanent Current Assets 4 financed by Long-term Capital 2 0 r l r l r l r l Jan Ap Ju Oct Ja n Ap Ju Oct Ja n Ap Ju Oct Jan Ap Ju Oct 23
- 24. The Objective of Working Capital Management 24
- 25. Aim of Working Capital Management A business needs to invest in current assets to sustain its business operations The aim of working capital management is to strike off a balance between FINANCIAL STABILITY and PROFITABILITY 25
- 26. Over-Capitalization -Working Capital Too much working capital will impinge on profitability Higher interest rate burden Opportunity Cost â long-term capital tied in current assets can be used to finance feasible projects 26
- 27. Inadequate Working Capital Inadequate Working Capital may lead to liquidity problems Overtrading Rapid expansion in business without having adequate working capital. 27
- 28. Inadequate Working Capital cont. Symptoms of Overtrading Accounts Payable period will increase Development of hard core element in bank overdraft plus encroachments Profit margins will start to decline as raising cash will be given priority to profitability 28
- 29. Optimum Working Capital Some textbooks suggest that: Over-Capitalised Under-Capitalised Current Ratio >2:1 <2:1 Quick Ratio >1:1 <1:1 Cash Operating Cycle Long Short However Working Capital needs depend on a number of factors. For example: ï± type of industry ï± accessibility to financial markets 29
- 30. Optimum Working Capital cont. J SAINSBURY â FOOD RETAIL INDUSTRY Inventory (13.8 days) Negative Working Capital Trade Payables (48.7 days) Source: Fitch Ratings figures as at 24-Mar-07 30
- 31. Optimum Working Capital cont. SABMILLER â BREWERY Inventory processing period (31.2 days) Debtors (27.4 days) Trade Payables (30.7 days) Cash Operating Cycle (27.9 days) Source: Fitch Ratings figures as at 31-Mar-07 31
- 32. Conclusion on Optimality Working Capital Needs differ among industries Optimality depends on the management of the constituents of Working Capital 32
- 33. Managing Working Capital 33
- 34. Inventory Management INVENTORY COSTS HOLDING COSTS funding storage insurance PROCUREMENT ordering delivery SHORTAGE COSTS lost contribution from missed sales 34
- 35. Economic Order Quantity 1/2 EOQ = 2 Co D Ch Where: EOQ (Q) economic order quantity Co Ordering Cost D Annual Demand Ch Cost of holding 1 unit 35
- 36. Economic Order Quantity cont. Example: The expected annual demand is 500,000. Purchase price is $100. It costs $ 500 to place an order and the cost of holding one unit in stock is 20%. 36
- 37. Economic Order Quantity cont. $' 000s Ch Co 300 TC 250 200 150 EOQ 100 50 - Q 00 00 00 00 00 0 0 00 00 00 00 00 ,0 0 0 0 0 ,0 ,0 ,0 1, 2, 3, 4, 5, 9, 10 6 7 8 37
- 38. Economic Order Quantity cont. Assumptions â Practical Implications ïŹGoods are delivered when they are ordered i.e. no lead times ïŹDemand is constant ïŹPrice is constant and no bulk purchases discounts 38
- 39. Just-in-Time JIT Toyota was the first company to develop JIT Toyota needed to reduce costs of production and JIT was the solution Kanban System â pull system of production i.e. items are only produced when they are needed 39
- 40. Just-in-Time JIT cont. Companies thinking of introducing JIT will first have to: Find reliable suppliers Train employees to minimize wastages and idle time Improve quality Minimize lead times 40
- 41. Trade Receivables A company which is selling on credit is actually lending money It must have a debtors policy, composed of a: ïŹCredit Analysis System ïŹCredit Control System ïŹDebt Collection procedure 41
- 42. Trade Receivables The objective of selling on credit is to increase sales, however: Sales Growth is vanity Profit is sanity Cash is king Ultimate objective should be profitability without jeopardizing liquidity 42
- 43. Increasing Trade Receivables Main benefit â increase in contribution Costs Increase in debtors administration costs Increase in the likelihood of bad debts Increase in funding costs 43
- 44. Factoring Three-tiered service Administration Credit Protection Invoice or Bills of Exchange Discounting 44
- 45. Factoring cont. Advantages Disadvantages Saving in administration Can be expensive costs Loss of goodwill if too Invoice discounting: aggressive at chasing for alternative source of funds payment Credit protection Can be deemed as a signal of liquidity problems 45
- 46. Trade Payables Factors to consider in choosing Suppliers: ïŹCredit Terms ïŹReliability ïŹPrice 46
- 47. Management of Cash 3 reasons for holding cash Transactions motive Precautionary motive Speculative motive (John Maynard Keynes) 47
- 48. Cash Flow Forecast Simple and Effective Cash Management tool Objective is to estimate future ïŹcash shortages ïŹcash surpluses 48
- 49. Cash Flow Forecast cont. Temporary Surpluses Benefit from early settlement discounts Increase current assets Make short-term investments Temporary Deficits Arrange for short-term funding Give early settlement discounts 49
- 50. Cash Flow Forecast cont. Permanent Deficits Raise long-term finance Permanent Surpluses Look for feasible long-term projects Reduce gearing Expand/Diversify 50
- 51. Large Organizations Cash management in large organizations tends to be more complex Most organizations have centralized treasuries and apply more sophisticated models to manage cash 51
- 52. Baumol Model The Baumol model is the same one which is used to estimate EOQ Cash is considered as inventory and two related costs are: Money Procurement costs Opportunity cost 52
- 53. Baumol Model example Division A Division B Cash flows Cash flows Treasury Cash flows Cash flows Division C Division D 53
- 54. Baumol Model example cont. According to the cash flow forecast, Division Bâs annual cash requirement is $ 1 million Procurement Costs - $ 700 Opportunity Cost - 3.5% 54
- 55. Baumol Model example cont. 1/2 EOQ = 2 Co D Ch Using the same formula for inventories, the optimal amount to be raised and transferred is U$ 200,000. 55
- 56. Conclusion Current Assets are essential in sustaining the operations of a business. Working Capital Management deals with how current assets are managed and financed. The objective of working capital management is to maximize profitability without jeopardizing liquidity. 56
- 57. QUESTION TIME 57
Hinweis der Redaktion
- The cash operating cycle estimates the time taken from the receipt of raw materials to actually receiving the cash from selling the finished good. It also measures the extent to which the investment in current assets is funded by free credit and how much is funded by long-term capital employed (working capital)
- Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
- Zero Cash Operating Cycle may not be achievable in practice Even if it is achievable, this may lead to liquidity problems
- Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
- Short-Term funding is cheaper since for example bank overdraft interest is charged on overdrawn amount only and limit is reviewed every year and can be reviewed upwards or downwards according to business needs Invoice Discounting â advantage is that the business can benefit from the credit worthiness of its customers (if this is better than that of business)
- Although Equity from a financial accounting perspective appears to be cheap, it is in fact the most expensive source of funding A business is not legally obliged to pay dividends but if the company does not pay dividends it has to deliver capital gains. Capital Gains are delivered if the return on investment is greater than the required return of shareholders.
- Deterioration in profit margins: Cash Discounts given by suppliers will be foregone Bank charges (returned cheques and encroachments) and interest burden will increase Cash Discounts given to debtors to raise cash Trade Discounts given to increase stock turnover with the objective of increasing cash flows from operations The best suppliers in the market will be reluctant to do business with you as you are no longer seen as a âgoodâ customer
- Accessibility to financial markets most often depends on the size of the business. Small and Medium sized companies normally resort to overdraft facilities. Large companies can access other types of short-term funding such as Commercial Paper which gives them more flexibility in managing their working capital needs. In addition, it is easier for large companies to raise medium and long-term funding Business practices might also affect working capital management, for example bank overdrafts are not common in Italy, where they rely more on Invoice Discounting. In analyzing the level of working capital whether it is over-capitalized or not, ratio analysis may prove to be useful. Trends Peer Group Analysis
- Food Retail Industry â Characteristics High Inventory Turnover Low Operating Margins (to mitigate this they diversify into non-food goods and also services). They can afford a higher gearing Stability of Revenue (although earnings from non-food sales are more volatile) Property Portfolio
- Working Capital needs may increase due to food inflation Earnings fairly stable but prone exchange rate risk as company has a major presence in emerging countries.
- For instance even among industries companies may have different production processes or different inventory management policies. On the other hand although debtors policies are formulated internally, these would be constrained by market practices The size of the company matters as well, since it can negotiate better terms with suppliers and also accessibility to capital markets.
- Inventory management deals with minimizing these costs. These costs are negatively correlated and the objective is to strike a balance between these costs Examples: To minimize shortage costs, companies need to hold buffer stock and therefore incur holding costs Procurement costs and holding costs are negatively correlated â trade off between more frequent order (maximize procurement costs and minimize holding costs) or less frequent orders (minimize procurement and maximize holding costs) A model that helps us striking an optimal balance is the Economic Order Quantity
- Reliable suppliers are essential as they have to deliver raw materials or components in time and of the right quality. Some companies might be willing to pay a premium over the normal purchase prices Since stock levels would be at a minimum, company cannot afford wastages due to bad workmanship Since the output of one process is the input of another, semi-finished goods must be of good quality otherwise the whole production process will stop Minimizing lead times is essential, otherwise in order that production continues a company would need to keep inventories If the company manages to achieve these, apart from the benefit of reduced inventories costs, efficiency in the organization would increase
- Credit Analysis System It is important that before selling on credit to a particular customer, the company assesses his credit worthiness. In addition to looking at the accounts to analyze the financial health of the company and possibly evaluating the track record of management, one can use bank references, trade references and the services of credit rating agencies. Credit Control System After the analysis, the company will determine the credit limit and period to be offered. This would need to be reviewed from time to time. Company should also monitor that customers are respective the credit terms given. Debt Collection System Prepare an aged listing of debtors Issue regular statements and reminders Have clear procedures for taking legal action Analyze whether to use cash discounts to encourage early payment
- The main benefit of invoice discounting is that you can borrow on the financial strength of your customers. In addition sales growth can be financed through sales Nonetheless the factor would not want to incur any bad debts and so can be quite aggressive. Apart from savings of administration costs, management can concentrate more on business rather than on collection of debtors.
- Credit Terms are usually given either through market practice or by supplier. Large corporations may have negotiating power for example large food retailers such as Tosco, Wal-Mart they can negotiate favourable terms. Good Relations are important and so company must ensure that trade payables are settled within the allowable period. Reliability â delivery in expected time and of the right quantity and quality â link with Just-in-Time Early Settlement Discounts should be evaluated in terms of the impact on cash operating cycle. Early settlement will be funded from short-term or long-term funding Price although important, should not be the main decisive factor
- Cash is not just vault cash and balances with bank but also unutilized amounts on overdraft facilities Holding cash is like holding inventory and there is a cost, more specifically an opportunity cost.
- Permanent Surpluses Temptation to invest in long-term finance assets such as equities or bonds. Nonetheless these should be avoided. If there are no feasible long-term investments return cash to shareholders (share buy-backs or one-time dividends) as they can invest in equities or bonds themselves.
- Money procurement costs can be lending processing fees, cost of transferring money or brokerage costs in selling short-term investments