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Understanding and Managing Finance 9 This Presentation is in Self-Study Form To start the presentation: Press F5 (Top Row of Keyboard) Then use the navigation
Understanding and Managing Finance 9 This Presentation is in
Self-Study Form To start the presentation: Press F5 (Top Row of
Keyboard) Then use the navigation buttons at the foot of each
page.
Slide 2
Managing Finance and Budgets Lecture 9 Working Capital (2)
Slide 3
Session 3 - Financial Statements (2) Learning outcomes:
Understand how the Working Capital Cycle can be affected by
management decisions. Specify changes in the management of stocks,
creditors and debtors in order to achieve reductions or increases
to Working Capital. Key concepts: Stock Control Debtor Management
Credit Management
Slide 4
Structure of the Presentation A : Working Capital
ReviewedWorking Capital Reviewed B : The Management of StocksThe
Management of Stocks C: The Management of DebtorsThe Management of
Debtors D: The Management of CreditorsThe Management of Creditors
E: Seminar 9Seminar 9
Slide 5
Section A: Working Capital Reviewed
Slide 6
SAQ 9.1 What exactly is Working Capital? What are the major
elements of it? Which type of industry would have greater
requirements for working capital, manufacturing or retail?
Solution
Slide 7
SAQ 9.1 Solution Working capital is defined as: Current Assets
- Current Liabilities Major elements are Stocks, Debtors, Cash,
Creditors, Short-term loans (Overdraft), Tax payable Working
capital requirements vary between different types of industry (e.g.
high in manufacturing, low in retail) & according to the
fluctuations in trading
Slide 8
The nature and purpose of working capital Major elementsMajor
element Stocks Trade debtors Cash (in hand and at bank) Trade
creditors less equals Current liabilitiesWorking capital Current
assets The summary diagram
Slide 9
The working capital cycle Cash sales Trade creditors Trade
debtors Finished goods Cash/ bank overdraft Work-in- progress Raw
materials Each pass through the Working Capital Cycle will generate
profit.
Slide 10
equals minus Operating cash cycle Average payment period for
creditors Average settlement period for debtors plus Average
stockholding period Calculating the Operating Cash Cycle The
Operating Cash Cycle is the time between outlay of funds, and money
returning to the business on one circuit of the Working Capital
Cycle Provided that we can maintain the same level of profit on
each cycle, we can increase overall profitability by reducing the
OCC to a minimum.
Slide 11
The Length of the Operating Cash Cycle Suppose that in a
business, each turnover of the Working Capital Cycle generates
10,000 of profit: OCC 3 months OCC 2 months 4 cycles per year,
profit = 40,000 6 cycles per year, profit = 60,000 What happens
though, if in shortening the cycle, we reduce our profit
margins?
Slide 12
Optimising Working Capital Even if we reduce profit margins at
each pass, we may still be able to increase profitability overall.
In the last example, suppose the effect of shortening the OCC was
to reduce the profit at each pass through the cycle by 25% to
7,500, we would now generate profit of: 6 cycles x 7,500 = 45,000
compared to 4 cycles x 10,000 =40,000 This is still 5,000 more
profit per year than before.
Slide 13
Optimising Working Capital As a rule of thumb, provided that
the percentage of profit lost at each cycle is less than the
percentage reduction in OCC, overall profitability will increase.
So the problem becomes: How can we reduce the Operating Cash Cycle
without reducing profitability by same amount?
Slide 14
Optimising Working Capital This means that, whatever the
business, Working Capital will be optimised by reducing the
Operating Cash Cycle to the minimum possible level which will allow
the maximum increase in profitability. This means: Reducing Stock
Levels Reducing Trade Debtors Increasing Trade Creditors The rest
of this session is concerned with methods which will allow each of
these to occur., SAQ 9.2
Slide 15
Discuss the following: Why is it important to keep careful
track of working capital requirements? Solution
Slide 16
SAQ 9.2 Solution The 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. Bankruptcy.
Slide 17
Section B: Management of Stocks
Slide 18
SAQ 9.3 In the previous section we identified the need to
Reduce Stocks as one of the ways to shorten the Operation Cash
Cycle. ( a) Can you think of any other advantages to carrying low
levels of stock? (b) Are there any disadvantages? Solution
Slide 19
SAQ 9.3 Solution Holding Low Stock Levels: (a) Advantages Low
cost, low overheads in terms of storage space, fewer staff needed
to secure and maintain, low depreciation costs. (b) Disadvantages
lack of flexibility, may run out, and therefore lose sales &
long term custom
Slide 20
The management of stocks Procedures and techniques Forecasts of
future demand Monitoring Recording and reordering systems Levels of
control Stock management models Materials requirements planning
(MRP) systems Just-in-time (JIT) stock management This slide
summarises important issues and techniques
Slide 21
Inventory Control Inventory = Stock There are two driving
forces behind inventory control systems 1. to ensure that stock-out
time either does not occur, or is reduced to a minimum, so that
there is continuity of supply, at both ends of the link in the
supply chain. (goods or services IN and goods or services OUT) 2.
To ensure that stock levels are kept to the minimum possible while
still satisfying (1)
Slide 22
Inventory Control There are two basic approaches: Inventory
Modelling Use an analysis of the existing business system to create
models of the inventory which will allow predictions to be made or
allow strategies to be developed Operations Management To redesign
the business system so that more efficient ways of managing the
flow of goods and services can be integrated.
Slide 23
Inventory Modelling We will briefly examine two different
models: Pareto Analysis This uses an analysis of stock values held
to try to reduce the overall quantity held. Economic Order Quantity
Model This creates a theoretic perfect model, and derives
mathematical solutions to a variety of problems. There are many
other models that are used, which involve, for example queuing
theory.
Slide 24
Inventory Models (1) Pareto Analysis Pareto Analysis is
sometimes called the 80-20 method. It takes as its underlying
principle the fact that a warehouse will contain different amounts
of stock at different prices. If we put the goods in order,
according to value, we often find that the first 20% of the items
will be worth 80% of the total value. The method derived from this
categorises the stocks into three bands A, B and C
Slide 25
ABC method of analysing and controlling stock Cumulative value
of stock items (%) Volume of stock items held (%) ABC
Slide 26
ABC method of analysing and controlling stock Cumulative value
of stock items (%) Volume of stock items held (%) ABC Category A: A
few, high valued items. Category A: A few, high valued items.
Category B: mid- valued items. Category B: mid- valued items.
Category C: A lot of low valued items. Category C: A lot of low
valued items.
Slide 27
ABC Method As a result of the Analysis we might do the
following: Category A: Attempt to severely reduce the numbers of
stock held in this category. If this is not possible, ensure that
we monitor carefully when orders are placed for these items. A
manager may personally wish to sign the order form. Category B Make
a small reduction in the numbers of these stocks. If this is not
possible, monitor the stock levels & review regularly. Category
C Do nothing.
Slide 28
ABC Method Example Ace Jewellers keep the following watches in
Stock: Type A:10 @ 4,000 each(40,000) Type B:40 @ 180 each( 7,200)
Type C: 200 @ 14 each ( 2,800) Analysis: Type A is 4% of the stock,
but80% of the total cost Type B is 16% of the stock, but 14.4% of
the total cost Type C is 80% of the stock, but 5.6% of the total
cost
Slide 29
ABC Method Example Solution Ace Jewellers, depending upon the
demand, might: Reduce Type A to a minimum (say 2 items) 2 @ 4,000
each8,000 Reduce Type B to half the quantity; 20 @ 180 each 7,200
Keep Type C as it is 200 @ 14 each 2,800 Total Stock:18,000
Reduction in Stock:32,000
Slide 30
Inventory Models (2) Economic Order Quantity This model takes
as its starting point the basic graph of stock movements over time.
A real graph of stock quantities held may look something like
this:
Slide 31
Stock Levels Deliveries of Stock Daily sales depleting stock
levels Out of Stock
Slide 32
Stock level Time Modelling stock movements over time: The Ideal
Situation Assumptions: 1. A steady demand pattern 2. Fixed re-order
quantity 3. Fixed time between deliveries. Assumptions: 1. A steady
demand pattern 2. Fixed re-order quantity 3. Fixed time between
deliveries. The new stock arrives just at the point at which the
previous stock runs out.
Slide 33
What are the problems with this? When we place an order, it
does not get delivered immediately. There is a delivery lead-in
time. The demand pattern may well be erratic, and will fluctuate on
a day-to-day basis. Holding any amount of stock will cost money in
lost sales, wastage, security etc. We will probably get charged for
placing an order. This might be a delivery charge, or an
administrative charge. Deliveries may not occur at regular
intervals.
Slide 34
Stockholding and stock order costs Annual costs () Stock level
(units) E Total costs Holding costs 0 Ordering costs The Total
Stock Cost comprises: Holding Costs ( value of the stock + loss of
interest) plus Ordering Costs The Total Stock Cost comprises:
Holding Costs ( value of the stock + loss of interest) plus
Ordering Costs
Slide 35
How do we achieve the ideal? This model can be further
developed to answer the following question: Suppose we know the
Annual Demand for stock. The Annual cost of holding 1 item of stock
The cost of an order. What quantity of goods should we order, and
when should we so as to achieve the greatest profit?
Slide 36
Economic Order Quantity We can calculate an Economic Order
Quantity (EOQ): Square Root of: ( 2 x Annual Demand x Order Cost )
Yearly holding cost for 1 stock unit and Time Between Deliveries =
EOQ x 365days Annual Demand
Slide 37
Economic Order Quantity Example John Jones Stationers sells
10,000 boxes of printer paper each year. It has been estimated that
the cost of holding one box is 2.50. The cost of placing an order
with the suppliers is 10.00. What is the Economic Order Quantity,
and how far apart should the deliveries be spaced? Economic Order
Quantity = (2 x 10,000 x 10) (2.50) = 283 boxes (nearest box) Time
between deliveries =283 x 365 = 10 days 10000
Slide 38
Inventory Control Operations Management Approach Stock is seen
as just one element in the overall product cycle. The approach is
to consider the problem as one of supply chain management. We can
take two opposing viewpoints: A Push ApproachPush Approach A Pull
ApproachPull Approach
Slide 39
A Push Approach This approach assumes that the driving force in
the supply chain comes from the beginning, and that goods &
services must be managed to ensure that the next process in the
chain can follow on effectively from the one before it Using this
approach, we make decisions about where an when our stocks enter
the system and we need to manage the process at each stage very
carefully. PUSH Process 1Process 3Process 2
Slide 40
A Pull Approach This approach assumes that the driving force in
the supply chain comes from the end of the chain, the customer.
This means that goods & services must be managed to ensure that
the each process in the chain leading to the customer, in turn is
serviced effectively by the process before it. Using this approach,
the customer needs drive the process, and we the decisions about
where and when our stocks enter the system are determined by the
needs of each step in the process. PULL Process 1Process 2Process
3
Slide 41
Inventory Control Operations Management Methods There is a wide
variety of different Operations Management Methods. Here we look at
two different approaches: Materials Requirement Planning Materials
Requirement Planning Just-in-Time Just-in-Time It is entirely
possible to adopt methods which merge different elements from each
of the techniques. SAQ 9.4
Slide 42
Example of a Push Approach Materials Requirement Planning
Materials Requirement Planning (MRP) uses sales forecasts &
production plans to schedule deliveries so that they occur at the
correct times that the processes need them. This is top-down
planning. Only those items which are necessary for the flow of
production are ordered and delivered. An important element in MRP
is the Master Production Schedule. This forecasts when things will
occur, and schedules events such as deliveries and prompts changes
in practice.
Slide 43
Materials Requirement Planning Example of Master Production
Schedule We start with a predicted demand: The stock level to
support this demand is then planned. This defines how the
production should be managed to meet the required stock levels.
This specifies the production quota. Orders for raw materials will
now be placed. This will drive the process
Slide 44
Example of a Pull Approach: Just-in-Time There are several
variations on this approach. The basic idea, is that deliveries
(and each stage in the production process) should occur just in
time as the stock levels to support the process run out. In this
way, the minimum amounts of stock are held. The net result of this
technique is that it forces suppliers to hold onto stocks longer.
These suppliers may then need to employ techniques of their own to
minimise costs. (one of which is to increase prices!)
Slide 45
Just-in-Time Variation: KANBAN Kanban is Japanese for card, but
has come to mean a whole way of working and organising production.
The basic idea is that every part of a production process (whether
manufacturing, retail or service) is delivered just-in-time to
enable the next stage to occur. The system uses a system of boxes
and cards to signal when items should be produced. KanBan was
developed by Toyota in the early 1970s.
Slide 46
The KANBAN Approach The production process is triggered by
orders of specific items. Only one or two of these items is held in
stock. As the order is delivered, this triggers production of the
item backwards in the chain. Workers at delivery end package up
item Workers at penultimate stage now caused to create a new item
from parts available Causes Workers further down create new parts
Order received Causes Workers further down create new parts
Slide 47
Just-in-Time Variation: KANBAN The claims of companies
introducing JIT are well documented. Hewlett Packard claim to have
reduced manufacturing time for the assembly of 31 circuit boards
from 15 days to 11.3 hours. At the same time the value of inventory
fell from $670,000 to $20,000 dollars. Traditional manufacturing
systems are termed "Push systems, because components are pushed
through processes into finished stores, then directed on to
individual orders. Components pass through the system in batches.
Batch size is determined after considering the inventory cost, set
up cost and demand. JIT/Kanban is a Pull system. Components are
made to a specific order. As a component is finished a void is
created which is filled by a component from further down the
line.
Slide 48
SAQ 9.4 Discuss the following: What do you think might be the
advantages and disadvantages of the JIT system of Stock Control?
Solution
Slide 49
SAQ 9.4 Solution JIT system of Stock Control Advantages low
overheads in terms of storage space, low depreciation costs.
Disadvantages difficult to maintain continuity of supply. Suppliers
may increase prices
Slide 50
Section C: Management of Debtors
Slide 51
Managing Debtors Selling goods on credit means that there is a
cost to the business. These costs can include: Administrative costs
- due to the credit transactions Opportunity costs - incurred as a
result of the money being unavailable for the business to uses Bad
debts money effectively lost because customers will not or cannot
pay.
Slide 52
Debt Collection Policies & Methods In order to manage
debtors effectively a business should have clear policies developed
in answer to the following questions: Which customers will be
offered credit? Which customers will be offered credit? What
payment time is acceptable? What payment time is acceptable? What
discounts will be offered? What discounts will be offered? What
collection policies will be in operation? What collection policies
will be in operation? Will external agencies be used? Will external
agencies be used? Again, it is possible to use a selection of
different methods in order to achieve the maximum effect.
Slide 53
The five Cs of credit Capital Capacity Collateral Conditions
Character Which customers should receive credit?
Slide 54
Offering Credit Capital: Is the customer financially sound?
Capacity: Does the customer have the capacity to pay the amounts
owed? Collateral: Can the customer offer any security? Conditions:
What is the current economic climate? Character: Does the customer
appear to have integrity? Sources of information: Trade refs, Bank
refs, Published accounts, Directors, employees, premises, credit
agencies
Slide 55
What payment time is acceptable? This is variable, but typical
criteria will be: Local Conditions: Credit terms operating within
the particular sector Degree of co-operation between companies in
the sector Bargaining power of particular customers Risk of bad
debt (either from particular customers or to the business as a
whole) The financial position of the business their ability to
offer credit. The marketing strategy is length of credit an
important feature (e.g. as a loss leader)?
Slide 56
Cash Discounts for Early Payments In order to encourage
customers to pay early, we may offer a discount of say 5% for early
payment (or alternatively impose a penalty for late payment same
effect.) We need to weigh the cost of this against the fact of
having the money.
Slide 57
Cash Discounts Example P & L has debtor period of around 80
days, but is attempting to reduce this to around 30 days, by
offering 5% discount on all sales for payment within one month of
delivery. Cost of discount is 5%, for 50 days cash gained. As an
annual rate this is 365 x 5% = 36.5% approx 50 This is a very high
rate of interest; we would need to be satisfied that the return on
the money gained (using say the ROCE) was greater than 36.5% in
order for this to be a sensible proposition.
Slide 58
Debt Collection Policies The first principle of debt collection
is that all current debts need to be recorded effectively, and
payments monitored carefully, so that it is clear which debtors
have paid which amounts. One way to do this is through an Ageing
Schedule of Debtors Another way is to devise a predicted payment
schedule, and to compare this with payments made.
Slide 59
Ageing Schedule of Debtors The Schedule will record the amount
and the length of debt. This will allow a business to monitor
individual and total amount of debt, for example total debt which
has remained unpaid for at least 3 weeks.
Slide 60
% Time 10 20 30 40 June 0 July August September Actual Budgeted
Comparison of actual and budgeted receipts over time
Slide 61
Using External Agencies There is a bewildering variety of
services available in this industry, ranging from straightforward
debt- collection companies working for a fee, to companies who will
effectively buy your debts from you. We look at two such methods:
Debt Factoring Invoice Discounting
Slide 62
Debt Factoring Debt Factoring is done by companies who
specialise in the administration & collection of debts. Factors
take over the debts of a business, and offer the business cash
payments in advance of the actual collection of debts. Typically, a
Factor will offer up to 80% of the face value of the debtors in
advance, but will charge interest on the money advances, as well as
a fee for the service.
Slide 63
Invoice Discounting This involves obtaining a loan from a third
party based on the proportion (normally about 75%) of the face
value of credit sales outstanding, while still retaining full
control over the sales ledger. There is normally a service charge
related to turnover (e.g. 0.2% ), and the loan is obtained for a
short period, for example 60 or 90 days. The business gets the
money immediately, and there is a much lower charge than with
Factoring; however the business still has the responsibility of
collecting the debts. Debt Factors often offer an Invoice
Discounting service.
Slide 64
Bad debts At the end of the day there may still be companies
who cannot or will not pay the money owed for goods delivered. This
can happen where a customer is declared bankrupt; creditors are
offered possibly a small proportion of the amount owed out of the
sale of assets. In this case, the deficit must be borne entirely by
the business, and the amount is written off against profit. Most
companies will include a provision for bad or doubtful debts in
their balance sheet. SAQ 9.5
Slide 65
Discuss the following: Why is there potential for conflict
between the credit control department and the sales department of
an organisation?
Slide 66
SAQ 9.5 Solution Potential conflict between credit control and
sales. Sales will wish to improve sales figures by making sales to
anyone. It will not be in their remit to worry about when or if the
customers actually pay. Sales defines a good customers as one who
orders large amounts. Credit control will be keen to improve their
performance by ensuring that customers pay, and pay promptly. CC
defines a good customer as one who pays on time.
Slide 67
Section D: Management of Creditors
Slide 68
Trade credit may be regarded as a free source of finance
However, exactly the same strategies that we may use to encourage
early payment and discourage late payment may be used on us, but in
reverse. In terms of Early Payment, discounts may be offered for
paying early and these may be more valuable than the trade credit
Paying late may have many disadvantages: We may be given lower
priority, forced to pay higher prices, and in the extreme case
there may even be a refusal to supply SAQ 9.6
Slide 69
Discuss the following: A suppliers normal credit terms are 70
days. They offer a 2% discount for payment in 30 days. What is the
approximate annual percentage cost of not taking up the discount?
Is it reasonable to compare the above figure directly to the cost
of capital for the organisation when deciding to take up the offer
or are there other factors which should be taken into account?
Solution
Slide 70
SAQ 9.6 Solution A suppliers normal credit terms are 90 days.
They offer a 2.5% discount for payment within 60 days. What is the
approximate annual percentage cost of not taking up the discount?
The loss will be 30 days free credit. The annual percentage cost of
this credit will be approximately 365 x 2.5%= 30.41% 30 This figure
is very high; for a business not to pay within 60 days, they would
need a very good reason, for example that they could earn more than
30.41% (if their ROCE was higher for example)
Slide 71
SAQ 9.6 Is it reasonable to compare the above figure directly
to the cost of capital for the organisation when deciding to take
up the offer or are there other factors which should be taken into
account? Other factors to be considered: Is there cash currently
available? Would the cash have been more profitably employed
elsewhere? Is there a better offer on other goods purchased by the
company? Is there somewhere that the cash can be invested which
would give more than 2% over the 40 days?
Slide 72
Seminar Nine - Activities Preparation: read all of Chapter 16
Working Capital Internet Links (Word Document) Use this document as
a resource, and follow up some of the links to pursue your own
research into managing working capital. You should try to find a
range of methods and examples of real businesses which have used
these methods. M & A Exercise 16.3 You should use the
Spreadsheet M&A 16.3 as a structure to answer the question;
this asks you to calculate other ratios and amounts. Here the
methods that you suggest in part (b) should be based on the
research you have carried out using the internet.