Financial management - Working capital management

7/29/2019 Financial management - Working capital management

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LECTURE TEN

WORKING CAPITAL MANAGEMENT

10.0 INTRODUCTION

Investment decisions apply to both current assets and plant and equipment assets.

However, the investment decision techniques for current assets may differ because

current assets have some unique characteristics:

(1) The amount of investment in each asset may vary from day to day

(2) Decisions regarding investment in one type of current asset may impact on the

investment in other current assets. For example, a relaxation in credit terms

that leads to an increase in debtors may call for an increased investment in

stocks.

This lesson has two goals: First we will discuss the concepts underlying the management

of working capital as a whole. Secondly, we will specifically focus on the management of

current liabilities. The next lesson will complete the topic by discussing the management

of current assets.

ObjectivesAt the end of this lecture you should be able to:

1. Provide a definition and explanation of

working capital concepts

2. Discuss the two polar working capital

strategies: aggressive and conservative

strategies.

3. Describe the basic types and

characteristics of current liabilities

(short term financing)

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10.1 DEFINITIONS AND GENERAL CONCEPTS OF WORKING

CAPITAL

Definitions of Working Capital

Working capital can be defined from two perspectives.

(1) Net working capital is defined as the difference between the firms current asset

and the firms current liabilities.

(2) Net working capital is the firms current assets financed with long-term funds.

Working Capital Management Decisions

In principle, current asset investment decisions, as in the case of investment in fixed

assets, calls for a cost-benefit evaluation of a large number of alternatives, and the

selection of that alternative that produces the greatest net benefit. The typical process

will feature the following activities:

(1) The financial manager estimates the costs and benefits of each alternative.

(2) The net present value (NPV) must be calculated for each alternative given the

discount rate approximate to the degree of risk involved

(3) The alternative with the highest NPV is chosen and implemented.

In practice, however, the NPV approach is rarely used for evaluating working capital

investment decisions. The alternative approach, commonly used, is to maximize average

net profit, with the amount invested treated as its equivalent annual cost. The

management of working capital boils down to balancing the risks and benefits of holding

excessive, to those of holding too little, working capital.

In this lesson and the next, we focus our attention on the management of each of the

individual current asset and current liability times. This is a preferred approach given the

fact that each item has its own unique characteristics. Generally, it is to be expected that

current liabilities be the preferred source of financing current assets (because current

liability is a cheap source of finance and the maturity of current liabilities parallels the

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liquidity of current assets). Management, however, must weigh the desire of a higher

return against the risk of insolvency (if, for example, the bank suspends its overdraft

facilities or creditors demand earlier payment).

Overcapitalization and Overtrading

The finance manager must be wary of two polar extremes in working capital

management. These extremes are, (i) over-capitalization and, (2) over-trading.

Over Capitalization (Conservative Financing Strategy)

If a company manages its working capital, so that there are excessive stocks, debtors and

cash and very few creditors, there will be an over-investment by the company in current

assets. Working capital will be excessive and the company is said to be overcapitalized

( i.e. the company will have too much capital invested in unnecessarily high levels of

current assets). The result of this would be that the return on investment will be lower

than it should, with long-term funds unnecessarily tied up when they could be more

profitably invested elsewhere.

Indicators of over-capitalization

Accounting ratios can assist in judging whether over capitalization is present.

(1) Sales/Working capital ratio:- the volumes of sales as a multiple ofworking capital should indicate whether the total volume of working capital is too high

(compared to the past and industry norms).

(2) Liquidity ratio. A current ratio and a quick ratio in excess of the industry

norm or past ratios will indicate over-investment in current assets

(3) Turn-over periods. Excessive stock and debtors turnover periods or too

short creditor payment period might indicate that the volume of debtors and stocks is

unnecessarily high, or creditors volume too low.

Over-trading (Aggressive Financing Strategy)

Overtrading occurs when a business tries to do too much too quickly with too little long-

term capital: The capital resources at hand are not sufficient for the volume of trade.

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Though initially an over-trading business may operate at a profit, liquidity problems

could soon set in, disrupting operations and posing insolvency problems.

Symptoms of over-trading

Accounting indicators of overtrading include:

(1) Rapid increases in turn-over ratios (over-heating)

(2) Stock turnover and debtors turnover might slow down with consequence that

there is a rapid increase in current assets.

(3) The payment period to trade creditors lengthens

(4) Bank over-drafts often reach or exceed the limit of facilities offered by the bank.

(5) The debt ratios rise

(6) The current ratio and quick ratio fall and the net working capital (NWC) could be

negative.

Operating and Cash Conversion Cycles

We can understand better the management of working capital by appreciating the inter-

linkages of flows in the current section of the balance sheet. Opportunities to improve

efficiency in collecting, holding and disbursing funds center on flows through this section

of the balance sheet, depicted in the bottom part of Figure 12.1. We diagram these flowsin more detail in Figure 12.2, which shows the steps along the way as funds flow through

the firms accounts. Let us assume that KQ Ltd. orders raw materials at point A and

receives them 14 days later at B. Terms of 2/10, net 30 are offered, so the firm pays the

invoice 10 days later at C. However, it takes 2 days for the check to clear, and KQs

bank account is not charged until point D. KQ turns its inventory six times per year, so 60

days after the materials are received, the product is sold and the customer is billed. The

collection period is 30 days, 28 for the customer to pay and 2 for the check to arrive by

mail (G), KQ processes the payment and deposits it 2 days later at H. Another 2 days

elapses while KQs bank collects the funds from the customers bank.

The firms total financing requirement is affected by the total time lag from point B to

point J. The firm itself can control some factors that determine the various lags, but some

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it cannot. Some of the lags affect the cash balance, while others affect other components

of working capital such as accounts receivable and inventory. When we address

ourselves to cash management, we are concerned with time period BCD and FGHJ.

Time period AB is beyond the firms control and does not directly affect its financial

statements although it may affect production schedules. Time period DE is determined

by the firms production process and inventory policy and affects the total investment in

inventory. Time period EF is determined by the firms credit terms and the payment

policies of its customers, and affects the total investments receivable.

Operating (trading) cycle (OC)

Operating cycle is the amount of time that elapses from the point when the firm inputs

materials and labour into the production process to the point when cash is collected from

the sale of the resulting finished product. The cycle is made up of two components; the

average age of inventory and the average collection period.

OC = average age of inventory (AAI) + average collection period (ACP). (12.1)

The Cash Conversion Cycle (CCC)

This is the amount of time the firms cash is tied up between payment for production

inputs and receipts of payment from the sale of the resulting finished product. For a

manufacturing firm, the cash conversion cycle indicates the length of time it takes for an

investment in raw materials to be ultimately realised as a cash receipt after sale of the

manufactured product. This cycle could be broken into several sub-periods: The period of

time it takes:

(a) Between ordering and receipt of raw materials;

(b) For trade creditors to be paid

(c) For raw materials held in stock to be introduced into the production

process

(d) For the finished goods held in stock to be sold

(e) For cash to be realised from debtors.

It is to be noted that purchase of input on credit allows the firm to partially offset the

length of time resources are tied up in the operating cycle.

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Assuming no time lag between the raising of sales and purchase orders and their

execution, the cash conversion cycle can be determined by:

CCC = Operating Cycle (OC) Average payment period (APP) (12.2)

Or

CCC = AAI + ACP APP (12.3)

For a manufacturing company,

CCC = Average age of raw materials + average age of work in

progress + average age of finished goods + average collection

period average payment period

The cash cycle is thus the period between payment of cash to creditors (cash out) and

the receipt of cash from debtors (cash-in).

The length of period has direct effect on the liquidity of a company. The amount tied

up in working capital (WC) will be equal to the value of raw materials (RM), Work-

in-progress (WIP), finished goods (FG) and debtors less creditors. The more the

amount of WC tied up, the less liquid the company is. If the turn-over periods for

stocks and debtors lengthen, or the payment period to creditors shortens:

(1) The cash cycle will lengthen

(2) The investment in working capital is increased.

Example

ABC Ltd sells merchandise on credit terms, requiring payment within 60 days of sale.

On average it takes 85 days to manufacture, warehouse and sale a finished product. Raw

material suppliers require payment within 45 days and employees are paid every 15 days.

The firm calculates its weighted average payment period for raw materials and labour to

be 35 days.

Determine (1) the operating cycle

(2) the cash conversion cycle.

Solution

(1) Average age of inventories (AAI) = 85 days

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Average collection period (ACP) = 70 days

Operating cycle(OC) = AAI + ACP = 85 + 70 = 155 days

(2) Cash conversion cycle (CCC) = OC APP = 155 35 = 120 days

10.2 MANAGEMENT OF CURRENT LIABLITIES

Current liabilities are sources of short term financing which assist firms finance current

assets and meet other short term financing needs. The three broad categories of short

term financing are:

1. Spontaneous sources

2. unsecured sources

3. secured sources

We will briefly discuss the characteristics of each of these sources .

Spontaneous Sources

Spontaneous financing arises automatically from the day-to-day operations of the firm.

The most common forms of spontaneous financing come from trade credit from

suppliers, and accrued expenses. This financing is interest free and requires no collateral.

Accounts payable

The purchaser obtains goods and services, agreeing to pay later in accordance with the

credit terms stated on suppliers invoice. Trade credit is credit extended in connection

with goods purchased for resale. It is this qualification that distinguishes trade credit from

other forms of credit.

Suppliers often give cash discounts on open accounts for payment within a specified

period. The credit terms specify the credit period, the size of the cash discount, the cash

discount period, and the date the credit period begins , which is usually at the end of each

month (EOM). For example, terms of 2/10, net 30 EOM, mean a discount of 2% may be

taken if the invoice is paid within 10 days of the invoice date; otherwise the full payment

is due within 30 days from the end of the month of purchase. If the EOM is not part of

the terms then counting begins from the date of the invoice.Prompt-payment cash

discounts are to be distinguished from quantity (bulk) discounts given for purchase of

large quantities, and also from trade discounts given at different points in the distribution

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chain (wholesale versus retail, etc.). Proper management of credit offered by suppliers

requires that:

1. The firm takes the cash discounts by paying on the last day of the discount period.

The annual percentage cost of giving up cash discounts is quite high. This cost

can be estimated using the following equation.

Cost of giving up discount = CD/(100%-CD)*365/N (12.4)

Where CD = stated cash discount as a percentage

N = number of days payment can be delayed by giving up the cash

discount

Example

ABC Ltd. purchased Sh.100,000 worth of merchandise on 27 February from a

supplier extending credit terms of 2/10, net 30 EOM. Calculate the cost of givingup the cash discount.

Solution

The annualized effective cost of giving the discount = CD/(100%- CD)*(365/N)

= 2%/(100%-2%)*(365/20)

= 37.24%

This is a very high cost indeed and is equivalent borrowing at 37.24%. (NB If we

were to take the discount the firm would pay on 10 March. By giving up the

discount it costs the firm Sh.2,000 (100,000-98,000)).

2. Stretch accounts payable The firm should pay its bills as late as possible without

damaging its credit rating. The full extent of the credit period should be utilized in

the case where cash discounts are not offered. Caution is to be exercised in

stretching payments as this may harm the firms reputation and at worst can cot

the firm its sources of supply.

Accruals

Accruals are the other major source of spontaneous financing. Accrued expenses arise

when a firm consumes services (other than trade services) without having to make

immediate payment for them .Typical expenses that generate accrued financing include

wages and salaries, utilities, rent, etc.

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Unsecured sources of short term financingUnsecured source of financing is one against which no specific assets are pledged as

collateral. Businesses obtain unsecured short term credit from three sources i.e. tradecredit, banks and commercial paper.

Trade credit Most trade credit is extended via the open account that results in accounts

payable discussed in the preceding section. There are however two other lesscommon sources of trade credit; The promissory note (trade) and the trade

acceptances.

1. Promissory note Is usually called a note payable (trade) on the balance sheet.Such notes bear interest and have specified maturity date. They are used in

situations in which a purchaser of goods on credit has failed to meet the terms of

an open credit agreement and the supplier wishes a formal acknowledgement ofthe debt and a specific agreement on a future payment date.

2. Trade acceptances Under this arrangement the purchaser acknowledges the debt

formally by accepting a draft drawn by then seller calling for payment on a

specified date at a designated bank. After acceptance, the draft is returned to the

seller and the goods are shipped.Bank loans Commercial banks are by far the largest suppliers of unsecured loans to

businesses. Businesses need to establish a cordial relationship with their bank that canfacilitate lending transactions. For a successful relationship to blossom banks will

generally look for honesty and integrity ,managerial competence and frank

communication in their clients. In addition detailed and specific information regardingthe nature of the financing requirement, the amounts and timing of the need, the uses to

which the funds will be put, and when and how the bank will be repaid may be needed.

Banks lend unsecured short term loans in three forms: a line of credit, a revolving credit

agreement, and a single payment note.

1. Single payment note This is a short term , one-time-loan, payable as a singleamount at its maturity. It generally has a maturity of 30-daysto 9 months and mayhave either a fixed or floating rate.

2. Lines of credit A line of credit is an agreement between a business and a bank

showing the maximum amount the business could borrow and owe the bank atany point in time. Lines of credit are not contractual and legally binding upon the

bank, but they are nearly always honored. The major benefit, to a business, of a

line of credit is its convenience and administrative simplicity. From the bankspoint of view the major attraction of a line of credit is that it eliminates the need

to examine the creditworthiness of a customer each time the customer wants to

borrow. The terms of a credit line may require a floating interest rate, operating

change restrictions, compensating balances, and annual cleanup provisions ( aperiod usually of 1or 2 months during which the loan is completely paid off). A

line of credit is often used to finance seasonal working capital needs or other

temporary requirements.

3. Revolving credit agreement Involve a contractual and binding commitment by

the bank to provide funds during a specified period of time. Because the bank

legally guarantees the availability of funds, the borrower pays a commitment feeof or percent per year on the average unused portion of the commitment.

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Revolving credit agreement, like a line of credit, permit the firm to borrow up to a

certain maximum amount; but unlike a line of credit, are not subject to clean-up

provisions.

Commercial Paper

A commercial paper is a form of financing that consists of short term promissory notes

issued by firms with high credit standing. Commercial paper is typically sold at adiscount from its par value. Consequently, the interest charged is determined by the size

of the discount and the time to maturity. Commercial paper distributed through the stock

exchange is known as a money market instrument.The use of commercial paper to raise funds is advantageous because the cost is lower

relative to bank loans and the borrower avoids the cost of maintaining compensating

balances required on bank loans. Additionally , borrowers who need to raise huge

amounts of money can satisfy their needs more conveniently by issuing commercialpaper.

Example

A company has issued a Sh.100,000,000 par value worth of commercial paper with a 90-

day maturity, for Sh.98,000,000. Find the effective annual rate of interest on the paper.SolutionThe effective annual rate = (1+D/N ) -1 (12.1)

Where D = discount

N = net proceeds from issue

n = 365/time to maturityThe effective 90-day rate is = D/Np = 2,000,000/98,000,000 = 0,0204

Therefore ,effective annual rate = (1+0.0204) - 1 = 0.0841 = 8.41%(n =365/90 = 4)

Secured Sources of Short Term FinancingA loan is one obtained by a borrower pledging specific asset(s) as security. In the case of

shot term loans, lenders insist on collateral that is reasonably liquid. Inventory, accountsreceivable, and marketable securities are the assets commonly used as security. Usuallythe interest on secured loans is higher than interest on unsecured loans because of the

perceived risk and the costs of negotiation and administration. The primary sources of

secured loans are the commercial banks and non-bank financial institutions.In considering the use of a companys asset as security we should keep in mind the

adverse effect of such action on unsecured creditors who may take them into account in

any future transactions.

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Financial management - Working capital management