Download Working Capital Lecture Note

Working Capital Management
by Binam Ghimire
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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
followings
Gross Working Capital
Net Working Capital/ Net Operating Working Capital
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WC: Classification
Working Capital (£)
 Permanent
 Variable
Variable WC
Permanent WC
Time
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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
 Policies
Working Capital Investment Policy
Working Capital Financing Policy
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WC Management
 Policies: Aggressive, Moderate and Conservative
Liquidity
Profitability
Current Assets (£)
Conservative
Moderate
Aggressive
Output (units)
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WC Management
 Policies: Aggressive (Short term funds to finance the
permanent CA)
Level of
Assets
CA/Sales ratio
Total Funds
Short term Funds
is ……
Permanent current assets or net working capital
Fixed Assets
Month
 Match the Fund requirement to the maturity of assets
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WC Management
 Policy: Conservative (long term fund for permanent CA)
Assets
Level of
CA/ Sales ratio
is ……
Permanent CA
Fixed Assets
Month
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Cash Conversion Cycle (CCC)
Cash
Receivables
Purchase
Sales
Payable
Inventory of
Finished Goods
Inventory of
Raw Materials
Inventory of Workin-progress
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CCC
 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)
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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
Income
Statement
£
Balance
Sheet
£
Sales
600,000
Receivables
100,000
Gross Profit
200,000
Inventory
80,000
Payables
120,000
 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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CCC, Example 1
Extracts for A Ltd. (£)
Income Statement:
Balance Sheet:
Turnover
250,000
Gross Profit
90,000
Inventory
30,000
Receivables
60,000
Payable
50,000
Prepare the operating cycle
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CCC, Example 2
Extracts for X Ltd. (£ ‘000)
Income Statement:
Balance Sheet:
Turnover
100
Cost of Sales
50
Inventory
10
Receivables
15
Payable
12
Prepare the trading cycle
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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 66,467
Cost of Goods Sold 54,226
Accounts Receivable 5,160
Inventory 643
Accounts 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.
Altman Z Score formula
Z = 3.3
EBIT
sales
market value of equity
+ 1.0
+.6
total assets
total assets
total book debt
+ 1.4
retained earnings
working capital
+ 1.2
total assets
total assets
 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
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MR: Aspects to Credit Management,
Assessing Credit Status, Altman Z
 If the Altman Z score of a company is as follows, would
we accept the client?
EBIT
 .12
total assets
retained earnings
=.4
total assets
sales
 1.4
total assets
working capital
=.12
total assets
market equity
 .9
book debt
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MR: Aspects to Credit Management,
Assessing Credit Status, Altman Z
Firm' s Z Score
(3.3x.12) + (.
1 0x1.4) + (.6x.9) + (.
1 4 x.4) + (.
1 2 x.12) = 3.04
 Z score is > 2.99
 So accept the client
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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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MR: Aspects to Credit Management, Terms of
Trade, Discount for early payment
 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


Discount

Effective Annual Rate  1 
 Discounted Price 
365
Extra DaysCredit
1
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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?


Discount

Effective Annual Rate  1 
 Discounted Price 
5

Effective Annual Rate  1  
 95 
365
365
50
Extra DaysCredit
1
1
= 0.454 (i.e. this is equivalent to 45.4 % a year)
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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
Customer' s
Less than
Name
A
1 month
10,000
B
More than
1 - 2 months
2 - 3 months
0
0
3 months
0
Total Owed
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
10,000
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MR:
Aspects to Credit Management
 Day to Day Management
 Recover the money and keep the customer
 Communicate frequently
 A Process
Time Line
Action
After 30 days
Send statement of account
+ 7 days
Reminder Letter
+ 7 days
2nd Reminder
+ 7 days
Legal action threat
+ 7 days
Take action
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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 discount
10m 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
= £1,036,712
This 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
 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?
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Inventory Management (IM):
Concept
 Minimise Total Inventory Cost
 Two basic but conflicting issues
 How?
 Neither inadequate nor excessive inventory
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IM:
Cost components
TC = OC + CC
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IM, Differentiate the following:
OC or CC?
1.
2.
3.
4.
5.
6.
7.
8.
9.
Cost of storage
Cost of preparing specifications
Cost of deterioration and obsolescence
Cost of receiving an order and checking it against the
invoice
Cost of running a purchasing department
Cost of writing a purchase order
Cost of processing the paperwork
Insurance and taxes
Personnel and telephone costs
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IM, Carrying Cost:
 Total Carrying Cost =
TCC = C x Q/2
Where,
C = carrying costs per unit
Q = order size of inventory
Q/2= average inventory unit
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IM, Ordering Cost:
 Total Ordering Cost =
TOC = O x R/ Q
Where,
O = ordering costs per order
R = total requirement of inventory for the period
R/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:
 TIC is minimum when CC = OC
Costs
Total costs
Carrying costs
Ordering costs
Order Size
(in units)
EOQ
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IM, Economic Order Quantity:
 Algebraically
2 x Co x D
EOQ 
Ch
Where
Co = Cost per Order
D = Annual Demand
Ch = Cost of holding one unit for one year
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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
Transaction
Precautionary
Speculative
 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
2 x Co x D
Q
Ch
Where
Q = Amount invested per Transaction
Co= Transaction cost of investing/ en-cashing a
security
D = Excess cash available to invest in short term
securities
Ch = Opportunity cost of holding cash
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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 =
 2 x 50 x 60,000 
Q 

0.06


1
2
= £10,000
 Numbers of transactions = D/ Q = 60,000/10,000 = 6
 Other models: Miller- ORR
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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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“Revenue is vanity, Profit is sanity”
Thank You
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