SESSION 13 – WORKING CAPITAL MANAGEMENT OVERVIEW Objective To appreciate the importance of working capital and therefore its effective management WORKING CAPITAL MANAGEMENT What is “working capital”? Investment in working capital Financing working capital ASSESSING THE LIQUIDITY POSITION Ratios Cash operating cycle Calculating the cash operating cycle Overtrading Solutions to liquidity problems 1301 SESSION 13 – WORKING CAPITAL MANAGEMENT WORKING CAPITAL MANAGEMENT 1.1 What is “working capital”? Definition The capital represented by net current assets which is available for day-to-day operating activities It normally includes inventories, trade receivables, cash and cash equivalents, less trade payables Net working capital is made up of Accounts receivable + Inventory + Cash – Accounts payable Each of these components needs a control system, but it is also essential to consider working capital as a whole and how these components fit together Working capital management is concerned with the liquidity position of the company, so the main aim is to generate cash as quickly as possible Working capital management is crucial to the effective management of a business because: (i) (ii) Current assets comprise over half the assets of some companies A failure to control working capital, and therefore liquidity, is a major cause of business failure Two questions must be considered: How much to invest in working capital? How to finance it? 1.2 Investment in working capital The firm faces a trade-off LIQUIDITY v PROFITABILITY High investment in working capital Low investment in working capital ⇒ less liquid ⇒ more liquid But may be using But may not be using working capital efficiently working capital efficently ⇒ more profitable ⇒ less profitable ⇒ Is there an OPTIMAL level of working capital? 1302 SESSION 13 – WORKING CAPITAL MANAGEMENT For each company there will be an optimal level of working capital However this can only be found by trial and error, and in any case it is constantly changing Businesses must avoid the extremes: overtrading – an insufficient working capital base to support the level of activity This can also be described as under-capitalisation over-capitalisation – too much working capital, leading to inefficiency 1.3 Financing working capital Whatever level of current assts the business decides to hold, they must be matched by liabilities i.e current assets must be financed The business must decide whether to use short-term or long-term finance It is generally true that short-term interest rates are lower than long-term rates as short-term finance is less risky for the provider/lender However short-term finance is not always cheaper and must be renegotiated when it expires The four principal sources of finance for current assets are: 1.3.1 Long-term Equity – new share issues – retained profits Debt – debentures – long-term bank loans 1.3.2 Short-term Overdraft – expensive as it is flexible – risky as repayable on demand Accounts payable – appears cheap but refusing quick settlement discounts can be expensive 1303 SESSION 13 – WORKING CAPITAL MANAGEMENT ASSESSING THE LIQUIDITY POSITION Liquidity is a company’s ability to meet its financial obligations as they fall due A secure liquidity position is desirable The firm’s liquidity position can be assessed in two ways 2.1 Ratios 2.1.1 Liquidity ratios Current ratio = Quick ratio = 2.1.2 Current assets Current liabilities Current assets − inventory Quick assets = Current liabilities Current liabilities Efficiency ratios Inventory turnover = Cost of goods sold Average stock shows how quickly inventory is sold Accounts receivable’ turnover = Credit sales Average accounts receivable shows how quickly debts are collected Accounts payable’ turnover = Credit purchases Average accounts payable shows how quickly accounts payable for supplies received on credit are paid 2.1.3 (i) Problems with ratios Seasonal and other factors may mean that statement of financial position values may not be typical (ii) There may be “window-dressing” e.g the finance director may make a large payment to suppliers at the year-end in order to reduce the reported payables days (iii) Concern the past and not the future (iv) They are of little value unless used in comparison to industry average data 1304 SESSION 13 – WORKING CAPITAL MANAGEMENT 2.2 Cash operating cycle The length of time between a firm paying out cash for raw materials and/or inputs and receiving cash for goods sold The number of days between paying suppliers and receiving cash from customers Can also be referred to as the working capital cycle or the cash conversion cycle THE CASH OPERATING CYCLE Cash payment CASH SUPPLIERS Cash collection Purchases CUSTOMER RAW MATERIALS Sales Production FINISHED GOODS WORK-IN-PROGRESS Production The length of the operating cycle is affected by various factors e.g type of industry, e.g retailing v house building; liquidity v profitability trade-off; efficiency of management e.g accounts receivable and accounts payable control Whilst it is desirable to have as short a cycle as possible, it is often difficult to differ significantly from competitors in the same trade 1305 SESSION 13 – WORKING CAPITAL MANAGEMENT 2.3 Calculating the cash operating cycle Accounts receivable days Accounts payable days Finished goods days WIP holding period = Average accaounts receivable × 365 Annual credit sales = x = Average accounts payable × 365 Annual credit purchases = (x) = Average stock of finished goods × 365 Annual cost of sales = x = Average stock of work in progress × 365 = Annual cost of sales × Degree x of completion of WIP Raw materials days = Average stock of raw materials × 365 Annual purchases Length of cycle Commentary Use year-end figures if averages not available Example Tipple plc has the following estimated figures for the coming year: Sales $3,600,000 Accounts receivable $306,000 Gross profit margin 25% Finished goods inventory $200,000 Work in Progress Inventory $350,000 Raw Materials Inventory $150,000 Accounts payable $130,000 WIP is 80% complete Purchases represent 60% of production cost Required: Calculate the length of the cash operating cycle 1306 = x x SESSION 13 – WORKING CAPITAL MANAGEMENT Solution Cost of sales = WORKINGS Days _ Number of days between payment and receipt 2.4 _ Overtrading Overtrading occurs when a company tries to support a large volume of trade from a small working capital base It can also be referred to as under-capitalisation and often occurs when a business grows very rapidly without increasing its level of long-term finance The result can be a liquidity crisis This can often happen at the start of a new business, since there is no reputation to attract customers, so a long credit period is likely to be extended in order to break into the market; if the business has found a “niche market”, rapid sales expansion may occur; smaller companies which are growing quickly will often lack the management skills to maintain adequate control of the debt collection period and the production period For the above reasons the amount of cash required will increase However, companies in this position will often find it hard to raise long-term finance and hence overtrading and business failure may result 1307 SESSION 13 – WORKING CAPITAL MANAGEMENT 2.4.1 Indicators of overtrading Decline in liquidity; Rapid increase in turnover; Increase in inventory days; Increase in accounts receivable days; Increase in short-term borrowing and a decline in cash holdings; Large and rising overdraft Reduction in profit margin; Increase in ratio of sales to fixed assets 2.5 Solutions to liquidity problems If a business is suffering from liquidity problems, then the aim will be to reduce the length of the cash operating cycle Possibilities to consider include: reducing the inventory-holding period for both finished goods and raw materials ; reducing the production period – not easy to but it might be worth investigating different machinery or working methods; reducing the credit period extended to accounts receivable, and tightening up on cash collection; increasing the period of credit taken from suppliers; an increase in the level of long-term finance i.e an equity or debt issue A new share issue is probably preferable to increasing debts in a risky company; reducing the level of sales growth to a more sustainable level 1308 SESSION 13 – WORKING CAPITAL MANAGEMENT Key points The key issues are (i) what level of current assets should a business hold and (ii) how should current assets be financed? There are not always unique answers to these questions; it is a matter of opinion Therefore you need (i) an appreciation of the advantages/disadvantages of holding cash, inventory and receivables (ii) the relative advantages of using short vs long-term finance Good knowledge of ratio analysis is essential in many exam questions on working capital management e.g estimating the length of the operating cycle There is no official definition of overtrading but it refers to a situation where a business is growing at an unsustainable rate compared to its level of long-term finance It is also associated with poor working capital management FOCUS You should now be able to: explain the nature and scope of working capital management; calculate appropriate ratios to analyse the liquidity and working capital management of a business; calculate the length of the operating cycle of a business; explain the relationship between working capital management and business solvency 1309 SESSION 13 – WORKING CAPITAL MANAGEMENT EXAMPLE SOLUTION Solution — Cash operating cycle Cost of sales = 75% × 3,600,000 = 2,700,000 Raw materials days Credit taken from suppliers WIP days Finished goods days Credit given to customers WORKINGS 150,000 × 365 2,700,000 × 60% 130,000 × 365 2,700,000 × 60% 350,000 × 365 2,700,000 × 80% 200,000 × 365 2,700,000 306,000 × 365 3,600,000 Number of days between payment and receipt 1310 Days 34 (29) 59 27 31 _ 122 _ ... capital management is concerned with the liquidity position of the company, so the main aim is to generate cash as quickly as possible Working capital management is crucial to the effective management. .. capital management FOCUS You should now be able to: explain the nature and scope of working capital management; calculate appropriate ratios to analyse the liquidity and working capital management. .. capital management and business solvency 1309 SESSION 13 – WORKING CAPITAL MANAGEMENT EXAMPLE SOLUTION Solution — Cash operating cycle Cost of sales = 75% × 3,600,000 = 2,700,000 Raw materials