1. Managing Finance and Budgets Presentation 8 Working Capital (1)

2. 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

3. Structure of the Presentation  A : What do we mean by Working Capital?What do we mean by Working Capital?  B : The Key Elements of Working CapitalThe Key Elements of Working Capital  C : The Operating Cash CycleThe Operating Cash Cycle  D : Controlling the CashControlling the Cash  E : Two examplesTwo examples  F : Seminar 8Seminar 8

4. Section A: What do we mean by Working Capital?

5. What is Working Capital? Working Capital is usually defined as: Current Assets Less Current Liabilities The major elements are:  Stocks, Debtors, Cash (Assets)  Creditors, Tax payable, Overdraft (Liabilities)

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

7. The Elements of Working Capital a summary Major elementsMajor element Stocks Trade debtors Cash (in hand and at bank) Trade creditors less equals Current liabilitiesWorking capital Current assets

8. 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.

9. Current Assets Total = £574,300 Current Liabilities Total = £233,360 Working Capital for 2002: £574,300 - £233,360 £340,940 Working Capital for 2002: £574,300 - £233,360 £340,940 Example Revisited Here 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.

10. 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 opportunities  An excess of Working Capital also represents money “locked up” in stocks and debtors - investment may not produce an appropriate return  Working capital, therefore, needs careful management

11. For 2001, Current Assets Total = £175,750 For 2001, Current Assets Total = £175,750 For 2001, Current Liabilities Total = £225,900 For 2001, Current Liabilities Total = £225,900 Working Capital for 2001 is negative £175,750 - £225,900 - £50,150 Working Capital for 2001 is negative £175,750 - £225,900 - £50,150 Further Example Here 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 could be Overtrading. Here 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 could be Overtrading.

12. The Problem of “Overtrading”  This is where the working capital is insufficient to finance the increasing volume of trade  Expansion means more money is required to finance higher stock levels, and higher levels of debt  Organisations try to achieve this by increasing amount of time taken to pay suppliers, or increasing overdraft up to or beyond limit  A minor difficulty in any element of the working capital (e.g. late client payment) can then cause catastrophe

13. 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

14. The Working Capital Cycle  Purchase materials, which we  Use for Work-in-Progress, then we  Pay employees, who  Develop Finished goods, which we  Sell for cash or on credit, so we can  Pay creditors, and then  Retain the Surplus, which we use to… This is essentially just a a simplified version of the how the operating activities link together and affect one other:

15. Working Capital in Summary  Working 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 position  An increase in business may well require a parallel increase in working capital SAQ 8.1

16. a. Why would the requirements for a greengrocer’s 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? Solution

17. SAQ 8.1a Solution a. Why would the requirements for a greengrocer’s 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.

18. 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 Change  Seasonal demand patterns  Economic climate  Changes in the Market  Competition

19. Section B: The Key Elements of Working Capital

20. The Working Capital Cycle Summary Diagram Cash sales Trade creditors Trade debtors Finished goods Cash/ bank overdraft Work-in- progress Raw materials

21. Key Elements of Working Capital There 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

22. Discuss the following:  Why do you think it is important to keep careful track of working capital requirements? Solution

23. SAQ 8.2 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.  Possible Bankruptcy.

24. Key Elements of Working Capital: Stock  The 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.

25. Key Elements of Working Capital: Stock Remember 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.

26. Stock Turnover Period Example 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

27. Stock Control  One 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.

28. Key Elements of Working Capital: Trade Debtors  Carrying 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.

29. Key Elements of Working Capital: Trade Debtors Remember 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.

30. Average Settlement Period (Debtors) Example of Debt Settlement period: A Company has the following totals for 2003:  Total amount of Trade Debt is £45,500  Total for Credit Sales is £243,000 Debtors (days) = 45500 x 365 243000 =68.34 days

31. 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.

32. Key Elements of Working Capital: Trade Creditors  Carrying 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.

33. Key elements of working capital Remember 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.

34. Average Settlement Period (Creditors) Example of Credit Settlement Period: A company’s accounts for 2003 shows that:  The amount currently owing is £43,500  The total amount of credit purchases is £198,000 Creditors (days) = 43500 x 365 198000 =80.19 days

35. Management of Creditors  Just 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 credit  Paying late may have disadvantages: lower priority, higher prices, refusal to supply  We will explore some of these issues next week. SAQ 8.3

36. Tina’s 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

37. SAQ 8.3  Tina 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 thousands  On 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.

38. Section C: The Operating Cash Cycle

39. The working capital cycle Summary Diagram Cash sales Trade creditors Trade debtors Finished goods Cash/ bank overdraft Work-in- progress Raw materials

40. The Working Capital Cycle - essential events The diagram below is an even more simplified version of the Working Capital Cycle: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit Assuming all trade is done on credit, this shows the four essential events, in the normal order in which things occur.

41. The Working Capital Cycle - essential events From the simplified diagram, purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit  We can see immediately:  The Debtor Period  The Creditor Period Debtor Period Creditor Period

42. The Working Capital Cycle - essential events There are two more important time periods: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit  The Stockholding Period (where is this?)  The Operating Cash Cycle (what is this?)

43. The Stockholding Period  The Stockholding period is the time from the purchase of goods to the sale of goods: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit

44. 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 credit Cash received from debtors payment to creditors for goods Sale of goods on credit

45. Operating Cash Cycle  The Operating Cash Cycle can be calculated using the following equation: Operating Cash Cycle = Average Settlement period for Creditors Average Settlement period for debtors Average Stockholding Period + -  Long Operating Cash Cycles have a significant influence on the financing of the business.  Most business will wish to reduce this to a minimum.

46. equals minus Operating cash cycle Average payment period for creditors Average settlement period for debtors plus Average stockholding period Calculating the Operating Cash Cycle

47. Example of Operating Cash Cycle  Using the amounts calculated previously : Operating Cash Cycle = 80.1968.3441.26 + - = 29.41 days  In this case, the average time between the cash laid out and cash returned is less than one month. Stock Turnover Days Debtor Days Creditor Days

48. Purchase of goods on credit Payment for goods Sale of goods on credit Cash received from debtors Stockholding period Operating cash cycle Creditor Period Debtor Period

49. Purchase of goods on credit Payment for goods Sale of goods on credit Cash received from debtors Stockholding period Operating cash cycle Creditor Period Debtor Period 41.26 Days 68.34 Days 80.19 Days 41.26+ 68.34 –80.19 = 29.41 Days

50. 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.

51. Comment on the Previous Example  If 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 around 41 + 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.

52. How can we reduce the OCC? The Operating Cash Cycle is calculated by: OCC = Stock + Debtors – Creditors So we try to:  Reduce Stock  Reduce Debtors  Increase Creditors

53. Reducing the OCC Example: 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 days  Increase 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

54. In 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

55. SAQ 8.4 Solution OCC 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.

56. Section D: Controlling the Cash

57. 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

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

59. SAQ 8.5 Solution  Why 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.

60. 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

61. Controlling the Cash Balance There are many techniques for controlling the cash element of Working Capital: One model proposes:  A Target Balance  Inner Limits (+/-) (close to the target)  Outer Limits (+/- ) (further away)

62. Inner limit Outer limit Target cash balance Inner limit Cash balance (£) Outer limit Time (days) 2 8 64 953 1 7 111210 0 Controlling the cash balance

63. Inner limit Outer limit Target cash balance Inner limit Cash balance (£) Outer limit Time (days) 2 8 64 953 1 7 111210 0 Controlling the cash balance Outer 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. Outer 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.

64. Inner limit Outer limit Target cash balance Inner limit Cash balance (£) Outer limit Time (days) 2 8 64 953 1 7 111210 0 Controlling the cash balance Return to within Inner Limit: After action taken (selling of assets for cash), the cash balance has returned to acceptable levels. Return to within Inner Limit: After action taken (selling of assets for cash), the cash balance has returned to acceptable levels. SAQ 8.6

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

66. 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.

67. Section E: Two Real-Life Examples

68. Two Large Comapnies  Two different examples have been selected to highlight the difference in practice in relation to Working Capital.  TESCO PLC is a large retailer which has very negligible amounts of Debtors, and works on a fast stock Turnaround time – high volumes, minimum stock levels.  FORD Motor Co. is a global corporation, carrying billions of dollars worth stock and other current assets (franchises, trade debt, leases, lendings etc.)

69. Example of a Retail Company: TESCO PLC Note that there is a net deficit of Working Capital. The Current Ratio is stable at 0.43 for both 2002 & 2003 Note that there is a net deficit of Working Capital. The Current Ratio is stable at 0.43 for both 2002 & 2003

70. Example of a Manufacturing Company: FORD Motor Co. (amounts in $’000) The Current Ratios in 2001 & 2002 were : 1.1 and 1.3 In 2000 there was a one off adjustment for a previous financial practice Note that there is a net surplus of Working Capital.

71. Seminar Eight - Activities  Preparation: read M & A Chapter 16  Describe key concepts: Working Capital Operating Cash Cycle  Working Capital Example  M & 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.