Attention needs to be paid by a company in managing: working capital

• Working capital = the requirement for cash to finance any work from day-to-day basis, having paid out the costs of production but not having received payment for any work done. • The working capital of a company = a company’s total current assets. • Current assets are made up of cash, stocks or raw materials and those incorporated in work in progress, the debtors of the company or current accounts receivable and short-term securities. • Short-term securities may, for example, include tax reserve certificates bought against the future payment of company tax.

• Working capital is required by a company for many of its regular short-term commitments:

• to pay salaries and wages • to buy raw materials for the construction of the works • to pay for hiring and operating plant • to provide the money required for the payment of interest, dividends and taxes as they fall due • to cover a delay between the expenditure on resources and the payment for goods subsequently provided.

• The restricted availability of working capital may often limit the progress which the firm can make in expanding its business by taking on new work. • For a contractor, in order to have a ready and continuous supply of working capital, it is desirable that a firm is profitable. • For a small firm, accurate and detailed consideration of working capital requirements should be a particular concern. (to avoid from turning to trade credit and bank overdraft for finance purposes; may lead to increase their current liabilities)

• It is necessary to have a plan and framework to ease future operations. • Forecast can be made depends on the future period which it is intended to cover and the depth and extent of relevant information which is available about the economic, commercial and governmental activities influencing the industry (five years is likely to be a realistic period for most situations in construction). • Among the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength.

• Take a simplistic case:

a spaghetti sauce company uses RM100 to build up its inventory of tomatoes, onions, garlic, spices, etc. A week later, the company assembles the ingredients into sauce and ships it out. A week after that, the cheque arrive from customers. That RM100, which has been tied up for two weeks, is the company's working capital.

• The quicker the company sells the spaghetti sauce, the sooner the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. • If the ingredients sit in inventory for a month, company cash is tied-up and can't be used to grow the spaghetti business. • Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. • Working capital also gets trapped when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.

• Normally, a big retailer like Carrefour has little to worry about when it comes to accounts receivable: customers pay for goods on the spot (cash). • However, inventories represent the biggest problem for retailers; as such, they must perform rigorous inventory forecasting or they risk being out of business in a short time.

Formula of Working Capital Turnover Ratio: • Following formula is used to calculate working capital turnover ratio: [Working Capital Turnover Ratio = Cost of Sales / Net Working Capital] • The two components of the ratio are cost of sales and the net working capital. • If the information about cost of sales is not available the figure of sales may be taken as the numerator. • Net working capital is found by deduction from the total of the current assets and the total of the current liabilities.

Significance: The working capital turnover ratio measure the efficiency with which the working capital is being used by a firm. A high ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack of sufficient working capital which is not a good situation.

Example: Calculate working capital turnover ratio Calculation: Working Capital Turnover Ratio = Cost of Sales / Net Working Capital Current Assets = RM10,000+RM5000+RM25,000+RM20,000 =RM60,000 Current Liabilities = RM30,000 Net Working Capital = Current assets – Current liabilities = RM60,000 − RM30,000 = RM30,000 The Working Capital Turnover Ratio = 150,000 / 30,000 = 5 times

Items RM

Cash 10,000

Bills Receivables 5,000

Sundry Debtors 25,000

Stock 20,000

Sundry Creditors 30,000

Cost of sales 150,000

Negative Working Capital Can Be Good ... Sometimes • Some companies can generate cash so quickly they actually have a negative working capital. This is generally true of companies in the restaurant business (McDonald's had a negative working capital of $698.5 million between 1999 and 2000). Amazon.com is another example. •This happens because customers pay upfront and so rapidly, the business has no problems raising cash. • Don't understand how a company can have a negative working capital?

• Think back to Warner Brothers / Wal-Mart example. When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. •In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they can pay each bill as it comes due, maximizing their efficiency.

Management of working capital Management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. 1. Cash management. Identify the cash balance which allows for

the business to meet day to day expenses, but reduces cash holding costs.

2. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; eg. Supply chain management; Just In Time (JIT)

3. Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers

4. Short term financing. Identify the appropriate source of financing, the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft)

5. Understand the operating cycle

6. Identify the controllable factors

7. Manage all factors in the cycle

8. Calculate the costs of working capital

9. Strategically invest in shortening the operating cycle

10. Communicate with management and board leaders

• Profit = what is left from what is received as a result of carrying out the work after paying all the charges that arise out of a project. • Profit/loss is expressed in absolute terms as money and it gives no measure of the productivity or efficiency of operations on site. • Profitability = rate of making profit in relation to a company’s investment that is required to carry out the work. • Since it is a rate of making profit, it is implied that profitability is related to a specific contract duration. Therefore, the three factors which determine profitability must be:

• the amount of profit • the duration of the contract • the company’s investment that is required

• For example:

Items Contract 1 Contract 2

Profit RM5000 RM6000

Investment RM10,000 RM8000

Durations 12 months 18 months

Contract 1: Return on the capital = profit / investment = RM5000/RM10,000 = 0.5 = 50% (for a year) Contract 2: Return on the capital = RM6000/RM8000 = 0.75 = 75% (for a year and half) = 50% (for a year) • It can be seen therefore that with quite different contract conditions, the two projects are equally profitable.

Definition of gross profit ratio: Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales. Components: The basic components for the calculation of gross profit ratio are gross profit and net sales. *Net sales means that sales minus sales returns. *Gross profit would be the difference between net sales and cost of goods sold. *Cost of goods sold in the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses.

Formula: Following formula is used to calculate gross profit ratios: [Gross Profit Ratio = (Gross profit / Net sales) × 100] Example: Required: Calculate gross profit ratio. Calculation: Net sales = 520,000 – 20,000 = 500,000 Gross profit = [(520,000 – 20,000) – 400,000] = 100,000 Gross Profit Ratio = (100,000 / 500,000) × 100 = 20%

Total sales RM520,000

Sales returns RM20,000

Cost of goods sold RM400,000

Significance: *Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be reduced without incurring losses on operations. *It reflects efficiency with which a firm produces its products. *As the gross profit is found by deducting cost of goods sold from net sales, higher the gross profit better it is. *There is no standard GP ratio for evaluation. It may vary from business to business. *However, the gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges and dividends.

Causes / reasons of increase or decrease in gross profit ratio: It should be observed that an increase in the GP ratio may be due to the following factors: •Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold. •Decrease in cost of goods sold without corresponding decrease in selling price. •Omission of purchase invoices from accounts. •Under valuation of opening stock or overvaluation of closing stock.

On the other hand, the decrease in the gross profit ratio may be due to the following factors: •Decrease in the selling price of goods, without corresponding decrease in the cost of goods sold. •Increase in the cost of goods sold without any increase in selling price. •Unfavorable purchasing or markup policies. •Inability of management to improve sales volume, or omission of sales. •Over valuation of opening stock or under valuation of closing stock

Top 7 Ways To Increase Profits 1. Marketing: Don’t advertise -- until you’ve maximized use of

free or inexpensive promotion. Market test every new product/service before investing in production or marketing. Evaluate your marketing efforts. Do more of what’s working, discontinue what’s not.

2. Customers: Customers don’t want money back guarantees. They want the product or service to be right. Get it right and customers become your best sales people. Get to know your customers and what’s important to them.

3. Competition: Look for ways to add value without adding to the cost. Stay at the cutting edge of your industry. Know the players and what they’re doing. Stay flexible. Differentiate your product.

4. Pricing: When you need to lower your price to get the business, try to cut your costs, not your profit. Be sure to use accurate historical financial information to determine costs.

5. Cost Containment: Discontinue services that don’t add to the bottom line. Keep operating costs as low as possible without jeopardizing outcomes. Justify every expenditure.

6. Debt: Borrow money only when you must. The additional burden of loan repayment eats into your cash flow, so be sure you have a flexible plan and budget to cover this additional expense.

7. Losses: Cut losses early. Monitor financials and operations monthly. Determine what has created the loss. Rethink your strategy. Double your marketing efforts.

Definition of 'Holding Costs'

The associated price of storing inventory or assets that remain unsold. Holding

costs are a major component of supply chain management, since businesses

must determine how much of a product to keep in stock. This represents an

opportunity cost, as the presence of the goods means that they are not being

sold while that money could be deployed elsewhere. In addition, holding costs

include the costs of goods being damaged or spoiled over time and the general

costs, such as space, labor and other direct expenses.

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costs.asp#ixzz2DX5DwJwQ

Definition of 'Supply Chain Management - SCM'

Supply chain management is the streamlining of a business' supply-side activities

to maximize customer value and to gain a competitive advantage in the

marketplace. Supply chain management (SCM) represents an effort by suppliers

to develop and implement supply chains that are as efficient and economical as

possible. Supply chains cover everything from production, to product

development, to the information systems needed to direct these undertakings.

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Investopedia explains 'Supply Chain Management - SCM'

Typically, SCM will attempt to centrally control or link the production, shipment

and distribution of a product. By managing the supply chain, companies are able

to cut excess fat and provide products faster. This is done by keeping tighter

control of internal inventories, internal production, distribution, sales and the

inventories of the company's product purchasers.

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Definition of 'Just In Time - JIT'

An inventory strategy companies employ to increase efficiency and decrease

waste by receiving goods only as they are needed in the production process,

thereby reducing inventory costs.

This method requires that producers are able to accurately forecast demand.

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Investopedia explains 'Just In Time - JIT'

A good example would be a car manufacturer that operates with very low

inventory levels, relying on their supply chain to deliver the parts they need to

build cars. The parts needed to manufacture the cars do not arrive before nor

after they are needed, rather they arrive just as they are needed.

This inventory supply system represents a shift away from the older "just in

case" strategy where producers carried large inventories in case higher

demand had to be met.

Read more: http://www.investopedia.com/terms/j/jit.asp#ixzz2DX8DMaiJ