1. Working Capital Nursery Management Understanding and Managing Finance

2. 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)

3. 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.

4. 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

5. 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 payment by parents etc) can then cause catastrophe

6. 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

7. 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 in manufacturing businesses and affect one other:

8. 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.

9. 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.

10. Key Elements of Working Capital: Stock Remember from the last session: 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.

11. 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

12. Key Elements of Working Capital: Trade Debtors Remember from the last session: 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.

13. 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

14. 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.

15. 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

16. 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.

17. 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.

18. 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

19. 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 and payback by 8 days. This means that we can re-invest our money sooner, and generate more turnover in the same year.