U3.3 Working Capital

About Cash Current asset In hand or At bank Liquidity

Cash Problems Lack of cash or working capital more often than lack of profit lead to: Insolvency Liquidation

Working Capital = Current Assets – Current Liabilities Money available for daily business operation Also known as Net Current Assets Shows available funds to pay immediate expenses Working Capital = Current Assets – Current Liabilities

Current Assets Cash Debtors Stocks

Current Liabilities Overdrafts Creditors Tax

Working Capital Cycle Production Costs Sales Cash

Working Capital Cycle Hold enough cash to cover production costs i.e. stock, wages, debt collection Without being wasteful by holding too much i.e. cash could be more profitably invested elsewhere

Current Ratio Desired ratio is 1:1 CA significantly higher indicates wastefulness CA significantly lower indicates liquidity problem

Cash vs. Profit Simply put Profit = Revenues – Costs Revenues are not always cash! There are sources of cash outside of revenues. Profitable companies can be cash poor. Unprofitable companies can be cash rich.

Cash Flow Forecasts Expected movement of cash in and out of a business: Cash Inflows receipts Cash Outflows payments, expenses, outgoings Net Cash Flow cash inflows – cash outflows

Cash Flow Statements Depicts the actual flow of cash in and out of a business over a given period of time.

Reasons for Cash Flow Forecasts Persuade banks and other lenders when seeking external finance. Aid in the anticipation and preparation for periods of time where cash flow shortages or surpluses may occur. Assists in business and strategic planning.

Constructing Cash Flow Forecasts Jul Aug Sept Oct Nov Dec Opening Balance 5,000 3,000 300 (1,400) (2,600) 600 Inflows Cash sales revenue 6,000 6,500 6,800 7,500 9,500 Other income 4,000 Total cash inflows 11,500 Outflows Stocks 2,500 2,200 2,700 3,300 Labor costs 3,500 Other costs 2,000 1,800 Total cash outflows 8,000 7,700 8,200 8,00 8,300 9,000 Net cash flow (2,000) (2,700) (1,700) (1,200) 3,200 500 Closing balance 1,100

Cash Flow Forecast Practice Jan ($) Feb ($) Mar ($) Apr ($) Cash sales 2,000 4,000 Stock purchases 600 900 1,200 Rent 1,000 Other costs 800 Opening cash balance 1,600 1,900 Net cash flow 300 1,800 Closing balance

Causes of Cash Flow Problems Overtrading: quick expansion Over borrowing: high geared Overstocking: poor inventory control Poor credit control: lenient credit policies Unforeseen changes: demand shifts

Managing Working Capital Dealing with liquidity problems: Seek alternative sources of finance Improve cash inflows Reduce cash outflows

Seeking Alternative Sources of Finance Overdrafts Sale and leaseback Selling off fixed assets Debt factoring Government assistance Growth strategies

Improving Cash Inflows Tighter credit control Cash payments only Change pricing policy Improved product portfolio Improved marketing planning

Reducing Cash Outflows Seek preferential credit terms Seek alternative suppliers Better stock control Reduce expenses

Combining Strategies Pareto principle Contingency fund 80/20 rule 80% time and resources boosting cash inflow 20% on cost cutting Contingency fund Cash set aside for unexpected, emergency use

Alternatives to Dealing with Cash Flow Problems Spread risks with wider customer base Require partial payments over time from customers of large or lengthy projects/services Establish systems to pay bills in regular installments Establish quality management systems

Limitations of Cash Flow Forecasting Marketing Human resources Operations management Competitors Changing fashion and tastes Economic changes External shocks

Working Capital and Business Strategy “More often than not, businesses fail because of cash flow problems rather than profitability problems.” Cash flow “forecasts and calculations are static, i.e. they only represent the cash flow situation of a firm at one point in time”. “Managers face a dilemma in balancing the conflict between the desire for sufficient working capital and the desire for profits.” “Working capital is regarded as being more important than profit in the short run.”

3.3.1 What is meant by working capital? Working capital (or net current assets) refers to the money available for the daily running of a business, i.e. it is used to pay for everyday costs such as wages, utility bills, and payment so suppliers. Working capital is mainly generated from the sale of goods and services.

3.3.2 explain the working capital cycle The working capital cycle refers to the interval between cash paid by a business for the costs of production and receiving the cash from customers. For example, if the customers pay by credit then payment is not received until a later date, although costs are incurred for the transaction. Due to its revamped menu, McDonald’s was able to entice more customers thereby helping to boost its sales by 6 per cent. However, cash is not the same as profit. The costs of product research and development for its new menu, for example, would contribute to higher operation costs and hence lower profits. It is likely that there is a significant time lag between investment expenditure (R&D and marketing costs for its revamped menu) and receiving sufficient sales revenue to recoup the costs. Hence, it is probably that overall profits declined despite sales revenue being slightly higher.

Explain the use of cash cards Credit cards allow customers to ‘buy now and pay later’ through a third party, i.e. a financial lender. The finance company pays the retailer (and charges the retailer a small fee for the service) and charges the customer at a later date. Since credit improves flexibility (customers do not need to carry so much cash with them) and allows customers to buy now but to postpone payment, it can attract a large number of customers to businesses, including McDonald’s. Hence, sales revenues may increase since customers have a greater choice of payment systems. However, retailers and restaurants such as McDonald’s will not receive their payment instantaneously, i.e. there is a (relatively short) delay in payment from the credit card company. This therefore extends the working capital cycle of the business that offers credit to its customers. In addition, the amount received from the finance company will be slightly lower since a fee will be charged by the creditor.

A firm faces a liquidity problem ;explain Definition of liquidity problem, i.e. the extent to which the firm can meet its short term debts. The firm seems to be suffering from worsening liquidity as seen by the closing balance figures. The net cash flow for the first four months of trading is also negative suggesting the firm has insufficient working capital.

3.3.5 Answer Key Profitable firms can experience cash flow problems for a number of reasons, such as: Overtrading Long working capital cycle Poor credit control Long credit periods