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Working Capital Managementby Binam Ghimire

Learning Objectives

Concept and Significance of WC management Cash Conversion Cycle Receivables Management and Credit Policy Inventory Management Cash Management and Cash Budget

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WC:Concept

Is Cash really a King?

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WC:Concept

“My techniques confine itself to the purchase of common stocks at less than their working capital value”

– Benjamin Graham

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WC:Concept

Look at the Balance Sheet given and find out the followingsGross Working CapitalNet Working Capital/ Net Operating Working

Capital

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WC: Classification

Permanent Variable

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Permanent WC

Variable WC

Working Capital (£)

Time

WC Management

Short-term financial management The management of current assets investment

and their financing Zero Working Capital Level of Working Capital: Optimal

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WC Management

PoliciesWorking Capital Investment PolicyWorking Capital Financing Policy

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WC Management

Policies: Aggressive, Moderate and ConservativeLiquidityProfitability

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Current Assets (£)

Conservative

Moderate

Aggressive

Output (units)

WC Management

Policies: Aggressive (Short term funds to finance the permanent CA)

Level ofCA/Sales ratiois ……

Match the Fund requirement to the maturity of assets 10

Assets

Month

Fixed Assets

Permanent current assets or net working capital

Total Funds Short term Funds

WC Management

Policy: Conservative (long term fund for permanent CA)

Level ofCA/ Sales ratiois ……

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Assets

Fixed Assets

Permanent CA

Month

Cash Conversion Cycle (CCC)

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Cash

Purchase

Inventory of Raw Materials

Inventory of Work-in-progress

Inventory of Finished Goods

Sales

Receivables

Payable

CCC

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The time intervals between outflow of cash and its inflow through sales and collection from customers.

CCC also known as trading cycle, Cash cycle, Operating cycle (Operating also includes the Date the order is placed i.e. the date firm purchases the inventory)

CCC, Formula

CCC =

Inventory Turnover Period (Inventory Days)

+ Average Collection Period (Receivable Days)

– Average Payable Period (Payable Days)

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CCC, Formula

Inventory Days: Inventory/Average Daily Cost of Goods Sold

Receivable Days: Receivables /Average Daily Sales

Payable Days:Payables/ Average Daily Costs of Good Sold

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CCC Consider the following information taken from a

company’s statements

Receivable Days = (100,000/ 600,000) x 365 = 61 days Inventory Days = (80,000/400,000) x 365 = 73 days Payable Days = (120,000/400,000) x 365 = 110 days CCC = 24 days

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Income Statement

£ Balance Sheet

£

Sales 600,000 Receivables

100,000

Gross Profit 200,000 Inventory 80,000Payables 120,000

CCC, Example 1

Extracts for A Ltd. (£)Income Statement:

Balance Sheet:

Prepare the operating cycle

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Turnover 250,000Gross Profit 90,000

Inventory 30,000Receivables 60,000Payable 50,000

CCC, Example 2

Extracts for X Ltd. (£ ‘000)

Income Statement:

Balance Sheet:

Prepare the trading cycle

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Turnover 100Cost of Sales 50

Inventory 10Receivables 15Payable 12

CCC, Case - solve and comment Given the following information from Elite PC’s

2006 income statement and balance sheet (numbers are in the $millions), calculate the company’s cash conversion cycle (CCC) and use it to evaluate the company’s efficiency and comment on the results:

Sales 66,467Cost of Goods Sold 54,226Accounts Receivable 5,160Inventory 643Accounts payable 10,234

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Managing Receivables (MR) Offer Credit

Advantages Retain customers More (old and new) customers

Disadvantages Bad Debts Slow Payers that increase WC Higher monitoring expenses

How can we manage credit?

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MR:Aspects to Credit Management Assessing Credit Status Terms of Trade Day to Day Management

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MR:Aspects to Credit Management Assessing Credit Status

Own record of sales Bank Reference Trade Reference Published Accounts Credit Rating Agencies Credit Scoring: subjective guidelines such as 5 Cs

(Character, Capacity, Capital, Collateral, Conditions) Altman Z score (Edward Altman Z Score)

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MR: Aspects to Credit Management, Assessing Credit Status, Altman Z Edward Altman developed a Z Score formula that

was able to identify bankrupt firms approximately 95% of the time.

If Z is < 1.81 likely to become bankrupt, 1.82 – 2.99 may become bankrupt, > 2.99 will not become bankrupt

Interested see – www.jaxworks.com/zscore3.htm 23

Altman Z Score formula

Z = 3.3EBIT

total assets+ 1.0

salestotal assets

+.6market value of equity

total book debt

+ 1.4retained earnings

total assets+ 1.2

working capitaltotal assets

If the Altman Z score of a company is as follows, would we accept the client?

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9.debtbook equitymarket

4.1assets total

sales

12.assets total

EBIT

retained earningstotal assets

working capitaltotal assets

=

=

.

.

4

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MR: Aspects to Credit Management, Assessing Credit Status, Altman Z

Z score is > 2.99

So accept the client

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Firm' s Z Score( . . ) ( . . ) ( . . ) ( . . ) ( . . ) .3 3 12 1 0 1 4 6 9 1 4 4 1 2 12 3 04x x x x x+ + + + =

MR: Aspects to Credit Management, Assessing Credit Status, Altman Z

MR: Aspects to Credit Management Terms of Trade

Credit limit amount Interest on overdue account Discount for early payment Number of Days Credit

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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

If a firm sells goods on terms of 2/30, net 60 This means a 2% discount for payment within 30

days or else must pay in full within 60 days. If the term is only net 60 days then no discount pay by 60 days

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What does it mean: A sells goods, terms 5/10, net 30 Which is wrong? (A or B)

A) 3/20, net 40 B) 4/20, net 10

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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

Suppose that a firm sells goods on terms of 2/10, net 20 On 1st of May you buy goods from the company with an

invoice value of £ 20,000. How much would you need to pay if you took the cash discount? What is the latest date on which the cash discount is available? By what date should you pay for your purchase if you decide not to take the discount?

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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

To get the cash discount, you have to pay the bill within 10 days, that is, by 11th May. With the 2% discount, the amount that needs to be paid by 11th May is £20,000 x 0.98 = £19,600. If you forego the cash discount, you don’t have to pay the bill until 21st May when you pay (£20,000)

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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

Trade Credit Rates (rate when firm does not accept the discount but makes the payment on the payment date)

What is the effective interest rate in such a case? (After all this is an implicit loan from the supplier)

The formula is then

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1PriceDiscounted

Discount1RateAnnualEffectiveCreditDaysExtra

365

MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

What is the implied interest rate on the trade credit if the discount for early payment is 5/10, 60?

= 0.454 (i.e. this is equivalent to 45.4 % a year)

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1PriceDiscounted

Discount1RateAnnualEffectiveCreditDaysExtra

365

19551RateAnnualEffective

50365

MR: Aspects to Credit Management, Terms of Trade, Discount for early payment

MR: Aspects to Credit Management, Terms of Trade, No. of Days Credit Collection Policy: Procedures to collect and monitor

receivables Aging Schedule - Classification of accounts

receivable by time outstanding

Sample aging schedule for accounts receivable

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Customer' sName

Less than1 month

1 - 2 months 2 - 3 monthsMore than3 months

Total Owed

A 10,000 0 0 0 10,000B 8,000 3,000 0 0 11,000* * * * * ** * * * * ** * * * * *Z 5,000 4,000 6,000 15,000 30,000

Total $200,000 $40,000 $15,000 $43,000 $298,000

MR:Aspects to Credit Management Day to Day Management

Recover the money and keep the customer Communicate frequently

A Process

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Time Line ActionAfter 30 days Send statement of

account+ 7 days Reminder Letter+ 7 days 2nd Reminder+ 7 days Legal action threat+ 7 days Take action

MR:Cost of financing receivables Total cost for a year

How much the receivables are costing in the course of a year

What interest rate to apply?

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MR:Cost of financing receivables, Formulas

Interest Cost =Receivable balance x Interest Rate

Receivable Days =

(Receivable balance/ Sales) x 365

Receivable Balance =

(Receivable Days x Sales)/ 365

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MR, Cost of financing receivables:Example 3 Sales = £10 m, Receivable = £3m. Interest Rate = 6%,

Calculate 1) the receivable days and 2) cost of financing receivables

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MR, Cost of financing receivables:Example 4 Discount for early settlement Same as example above, Now 0.5% discount to

customers who pay after 30 days (i.e. they pay after 30 days after the sale) instead of current average of 109.5 days. Assume 40% of customers are expected to take the offer]

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MR, Cost of financing receivables:Example 4, Solution Step 1: Calculate the receivable balance for those

who continue with the existing terms (60% of customers)

Receivable balance = (10m x 60% x (109.5/ 365)) = £1,800,000

Step 2: Calculate the receivables balance for those who pay after 30 days

Receivable balance = (10m x 40% x (30/365)) = £328,767

Step 3 Calculate the interest cost of these to A ltd(1800,000 x 0.06) + (328,767 x 0.06)= 108,000 + 19,726 =127,726

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MR, Cost of financing receivables:Example 4, Solution

Step 4 Calculate the cost of the discount10m x 40% x 0.5% = £ 20,000 Therefore total cost of finance =£127,726+ £20,000 = £147,726

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MR, Cost of financing receivables:Example 5 Shankley Ltd. has sales of £ 40 m. for the previous year,

receivables at the year end year £8 m. The cost of financing debtors is covered by an overdraft at the interest rate of 14 %.

What are the receivable days for Shankley. Calculate the cost of financing receivables

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MR, Cost of financing receivables:Example 6 Shankley Ltd. As above but discount of 2% is offered for

payment within 10 days. Should the company introduce the discount given that

50% of the customers take up the discount?

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MR, Cost of financing receivables:Example 6, Solution Step 1: Calculate the cost of receivables for those who

continue with the current terms (note that this step and step 2 combines the calculation of the receivables balance with the calculation of the interest on that balance)

£40m x 50% x 73/ 365 x 0.14 = £560,000 Step 2: Calculate the cost of the receivables for those

who take the early settlement discount£40m x 50% x 10/ 365 x 0.14 = £76,712

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MR, Cost of financing receivables:Example 6, Solution Step 3: Calculate the cost of the discount£40m x 50% x 2% = £400,000 Step 4: Calculate the total cost of finance£560,000 + 76,712+ 400,000= £1,036,712This is cheaper than the previous cost of £1,120,000.

therefore the new offer is cost effective

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MR, Factoring Factoring: Outsourcing of credit control department to a

third party The factor takes the responsibility to collect the debt for

a fee

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MR:Factoring, Example 7

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Continue Example 6. Rather than offer a discount, the company has been offered a contract by a factor whereby the factor offers to collect the debt for a fee of 0.75% of turnover. They believe they can collect the debt in 80 days. Admin savings of £ 20,000 are expected.

Should A Ltd. accept the offer?

Inventory Management (IM):Concept

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Minimise Total Inventory Cost Two basic but conflicting issues

How? Neither inadequate nor excessive inventory

IM:Cost components

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TC = OC + CC

IM, Differentiate the following:OC or CC?

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1. Cost of storage2. Cost of preparing specifications 3. Cost of deterioration and obsolescence4. Cost of receiving an order and checking it

against the invoice5. Cost of running a purchasing department6. Cost of writing a purchase order7. Cost of processing the paperwork 8. Insurance and taxes9. Personnel and telephone costs

IM, Carrying Cost: Total Carrying Cost =

TCC = C x Q/2

Where, C = carrying costs per unitQ = order size of inventoryQ/2= average inventory unit

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IM, Ordering Cost: Total Ordering Cost =

TOC = O x R/ Q

Where,O = ordering costs per orderR = total requirement of inventory for the

periodR/Q= number of order to be placed

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IM, Total Cost of Inventory : Total Inventory Cost =

TIC = C x Q/2 + O x R/ Q

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IM, Economic Order Quantity:

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TIC is minimum when CC = OCCosts

EOQ

Total costs

Carrying costs

Ordering costs

Order Size (in units)

IM, Economic Order Quantity: Algebraically

WhereCo = Cost per OrderD = Annual DemandCh = Cost of holding one unit for one year

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ChDxCox2EOQ

IM, Example 8: A company requires 20,000 Kg. of a raw material

per annum. The cost of placing an order is £ 40 regardless of the size of the order. The holding costs are £ 0.5 per unit per month. What is the EOQ?

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Cash Management Reasons for Holding Cash

TransactionPrecautionarySpeculative

How much to hold?Liquidity and Profitability

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Cash Management Baumol Model This is simply the EOQ model to manage the cash Formula

WhereQ = Amount invested per TransactionCo= Transaction cost of investing/ en-cashing a

securityD = Excess cash available to invest in short term

securitiesCh = Opportunity cost of holding cash

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ChDxCox2Q

Cash Management Baumol Example A company generates £5,000 per month excess

cash. The interest rate it can expect to earn on its investment is 6% p.a. The transaction cost associated with its separate investment of funds is constant at £50.

What is the optimum amount of cash to be invested in each transaction. How many transaction will arise each year

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Cash Management Optimum amount of cash to be invested =

= £10,000

Numbers of transactions = D/ Q = 60,000/10,000 = 6

Other models: Miller- ORR

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0.0660,000x50x2Q

Cash Budget A cash budget is a statement of all the inflows

and outflows of cash for a given period Financial Manager can use the Cash Budget to

identify short-term financial needs. The cash budget tells the manager what

borrowing is required or what lending will be possible in the short term.

The firm has a number of possible ways of acquiring funds to meet short-term shortfalls, including unsecured (line of credit from a bank) and secured loans (accounts receivable or inventories).

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Thank You

“Revenue is vanity, Profit is sanity”