Download - Pcf week 16 working capital management
Working Capital Management
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Working CapitalIn this lecture we will look at
short and medium term methods of financing short term financing concerns inventory levels, trade payables and
receivables the cash conversion cycle why it is important to manage working capital
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Short and medium term financing SHORT (repayment in under 1 year?) Overdraft Trade credit Factoring
MEDIUM (repayment in 1 to 7 years?) Term loan Hire purchase Leasing
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Overdraft facilities timescale of months interest charged on the daily outstanding balance
flexible - no term structure available to smaller and riskier businesses
lender can remove facility at short notice
conditions: cash flow projections creditworthiness commitment from the borrower security in the form of assets
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Trade Credit company receives goods and services invoice paid at a later time some flexibility in credit terms
vital source of finance for large as well as small companies
“Tesco and Asda typically have over twice as much owing to suppliers at any one time as the value of all the goods on their shelves – more than £2.2bn for Tesco and £1.5bn for Asda.”
Arnold, chapter 12, page 482
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Factoring immediate transfer of cash to firms with
outstanding receivables when invoices are paid then factoring
company receives payment carried out by subsidiaries of major banks fee and interest charged on amount advanced comparable with overdraft interest rates transfer of risk to factoring company
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Hire purchasing company takes possession of the goods a series of regular payments are made until
the company owns the goods payments include principal repayment and
interest
no large payments up front
plant and machinery; agricultural equipment; hotel equipment; office equipment; commercial vehicles
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Leasing lessor gives right to use equipment in return
for regular payments no transfer of legal ownership
Operating lease short term contract asset then sold or leased to another client
photocopiers
Finance lease full cost of equipment recovered over the life of
the lease risks borne by lessee
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Issues
Balance:cash
inventory
receivables
payables risk
too little/too much
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What is working capital? Current assets less current liabilities
inventory cash receivables
payables
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Working Capital Management
inventory Conversion Period
Cash Conversion Cycle
Credit from Suppliers
Raw Mat
WIPFin. Goods
£
Receivables
Conversion period
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Cash conversion cycle
Cash conversion cycle = inventory days + receivables days – payables days
For example: Buy raw materials on 33 days’ credit Takes 50 days to turn raw materials into finished
product Give 30 days’ credit on finished product
CCC = 50 + 30 – 33 = 47 days
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Some ratios: LIQUIDITY
Current ratio (working capital ratio)= CA / CL
o a ratio of less than one might indicate liquid resources not enough to meet short term payments
o a ratio of more than one might indicate high levels of inventory and not enough cash
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Some ratios: EFFICIENCY receivables (days)
= (receivables/sales ) x 365
payables (days) = (payables/cost of sales )
x 365 inventory turnover (days)
= (inventory / cost of sales ) x 365
Example – 2007
Balance Sheet
Sainsbury plc
Rolls Royce Group
£m
inventory 590 2,203
receivables 30 889
inventory + receivables
620 3,092
payables 1,706 778
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Example – 2007
P&L Sainsbury plc
Rolls Royce Group
£m
Sales 17,151 7,435
Cost of Sales
15,979 6,003
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Example – 2007
Ratios Sainsbury plc Rolls Royce Group
receivables days (30/17,151) x 365= 0.6 days
(889/7,435) x 365= 44 days
payables days (1706/15,979) x 365= 39 days
(778/6,003) x 365= 47 days
inventory turnover days
(590/15,979) x 365= 13 days
(2,203/6,003) x 365= 134 days
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Overtrading Not to be able to provide the level of working
capital required to sustain a particular level of trading is known as overtrading Failure to meet increases in turnover with
appropriate increases in working capital requirement
Possible for a firm to double its sales and profits and yet become insolvent
Too much money is tied up in inventory and trade receivables?
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Managing working capital INVENTORY TRADE PAYABLES TRADE RECEIVABLES CASH
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Managing inventory
Determined by what the firm does There will be large differences in inventory
levels between traders due to the nature of the goods the speed of the inventory turnover seasonal fluctuations
Costs of holding inventory need to be balanced against the opportunity costs
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Balance Risks of holding high inventory storage costs handling costs money tied up obsolescence insurance costs
Risks of holding low inventory loss of production loss of sales loss of customer goodwill
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Policy decisions Optimum reorder quantities need to be
established for each item of inventory Companies need to take into account how
fast inventory is used up and how long orders take to be fulfilled
Many firms like to hold a “buffer” of inventory to meet unexpected changes in demand
Other firms operate “just in time” policies
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Managing Trade payables ‘Free’ source of finance No interest Costs
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Policy decisions Take into account
discounts offered attitude of suppliers
Exploit trade credit Manage exchange rate risk Use ratios for monitoring
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Companies that take the longest to pay are in the construction, manufacturing, pharmaceuticals and retail sectors
Large number of small suppliers Average payment time is
44 days for all plcs 34 days for 350 largest plcs
Based on article by David Oakley, FT, March 2008
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Managing receivables Attitudes vary Credit sales = interest free loans A balance must be arrived at between the
costs of granting credit and those associated with denying or restricting credit
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Balance granting credit
higher sales customer goodwill
risk costs of administration costs of financing
denying credit loss of customers
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Policy decisions Establish a credit policy Assess credit worthiness of customers Establish a policy on bad debts Consider cash discounts and factoring/ invoice
discounting Manage exchange rate risk What are competitors offering?
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Managing Cash Balances Cash needs to be held
to meet planned needs transaction motive
to meet unplanned obligations precautionary motive
to enable unexpected opportunities to be taken speculative motive
Surplus cash should be invested Cash needed varies over time
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Balance
Holding too much cash loss of interest
Holding too little cash liquidity risk loss of goodwill inability to meet
emergency requirements
missed opportunities borrowing costs deterioration in
liquidity measures
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Financing WC Firms need mixture of LT and ST funds Assets needing to be financed
Fixed Permanent CA Fluctuating CA
Policies Matching Conservative Aggressive
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Matching
Funds
Fixed Assets
Permanent CA
Fluctuating CA
Time
Short-term finance
Long-term finance
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Conservative
Funds
Fixed Assets
Permanent CA
Fluctuating CA
Time
Short-term finance
Long-term finance
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Aggressive
Funds
Fixed Assets
Permanent CA
Fluctuating CA
Time
Short-term finance
Long-term finance
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Summary Efficient management of working capital – key
to business success Relates to management of:
inventory receivables payables Cash
Poor working capital management one of the more common reasons for corporate failure
Further reading and prep for seminar
Watson, D. and Head, A. Corporate Finance Principles and Practice, 5th edn Chap 3.
Arnold, G. Corporate Financial Management, Chapter 12, Chapter 13 (pp 529-550)
Self test questions page 91 of Watson and Head