Paper P1 Performance Operations

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

Now that we know where the CCC fits into working-capital management and how its calculated, we need to consider the significance of every element of the CCC and how each of these can be improved.

Receivables daysThe figure for receivables days needs to be as low as possible to encourage an injection of cash into the company. This can be achieved in the following ways: Introduce payment terms. Decrease current payment terms. Introduce a discount for early settlement. Introduce late-payment fees and/or interest charges. Improve the debt-chasing process. Outsource the process to a debt-factoring specialist.

If the company has attracted custom by operating either no payment terms or easy ones, introducing some or making existing terms tougher could deter this custom. Such measures could signal that the firm is short of cash, which could also put off suppliers and customers. This problem can be overcome by discussing potential payment terms with key suppliers and promoting improved working-capital management.

Early-settlement discounts or interest charges could be introduced, but you need to take care when charging interest or applying late-payment fees, because such practices can alienate customers and have a negative effect on the companys reputation and sales.

It may be that the companys credit-control department is ineffective at chasing debts. In such cases, the management team would need to re-evaluate the credit-control process, highlight any problems and act to solve them. A performance measurement system linked with a reward package could be introduced in an effort to improve results in this area. But the costs versus the benefits of doing so would need to be considered carefully.

On the other hand, the firm could pay a debt-factoring company to chase the debt on its behalf. GlaxoSmithKline (GSK) did this seven years ago: Accenture helped the pharma giant to realise 1.5bn of working-capital benefits in only 18 months. This enabled GSK to invest more in its strategic priorities, which in turn helped to increase shareholder wealth. Debt factors possess the specialist expertise to obtain money on a timely basis. But the client company will have no control over their methods, which may be so aggressive as to alienate some customers.

Inventory daysThe figure for inventory days depends on the amount of raw material, work in progress and finished goods held. Optimum levels need to be maintained to meet demand but sell quickly enough to limit storage costs. This can be done by improving the firms stock-control systems.

It has been suggested that companies should focus on reducing inventory days by implementing the lean production methods pioneered by Toyota and others in Japan. This involves streamlining all processes to reduce the costs of inefficiency. Defects and waste should be targeted for reduction and inventory should arrive just in time (JIT) for production. The production process should be tailored to limit inventory to a buffer level, thereby reducing the amount of stock risking damage or obsolescence while in storage. But not all companies have the resources to adopt such a system. Again, the implementation costs need to be weighed against the benefits. Also, non-financial factors such as whether the supplier-customer relationship is strong enough to allow such a system to be effective should be considered.

Payables daysIt has been suggested that a large proportion of companies tend to concentrate more on deferring payments to

their suppliers than they do on improving their own stock-management systems. The issues here are similar to those raised by receivables days: new suppliers may be deterred from providing goods to the company if it has a poor reputation for settling invoices on time, or it may end up paying more because they deem it to pose a higher risk of late payment. You could also question whether it is ethical to put off paying your suppliers. Doing so could impair the reputation of the company and deter custom.

If youd like some relevant exam practice, why not check your understanding of the topics covered in this article by attempting to answer questions 1.2 and 1.6 from November 2012s P1 paper?

With this extra information, we can calculate the relevant ratios as follows: Receivables days: 365 x ([185 + 196] 2) ([476 + 432] 2) = 154 days. Inventory days: 365 x ([66 + 72] 2) ([297 + 307] 2)= 84 days. Payables days: 365 x ([109 + 94] 2) ([297 + 307 + 66 + 72 109 94] 2) = 138 days.

This gives a weighted CCC of: 154 + 84 138 = 100 days. This is a very different answer from that obtained using

the first method, because it reflects significant movements in trade receivables, sales revenues, trade payables and purchases. These have led to an increase in receivables days and a decrease in payables days, producing a much higher CCC figure. The more information there is available to us on these aspects, the better, as we can make comparisons year on year to pinpoint key variances that managers can in turn tackle in order to improve the CCC.

The management accountant of a company called WCM has provided us with the following figures from its financial statements and asked us to calculate the firms CCC ready for a finance meeting.

With this information, we can calculate the relevant ratios as follows: Receivables days: 365 x (185 476) = 142 days. Inventory days: 365 x (66 297) = 81 days. Payables days: 365 x (109 [297 + 66 109]) = 157 days.

This gives us a CCC of: 142 + 81 157 = 66 days. So it takes 66 days for the company to receive payment for its finished goods after paying for its raw materials. This is a simplified example, of course. In reality, there will be several other creditors to take into account.

If we have access to the requisite figures covering more than one year, we can apply a method called the weighted CCC. The ratios are calculated in exactly the same way, but an average figure for the years covered is used instead. So lets return to WCM and produce a weighted CCC.

goods, sold and converted into cash, thereby increasing liquidity. The surplus cash can then either be invested in resources to generate more sales to meet further demand and increase profit, or be invested in projects that are expected to generate further returns to shareholders. Alternatively, a business may need to increase its liquidity to match an approaching debt repayment. In this case, any surplus cash generated may be put aside for this purpose.

When trading conditions worsen during a credit crunch, say and some competitors are unlikely to survive, a company with a buffer can take the chance to acquire its rivals market share. This will allow for an increase in returns to its shareholders and may attract new investors.

The cash-conversion cycleThe cash-conversion cycle (CCC) represents the period between a companys payment of suppliers for raw materials and its payment by customers for finished goods.

As a simple example, imagine that youre a market trader who sells fruit. You make most of your sales in cash, but you may be lucky enough to supply a local restaurant, to which you offer 30 days credit. Your ideal situation would be to sell your inventory as quickly as possible, enabling you to use the cash to buy more fruit or invest in another stall. Your situation would be improved further if your fruit supplier were to offer you extended credit.

Lets go through a worked example, based on a question in November 2012s P1 paper, to see how the CCC can be calculated using the ratios in the diagram below.

accounts, bonds or shares. This situation is exacerbated if customers have longer payment terms 60 or 90 days, say or they pay late. The administration costs associated with chasing any late payments create a further outflow of cash that could otherwise be earning interest for the company.

There is also potential cash tied up as trade payables. The length of time available to a company to pay its suppliers will obviously affect the amount of cash thats available to it. The sooner that suppliers are paid, the higher the opportunity cost, because the company is losing interest on this balance.

The following three elements can be referred to collectively as the working-capital cycle (see diagram, below): trade payables; inventory of raw materials, work in progress and finished goods; and trade receivables.

Working-capital management is the process of adjusting the liquidity of a company in line with its strategy to enable business objectives to be achieved. The optimum level of liquidity for a company will depend on factors including: The volatility of the firms markets. The firms ability to predict output levels accurately. Its cash motives. Its attitude to risk.

The more efficient the working-capital cycle is, the more quickly raw materials can be transformed into finished

According to a survey this year by EY, 2,000 leading European and American companies have about $1.3trn tied up unnecessarily in non-liquid assets. Surely this potential cash could be released and invested elsewhere to increase shareholder wealth? Lets consider why companies should be managing their working capital effectively and how they can achieve this.

Working capital is simply the difference between a companys current assets and its current liabilities. The figure represents its ability to fund day-to-day operations, such as paying employees and suppliers, and to invest in profit-generating projects. This value can be tied up in less liquid assets, such as inventory and trade receivables. For example, if excess inventory is held, theres not only a risk of obsolescence, damage and excessive storage costs; theres also an opportunity cost. This potential cash could be released and earning interest via investments in deposit

Effective working-capital management is a crucial part of ensuring that a firm has enough liquidity to meet its short-term obligations. A strong grasp of the cash- conversion cycle is key to achieving this By Rachel Tattersall

Rachel Tattersall is a lecturer in accounting and finance at De Montfort University

RESOURCE STUDY NOTES

Accounts payableProviding the raw materials

CCCTrade receivables days

Trade receivables x 365 Sales revenues

Inventory days Inventory x 365 Cost of sales

Trade payables days Trade payables x 365 Purchases

Labour and machine hours Work in progress

Organisations cash account

Finished goods Cash sale Accounts receivable sale

The working-capital cycle

The cash-conversion cycle

Cash-conversion cycle

= +

Extract from WCMs statement of financial position, as at 30 June 2014

000Non-current assets 320Inventories 66Trade receivables 185Cash 72Trade payables (109)Non-current liabilities (260)Net assets 274

Extracts from WCMs statements of financial position

30 June 2014 30 June 2013 000 000Non-current assets 320 290Inventories 66 72Trade receivables 185 196Cash 72 67Trade payables (109) (94)Non-current liabilities (260) (258)Net assets 274 273

Extract from WCMs income statement for the year ended 30 June 2014

000Sales 476Cost of sales (297)Operating profit 179

Extracts from WCMs income statements

30 June 2014 30 June 2013 000 000Sales 476 432Cost of sales (297) (307)Operating profit 179 125

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(F1 under the 2015 syllabus)