Managing Finance and Budgets

Lecture 9

Working Capital (2)

The nature and purpose of working capital

Major elements Major element

Stocks

Trade debtors

Cash (in hand and at bank)

Trade creditors

lessequals

Current liabilitiesWorking capital Current assets

The summary diagram

The summary diagram

The working capital cycle

Cash sales

Trade creditors

Trade debtors

Finished goods

Cash/bank overdraft

Work-in-progress

Raw materials

Each ‘pass’ through the Working Capital Cycle will generate profit.

Each ‘pass’ through the Working Capital Cycle will generate profit.

equals

minus

Operating cash cycle

Average payment period for creditors

Average settlement period for debtors

plus

Average stockholding period

Calculating the Operating Cash Cycle

The Operating Cash Cycle is the time between outlay of funds, and money returning to the business on one circuit of the Working Capital Cycle

The Operating Cash Cycle is the time between outlay of funds, and money returning to the business on one circuit of the Working Capital Cycle

Provided that we can maintain the same level of profit on each cycle, we can increase overall profitability by reducing the OCC to a minimum.

Provided that we can maintain the same level of profit on each cycle, we can increase overall profitability by reducing the OCC to a minimum.

The Length of the Operating Cash Cycle

Suppose that in a business, each ‘turnover’ of the

Working Capital Cycle generates £10,000 of profit:

OCC

3 months

OCC

2 months

4 cycles per year, profit = £40,000

6 cycles per year, profit = £60,000

What happens though, if in shortening the cycle, we reduce our profit margins?

Optimising Working Capital

Even if we reduce profit margins at each pass, we may still be able to increase profitability overall.

In the last example, suppose the effect of shortening the OCC was to reduce the profit at each pass through the cycle by 25% to £7,500,

we would now generate profit of:

6 cycles x £7,500 = £45,000

compared to

4 cycles x £10,000 = £40,000

This is still £5,000 more profit per year than before.

Optimising Working Capital

This means that, whatever the business, Working Capital will be optimised by reducing the Operating Cash Cycle to the minimum possible level which will allow the maximum increase in profitability.

This means: Reducing Stock Levels Reducing Trade Debtors Increasing Trade Creditors

The rest of this session is concerned with methods which will allow each of these to occur.,

The management of stocks

Procedures and techniques

Forecasts of future demand

Monitoring

Recording and reordering systems

Levels of control

Stock management models

Materials requirements planning (MRP) systems

Just-in-time (JIT) stock management

This slide summarises important issues and techniques

This slide summarises important issues and techniques

Pareto Analysis

Pareto Analysis is sometimes called the 80-20 method. It takes as its underlying principle the fact that a

warehouse will contain different amounts of stock at different prices.

If we put the goods in order, according to value, we often find that the first 20% of the items will be worth 80% of the total value.

The method derived from this categorises the stocks into three bands A, B and C

Economic Order Quantity

This model takes as its starting point the basic graph of stock movements over time.

A real graph of stock quantities held may look something like this:

Stock Monitoring

-100

0

100

200

300

400

500

1 3 5 7 9 11 13

15

17

19

21

23

25

27

29

January

Sto

ck L

evel

Stockholding and stock order costs

Annual costs

(£)

Stock level (units)E

Total costs

Holding costs

0

Ordering costs

The Total Stock Cost comprises:

Holding Costs ( value of the stock + loss of interest) plus Ordering Costs

The Total Stock Cost comprises:

Holding Costs ( value of the stock + loss of interest) plus Ordering Costs

Economic Order Quantity

We can calculate an Economic Order Quantity (EOQ):

Square Root of: ( 2 x Annual Demand x Order Cost )

Yearly holding cost for 1 stock unit

and

Time Between Deliveries = EOQ x 365days

Annual Demand

Materials Requirement Planning

Materials Requirement Planning (MRP) uses sales forecasts & production plans to schedule deliveries so that they occur at the correct times that the processes need them. This is ‘top-down’ planning.

Only those items which are necessary for the flow of production are ordered and delivered.

An important element in MRP is the Master Production Schedule. This forecasts when things will occur, and schedules events such as deliveries and prompts changes in practice.

Just-in-Time

There are several variations on this approach. The basic idea, is that deliveries (and each stage in

the production process) should occur ‘just in time’ as the stock levels to support the process run out.

In this way, the minimum amounts of stock are held. The net result of this technique is that it forces

suppliers to hold onto stocks longer. These suppliers may then need to employ techniques of their own to minimise costs. (one of which is to increase prices!)

Managing Debtors

Selling goods on credit means that there is a cost to the business. These costs can include: Administrative costs - due to the credit transactions Opportunity costs - incurred as a result of the money being

unavailable for the business to uses Bad debts – money effectively lost because customers will

not or cannot pay.

Therefore the business should have clear policies on: Which customers will be offered credit What payment time is acceptable Whether discounts are offered What collection policies will be in operation

Offering Credit

Capital: Is the customer financially sound? Capacity: Does the customer have the capacity to

pay the amounts owed? Collateral: Can the customer offer any security? Conditions: What is the current economic climate? Character: Does the customer appear to have

integrity? Sources of information: Trade refs, Bank refs,

Published accounts, Directors, employees, premises, credit agencies

What payment time is acceptable?

This is variable, but typical criteria will be: Local Conditions: Credit terms operating within the

particular sector Degree of co-operation between companies in the sector Bargaining power of particular customers Risk of bad debt (either from particular customers or to

the business as a whole) The financial position of the business – their ability to

offer credit. The marketing strategy – is length of credit an important

feature (e.g. as a ‘loss leader’)?

Cash Discounts for Early Payments

In order to encourage customers to pay early, we may offer a discount of say 5% for early payment (or alternatively impose a penalty for late payment – same effect.)

We need to weigh the cost of this against the fact of having the money.

Ageing Schedule of Debtors

The Schedule will record the amount and the length of debt.

Weeks Outstanding1 week 2 weeks 3 weeks 4 weeks

A & B Merchants £300 £400C & D Stores £500E & F Retailers £200 £400G & H Markets £100 £500

Total £500 £1,000 £400 £500

This will allow a business to monitor individual and total amount of debt, for example total debt which has remained unpaid for at least 3 weeks.

Debt Factoring

Debt Factoring is done by companies who specialise in the administration & collection of debts.

Factors take over the debts of a business, and offer the business cash payments in advance of the actual collection of debts.

Typically, a Factor will offer up to 80% of the face value of the debtors in advance, but will charge interest on the money advances, as well as a fee for the service.

Invoice Discounting

This involves obtaining a loan from a third party based on the proportion (normally about 75%) of the face value of credit sales outstanding, while still retaining full control over the sales ledger.

There is normally a service charge related to turnover (e.g. 0.2% ), and the loan is obtained for a short period , for example 60 or 90 days.

The business gets the money immediately, and there is a much lower charge than with Factoring; however the business still has the responsibility of collecting the debts.

Debt Factors often offer an Invoice Discounting service.

Bad debts

At the end of the day there may still be companies who cannot or will not pay the money owed for goods delivered.

This can happen where a customer is declared bankrupt; creditors are offered possibly a small proportion of the amount owed out of the sale of assets.

In this case, the deficit must be borne entirely by the business, and the amount is ‘written off’ against profit.

Most companies will include a provision for bad or doubtful debts in their balance sheet.

Management of Creditors

Trade credit may be regarded as a “free source of finance”

However, exactly the same strategies that we may use to encourage early payment and discourage late payment may be used on us, but in reverse.

In terms of Early Payment, discounts may be offered for paying early and these may be more valuable than the trade credit

Paying late may have many disadvantages: We may be given lower priority, forced to pay higher prices, and in the extreme case there may even be a refusal to supply

Seminar Nine - Activities

Preparation: read all of Chapter 16 Working Capital Internet Links (Word Document)

Use this document as a resource, and follow up some of the links to pursue your own ‘research’ into managing working capital. You should try to find a range of methods and examples of real businesses which have used these methods.

M & A Exercise 16.3You should use the Spreadsheet M&A 16.3 as a structure to answer the question; this asks you to calculate other ratios and amounts.

Here the methods that you suggest in part (b) should be based on the research you have carried out using the internet.