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1 Working Capital Management Week 11. 2 Working Capital You will recall the elements of Working Capital Stock Debtors Cash Creditors The liquidity ratios.

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Presentation on theme: "1 Working Capital Management Week 11. 2 Working Capital You will recall the elements of Working Capital Stock Debtors Cash Creditors The liquidity ratios."— Presentation transcript:

1 1 Working Capital Management Week 11

2 2 Working Capital You will recall the elements of Working Capital Stock Debtors Cash Creditors The liquidity ratios examine the elements of working capital

3 3 Significance of working capital management In a typical manufacturing firm, current assets exceed one-half of total assets Excessive levels can result in a substandard Return on Investment (ROI) Current liabilities are the principal source of external financing for small firms Requires continuous, day-to-day managerial supervision Working capital management affects the companys risk, return, and share price

4 4 Key elements of Working Capital Invest in current assets, so long as the return from such investment exceeds the cost of the capital used to fund them Make use of short term funding, so long as it has a lower cost than other sources of funding and can be used to make profitable investments, after allowing for the cost of the funding

5 5 The Working Capital Cycle Cash Conversion Period = Inventory Transformation Period + Debtor Collection Period – Creditor Deferral Period Eg the quicker you turnover stock and collect debtors and the longer you leave creditors, the better

6 6 Stock Stock is the least liquid of current assets Companies will often hold more stock than they need and This can be costly in terms of Capital tied up Costs of holding stock

7 7 So why hold stock, then? Transactions Motive to meet anticipated production/sales and service delivery requirements Precautionary Motive to maintain a cushion or buffer so that they can cope with any underestimates of demand that may have been made Speculative Motive to take advantage of temporary opportunities to buy items of stock at less expensive purchase prices

8 8 The two elements of stock The more stock held the greater the holding (storage) costs BUT The less the order costs And vice versa The art is to balance the two for optimal cost effectiveness

9 9 Economic Order Quantity (EOQ) EOQ represents the minimum point in total stock costs. Carrying Costs Ordering Costs Order Size (Q) Costs Total stock costs EOQ

10 10 Formula for EOQ O = Cost of placing an order S = Annual demand C = Holding cost of one unit EOQ = 2 (O) (S) C

11 11 An Example Assume a company has an annual demand for a stock item of 150,000 The cost of placing an order is £40 per order It is calculated that the cost of holding 1 unit of the stock item is £2 The item can only be ordered in batches of 1,500, 2,500, 3,500 or 4,500 Which batch size (all other things being equal) would optimise costs?

12 12 By tabulation BatchNo. ofAv holdingOrder SizeOrders CostsCosts Total 1,5001001,5004,0005,500 2,500602,5002,4004,900 *** 3,500433,5001,7205,220 4,500334,5001,3205,820

13 13 By formula EOQ = 2,449 Therefore, 2,500 is optimum batch size EOQ = 2 (40) (150,000) 2

14 14 Pros & Cons of EOQ It is quite effective in situations of regular demand It can focus management thinking on cost reduction BUT it is inflexible It assumes zero lead time in ordering (Sawtooth pattern)

15 15 Zero lead time with EOQ

16 16 Materials Requirement Planning (MRP) The system starts by seeing what production is planned and then develops a timetable for orders so the materials arrive in time for their use. Thus the resulting stock of materials depends directly on the known demand. Advantages of MRP Reduced stock levels. Stock is related to demand, therefore there should be fewer shortages of materials and consumer satisfaction should be higher. The stock turnover will be higher, which should have positive implications for the quality of the materials present in the final product. Delivery of finished goods should be more reliable. There will be improved plant efficiency, because facilities will be utilised when required, as the materials will be ready for immediate use.

17 17 Disadvantages of MRP The successful implementation of MRP requires the construction of a detailed master schedule of all the parts that will be required in the production process. If this master schedule has not been drawn up, the system can't operate. Even if there is a master schedule, it may not be accurate and hence there may be shortages or surpluses of stock. Plans are frequently changed and/or not made far enough in advance causing problems in accurate scheduling. If the master schedule is to be accurate, information about current stocks, orders outstanding and the reliability of stock surpluses will be required. It will be necessary to have information on the length of time it takes to acquire deliveries of stock in time for use.

18 18 Just in Time Stock Control Instead of holding stock at the factory only order stock on a Just in Time basis (raw materials are ordered only as they are needed). Advantages of Just in Time There is less stock in the factory, so costs are lower. This results in a lower unit cost. Disadvantages of Just in Time If supplies are disrupted for some reason, the business will have no stock to fall back on. This will affect their production rates very quickly.

19 19 Control of Debtors Key aspects of debtor management A clear statement of the general terms on which it is prepared to grant credit to customers Credit rating procedures A credit management system Terms of credit - need to consider Custom and practice in the relevant industrial/commercial sector Cash settlement discounts The likely/acceptable level of bad debts

20 20 Control of Debtors Costs of relaxing credit standards A larger credit department Additional clerical work Servicing additional accounts Bad-debt losses Opportunity costs Analysing the credit applicant Obtaining information on the credit applicant Analysing this information to determine the applicants creditworthiness Making the credit decision

21 21 Encouragement to pay Offering Discounts Everything costs so if you have debtors there will be a cost attached to that income deferred Either through loss of alternate use Or by having an overdraft because you havent got the money

22 22 Offering Discounts – An example Vole Ltd has an overdraft and pays 17% p.a. on it Annual sales are £365,000 and debtors run at present at £90,000 If a 2.5% discount for settlement in 10 days was taken up by 1/3 rd of customers What would the saving be, if any? What is the maximum discount that could be given and not dent profit?

23 23 Vole Ltd - 1 Annual cost of debtors = £90,000 X 17% = £15,300 Annual sales are £365,000 (ie £1,000 per day) Existing debtors = £90,000 (ie 90 days) Expected reduction = 1/3 rd (ie £30,000) A reduction from 90 to 10 days = 8/9 8/9 X £30,000 = £26,667 Annual interest saved = 17% X £26,667 = £4,533 Annual cost of discount on 1/3 rd of annual sales = £121,667 X 2.5% = £3,042 Therefore, there would be a saving

24 24 Vole Ltd - 2 If 2.5% wasnt enough to tempt customers Then maximum discount without affecting profits would be up to interest saved (ie £4,533) Therefore, interest saved as a percentage of 1/3 rd annual sales = 3.726%

25 25 Managing Creditors The basic rule is Defer as long as possible Remember the cash conversion period is reduced the longer the creditor deferral period The downside is potential harm to supplier relations Not good if say operating Just in Time system

26 26 You say creditor, I say debtor To all of your creditors You are a debtor, so They will be trying to get you to pay promptly If they offer discounts is it worth taking them?

27 27 Calculation of annualised interest rate Most small companies, because of cashflow considerations, cannot take advantage of discounts. But annualising the effective interest rate shows the true cost of ignoring discounts

28 28 Formula to calculate annualised interest rate Cost = Discount% X 365 (100-discount%)Final due date – discount period) Assume a company is offered 2.5% to pay within 10 days on 28 day invoice Effective interest rate is 2.5/97.5 X 365/(28-10) = 46.15 %

29 29 Maintaining control of creditors Keep records of what is owed and how long you have to pay Train whoever pays invoices to pay these when it suits your cashflow Agree clear terms of payment with all your suppliers Consider paying for non-current assets over a longer period Decide whether or not you need to always pay on delivery Pay as late as possible – without incurring penalties or losing goodwill.

30 30 Management of Cash Balances The financial manager wants to keep cash balances to a minimum The goal is to speed up the inflow of cash and slow down the outflow of cash

31 31 Management of Cash Balances Speeding Up Cash Inflow Expedite preparing and mailing invoices Accelerate mailing of payments from customers Reduce the time during which payments received by the firm remain uncollected Use Electronic Funds Transfer Slowing Down Cash Payouts Control of disbursements Remote and controlled disbursing

32 32 Management of Cash Balances Source of short-term finance available to commercial entities: Trade credit. Bank borrowing Instalment credit Financial instruments Factoring

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