Nursery ManagementUnderstanding and Managing FinanceSession 9

The Length of the Operating Cash CycleSuppose that in a business, each turnover of the Working Capital Cycle generates 10,000 of profit:OCC3 monthsOCC2 months4 cycles per year, profit = 40,0006 cycles per year, profit = 60,000What happens though, if in shortening the cycle, we reduce our profit margins?

Optimising Working CapitalEven 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 = 45,000compared to 4 cycles x 10,000 =40,000

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

Optimising Working CapitalAs a rule of thumb, provided that the percentage of profit lost at each cycle is less than the percentage reduction in OCC, overall profitability will increase.

So the problem becomes:

How can we reduce the Operating Cash Cycle without reducing profitability by same amount?

Optimising Working CapitalThis 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 LevelsReducing Trade DebtorsIncreasing Trade Creditors

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

Activity 1Discuss the following:

Why is it important to keep careful track of working capital requirements?What action do you take to ensure that you have prompt payment for the children in your care?

Activity 1 SolutionThe need to keep track of working capital requirements:

Failure to do so could lead to:Debts not being collected on time, possibly with customers defaulting on payments. Suppliers refusing credit, or even refusing to supply.Stock not being available for manufacturing and other processes.Payments to employees being delayed or impossible.Insolvency.

Managing DebtorsSelling goods on credit means that there is a cost to the business. These costs can include:Administrative costs - due to the credit transactionsOpportunity costs - incurred as a result of the money being unavailable for the business to usesBad debts money effectively lost because customers will not or cannot payIt may be possible to sue parents/guardians through the Courts but this does not guarantee payment- even if you win your case!

Debt Collection Policies and MethodsIn order to manage debtors effectively a business should have clear policies developed in answer to the following questions:Which customers will be offered credit?What payment time is acceptable?What discounts will be offered?What collection policies will be in operation?Will external agencies be used?

Again, it is possible to use a selection of different methods in order to achieve the maximum effect.

Offering CreditCapital: 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 references, Bank references, 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 sectorDegree of co-operation between companies in the sectorBargaining power of particular customersRisk 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 PaymentsIn 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.

Cash Discounts ExampleP and L has debtor period of around 80 days, but is attempting to reduce this to around 30 days, by offering 5% discount on all sales for payment within one month of delivery.

Cost of discount is 5%, for 50 days cash gained.As an annual rate this is 365 x 5% = 36.5% approx 50 This is a very high rate of interest; we would need to be satisfied that the return on the money gained (using say the ROCE) was greater than 36.5% in order for this to be a sensible proposition.

Debt Collection PoliciesThe first principle of debt collection is that all current debts need to be recorded effectively, and payments monitored carefully, so that it is clear which debtors have paid which amounts. One way to do this is through an Ageing Schedule of DebtorsAnother way is to devise a predicted payment schedule, and to compare this with payments made.

Ageing Schedule of Debtors

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

Using External AgenciesThere is a bewildering variety of services available in this industry, ranging from straightforward debt-collection companies working for a fee, to companies who will effectively buy your debts from you.We look at two such methods:Debt FactoringInvoice Discounting

Debt FactoringDebt Factoring is done by companies who specialise in the administration and 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 DiscountingThis 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 debtsAt 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 financeHowever, 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 creditPaying 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

Activity 2Discuss the following:

A suppliers normal credit terms are 70 days. They offer a 2% discount for payment in 30 days. What is the approximate annual percentage cost of not taking up the discount?Is it reasonable to compare the above figure directly to the cost of capital for the organisation when deciding to take up the offer or are there other factors which should be taken into account?

Activity 2 Solution

A suppliers normal credit terms are 90 days. They offer a 2.5% discount for payment within 60 days. What is the approximate annual percentage cost of not taking up the discount?

The loss will be 30 days free credit. The annual percentage cost of this credit will be approximately 365 x 2.5%= 30.41% 30 This figure is very high; for a business not to pay within 60 days, they would need a very good reason, for example that they could earn more than 30.41% (if their ROCE was higher for example)

Activity 2

Is it reasonable to compare the above figure directly to the cost of capital for the organisation when deciding to take up the offer or are there other factors which should be taken into account?

Other factors to be considered:Is there cash currently available?Would the cash have been more profitably employed elsewhere?Is there a better offer on other goods purchased by the company?Is there somewhere that the cash can be invested which would give more than 2% over the 40 days?