Chapter 12 MANAGING WORKING CAPITAL

Identify the main elements of working capital LEARNING OUTCOMES You should be able to: Discuss the purpose of working capital and the nature of the working capital cycle Identify the main elements of working capital Explain the factors that have to be taken into account when managing each element of working capital Explain the importance of establishing policies for the control of working capital

The nature and purpose of working capital Major elements Major element Inventories Trade receivables Cash (in hand and at bank) Trade payables less equals Current liabilities Working capital Current assets

The working capital cycle Trade payables Trade receivables Finished goods Cash/ bank overdraft Work in progress Raw materials Cash sales Credit sales Cash Figure 12.1 The working capital cycle

Working capital opportunity assessment €800B Total working capital opportunity €700B €600B €500B €400B €300B €200B €100B Trade receivables opportunity Inventories opportunity Trade payables opportunity €890B €293B €296B €900B Figure 12.2 Working capital opportunity assessment

Inventories financing cost Business Type of operations Cost of capital Average inventories held Financing cost of holding inventories Operating profit/ (loss) Financing cost as % of operating profit/(loss) (a) (b) (a) × (b) % Associated British Foods Food producer 11.4 £1,540m £176m £1,093m 16.1 SIG Group Builders merchants 8.2 £224m £18m £58m 31.0 J Sainsbury Supermarket 10.0 £962m £96m £887m 10.8 Babcock Int. Engineering 7.5 £78m £6m £235m 2.6 Source: Annual Reports for years ending in 2012 and 2013

Managing inventories Budgeting future demand Financial ratios Recording and reordering systems Inventory management models Materials requirements planning (MRP) system Levels of control Just-in-time (JIT) stock management Procedures and techniques that can be used to ensure the proper management of inventories

Average inventories turnover period Financial ratios Average inventories turnover period Average inventories held × 365 Cost of sales =

ABC method of analysing and controlling inventories Cumulative value of inventories items (%) Volume of inventories items held (%) A B C 100 Figure 12.3 ABC method of analysing and controlling inventories

Patterns of inventories movements over time Inventories level Time Figure 12.4 Patterns of inventories movements over time

Average inventories level (units) Annual costs (£) Average inventories level (units) E Total costs Holding costs Ordering costs Inventories holding and order costs Figure 12.5 Inventories holding and order costs

The economic order quantity (EOQ) model Where: D = the annual demand for the inventories item (expressed in units of the inventory item); C = the cost of placing an order; H = the cost of holding one unit of the inventories item for one year. EOQ = 2DC H

Just-in-time inventories management May result in hidden costs (taking advantage of cheap sources of supply) Requires close relationship with suppliers May require re-engineering production process Can be seen as part of TQM approach

Managing trade receivables Which customers should receive credit Questions to ask How much credit should be offered What length of credit it is prepared to offer Whether discounts will be offered for prompt payment What collection policies should be adopted How the risk of non-payment can be reduced

Which customers should receive credit? The five Cs of credit Capital Capacity Collateral Conditions Character

Sources of credit information Bank references Published financial statements Trade references Credit agencies Register of County Court Judgements The customer

Length of credit period The typical credit terms operating within the industry The degree of competition within the industry The bargaining power of particular customers The risk of non-payment The capacity of the business to offer credit The marketing strategy of the business May be influenced by:

Ageing schedule of trade receivables at 31 December Customer Days outstanding Total 1 to 30 days 31 to 60 days 61 to 90 days More than 90 days £ A Ltd 12,000 13,000 14,000 18,000 57,000 B Ltd 20,000 10,000 – 30,000 C Ltd 24,000 32,000 47,000 111,000

Collection policies Develop customer relationships Publicise credit terms Issue invoices promptly Develop customer relationships Produce an ageing schedule of receivables Answer queries quickly Monitor outstanding debts Deal with slow payers

Comparison of actual and expected (budgeted) receipts over time % Time 10 20 30 40 June July August September Actual Budgeted Figure 12.6 Comparison of actual and expected (target) receipts over time for Example 12.5

Why hold cash? There are three reasons: To meet day-to-day commitments To deal with uncertain cash flows To exploit profitable opportunities

Factors influencing the amount of cash held The opportunity cost of holding cash The level of inflation The nature of the business The cost of borrowing Economic conditions The availability of near-liquid assets Relationships with suppliers Possible factors may include:

Managing cash Main techniques Controlling the cash balance Preparing cash budgets Controlling the cash balance Managing the operating cash cycle

The operating cash cycle Purchase of goods on credit Payment for goods Sale of goods on credit Cash received from credit customer Inventories holding period Operating cash cycle Figure 12.7 The operating cash cycle

Calculating the operating cash cycle equals minus plus Operating cash cycle Average settlement period for payables Average settlement period for receivables Average inventories holding period Figure 12.8 Calculating the operating cash cycle

Working capital performance for the US and Europe 2002-2012 2005 2004 2003 2006 36 38 40 42 44 46 48 50 2002 2007 2008 2009 2010 2012 2011 US Europe OCC Figure 12.9 Working capital performance of large European and US businesses over time Source: All Tied Up: Working Capital Management Survey 2013, Ernst and Young, p. 6 , www.ey.com.