WOKRING CAPITAL INVESTMENT
Working capital
Net working capital = current assets - current liabilities
Objectives of working capital management
1 To increase the profits of a business (profitability)
If a business operates with excessively low levels of working capital then this may lead to trading problems, and lower
profits
One of the central concerns of working capital management is how much money to invest in short-term assets to
address the problems of operating with excessively low levels of working capital
2 To ensure sufficient liquidity to meet short-term obligations as they fall due
Every business needs adequate liquid resources to maintain day to day cash flow such as wages and payments
to suppliers
If money is tied up in short-term assets such as inventory and receivables, this may casue liquidity problems
Liquidity can be maintained by ensuring that the amounts of cash tied up in inventory and receivables is not excessive
* Working capital finance:
The approach taken to financing the level, and fluctuations in the level, of net working capital
* Conflict between objectives of liquidity and profitability
The objectives of liquidity and profitability may conflict
For example -> invest in higher inventory (reduce delivery lead time) or receivables (to allow longer credit terms)
in order to boost sales and profits --> reduce liquidity
However, there will not always be a conflict between the objectives of liquidity and profitability
For example -> levels of inventory and receivables are high because working capital is not being manged well,
then improved management of the warehouse (to keep inventory lower) and credit control may allow both
higher liquidity and higher profitability
* Role of working capital in financial management
Working capital management involves an investment decision and financing decision.
Working capital planning
Influences on the level of investment in working capital
1 General factors (eg the industry)
2 Company-specific factors (eg different working capital strategies)
* General factos
- The nature of the industry
- Policies of competitors (eg more favourable credit terms from competitors)
- Seasonal factors (eg peak season)
* Company specific factors
The level of net working capital will also depend on a company's sales and its working capital strategy
If sales are higher, then net working capital will normally rise too. However, different companies will plan to allow
net working capital to rise at different rates depending on their working capital investment strategy.
Aggressive strategy - minimises net working capital
- Aims to keep inventories and receivables as low as possible
- Payables are maximised (suppliers paid as late as possible)
- This priortises liquidity but may create trading problem
Conservative strategy - maximises net working capital
- Allows high levels of inventories and receivables and plans to pay suppliers on time (keep payables low)
- This aim to reduce the risk of trading problems (eg stock-outs) but may compromise liquidity
Planning overall working capital needs
Working capital ratios
- Inventory days (or inventory turnover period) = (Finished goods / Cost of sales) x 365
- Inventory turnover = Cost of sales / Average inventory
- Receivables days = (Receivables / (credit) sales) x 365
- Payables days = (Payables / (credit) purchases) x 365
The cash operating cycle
* The period of time that elapses between the point at which cash begins to be expended on the production
of a product or service and the collection of cash from a customer
* The cash operating cycle = Cash to be received (in days) - Cash to be paid out (in days)
- Cash to be received = inventory days + receivables days
- Cash to be paid out = payables days
* There is no optimal length of the operating cycle for every company (due to general factors and company
specific factors. However, by comparing th cash operating cycle from one period to the next or one company
to another, it should be possible to identify unwelcome trends.
It also be used to identify the possibility of a cash shortfall if sales rise too rapidly (overtrading)
Sales to net working capital ratio
It is used to identify the possibility of a cash shortfall if sales rise too rapidly
The ratio = Sales revenue / (Receivables + Inventory - Payables)
This shows the level of working capital (excluding cash) required to support sales
Risk of overtrading
Overtrading: A situation where a business has inadequate cash to support its level of sales (= undercapitalisation)
Symptoms of overtrading:
- A rapid increase in sales revenue, and often a fall in profit margins as discounts are used to chase higher sales
- A rapid increase in receivables and inventory, eg better credit terms -> chase new sales, higher inventory ->
support higher sales
- Rapid increase in trade payables and a rising bank overdraft indicating liquidity problems
- Worsening liquidity ratios causing a significant increase in the operating cycle
Managing the risk of overtrading/undercapitalisation
- Plan the introduction of new long-term capital
- Improve working capital management
- Reduce business activity
It is also possible for a business to hold excessive levels of cash, this is called overcapitalisation
Managing inventory
Economic order quantity (EOQ) model
The economic order quantity (EOQ): The optial ordering quantity for an item of inventory which will minimise
inventory related costs
Inventory related costs
- Holding costs increase if the order sice increases
Eg warehousing, insurance, obsolescence and opportunity cost of capital
- Ordering costs decrease if the order size increases
Eg costs of administering orders and delivery costs
- Purchasing costs may decrease if the order size increases if bulk discounts are offered (although discounts are
ignored by the simple EOQ model)
Formula
Holding costs = Ch x (Q/2)
Ordering costs = Co x (D/Q)
EOQ = ((2Co x D)/Ch)^1/2
Q: Initial order -> Average inventory level = Q/2
Ch: Annual cost of holding one unit in inventory
D: annual demand in units
Co: Cost of placing an order
Drawbacks
- Assumes zero lead times, and no bulk purchase discounts
- Ignores the need to increase order sizes
- Ignores the possibility of fluctuations in demand (the order quantity is constant)
- Ignores the benefit of holding inventory to customers (eg shorter lead time)
- Ignores the hidden costs of holding inventory (just in time)
Bulk purchase discounts
-> EOQ formula cannot be used and we need to adjust our approach as follows
a. Calculate EOQ in normal way and inventory related costs at the EOQ
b. Calculate inventory related costs at the lower boundary of each discount above the EOQ
c. Select the order quantity that minimises inventory related costs
Buffer inventory
If buffer inventory (B) is required -> the average inventory level = B + Q/2
Just-in-time
is a philosophy which involves the elimination of inventory
Benefits
- Avoid holding buffer inventory
- Avoid hidden costs of holding inventory
- Reduce inventory holding costs
Drawbacks
JIT will not be appropriate if production processes and suppliers are unrealiable, and especially where the
consequences of a stock-out are serious
Managing receivables
The decision to offer credit can be viewed as an invest ment decision, intended to result in higher profits.
For many businesses, offering generous payment terms (or credit period) to customers is esstial in order to be competitive
Offering credit comes at a cost
- Interest charged
- bad debts
=> the decision to offer credit will need to be carefully assessed to see if benefit from the policy is greater than its cost
The policy will be assessed by comparing whether the benefit from higher sales is greater than the finance costs associated
with higher receivables
Offer extended credit is the same as offer credit
Early settlement discount
-> result in a cost but will result in lower receivables -> benefit by reducing the cost of the interest charged
since money is being received from customers earlier
- The policy can be assessed by comparing the cost of the discount to the benefit of lower finance costs associated
with lower receivables
Framework for managing receivables
After a credit policy has been agreed, a framework is needed to ensure it is implemented effectively
1 Planning stage
- Before offering credit -> analyse the risk of trading -> by asking bank references & reade references
- A credit rating agency -> provide a customer's trading history, debt levels and payment performance
- A new customer's credit limit -> should be fixed at a low level -> only increased if their payment
record subsequently warrants it
- For large value customers, a file shoud be maintained of any available financial information about
the customer -> should be reviewed regularly. Information is available from the company's annual report
and accounts an press comments may give information about what a company is currently doing
2 Monitoring stage
Credit customers should be monitored to ensure that they are complying with the agreed credit period.
-> It is important that this is not exceeded without senior management approval.
Credit analysis should also be periodcially re-applied, especially if dealing with a large customer
3 Collection stage
A clear process needs to be in place for chasing late payment
a) Prepare an aged listing of receivables
b) Issue regular statements and reminders
c) Impose sanctions after a certain time limit (eg legal action or charging interest)
d) Consider the use of a debt factor
A debt factor can be used simply to chase late payment or to have a wider role in managing receivables
A debt factor offers a range of potential services:
a) Administration of the client's invoicing, sales accoutting and debt colletion service
b) Credit insurance whereby the factor takes over the risk of loss from bad debts so 'insures' the client
against such losses. This is known as a non-recourse service. Not all factoring agreements are
non-recousrse. If tis service is not being offered, then this is a with-recouse service
c) Making payments to the client in advance of collecting the debts. A factor will purchase selected invoices
and advance a percentage of their value (charging interest on the amount advanced). When the customer
pays, the factor will pay over the balance, less charges. This is sometimes referred to as invoice discounting
Non-recourse factoring: The debt factor has no recourse to the client in the event of non-payment, ie bad
debts insurance is being provided by the debt factor.
Advantages of debt factor Disadvantages of debt factor
Saving in internal administration costs The fees charged by a debt factor for its services
Expertise in credit analysis will reduce the potential Possible loss of customer goodwill if the factor is too
for bad debts aggressive in chasing for payment
A flexible source of finance, especially if cash flows In the past, was viewed as an indication that the
are under pressure due to rising sales (ie company using the factor is in financial difficulty. As
overtrading) the popularity of factoring has increased, this has
become less of an issue
Managing foreign accounts receivable
Foreign debts raise the following special problems:
- It may be harder to build an accurate credit analysis of a company in a distant country
- It may be harder to chase foreign customers for payments
- If a foreign debtor refuses to pay a debt, the exporter must pursue the debt in the debtor's own country and may
lack an understanding of the procedures and laws of that country
Some businesses may decided to trust the foreign receivables and not take any special measures to reduce
the non-payment risk. This method is known as open account and may be suitable for small transactions
However, there are serveral measures available to exporters to help overcome the risks of non-payment or late
payment on larger transactions
Methods of reducing risks
Bill of exchange An IOU shigned by the customer. Until it is paid, shipping documents that
transfer ownership to the customer are withheld. A Bill of Exchange can also be
sold to raise finance
Letter of credit The customer's bank guarantees it will pay the invoice after delivery of the
goods
Invoice discounting Sale of selected invoices to a debt factor, at a discount to their face value
Managing trade payables
Effective management of trade accounts payble involves
- seeking satisfactory credit terms from supplier
- maintaining good relations with suppliers
Evaluating discounts
Early settlement discounts from supplier -> lower payables -> incur a cost to the company by
increasing the cost of interest charged on an overdraft, since money is being paid to suppliers earlier
-> can be assessed by comparing
- benefit of the discount
- the cost of higher finance costs associated with lower payables
The benefit of an early payment discount can be expressed in percentage terms
R Annual rate
(1+R) = (1+r)^n r Period rate
n No. of periods in a year
Managing foreign accounts payable
To avoid the risk of an adverse exchange rate movement by the time a foreign currency invoice is
due to paid, companies somtimes pay the invoice early. This is sometimes called leading
CASH MANAGEMENT AND WORKING CAPITAL FINANCE
Cash management
There are three main motives for holding cash
- Transactions motive -> maintain for paying suppliers, employees,...
- Precautionary motive -> need to meet unexpected occurences
- Speculation motive -> to take advantage of attractive investment opportunities
=> holding cash has a cost: the loss of profits, which would otherwise have been obtained by using the
funds in another way -> the financial manager must try to balance liquidity with profittability
Cash flow forecasting
A detailed forecast of cash inflows and outflows incorporating both revenue and capital items
-> deal with expected cash flow surpluses or shortages
Cash flow forecasts will be prepared continuously during the year and will allow a business to
plan how to deal with expected cash flow surpluses or shortages.
Working capital movements
If a question provides you with operating cash flows and working capital movements, you may
be required to adjust the operating cash flows for the cashflow impact of working capital
movements to calculate monthly cash flows.
Methods of easing cash shortages
- Delaying non-essential capital expenditure
- Accelerating cash inflows which would otherwise be expected in a later period.
- Reversing past investment decisions by selling assets previously acquired
- Negotiating a reduction in cash outflows to postpone or reduce payments
+ Longer credit
+ Loan repayments
+ Dividend payments could be reduced.
Managing cash surpluses
- If cash surpluses are only forecast for the short-term (eg due to seasonal factors) and will be
required to offset cash deficits in the near-future, then it will be important to invest these cash
surpluses in a way that minimises risk (because the funds will be needed soon).
- Desirable investments would generally be low risk and liquid (ie easy to turn in to cash). These
could include:
Definition
Treasury bills Short-term government IOUs, can be sold when needed
Term deposits Fixed period deposits
Issued by banks, entitle the holder to interest plus principal, can be
Certificates of deposit
sold when needed
Commercial paper Short-term IOUs issued by companies, unsecured
If cash surpluses are forecast for the long-term (eg due to seasonal factors) then a different
perspective can be taken. Long-term cash surpluses may be used to fund:
(a) Investments – new projects or acquisitions
(b) Financing – repay debt, buy back shares
(c) Dividends – returning funds to shareholders
Mathematical models
Baumol model
The Baumol model is based on the idea that deciding on optimum cash balances is like deciding
on optimum inventory levels. It assumes that cash is steadily consumed over time and a business
holds a stock of marketable securities that can be sold when cash is needed. The Baumol model is
an adaptation of the EOQ model to manage cash.
Drawbacks
(a) In reality, it is difficult to predict amounts required over future periods with much accuracy.
(b) It is unlikely that cash will be used at a constant rate over any given period (there will points
in time when cash out flows will spike as machinery is bought or an interest payment on a
loan is made etc).
Miller-Orr model
Another cash management model is the Miller-Orr model, which recognises that cash inflows and
outflows vary considerably on a day to day basis. This is clearly more realistic than the Baumol
model’s assumption of constant usage of cash during a period.
It works as follows:
(a) A safety level (lower limit) of cash is decided upon (often this will be imposed by a bank).
(b) A statistical calculation is completed to establish the upper limit (the maximum cash that will
be required) taking into account the variability in a firm’s cash flows. The difference between
the lower and upper limits is called a spread, this is calculated using a formula (which is
given):
The return point is calculated as: Lower limit + (1/3 × spread)
(c) The cash balance is managed to ensure that the balance at any point in time is kept between
the lower and upper limits.
If the cash balance reaches an upper limit (point A in the following diagram) the firm buys
sufficient securities to return the cash balance to a normal level (called the ‘return point’).
When the cash balance reaches a lower limit (point B), the firm sells securities to bring the
balance back to the return point.
Drawbacks
The usefulness of the Miller-Orr model is limited by the assumptions on which it is based:
• The estimates used (for example of variability) are likely to be based on historic information
which may unreliable as a predictor of future variability (for example if the economic or
competitive environment changes).
• The model does not incorporate the impact of seasonality: for example, for a retailer, seasonal
factors are likely to affect cash inflows.
Working capital finance
The approach taken to financing the level, and fluctuations in the level, of net working capital.
- Non-current (fixed) assets
Long-term assets from which an organisation expects to derive benefit over a number of
periods; for example, buildings or machinery.
- Permanent current assets
The minimum current asset base (eg inventory, receivables) required to sustain normal
trading activity.
- Fluctuating current assets
The variation in current assets during a period, for example due to seasonal variations.
Working capital finance strategies
There are different ways in which long- and short-term sources of funding can be used to finance
current and non-current assets.
Long-term finance and short-term finance compared
Long-term finance is usually more expensive than short-term finance because investors require a
higher return for locking their money away for longer time periods.
However, long-term finance provides higher security to the borrower than short-term finance,
because there
Aggressive and conservative w orking capital financing strategies
In the previous chapter we identified that working capital investment strategies can be
aggressive (low net working capital) or conservative (high net working capital).
Similar terminology exists when we discuss working capital financing strategies.
Aggressive financing strategy Conservative financing strategy
Minimal long-term finance for working High level of long-term finance for working
capital capital
Mainly uses cheaper short-term sources of
finance – problems if short-term finance is Mainly uses more secure long-term sources
not available when required. This strategy is of finance – this strategy is safer but can be
therefore risky expensive
Choice of working capital finance strategy
The working capital finance strategy that is most appropriate to a company depends on
(a) Management attitude to risk – short-term finance is higher risk to the borrower because it
may not be available in the future when needed. For example, it may not be possible to
access trade credit from suppliers when it is required.
(b) Strength of relationship with the bank providing an overdraft – if strong this will encourage
the use of short-term finance as it makes it more likely that a bank overdraft will be available
when required to provide short-term finance.
(c) Ability to raise long-term finance – if this is weak (perhaps because the organisation is small
and/or has not used long-term finance wisely in the past) this will mean there
Treasury management
Functions of t reasury management
1 Liquidity management
This is the short-term management of cash that we have referred to at the start of this chapter.
The aim is to ensure that a company has access to the cash that it needs but does not hold
unnecessarily high levels of cash and does not incur high costs from needing to organise
unforeseen short-term borrowing.
2 Funding
This involves deciding on suitable forms of finance and organising suitable bank and capital
market debt.
3 Corporate finance
This is the examination of a company’s financial strategies. For example, is the capital structure
appropriate, how are investments appraised, and how are potential acquisitions valued?
4 Risk management
This involves understanding and quantifying the risks faced by a company.
In this exam the main focus is on currency risk and interest rate risk (covered in
Centralisation of treasury management
Within a centralised treasury department, the treasury department is normally based at Head
Office and acts as an in-house bank serving the interests of the group.
Advantages of centralisation
Borrowing required for a number of subsidiaries can be
arranged in bulk (meaning lower administration costs and
Economies of scale
possibly a better loan rate), also combined cash surpluses
can be invested in bulk.
Foreign exchange risk management is likely to be improved
because a central treasury department can match foreign
currency income earned by one subsidiary with expenditure
Improved risk management in the same currency by another subsidiary. In this way, the
risk of losses on adverse exchange rate movements can be
avoided without incurring the time and expense in managing
foreign exchange risk
Cash surpluses in one area can be used to match to the cash
needs in another, so an organisation avoids having a mix of
Reduced borrowing
overdrafts and cash surpluses in different localised bank
accounts.
The centralised pool of funds required for precautionary
purposes will be smaller than the sum of separate
Lower cash balances
precautionary balances which would need to be held under
decentralised treasury arrangements.
Experts can be employed with knowledge of the latest
Expertise
developments in treasury management.
However, some companies prefer to decentralise treasury management because:
(a) Sources of finance can be diversified and can match local assets.
(b) Greater autonomy can be given to subsidiaries and divisions because of the closer
relationships they will have with the decentralised cash management function.
(c) A decentralised treasury function may be more responsive to the needs of individual
operating units.
