Working Capital & Cash Flow

The difference between cash flow and profit There are many types of cash transactions. They can form distinguished by their purpose, their form 9how they are implemented) and their frequency.

Cash flows and Profit

1. Cash may be obtained from a transaction which has nothing to do with profit or loss. E.g. issue of shares for cash or loan stock for cash has no immediate effect on profit but is obviously a source of cash. Similarly, an increase in bank overdraft provides a source of cash for payments but it is not reported in the income statement.

2. Cash may be paid for the purchase of non-current assets, but the charge in the income statement is depreciation which is only a part of an asset’s cost.

3. When a non-current asset is sold there is a profit or loss on sale equal to the difference between the sale proceeds and the net book value of the asset in the statement of financial position at the time it is sold.

4. Cash flows also differ from trading profits due to changes in the amount of the company’s inventories, receivables and payables between the start and end of a period.

Indicate which of the following transactions represent cash inflow, cash outflow or neither

(a) Payment of dividends – (b) Providing for depreciation - (c) Purchase of fixed assets – (d) Payment of tax – (e) Sales on credit - (f) Sale of fixed asset –

The difference between profit and cash flow has important implications.

1. If a company is profitable but short of cash, one reason could be an increase in the other elements of working capital. Instead of seeking credit from a bank to finance the growth in working capital, management may consider whether operational cash flows could be improved by squeezing working capital.

Reducing receivables (Trade Debtors) Reducing inventories (Stocks) Taking more trade credit from suppliers

Better control over working capital could remove the need to borrow

2. If a company is making losses, it could try to maintain a positive operational cash flow by taking more credit (i.e. increasing its payables and so reducing working capital).

Working Capital Cycle

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Working capital is the capital available for conducting the day-to-day operations of an organisation; normally the excess of current assets over current liabilities.

The current assets of a business can be subdivided into permanent current assets (core levels of inventory and receivables) and fluctuating current assets which vary from period to period.

Working Capital Management This is ensuring that sufficient liquid resources are maintained. This involves achieving a balance between the requirement to minimize the risk of insolvency and the requirement to maximise the return on assets.

a) A business pursuing an aggressive working capital policy will hold minimal cash and inventories and use short-term financing to fund both permanent and fluctuating current assets.

b) A business pursuing a conservative policy will have large levels of ready cash and safety inventory and use long-term funding for both non-current and most current assets. This is the least risky option but results in the lowest expected return.

Working Capital Cycle/Cash Cycle/Operating Cycle/Trading CycleWorking Capital Cycle is the period of time which elapses between the point at which cash begins expended on the production of a product and the collection of cash from a purchaser.

Method 1: The working cycle in a manufacturing business equals:

Average time that raw materials remain in inventory XLess the period of credit taken from suppliers (X)Plus the time taken to produce the goods XPlus the time finished goods remain in inventory after production XPlus the time taken by customers to pay for the goods X

Example Wines Co buys raw materials from suppliers that allows Wines 2.5 months credit. The raw materials remain in inventory for 1 month, and it takes Wines 2 months to produce the goods. The goods are sold within a couple of days of production being completed and customers take on average 1.5 months to pay.

Calculate Wines’ working capital cycle

Solution

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Months The average time that raw materials remain in inventory Less: time taken to pay suppliers The time taken to produce the goods The time taken by customers to pay for the goods

Total

Method 2: Alternative way to calculate the Working Capital Cycle with ratio analysis

Year 1Days Debtors XDays Stock X

Days Creditors (X)WC Cycle X

1: From the following data, work out the working capital cycle of A business for years 1 and 2 and discuss the implications of your figures.

Profit and Loss account for years 1 and 2

Year 1 Year 2Sales revenue 1000 1500Cost of sales 750 1125Gross Profit 250 375Overheads 100 150Net Operating Profit 150 225

Balance sheet values

Year 1 Year 2Stock 103 216Debtors 247 452Creditors 62 185

Solution

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Year 1 Year 2Debtors DaysStock Turnover Days

Creditors DaysWC Cycle

2: The table below gives data from the accounts of A Co plc for the past three years.

Year 1 (000s) Year 2 (000s) Year 3 (000s)Sales revenue 864 1080 1188Cost of sales 518 702 720Stocks 270 373 416Debtors 173 259 297Creditors 86 105 126

What is the working capital cycle for each year? How might the cycle be reduced and what are the possible disadvantages of doing so?

Managing the Cycle A longer working capital cycle requires more financial resource, so management will seek whenever possible to reduce the length of the cycle. Their possible options are as follows:

1. Reduce levels of raw materials inventory. May be done through the introduction of some type of JIT system which will necessitate more efficient links with suppliers. Production delays due to running out of inventory must be avoided.

2. Reduce WIP by reducing production volume or improving techniques and efficiency

3. Reduce finished goods inventory perhaps by improving distribution. This may lead to delays in fulfilling customer orders

4. Delay payments to suppliers – can lead to loss of discounts and of supplier goodwill

5. Reduce period of credit given to customers – this may mean offering discounts and more aggressive credit control may lead to a loss of customers.

Cash forecasts

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Cash forecasting ensures that sufficient funds will be available when they are needed to sustain the activities of an enterprise. A cash budget is a detailed budget of estimated cash inflows and outflows, incorporating both revenue and capital items. It is formally adopted as part of the business plan or master budget for the period.

It is often said that in business “Cash is King”, this is said because cash is all-important to businesses. Without cash employees cannot be paid, suppliers cannot be paid, and therefore the business will grind to a halt. Cash is the oil in the machine of business, and a Cash Flow Statement tells us how much cash is or will be available within the business or how much cash will be needed to keep the business running.

Remember that, “A Cash Flow Statement tells us how much cash is or will be available in a business or how much cash will be needed to keep the business running”.

This is the Cash Flow Statement of GoodWood Trading

The predicted cash flow statement for the first six months of trading is shown below.

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Jan Feb Mar Apr May Jun

Revenue

Cash Sales 600 1200 1750 2300 2600 3000

Debtors Payments 0 600 850 1300 1490 1430

Total Revenue

Expenses

Raw Materials 970 1200 1350 1380 1670 1500

Wages 800 800 800 900 900 900

220 220 220 220 220 220

Rates 40 40 40 40 40 40

Electricity 60 60 60 100 100 100

Travelling 80 80 150 150 150 150

Sundries 130 80 80 80 80 80

Exhibition Charges 150 150 250 250 300 300

Total

Net Cash Flow

Opening Balance 750

+ / - Net Cash Flow

Closing Balance

REASONS FOR PREPARING CASH FLOW FORECASTS

(1) Identifying the timing of cash shortages and surpluses

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If there is a projected shortage then this is a good time to borrow funds. If there is a projected surplus, then it is a good time to plan the purchase of machinery and equipment.

(2) Supporting applications for funding When trying to raise finance, lenders often insist that businesses support their applications with documents showing business performance.

(3) Enhancing the planning process Helps to clarify aims and improve performance.

(4) Monitoring Cash Flow At the end of the financial year the forecast is measured against the actual statement to detect any significant variance in figures. From this you can identify areas of concern, and plan ways to rectify them.

Four possible cash positions

Cash Position

Appropriate management action

Short-term surplus

Pay suppliers early to obtain discount Attempt to increase sales by increasing

receivables and inventories Make short-term investments

Short-term deficit

Increase payables Reduce receivables Arrange an overdraft

Long-term surplus

Make long-term investments Expand Diversify Replace/update non-current assets

Long-term deficit

Raise long-term finance (issue of share capital) Consider shutdown/divestment opportunities

Preparing Cash Budgets

1. Format for cash budgets a) A clear distinction between the cash receipts and cash

payments for each control period. It should be logically

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arranged with a subtotal for receipts and a subtotal for payments

b) A figure for the net cash flow for each period. Managers find in practice that a figure for the net cash flow helps to draw attention to the cash flow implications of their actions during the period.

c) The closing cash balance for each control period. The closing balance for each period will be the opening balance for the following period.

2. Depreciation is not included in cash budgets 3. Allowance must be made for bad and doubtful debts

Illustration Watson Ltd is preparing budgets for the next quarter. The following information has been prepared so far:

Sales value June (estimate) $12500July $13600August $17000September $16800

Direct wages $1300 per month

Direct Material Purchase June (estimate) $3450

July $3780August $2890September $3150

Other information Watson sells 10% of its goods for cash. The remainder of

customers receive one month’s credit Payments to material suppliers are made in the month

following purchase

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Wages are paid as they are incurred Watson takes one month’s credit on all overheads Production overheads are $3200 per month Selling, distribution and administration overheads amount to

$1890 per month Included in the amounts for overheads given above are

depreciation charges of $300 (production) and $190 (selling, distribution and administration) respectively

Watson expects to purchase a delivery vehicle in August for a cash payment of $9870

The cash balance at the end of June is forecast to be $1235

Prepare a cash budget for July to September inclusive

Solution: Watson Ltd cash budget for July to September July August September

Sales Receipts

10% in cash

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90% in one month

Total Receipts

Payments

Material Purchases

Direct wages

Production overheads

Selling, distribution and administration

Delivery vehicle

Total Payments

Net cash flow

Opening cash balance

Closing cash balance

Evaluation of cash budget

Cash Flow Forecasts

1: A Co. Ltd has budgeted for the following sales

April May June July August September10000 12000 12000 13000 16000 16000

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10% of sales are for cash with the balance on credit requiring payment by the last day of the month following month of invoice.

Purchases are budgeted at $9000 per month with payment at the end of the second month following month of invoice.

Wages are budgeted at $3000 per month and general expenses at $2000 per month.

Bank interest of $1500 will be paid in June Plant and machinery costing $10000 will be bought and paid

for in August The present cash position shows an overdrawn balance at the

bank of $4000 at the end of March (the account is in deficit)

Draw up a cash budget for the period April to September inclusive

Answer A Co Ltd Cash Budget for period April to September

April May June July August SeptemberReceiptsCash salesReceipts

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from debtorsTotal receiptsPaymentsPayments to creditorsWagesGeneral expensesBank interestPlant and machineryTotal PaymentsNet Cash flowOpening balanceClosing balance

2: You are presented with the following budgeted data for your organisation for the period November 2012 to June 2013.

Nov Dec Jan Feb Mar Apr May JuneSales 80000 100000 110000 13000

0140000 15000

0160000 180000

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Purchases 40000 60000 80000 90000 110000 130000

140000 150000

Wages 10000 12000 16000 20000 24000 28000 32000 36000

Overheads 10000 10000 15000 15000 15000 20000 20000 20000

Dividends 20000 40000Capital Expenditure

30000 40000

Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sales

Purchases are paid the month following purchase 75% of wages are paid in the current month and 25% the

following month Overheads are paid the month after they are incurred Dividends are paid three months after they are declared Capital expenditure is paid two months after it is incurred The opening cash balance on 1 January 2002 is $15000

The managing director is pleased with the above figures as they show sales will have increased by more than 100% in the period under review. In order to achieve this, he has arranged a bank overdraft with a ceiling of $50000 to accommodate the increased inventory levels and wage bill for overtime worked.

Answer Working Out Sales January: 44000 + 48000 = $92000February: March: April: May: June:

Wages January: 16000 x .75 + 12000 x .25 = 15000February: March: April:May:

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June:

January February March April May JuneReceiptsSalesT. Receipts

PaymentsPurchasesWagesOverheadsDividendsC. ExpT. Payments

Opening BalanceNCFClosing Balance

(b) Comment upon your results in the light of the managing director’s comments and offer advice

3: Superfix operates a 24 hour repair and maintenance service for photocopying machines. The company, which was set up 3 years ago, employs four people and is based in Ealing, West London. It relies mainly on emergency calls from customers who obtain Superfix’s number from Yellow Pages when their machines malfunction. At the moment the company faces two main problems. First it can struggle

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to receive payment from customers after work has been carried out. Indeed, bad debts are common for Superfix. Second, it faces quite high labour costs because its staff is not gainfully employed because there are no calls. The managing director of Superfix is about to draw up the cash flow forecast statement for the next trading year. The monthly sales revenue figures are as follows:

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

6000

5800 5500 6500

6600 6000 6800

6700 6800 7000

6900 7200

The expenses are as follows: Wages are expected to be $4000 per month Motor Expenses are expected to be $650 per month Telephone charges are expected to be $150 (March); $150 (June)

$170 (September) and $170 (December)

Insurance is $450 and paid in July Accountancy fees are expected to be $700 and will be paid in

December. Advertising is paid twice a year in February and August

approximately $300 each time. An allowance of $200 per month is made for miscellaneous

expenditure. Drawings of $1000 per month will be made by the managing

director. Annual ground rent of $4000 is payable in June. The opening cash balance for Superfix is $850.

(a) Produce a cash flow forecast for Superfix

After analyzing the statement, the managing director decides that something positive must be done to improve the company’s position. It is decided that Superfix will launch an insurance scheme, which will be sold by a specialist salesperson directly to users. For an annual fee the insurance scheme will provide annual maintenance and free callout and labour charges for emergency calls. As a result of this scheme a number of additional cash inflows and outflows are to be expected.

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A new salesperson will be recruited at the start of April at a cost of $1500 per month, for the rest of the year.

Extra revenue will be generated resulting from the sale of insurance policies (May $1000; June $1500; July $2000; August $2500; September $3000; October $3100; November $3200 and December $3300)

Motor Expenses will rise by $150 per month from 1st of April onwards.

(b) Produce an amended cash flow statement

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Cash flow problems Making losses: continual losses will eventually mean problems

whose timing depends on the size of losses and whether depreciation is significant

Inflation: ever-increasing cash flows required just to replace used-up and worn-out assets

Growth: business needs to support more receivables and inventory

Seasonality: difficulties may occur at certain times when cash inflows are low and outflows high.

Once-off expenditure: large items such as a loan repayment or purchase of expensive non-current asset such as freehold land

Poor credit control procedures: long average time for credit customers to pay may cause problems

Methods of easing cash shortages 1. Improving the business: cash deficits can arise out of basic

trading factors underlying the business such as falling sales or increasing costs. Clearly, the way to deal with these items is to take normal business measures, rectifying the fall in sales by marketing activities, or if this cannot be achieved, by cutting costs

2. Controlling the operating cycle: short-term deficiencies: cash deficits can also arise out of the business’ management of the operating cycle and from timing differences. The following are possibilities:

a) Borrowing from the bank. This is only a short-term measure. It is possible that a bank will convert an overdraft into a long-term loan, or perhaps new overdraft limits can be set up.

b) Raising Capital: this is likely to be expensive and should be generally used for long-term investment, not short-term cash management.

c) Different sources of finance (such as leasing) might be used

3. When a company cannot obtain resources from any other source such as a loan or an increased overdraft, it take the following steps:a) Postponing capital expenditure: it might be imprudent to

postpone expenditure on non-current assets which are needed for the development and growth of the business. On the other hand, some capital expenditures might be

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postponable without serious consequences. If a company’s policy is to replace company cars every two years, it may decide, if cash is short, to replace the cars every three years.

b) Accelerating cash inflows which would otherwise be expected in a later period: the most obvious way of bringing forward cash inflows would be to press receivables for earlier payment (leading and lagging receivables)

c) Reversing past investment decisions by selling assets previously acquired

d) Negotiating a reduction in cash outflows so as to postpone or even reduce payments: there are several ways this could be done.

I. Longer credit might be taken from suppliers (leading and lagging payables)

II. Loan repayments could be rescheduled by agreement with a bank

III. A deferral of the payment of tax could be agreed with the taxation authorities

IV. Dividend payments could be reduced. Dividend payments are discretionary cash outflows, although a company’s directors might be constrained by shareholders’ expectations

V. Inventory levels could decrease to reduce the amount of money tied up in their production cost.

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