working capital management
TRANSCRIPT
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Working Capital ManagementWorking Capital Management
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PROGRAMMEPROGRAMME
The nature of working capitalThe cash operating cycleFunding the cash operating cycleThe objectives of working capital Inventory managementManaging trade receivablesRelationship with suppliersManaging Cash
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The Nature ofThe Nature ofWorking CapitalWorking Capital
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Definition of Working CapitalDefinition of Working Capital
Current Assets less Current Liabilities
Inventories Trade PayablesRaw Materials AccrualsWork-in-Progress Taxation/DividendsFinished Goods Short-Term Borrowings
Trade ReceivablesPrepaymentsBank/Cash
Current Assets Current Liabilities
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Why Invest in Current AssetsWhy Invest in Current Assets
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Example: Raw MaterialsExample: Raw Materials
Despite running at full capacity, steel suppliers in Japan and elsewhere in Asia struggled to satisfy Japan’s booming exporters
Nissan had to cut down its production by an estimated 40,000 vehicles to meet demand in March (March is the month where demand for cars in Japan hits a peak)Source FT Dec 2004
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Funding Current AssetsFunding Current Assets
The Cheapest way to finance current assets is to use free credit from suppliers
This may lead to LIQUIDITY PROBLEMS. This risk can be illustrated using aCash Operating Cycle
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The The Cash Operating CycleCash Operating Cycle
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Cash Operating Cycle Cash Operating Cycle
Inventory Turnover Period
Raw Materials holding period
Production Period
Finished Goods holding
period
x 365
x 365
x 365
Cost of ProductionAverage Work-in-Progress
Average InventoryCost of Sales
Avg Raw MaterialsCredit Purchases
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Cash Operating Cycle Cash Operating Cycle cont.cont.
x 365Average Trade ReceivablesCredit Sales
The accounts receivable payment period
How long our customers take, on average, to settle their bills
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Cash Operating Cycle Cash Operating Cycle cont.cont.
Accounts payable payment period
x 365Average Trade PayablesCredit Purchases
How long, on average, we take to pay our customers
FREE CREDIT DAYS!!
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Ratios are not perfectRatios are not perfect
Ratios have limitations particularly when comparing P/L items with Balance Sheet Figures
Example: In December retailers normally have below average stock levels and therefore an average based on December figures may not reflect the annual average
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Beware Averages Beware Averages
If you are 6 feet tall and you don’t know how to swim, would you wade across a pool with an average depth of 3 feet?
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Cash Operating CycleCash Operating Cycle
Trade Payables
Raw Materials W-I-P Finished Goods Debtors
Cash Outflow
Cash Inflow
Financing current assets entirely from trade payables will keep the cost of interest down
BUT this may lead to liquidity problems
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Liquidity Risk?Liquidity Risk?
Deferral of Cash InflowsStock becoming obsolete or out-of-fashion
Disruptions in production processes
Debtors failing to meet credit deadlines
Foregone Cash InflowsBad Debts
Other Cash Outflows - Overheads
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The need for working capital The need for working capital
The duration of the trade payables period is normally dictated by suppliers or the market in general. Therefore it may not match the current asset turnover period
In addition the conversion of current assets into cash may be deferred or at worse foregone (Bad Debts)
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Cash Operating CycleCash Operating Cycle
Trade Payables
Raw Materials W-I-P Finished Goods Debtors
Funding the cash operating cycle
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Funding the Funding the Cash Operating CycleCash Operating Cycle
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Funding the Cash Operating CycleFunding the Cash Operating Cycle
Short-Term Borrowings Bank Overdraft Commercial Paper Invoice or Bills of Exchange Discounting
Long-Term Capital Employed Debt / Equity
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Funding the Cash Operating CycleFunding the Cash Operating Cycle
AGRESSIVE CONSERVATIVE
SHORT-TERM FUNDING LONG-TERM FUNDING
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Funding the Cash Operating CycleFunding the Cash Operating Cycle
MATCHINGCurrent assets are assets which are either cash or expected to be converted into cash with one year
For funding purposes these can be classified into:
Permanent Fluctuating
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Funding the Cash Operating CycleFunding the Cash Operating Cycle
Permanent Inventory
Inventory required to stock the shops plus to keep some buffer stock in warehouse/s
Fluctuating
Inventory levels before the Easter, Summer and Christmas holidays will normally be above average
Example: Toy Shop
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Funding the Cash Operating CycleFunding the Cash Operating Cycle
0
2
4
6
8
10
12
14
16
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Permanent Current Assets
financed by Long-term Capital
Fluctuating
Current Assets
financed by
Short-Term
Funding
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The Objective of The Objective of Working Capital ManagementWorking Capital Management
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Aim of Working Capital ManagementAim of Working Capital Management
A business needs to invest in current assets to sustain its business operations
The aim of working capital management is to strike off a balance between FINANCIAL STABILITY and PROFITABILITY
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Over-Capitalization -Working CapitalOver-Capitalization -Working Capital
Too much working capital will impinge on profitability
Higher interest rate burden
Opportunity Cost – long-term capital tied in current assets can be used to finance feasible projects
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Inadequate Working CapitalInadequate Working Capital
Inadequate Working Capital may lead to liquidity problems
Overtrading
Rapid expansion in business without having adequate working capital.
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Inadequate Working CapitalInadequate Working Capital cont.cont.
Symptoms of Overtrading
Accounts Payable period will increase
Development of hard core element in bank overdraft plus encroachments
Profit margins will start to decline as raising cash will be given priority to profitability
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Optimum Working CapitalOptimum Working Capital
Over-Capitalised Under-Capitalised
Current Ratio > 2 : 1 < 2 : 1Quick Ratio > 1 : 1 < 1 : 1Cash Operating Cycle Long Short
Some textbooks suggest that:
However Working Capital needs depend on a number of factors. For example:
type of industry accessibility to financial markets
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Optimum Working Capital Optimum Working Capital cont.cont.
Trade Payables (48.7 days)
Inventory (13.8 days)
J SAINSBURY – FOOD RETAIL INDUSTRY
Negative Working Capital
Source: Fitch Ratings figures as at 24-Mar-07
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Optimum Working Capital Optimum Working Capital cont.cont.
Trade Payables (30.7 days)
Inventory processing period (31.2 days) Debtors (27.4 days)
Cash Operating Cycle (27.9 days)
SABMILLER – BREWERY
Source: Fitch Ratings figures as at 31-Mar-07
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Conclusion on OptimalityConclusion on Optimality
Working Capital Needs differ among industries
Optimality depends on the management of the constituents of Working Capital
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Managing Managing Working CapitalWorking Capital
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Inventory ManagementInventory Management
INVENTORY COSTSHOLDING COSTS funding
storage insurance
PROCUREMENT ordering delivery
SHORTAGE COSTS lost contribution from missed sales
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Economic Order QuantityEconomic Order Quantity
EOQ = 2 Co D 1/2
Ch
Where:EOQ (Q) economic order quantityCo Ordering CostD Annual DemandCh Cost of holding 1 unit
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Economic Order Quantity Economic Order Quantity cont.cont.
Example:The expected annual demand is 500,000. Purchase price is $100. It costs $ 500 to place an order and the cost of holding one unit in stock is 20%.
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Economic Order Quantity Economic Order Quantity cont.cont.
-
50
100
150
200
250
300
Q
$' 000s Ch
Co
TC
EOQ
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Economic Order Quantity Economic Order Quantity cont.cont.
Assumptions – Practical ImplicationsGoods are delivered when they are
ordered i.e. no lead timesDemand is constantPrice is constant and no bulk
purchases discounts
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Just-in-Time JITJust-in-Time JIT
Toyota was the first company to develop JIT
Toyota needed to reduce costs of production and JIT was the solution
Kanban System – pull system of production i.e. items are only produced when they are needed
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Just-in-Time JIT Just-in-Time JIT cont.cont.
Companies thinking of introducing JIT will first have to:
Find reliable suppliers
Train employees to minimize wastages and idle time
Improve quality
Minimize lead times
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Trade ReceivablesTrade Receivables
A company which is selling on credit is actually lending money
It must have a debtors policy, composed of a:Credit Analysis SystemCredit Control SystemDebt Collection procedure
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Trade ReceivablesTrade Receivables
The objective of selling on credit is to increase sales, however:
Sales Growth is vanity
Profit is sanity
Cash is king
Ultimate objective should be profitability without jeopardizing liquidity
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Increasing Trade ReceivablesIncreasing Trade Receivables
Main benefit – increase in contribution
Costs
Increase in debtors administration costs
Increase in the likelihood of bad debts
Increase in funding costs
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FactoringFactoring
Three-tiered service
Administration
Credit Protection
Invoice or Bills of Exchange Discounting
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Factoring Factoring cont.cont.
Saving in administration costs
Invoice discounting: alternative source of funds
Credit protection
Can be expensive
Loss of goodwill if too aggressive at chasing for payment
Can be deemed as a signal of liquidity problems
Advantages Disadvantages
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Trade PayablesTrade Payables
Factors to consider in choosing Suppliers:Credit TermsReliability Price
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Management of CashManagement of Cash
3 reasons for holding cash
Transactions motive
Precautionary motive
Speculative motive(John Maynard Keynes)
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Cash Flow ForecastCash Flow Forecast
Simple and Effective Cash Management tool
Objective is to estimate futurecash shortagescash surpluses
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Cash Flow Forecast Cash Flow Forecast cont.cont.
Temporary Surpluses Benefit from early settlement discountsIncrease current assetsMake short-term investments
Temporary DeficitsArrange for short-term fundingGive early settlement discounts
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Cash Flow Forecast Cash Flow Forecast cont.cont.
Permanent Deficits
Raise long-term finance
Permanent Surpluses
Look for feasible long-term projects
Reduce gearing
Expand/Diversify
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Large OrganizationsLarge Organizations
Cash management in large organizations tends to be more complex
Most organizations have centralized treasuries and apply more sophisticated models to manage cash
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Baumol ModelBaumol Model
The Baumol model is the same one which is used to estimate EOQ
Cash is considered as inventory and two related costs are:
Money Procurement costs
Opportunity cost
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Baumol Model exampleBaumol Model example
Treasury
Division A
Division DDivision C
Division B
Cash flowsCash flows
Cash flowsCash flows
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Baumol Model example Baumol Model example cont.cont.
According to the cash flow forecast, Division B’s annual cash requirement is $ 1 million
Procurement Costs - $ 700
Opportunity Cost - 3.5%
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Baumol Model example Baumol Model example cont.cont.
EOQ = 2 Co D 1/2
Ch
Using the same formula for inventories, the optimal amount to be raised and transferred is U$ 200,000.
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ConclusionConclusion
Current Assets are essential in sustaining the operations of a business.
Working Capital Management deals with how current assets are managed and financed.
The objective of working capital management is to maximize profitability without jeopardizing liquidity.
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QUESTION TIME