Understanding and Managing Finance 8This Presentation is in Self-Study FormTo start the presentation:Press F5 (Top Row of Keyboard)Then use the navigation buttons at the foot of each page.

Managing Finance and BudgetsPresentation 8Working Capital (1)

Session 3 - Financial Statements (2)Learning outcomes:Understand what is meant by the term Working Capital, and be able to describe some of the elements of which it comprises.Understand what is meant by the Operating Cash Cycle and how it might affect a business.Manipulate and use financial statements to inform decision-making specifically related to Working Capital.Key concepts:Cash Flow Statement Working Capital

Structure of the Presentation

A : What do we mean by Working Capital?B : The Key Elements of Working CapitalC : The Operating Cash Cycle D : Controlling the CashE : Seminar 8

Section A:What do we mean by Working Capital?

What is Working Capital?Working Capital is usually defined as:

Current AssetsLess Current Liabilities

The major elements are:Stocks, Debtors, Cash (Assets)Creditors, Tax payable, Overdraft (Liabilities)

For 2002, Current Assets Total = 574,300For 2002, Current Liabilities Total = 233,360Working Capital for 2002: 574,300 - 233,360 340,940Example

The Elements of Working Capitala summaryMajor elementsMajor elementlessequalsCurrent liabilitiesWorking capitalCurrent assets

Why is Working Capital Important?Working Capital is money which is used to keep the organisation running on a day to day basis represents a net investment in short term assets. defines the Liquidity of the business (whether or not the business is solvent in the short term)is directly related to the Cash Flow from Operating Activities.

Current Assets Total = 574,300Current Liabilities Total = 233,360Working Capital for 2002: 574,300 - 233,360 340,940Example RevisitedHere we can see that although we have a large amount of Working Capital, it is all locked up in Stock & Debtors. The amount of actual cash (33,500) is low in comparison; this may not be sufficient for needs.

Why do we need to Manage Working Capital?A shortage of Working Capital may lead to operating difficulties - shortage of stock, inability to offer credit to clients, slow payment to creditors, missed opportunitiesAn excess of Working Capital also represents money locked up in stocks and debtors - investment may not produce an appropriate returnWorking capital, therefore, needs careful management

For 2001, Current Assets Total = 175,750For 2001, Current Liabilities Total = 225,900Working Capital for 2001 is negative 175,750 - 225,900 - 50,150Further ExampleHere we can see that the business has a deficit of Working Capital; it owes more money to creditors than it has in Stocks & Debtors. It might be Overtrading.

The Problem of OvertradingThis is where the working capital is insufficient to finance the increasing volume of tradeExpansion means more money is required to finance higher stock levels, and higher levels of debtOrganisations try to achieve this by increasing amount of time taken to pay suppliers, or increasing overdraft up to or beyond limitA minor difficulty in any element of the working capital (e.g. late client payment) can then cause catastrophe

How exactly do we Manage Working Capital?In order to be able to Manage Working Capital effectively, we need to know:The elements of Working Capital (stocks, debtors, creditors)Detailed information about these elements; whether the levels are high or low, and whether we are are using them efficiently.What actions can be taken to affect the situation.

All of the above relies on an knowledge how each of these elements affects the Working Capital Cycle

The Working Capital Cycle

Purchase materials, which weUse for Work-in-Progress, then wePay employees, whoDevelop Finished goods, which we Sell for cash or on credit, so we canPay creditors, and then Retain the Surplus, which we use toThis is essentially just a a simplified version of the how the operating activities link together and affect one other:

Working Capital in SummaryWorking Capital is the lubricant which allows the business to run smoothly Requirements vary between different types of industry (e.g. high in manufacturing, low in retail) & according to the fluctuations in the trading positionAn increase in business may well require a parallel increase in working capital

SAQ 8.1

SAQ 8.1a. Why would the requirements for a greengrocers working capital be very different from that of a builder?

b. What changes in the general business environment might lead a company to change the level of their Working Capital investment?

SolutionSolution

SAQ 8.1a Solution Why would the requirements for a greengrocers working capital be very different from that of a builder?

Greengrocer: stock has very short shelf-life -often a matter of a day or two; Amount of stock is kept to the minimum possible, otherwise large wastage. In the retail trade, there are virtually no trade debtors, but may be some trade creditors. All this suggests very low levels of Working Capital: hundreds of pounds.Builder: Often needs to outlay lots of expense: building materials, hire of equipment etc. Often this is on credit. Stock here is the half-completed job. Often people take a long time to pay . All of this suggests that Working Capital will involve much larger sums of money thousands of pounds even for a small builder.

SAQ 8.1b Solution b. What changes in the general business environment might lead a company to change the level of their Working Capital investment?

Some possibilities:Interest Rate ChangeSeasonal demand patternsEconomic climateChanges in the MarketCompetition

Section B:The Key Elements of Working Capital

The Working Capital CycleSummary diagram

Key Elements of Working CapitalThere are three key elements to Working Capital:

Stock(absorbs working capital)Trade Debtors(absorbs working capital)Trade Creditors(releases working capital)

Each one of these needs to be monitored effectively.SAQ 8.2

SAQ 8.2Discuss the following:

Why do you think it is important to keep careful track of working capital requirements?Solution

SAQ 8.2 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.Possible Bankruptcy.

Key Elements of Working Capital:StockThe higher the levels of stock, the more money the business has tied up in goods.There may be very good reasons why some businesses need to carry high stock levels (Tesco, for example needs to carry a huge range of items; it will also need to have some basic items such as bread, milk and potatoes in large quantities)Normally, holding large volumes of stock is not a good idea; if stock is held for long periods, the money is dead, and not being used effectively.Typically, the highest profitability occurs when stock levels are at the minimum levels to supply customer needs.

Key Elements of Working Capital:StockRemember from last week:

Stock Turnover period:

Stock holding (days) = Average Stock Value x 365 Cost of Sales

This provides an indication of the average length of time that stock is held before it is sold.

Stock Turnover PeriodExample calculation of the Stock Turnover Period:

A company has opening and closing stock levels for 2003 of 36,000 and 42,000.The Cost of the Sales in 2003 was 345,000

Stock holding (days) = (36000+42000)/2 x 365 345000

= 41.26 days

Stock ControlOne of the important issues here is how we can monitor and control stock levels.

There are several standard techniques for doing this.Some require simple arithmetical calculations. Others require a complete redesign of production processes or retail layout

We will explore some of these issues next week.

Key Elements of Working Capital:Trade DebtorsCarrying higher levels of Trade Debtors means that the business has a lot of money tied up, which it is not able to use to generate profit.The businesses that owe us money, are effectively using it to invest in their business, and so create profits for them.There may be good reasons why some businesses need to carry high levels of Trade debtors. (Builders, for example typically work on contracts for several months before getting paid.)In the normal cut & thrust of trade, most businesses would typically expect payment within one calendar month.

Key Elements of Working Capital:Trade DebtorsRemember from last week:

Average settlement period for Debtors:

Debtors (days) = Trade Debtors x 365 Credit Sales

This indicates how long, on average the business has to wait before it gets its money from its customers.

Average Settlement Period (Debtors)Example of Debt Settlement period:

A Company has the following totals for 2003:

Total amount of Trade Debt is 45,500Total for Credit Sales is 243,000

Debtors (days) = 45500 x 365 243000=68.34 days

Management of Debtors

Just as with stock, an important issue is how we can monitor and control the levels of trade debtors.

There are several standard techniques for doing this.Organisational policies required regarding offering credit; credit terms etc.Debt Collection Policies and their management. Cash Discounts offered for early payment.

We will explore some of these issues next week.

Key Elements of Working Capital:Trade CreditorsCarrying high levels of Trade Creditors means that the business has access to a lot of resources (such as stock, rent, fuel etc.), but for which it has not paid.This means that other businesses have effectively provided us (until we pay) with free resources, that we can use to create create profits for us.Before we get carried away, there are good reasons why we should not carry high levels of Trade Credit.In the normal cut & thrust of trade, most businesses would typically expect payment within one calendar month; if this does not happen, we may incur penalties, and ultimately suppliers may refuse to trade with us.

Key elements of working capitalRemember from last week:

Average settlement period for Creditors:

Creditors (days) = Trade Creditors x 365 Credit purchases

This indicates how long, on average, the business takes to pay what it owes.

Average Settlement Period (Creditors)Example of Credit Settlement Period:

A companys accounts for 2003 shows that:

The amount currently owing is 43,500The total amount of credit purchases is 198,000

Creditors (days) = 43500 x 365 198000

=80.19 days

Management of CreditorsJust as with stock and trade debtors, an important issue is how we can monitor and control the levels of trade creditors.

There are several issues here.Discounts may be offered for paying early and may be more valuable than the trade creditPaying late may have disadvantages: lower priority, higher prices, refusal to supply

We will explore some of these issues next week.SAQ 8.3

SAQ 8.3Tinas Dressmaking Fabrics & Accessories Ltd. prides itself on stocking a wide range of fabrics in all colours, sizes and materials as well as a huge collection of trimmings, buttons, and ornamentations. It plies its business with specialist dressmakers, who buy mainly on credit, and takes its supplies directly from manufacturers, buying in bulk at a discount, on credit, but in order to qualify for the discount, payment must be made within seven days.

What level of working capital do you think Tina needs?Do you think that this is an efficient way to run the business?Solution

SAQ 8.3Tina carries very high levels of stock (probably in the hundreds of thousands of pounds); unless she has a credit policy, it is likely that there would be huge amounts of trade debtors, certainly in the tens of thousandsOn the other hand, given the 7-day discount, it is likely that she will keep the amounts owed to trade creditors very low, certainly much lower than the trade debtors.All this suggests that the Working Capital requirements would be enormous; a huge proportion of this being tied up in stock which may not actually be needed in the short term.It might be more profitable to hold lower levels of the less popular stocks, and run the risk of running out. If suppliers require payment within 7 days, then it is likely that they offer delivery within that time; hence customer service would not be affected greatly.

Section C:The Operating Cash Cycle

The working capital cycle:summary diagram

The Working Capital Cycle- essential eventsThe diagram below is an even more simplified version of the Working Capital Cycle:

Assuming all trade is done on credit, this shows the four essential events, in the normal order in which things occur.

The Working Capital Cycle- essential eventsFrom the simplified diagram,

purchase of goods on creditCash received from debtorspayment to creditors for goods Sale of goods on creditWe can see immediately:The Debtor PeriodThe Creditor Period

Debtor PeriodCreditor Period

The Working Capital Cycle- essential eventsThere are two more important time periods:

The Stockholding Period (where is this?)The Operating Cash Cycle (what is this?)

The Stockholding PeriodThe Stockholding period is the time from the purchase of goods to the sale of goods:

purchase of goods on creditCash received from debtorspayment to creditors for goods Sale of goods on credit

The Operating Cash Cycle The Operating Cash Cycle is defined as the time between the outlay of cash necessary for the purchase of stocks to the ultimate receipt of cash from the sale of goods.purchase of goods on creditCash received from debtorspayment to creditors for goods Sale of goods on credit

Operating Cash Cycle The Operating Cash Cycle can be calculated using the following equation:Long Operating Cash Cycles have a significant influence on the financing of the business.Most business will wish to reduce this to a minimum.

Calculating the Operating Cash Cycle

Example of Operating Cash Cycle Using the amounts calculated previously : = 29.41 days In this case, the average time between the cash laid out and cash returned is less than one month.Stock Turnover DaysDebtor DaysCreditor Days

41.26 Days68.34 Days80.19 Days41.26+ 68.34 80.19 = 29.41 Days

Why is the OCC important?Effectively the OCC is the time it takes for cash to circulate around the Operating Activities of the business.On every pass through the cycle, profit will be generated.The shorter the cycle, the faster cash goes around, and the more profit will be generated over the accounting period.

Comment on the Previous ExampleIf it were the case that we were taking 80 days to pay suppliers, then in all likelihood we would have incurred penalties.It is more likely that the creditor payment period would be around 30 days or so.This would give an OCC of around41 + 68 30 = 78 days.This more than doubles the OCC. If the OCC were to increase like this, it would stretch out our finances ever more thinly; this is like paying out all our cash on one day, and not seeing any of it until 78 days later.

How can we reduce the OCC?The Operating Cash Cycle is calculated by:

OCC = Stock + Debtors Creditors

So we try to:Reduce StockReduce DebtorsIncrease Creditors

Reducing the OCCExample: OCC = Stock + Debtors Creditors

OCC = 41.26 + 68.34 80.19 = 29.41 days Suppose we:Reduce Stock to 40.26 ; OCC = 28.41 days Reduce Debtors to 63.34; OCC = 23.41 daysIncrease Creditors to 82.19; OCC = 21.41 days

Effectively we have reduced the time between payout & payback by 8 days. This means that we can re-invest our money sooner, and generate more turnover in the same year.SAQ 8.4

SAQ 8.4In the lecture example from week 7, (m & N Manufacturing) we calculated the following ratios. Calculate the OCC for 2002 & 2003, and comment on the differences.Solution

SAQ 8.4 SolutionOCC for 2002:58.7 + 39.2 -38.7 =59.2 days

OCC for 2003:51.3 + 31.7 44.1=38.9 days

Comments:The OCC has been reduced by 20 days, about a third of the original time. This is a vast improvement In terms of cash flow, this means that M & N are now utilising their cash with much greater efficiency than they did before. NB This, by itself will not mean that they are more profitable: they may be spending it in the wrong things! See week 7.

Section D:Controlling the Cash

Controlling Working Capital through the Cash Balance

We have seen that three important elements of Working Capital are Stocks, Debtors and Creditors.Another element is the Cash Balance at the Bank.This is important because sooner or later, we need to get money from our Debtors, and pay our creditors.In order to manage this process, we need to monitor our current cash flow situation, and our current bank balance.

SAQ 8.5

SAQ 8.5

Why might a business want to hold some of its assets in the form of cash?Solution

SAQ 8.5 SolutionWhy might a business want to hold some of its assets in the form of cash?

For day-to-day trading purposes: Some of this may need to be in cash; we need to pay rent, rates, fuel bills, tax & interest. As an insurance against cash-flow problems: we may need a cash buffer to ensure that we do not exceed our overdraft limit at particular times in the year.To take advantage of opportunities that arise: there may be bargains that we spot, or we may wish to secure short-term investments which offer high profitability.

Controlling the Cash Balance

The Cash element of Working Capital now becomes of crucial importance.If we have too high a Bank Balance, then the money might be gaining interest, but hopefully, we would obtaining a better ROCE employing it in the business.If we have too low a Bank Balance (or an overdraft), then we are in danger of incurring penalties in the form of overdraft interest payments

Controlling the Cash Balance

There are many techniques for controlling the cash element of Working Capital:One model proposes:A Target BalanceInner Limits (+/-) (close to the target)Outer Limits (+/- ) (further away)

Controlling the cash balance

Controlling the cash balanceOuter Limit breeched:Managers must decide whether this will return to inside inner limit with a few days, if not, take action to generate cash inflow.

Controlling the cash balanceReturn to within Inner Limit:After action taken (selling of assets for cash), the cash balance has returned to acceptable levels.SAQ 8.6

SAQ 8.6

When deciding what is a suitable Target level of cash to hold, what factors would we need to take into consideration?Solution

SAQ 8.6

When deciding what is a suitable Target level of cash to hold, what factors would we need to take into consideration?

The type of business : businesses such as gas/electricity suppliers have cash flows which are steady & predictable. Xmas tree producers have cash flows which are seasonal and unpredictable).The cost of holding cash & borrowing: this includes factors such as the the current interest rate, overdraft conditions etc.The general economic climate: Following 9/11 there was a downturn in many areas; some business responded by holding more cash, some less, depending upon the sector.

Seminar Eight - ActivitiesPreparation: read M & A Chapter 16Describe key concepts:Working CapitalOperating Cash CycleWorking Capital ExampleM & A Exercise 16.1 (answers in M & A)

NB Seminar 8 mainly consists of answers to the example, followed by Test 2, which will last the rest of the time.