chapter8-wcmgt-working capital.doc

8/10/2019 Chapter8-WCMgt-working capital.doc

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Chapter 8 Working Capital Management

LEARNING OBJECTIVES

1. Describe the nature of working capital and identify its elements.

2. Identify the objectives of working capital management in terms of liquidity and

profitability, and discuss the conflict between them.

. !"plain the cash operating cycle and the role of accounts payable and accounts

receivable.

#. !"plain and apply relevant accounting ratios.

$. !"plain the concept of overtrading and its application.

! l e m e n t s

o f

% &

' r a d e ( o f f b e t w e e n

) i q u i d i t y *

+ r o f i t a b i l i t y

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% o r k i n g & a p i t a l

- a n a g e m e n t

. d v a n t a g e s t o

I m p r o v e % &

- a n a g e m e n t

/ b j e c t i v e s

o f

% &

- a n a g e m e n t

- e a n i n g

& a l c u l a t i o n

0 i g n i f i c a n c e o f

& a s h / p e r a t i n g

& y c l e

% & - a n a g e m e n ta n d 1 u s i n e s s

0 o l v e n c y

2 a c t o r s I n f l u e n c e

/ p t i m u m & a s h

) e v e l

& a s h

/ p e r a t i n g

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3 , a t i o s

& a l c u l a t i o n o f

% o r k i n g & a p i t a l

, e q u i r e m e n t

% o r k i n g

& a p i t a l

, a t i o s

0 y m p t o m s

/ v e r t r a d i n g

% o r k i n g

& a p i t a l

- a n a g e m e n t

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! The Element" o# Working Capital

1.1 %orking capital is the capital available for conducting the $a%&to&$a% operation"of

an organi4ation5 normally the e"cess of current assets over current liabilities.

1.2 Working Capital Management

%orking capital management is the management o# all a"pe't" o# (oth ')rrent

a""et" an$ ')rrent lia(ilitie", to minimi*e the ri"k o# in"ol+en'% while

ma,imi*ing the ret)rn on a""et".

1. Investing in working capital has a cost, which can be e"pressed either as6

7a8 the cost of funding it, or

7b8 the opportunity cost of lost investment opportunities because cash is tied up

and unavailable for other uses.

1.# %orking capital is an investment which affects cash flows.7a8 %hen in+entor% i" p)r'ha"e$, 'a"h i" pai$to acquire it.

7b8 Re'ei+a(le" represent the cost of selling goods or services to customers,

in'l)$ing the 'o"t" o# the material" an$ the la(o)r in')rre$.

7c8 'he 'a"h tie$ )pin working capital is re$)'e$to the e"tent that in+entor%is

#inan'e$ (% tra$e pa%a(le". If ")pplier"gi+e a #irm time to pa%, the firm9s

'a"h #lo-" are impro+e$and working capital is reduced.

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.! The O(/e'ti+e" o# Working Capital Management

.! O(/e'ti+e" o# -orking 'apital management

2.1.1 &urrent assets are a major balance sheet item and especially significant to smaller

firms.

2.1.2 Mi"managementof working capital is a common cause of business failure, e.g.6

7a8 inability to meet bills as they fall due

7b8 overtrading during periods of growth

7c8 overstocking.

2.1. O(/e'ti+e" o# Working Capital Management 01e' 234 J)n 24 1e' 56

7a8 'he t-o main o(/e'ti+e"of working capital management are to ensure6

7i8 it has ")##i'ient li7)i$ re"o)r'e" to continue in business and to

in'rea"e it" pro(a(ilit%.

7ii8 the o(/e'ti+e o# pro#ita(ilit% supports the primary financial

management objective, which is "harehol$er -ealth ma,imi*ation.

7iii8 the o(/e'ti+e o# li7)i$it%ensures that lia(ilitie" 'an (e metas they

#all $)e.

7b8 Con#li'tbetween two objectives67i8 li7)i$ a""et" such as bank accounts earn +er% little ret)rn or no

ret)rn, so liquid assets $e'rea"e pro#ita(ilit%.

7ii8 pro#ita(ilit% is met by in+e"ting o+er the longer term in order to

achieve higher returns.

7c8 Tra$e&o##between two objectives6

7i8 it $epen$" on the parti')lar 'ir')m"tan'e"of an organi4ation.

7ii8 li7)i$it% may be more important o(/e'ti+e when "hort&term

#inan'e i" har$ to #in$.

7iii8 pro#ita(ilit% may become a more important o(/e'ti+e when 'a"h

management ha" (e'ome too 'on"er+ati+e.

7iv8 (oth o(/e'ti+e" are importantand neither can be neglected.

)e"tion

Identify the objectives of working capital management and discuss the conflict that may

arise between them. 7 marks8

7&& : inancial -anagement December 2;;< =#7a88

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)e"tion .

Discuss whether profitability or liquidity is the primary objective of working capital

management. 7# marks87&& : inancial -anagement >une 2;1; =17c88

2.1.# E,ample

%hat differences would there be in working capital policies for a manufacturing

company and a food retailer?

Sol)tion9'he manufacturing company will need to invest heavily in spare parts and may be

owed large amounts of money by its customers. 'he food retailer will have a large

inventory of goods for resale but will have low accounts receivable.

'he manufacturing company will therefore need a carefully considered policy on

the management of accounts receivable which will need to reflect the credit policies

of its close competitors.

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'he food retailer will be more concerned with inventory management.

.!. Central role o# -orking 'apital management

2.2.1 Central role o# -orking 'apital management 01e' 56

%orking capital management is central to financial management for several reasons6

7a8 Ca"h i" the li#e&(loo$ of a company9s business activities and -itho)t

eno)gh 'a"h to meet "hort&term lia(ilitie", a company would #ail.

7b8 C)rrent a""etcan a''o)nt #or more than hal# o# a 'ompan%:" a""et"and so

must be carefully managed. ;oor managementof current assets can lead to

lo"" o# pro#ita(ilit% an$ $e'rea"e$ ret)rn"to shareholders.

7c8 or SME" ')rrent lia(ilitie" are a ma/or "o)r'e o# #inan'e and must be

carefully managed in order to ensure continuing availability of such finance.

)e"tion 5

Identify the objectives of working capital management and discuss the central role of

working capital management in financial management. 7< marks8

7&& : inancial -anagement December 2;1 =7d88

2.2.2 )iquidity in the conte"t of working capital management means having enough cash or

ready access to cash to meet all payment obligations when these fall due. 'he main

sources of liquidity are usually6

7a8 cash in the bank

7b8 short(term investments that can be cashed in easily and quickly

7c8 cash inflows from normal trading operations 7cash sales and payments by

receivables for credit sales8

7d8 an overdraft facility or other ready source of e"tra borrowing.

2.2. firm choosing to have a lo-er le+el o# -orking 'apital than ri+al"is said to havean @aggre""i+e9 approach, whereas a firm with a higher le+el o# -orking 'apitalhas a

@$e#en"i+e9 approach.

2.2.# 'here is a trade(off under which trading growth and increased profitability squee4e

cash. Altimately, if not properly managed, increased trading can carry with it the

spectre of overtrading and inability to pay the business creditors.

2.2.$ It is worth while stressing the difference between cash flow and profits. &ash flow is

as important as profit. Anprofitable companies can survive if they have liquidity.

+rofitable companies can fail if they run out of cash to pay their liabilities 7wages,

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amounts due to suppliers, overdraft interest, etc.8.

2.2.B 0ome e"amples of transactions that have this @trade(off9 effect on cash flows and on

profits are as follows6

7a8 ;)r'ha"e o# non&')rrent a""et"for cash. 'he cash will be pai$ in #)llto the

supplier when the asset is delivered5 however pro#it" will be 'harge$

gra$)all% o+er the li#e o# the a""etin the form of depreciation.

7b8 Sale o# goo$" on 're$it. ;ro#it"will be 're$ite$ in #)llonce the sale has been

confirmed5 however the 'a"h may not (e re'ei+e$ for some considerable

period afterwards.

7c8 %ith some payments such as ta,there may be a "igni#i'ant timing $i##eren'e

between the impact on reported profit and the cash flow.

2.2.< &learly, cash balances and cash flows need to be monitored just as closely as trading

profits. 'he need for adequate cash flow information is vital to enable management to

fulfil this responsibility.

2.2.3 Te"t %o)r )n$er"tan$ing

ill in the blanks in the table to identify the advantages of having more or less

working capital.

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.!5 A$+antage" to take "tep" to impro+e -orking 'apital management

2..1 A$+antage" to take "tep" to impro+e -orking 'apital management

7a8 Cre$it management e##e't9

7i8 'he fundamental objective of the company is to ma"imise the wealth of

its shareholders and good working capital management helps to achieve

this by minimi"ing the 'o"tof investing in current assets.

7ii8 Goo$ 're$it management, for e"ample, aim" to minimi"e the ri"k o#

(a$ $e(t" an$ e,pe$ite the prompt pa%ment o# mone% $)e #rom

$e(tor"in accordance with agreed terms of trade.

7iii8 'aking steps to optimi"e the le+el an$ age o# $e(tor"will minimi"e

the 'o"t o# #inan'ing them, leading to an increase in the returns

available to shareholders.

0(6 In+entor% management e##e't9

7i8 Goo$ in+entor% management, #or e,ampleusing techniques such as

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the e'onomi' or$er 7)antit% mo$el, & analysis, inventory rotation

and ()##er in+entor% managementcan minimi"e the 'o"t" o# hol$ing

an$ or$ering in+entor%.

7ii8 'he appli'ation o# /)"t&in&timemethods of inventory procurement andmanufacture can re$)'e the 'o"t o# in+e"ting in in+entor%. 'aking

steps to impro+e in+entor% management 'an there#ore re$)'e 'o"t"

an$ in'rea"e "harehol$er -ealth.

0'6 Other e,ample9

7i8 Ca"h ()$get"can help to $etermine the tran"a'tion" nee$ #or 'a"h

in each budget control period, although the optimum cash position will

also depend on the precautionary and speculative need for cash.

7ii8 &ash management models such as the Ba)mol mo$el an$ the Miller&Orr mo$el 'an help to maintain 'a"h (alan'e" 'lo"e to optim)m

le+el".

'he different elements of good working capital management therefore combine to

help the company to achieve its primary financial objective.

)e"tion I' methods8,

7b8 re$)'ing the $e(tor $e#erral perio$ 7for e"ample by improving debtor

management8, or

7c8 in'rea"ing the 're$itor $e#erral perio$7for e"ample by settling invoices as

late as possible8.

In this way an understanding of the cash operating cycle can assist in taking steps to

improve working capital management and profitability.

..$ /n the other hand, if there are e,'e""i+e le+el" o# -orking 'apital, the firm has

unnecessary additional costs6 the 'o"t o# t%ing )p #)n$", plus the storage, ordering

and handling costs of being overburdened with stock. unning throughout is the risk

of being temporarily "hort o#that vital lifeblood of a business E 'a"h7that is, suffering

a li7)i$it% ri"k8.

)e"tion ?

!"plain the meaning of the term @cash operating cycle9 and discuss its significance in

determining the level of investment in working capital. Hour answer should refer to the

working capital needs of different business sectors. 7< marks8

7&& 2.# inancial -anagement and &ontrol >une 2;;# =27c88

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5!< Working 'apital management an$ ()"ine"" "ol+en'%

.#.1 'he main reason that 'ompanie" #ail4though, is because they r)n o)t o# 'a"hand so

good cash management is an essential part of good working capital management.

B)"ine"" "ol+en'% 'annot (e maintaine$if working capital management in the form

of cash management is of a poor standard.

5!? @a'tor" that in#l)en'e the optim)m 'a"h le+el #or a ()"ine""

.$.1 irst, it is important to note that cash management is a forward(looking activity, in that

the optim)m 'a"h (alan'e m)"t re#le't the e,pe'te$ nee$ #or 'a"h in the ne,t

()$get perio$, for e"ample in the ne"t month. 'he cash budget will indicate e"pected

cash receipts over the ne"t period, e"pected payments that need to be made, and any

shortfall that is e"pected to arise due to the difference between receipts and payments.

'his is the tran"a'tion" nee$for cash, since it is based on the amount of cash needed

to meet future business transactions.

.$.2 Cowever, there may be a $egree o# )n'ertaint% a" to the timing o# e,pe'te$

re'eipt". Debtors, for e"ample, may not all pay on time and some may take e"tended

credit, whether authorised or not. In order to g)ar$ again"t a po""i(le "hort#all o#

'a"h to meet future transactions, companies may keep a ()##er "to'k: o# 'a"h (%

hol$ing a 'a"h re"er+egreater than called for by the transactions demand. 'his is the

pre'a)tionar% $eman$ for cash and the optimum cash balance will reflect

management9s assessment of this demand.

.$. eyond this, a company may decide to hol$ a$$itional 'a"h in or$er to take

a$+antage o# an% ()"ine"" opport)nitie"that may arise, for e"ample the possibility

of taking over a rival company that has fallen on hard times. 'his is the "pe')lati+e$eman$ for cash and it may contribute to the optimum cash level for a given

company, depending on that company9s strategic plan.

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)e"tion !"tracts from the recent financial statements of njo plc are as follows6

In'ome "tatement" .22 .22?

;;; ;;;

'urnover 1$,B;; 11,1;;

&ost of sales :,;; B,B;;

Jross profit B,;; #,$;;

dministration e"penses 1,;;;


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Re7)ire$9

7a8 &alculate the following ratios for each year and comment on your findings.

7i8 Inventory days

7ii8 eceivables days

7iii8 +ayables days

7B marks8

7b8 &alculate the length of the cash operating cycle 7working capital cycle8 for each year

and e"plain its significance. 7# marks8

7c8 Discuss the relationship between working capital management and business solvency,

and e"plain the factors that influence the optimum cash level for a business. 7< marks8

7d8 factor has offered to take over sales ledger administration and debt collection for an

annual fee of ;.$K of credit sales. condition of the offer is that the factor will

advance njo plc 3;K of the face value of its debtors at an interest rate 1K above the

current overdraft rate. 'he factor claims that it would reduce outstanding debtors by

;K and reduce administration e"penses by 2K per year if its offer were accepted.

Re7)ire$9

!valuate whether the factor9s offer is financially acceptable, basing your answer on the

financial information relating to 2;;B. 73 marks8

7'otal 2$ marks8

7&& 2.# inancial -anagement and &ontrol December 2;;B =8

statement figure they represent.

#. Working Capital Ratio"

%orking capital ratios may help to indicate whether a company is o+er&'apitali"e$ ,

with e,'e""i+e -orking 'apital, or if a business is likely to fail. business is

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#.< &onventional wisdom has it that an ideal current ratio is 2 and an ideal quick ratio is 1.

It is very tempting to draw definite conclusions from limited information or to say that

the current ratio should be 2, or that the quick ratio should be 1.

#.3 Cowever, this is not very meaningful without taking into account the type of ratio

e"pected in a similar business or within a business sector. ny assessment of working

capital ratios must take into account the nature of the business involved.

#.: or e"ample a supermarket business operating a >I' system will have little inventory

and since most of sales are for cash they will have few receivables. In addition the

ability to negotiate long credit periods with suppliers can result in a large payables

figure. 'his can result in net current liabilities and a current ratio below 1 E but does

not mean the business has a liquidity problem.

#.1; 0ome companies use an overdraft as part of their long(term finance, in which case the

current and quick ratios may appear worryingly low. In such questions you could

suggest that the firm reschedule the overdraft as a loan. Lot only would this be

cheaper but it would also improve liquidity ratios.

#.11 E,ample 5

&alculate liquidity and working capital ratios from the following accounts of a

manufacturer of products for the construction industry, and comment on the ratios.

.22 .22

m m

0ales revenue 2,;B$.; 1,


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Let current assets


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inventory levels are strictly controlled, which is reinforced by the low

inventory turnover period.

7d8 'he ratio of sales revenueGnet working capital indicates that working capital

has not increased in line with sales. 'his may forecast future liquidityproblems.

It would seem that working capital is tightly managed, to avoid the poor liquidity

which could be caused by a high accounts receivable turnover period and

comparatively high accounts payable. Cowever, turnover has increased but net

working capital has declined due in part to the fall in short term investments and the

increase in loans and overdrafts.

#.12 Te"t =o)r >n$er"tan$ing 5

'he following data relate to & &o, a manufacturing company.

0ales revenue for year6 1,$;;,;;;

&osts as percentage of sales6

Direct materials ;K

Direct labour 2$K

Mariable overheads 1;K

i"ed overheads 1$K

0elling and distribution $K

verage statistics relating to working capital are as follows6

718 eceivables take 2.$ months to pay

728 aw materials are in inventory for three months

78 %I+ represents two months9 half(produced goods

7#8 inished goods represent one month9s production

7$8 &redit it taken6

( -aterials 2 months( Direct labour 1 week

( Mariable overheads 1 month

( i"ed overheads 1 month

( 0elling and distribution 1G2 month

%I+ and finished goods are valued at the cost of material, labour and variable

e"penses.

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Re7)ire$9

&ompute the working capital requirement of & &o assuming that the labour

force is paid for $; working weeks in each year.

Sol)tion9

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?! O+ertra$ing

01e' 284 J)n .6

$.1 O+ertra$ing 0or )n$er&'apitali"ation6

/vertrading occurs when a business has in")##i'ient #inan'e #or -orking 'apitalto ")"tain it" le+el o# tra$ing.

$.2 business is said to be overtrading when it tries to engage in more business than its

working capital will allow. It could be that too m)'h mone%is tie$ )p in "to'k" an$

tra$e $e(tor", and 'a"his not 'oming in 7)i'kl% eno)ghto meet $e(t"as they fall

due.

$. It could be that the firm #aile$ to o(tain ")##i'ient e7)it% #inan'e when it was

established to support its trading level, or it could be that the managers are particularly

(a$ at managing the -orking 'apital re"o)r'e"that they have.

$.# !ven if an o+ertra$ing ()"ine"" operate" at a pro#it, it could ea"il% r)n into "erio)"

tro)(lebecause it is short of money. 0uch liquidity troubles stem from the fact that it

does not ha+e eno)gh 'apitalto provide the cash to pay its debts as they fall due.

$.$ S%mptom" o# o+ertra$ing

S%mptom"of overtrading are as follows.

7a8 'here is a rapi$ in'rea"ein t)rno+er.7b8 'here is a rapi$ in'rea"ein the +ol)me o# ')rrent a""et"and possibly also

fi"ed assets. In+entor% t)rno+er an$ a''o)nt" re'ei+a(le t)rno+ermight

"lo- $o-n, in which case the rate of increase in inventories and accounts

receivable would be even greater than the rate of increase in sales.

7c8 'here is only a "mall in'rea"e in proprietor": 'apital 7perhaps through

retained profits8. -ost of the increase in assets is financed by credit,

especially6

7i8 Tra$e a''o)nt" pa%a(leE the payment period to accounts payable

is likely to lengthen

7ii8 (ank o+er$ra#t, which often reaches or even e"ceeds the limit of

the facilities agreed by the bank

7d8 0ome $e(t ratio"and li7)i$it% ratio" alterdramatically

7i8 'he proportion o# total a""et"financed by proprietors9 capital #all",

and the proportion #inan'e$ (% 're$it ri"e".

7ii8 'he ')rrent ratio an$ the 7)i'k ratio #all.

7iii8 'he business might have a li7)i$ $e#i'it, that is, an e,'e"" o#

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redeemable in ten years9 time.

factor has offered to take over the administration of trade receivables on a non(recoursebasis for an annual fee of K of credit sales. 'he factor will maintain a trade receivables

collection period of ; days and Jorwa &o will save 1;;,;;; per year in administration

costs and $;,;;; per year in bad debts. condition of the factoring agreement is that the

factor would advance 3;K of the face value of receivables at an annual interest rate of


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M)ltiple Choi'e )e"tion"

1. company has a liquidity ratio equal to ;.$. 'he directors believe that the company has

to reduce its bank overdraft and have agreed to alter the companyNs credit terms to

customers from two months to one month.

%hat would be the effects on the companyNs cash operating cycle and liquidity ratio if

this change were to be achieved?

&ash operating cycle )iquidity ratio

Decrease Decrease

Decrease Lo change

& Decrease Increase

D Increase Increase

2. 'he key trade(off that lies at the heart of the working capital management is that

between6

usiness stability and solvency

Debtors and creditors

& &urrent assets and current liabilities

D )iquidity and profitability

. %hich of the following is not a typical symptom of overtrading?

rapid increase in sales revenue

bank overdraft which may reach the limit of the facilities agreed by the bank

& n decrease in the current ratio and the quick ratio

D n decrease in trade payables days.

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#. rchie plc manufactures plastic cutlery. 'he company buys raw materials from suppliers

that allow the company 2.$ months credit. 'he raw materials remain in inventory for 2

months and it takes rchie plc 2 months to produce the goods, which are sold

immediately production is completed. &ustomers take an average of 1.$ months to pay.

%hat is rchie plc9s cash operating cycle?

2 months

2.$ months

& months

D < months

$. %hich of the following will shorten the cash operating cycle?

n increase in the raw materials inventory holding period

n increase in the trade payables days

& n increase in the trade receivables days

D n increase in the production period

B. %hich one of the following would lengthen the working capital cycle?

Delaying payments made to suppliers

educing raw material inventory

& Increasing the turnover of finished goods inventory

D Increasing credit given to customers

chapter8-wcmgt-working capital.doc

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