Managing Finance and Budgets

1
Managing Finance and Budgets

• Presentation 8
• Working Capital (1)

2
Session 3 - Financial Statements (2)

• Learning outcomes
• Understand what is meant by the term Working
  Capital, and be able to describe some of the
  elements of which it comprises.
• Understand what is meant by the Operating Cash
  Cycle and how it might affect a business.
• Manipulate and use financial statements to inform
  decision-making specifically related to Working
  Capital.
• Key concepts
• Cash Flow Statement
• Working Capital

3
Structure of the Presentation

• A What do we mean by Working Capital?
• B The Key Elements of Working Capital
• C The Operating Cash Cycle
• D Controlling the Cash
• E Two examples
• F Seminar 8

4
Section A

• What do we mean by
• Working Capital?

5
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)

6
Example
For 2002, Current Assets Total 574,300
For 2002, Current Liabilities Total 233,360
Working Capital for 2002 574,300
- 233,360 340,940
7
The Elements of Working Capital a summary
Major elements
Major element
Current assets
Current liabilities
Working capital
equals
less
8
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.

9
Example Revisited
Current Assets Total 574,300
Current Liabilities Total 233,360
Working Capital for 2002 574,300
- 233,360 340,940
Here we can see that although we have a large
amount of Working Capital, it is all locked up in
Stock Debtors. The amount of actual cash
(33,500) is low in comparison this may not be
sufficient for needs.
10
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

11
Further Example
For 2001, Current Assets Total 175,750
For 2001, Current Liabilities Total 225,900
Working Capital for 2001 is negative
175,750 - 225,900 - 50,150
Here we can see that the business has a deficit
of Working Capital it owes more money to
creditors than it has in Stocks Debtors. It
could be Overtrading.
12
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 client payment) can then cause
  catastrophe

13
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

14
The Working Capital Cycle
This is essentially just a a simplified version
of the how the operating activities link together
and affect one other

• 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

15
Working Capital in Summary

• Working Capital is the lubricant which allows
  the business to run smoothly
• Requirements vary between different types of
  industry (e.g. high in manufacturing, low in
  retail) according to the fluctuations in the
  trading position
• An increase in business may well require a
  parallel increase in working capital

SAQ 8.1
16
SAQ 8.1

• a. Why would the requirements for a
  greengrocers working capital be very different
  from that of a builder?
• b. What changes in the general business
  environment might lead a company to change the
  level of their Working Capital investment?

Solution
Solution
17
SAQ 8.1a Solution

• Why would the requirements for a greengrocers
  working capital be very different from that of a
  builder?
• Greengrocer stock has very short shelf-life
  -often a matter of a day or two Amount of stock
  is kept to the minimum possible, otherwise large
  wastage. In the retail trade, there are virtually
  no trade debtors, but may be some trade
  creditors. All this suggests very low levels of
  Working Capital hundreds of pounds.
• Builder Often needs to outlay lots of expense
  building materials, hire of equipment etc. Often
  this is on credit. Stock here is the
  half-completed job. Often people take a long
  time to pay . All of this suggests that Working
  Capital will involve much larger sums of money
  thousands of pounds even for a small builder.

18
SAQ 8.1b Solution

• b. What changes in the general business
  environment might lead a company to change the
  level of their Working Capital investment?
• Some possibilities
• Interest Rate Change
• Seasonal demand patterns
• Economic climate
• Changes in the Market
• Competition

19
Section B

• The Key Elements of
• Working Capital

20
The Working Capital Cycle Summary Diagram
21
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.

SAQ 8.2
22
SAQ 8.2

• Discuss the following
• Why do you think it is important to keep careful
  track of working capital requirements?

Solution
23
SAQ 8.2 solution

• The need to keep track of working capital
  requirements
• Failure to do so could lead to
• Debts not being collected on time, possibly with
  customers defaulting on payments.
• Suppliers refusing credit, or even refusing to
  supply.
• Stock not being available for manufacturing and
  other processes.
• Payments to employees being delayed or
  impossible.
• Possible Bankruptcy.

24
Key Elements of Working CapitalStock

• 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.

25
Key Elements of Working CapitalStock

• Remember from last week
• 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.

26
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) (3600042000)/2 x 365
• 345000
• 41.26 days

27
Stock Control

• One of the important issues here is how we can
  monitor and control stock levels.
• There are several standard techniques for doing
  this.
• Some require simple arithmetical calculations.
• Others require a complete redesign of production
  processes or retail layout
• We will explore some of these issues next week.

28
Key Elements of Working CapitalTrade Debtors

• Carrying higher levels of Trade Debtors means
  that the business has a lot of money tied up,
  which it is not able to use to generate profit.
• The businesses that owe us money, are effectively
  using it to invest in their business, and so
  create profits for them.
• There may be good reasons why some businesses
  need to carry high levels of Trade debtors.
  (Builders, for example typically work on
  contracts for several months before getting
  paid.)
• In the normal cut thrust of trade, most
  businesses would typically expect payment within
  one calendar month.

29
Key Elements of Working CapitalTrade Debtors

• Remember from last week
• 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.

30
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

31
Management of Debtors

• Just as with stock, an important issue is how we
  can monitor and control the levels of trade
  debtors.
• There are several standard techniques for doing
  this.
• Organisational policies required regarding
  offering credit credit terms etc.
• Debt Collection Policies and their management.
• Cash Discounts offered for early payment.
• We will explore some of these issues next week.

32
Key Elements of Working CapitalTrade Creditors

• Carrying high levels of Trade Creditors means
  that the business has access to a lot of
  resources (such as stock, rent, fuel etc.), but
  for which it has not paid.
• This means that other businesses have effectively
  provided us (until we pay) with free resources,
  that we can use to create create profits for us.
• Before we get carried away, there are good
  reasons why we should not carry high levels of
  Trade Credit.
• In the normal cut thrust of trade, most
  businesses would typically expect payment within
  one calendar month if this does not happen, we
  may incur penalties, and ultimately suppliers may
  refuse to trade with us.

33
Key elements of working capital

• Remember from last week
• Average settlement period for Creditors
• Creditors (days) Trade Creditors x 365
• Credit purchases
• This indicates how long, on average, the business
  takes to pay what it owes.

34
Average Settlement Period (Creditors)

• Example of Credit Settlement Period
• A companys accounts for 2003 shows that
• The amount currently owing is 43,500
• The total amount of credit purchases is 198,000
• Creditors (days) 43500 x 365
• 198000
• 80.19 days

35
Management of Creditors

• Just as with stock and trade debtors, an
  important issue is how we can monitor and control
  the levels of trade creditors.
• There are several issues here.
• Discounts may be offered for paying early and may
  be more valuable than the trade credit
• Paying late may have disadvantages lower
  priority, higher prices, refusal to supply
• We will explore some of these issues next week.

SAQ 8.3
36
SAQ 8.3

• Tinas Dressmaking Fabrics Accessories Ltd.
  prides itself on stocking a wide range of fabrics
  in all colours, sizes and materials as well as a
  huge collection of trimmings, buttons, and
  ornamentations. It plies its business with
  specialist dressmakers, who buy mainly on credit,
  and takes its supplies directly from
  manufacturers, buying in bulk at a discount, on
  credit, but in order to qualify for the discount,
  payment must be made within seven days.
• What level of working capital do you think Tina
  needs?
• Do you think that this is an efficient way to run
  the business?

Solution
37
SAQ 8.3

• Tina carries very high levels of stock (probably
  in the hundreds of thousands of pounds) unless
  she has a credit policy, it is likely that there
  would be huge amounts of trade debtors, certainly
  in the tens of thousands
• On the other hand, given the 7-day discount, it
  is likely that she will keep the amounts owed to
  trade creditors very low, certainly much lower
  than the trade debtors.
• All this suggests that the Working Capital
  requirements would be enormous a huge proportion
  of this being tied up in stock which may not
  actually be needed in the short term.
• It might be more profitable to hold lower levels
  of the less popular stocks, and run the risk of
  running out. If suppliers require payment within
  7 days, then it is likely that they offer
  delivery within that time hence customer service
  would not be affected greatly.

38
Section C

• The Operating Cash Cycle

39
The working capital cycle Summary Diagram
40
The Working Capital Cycle- essential events

• The diagram below is an even more simplified
  version of the Working Capital Cycle

Assuming all trade is done on credit, this shows
the four essential events, in the normal order in
which things occur.
41
The Working Capital Cycle- essential events

• From the simplified diagram,

purchase of goods on credit
Creditor Period
Cash received from debtors
payment to creditors for goods
Sale of goods on credit
Debtor Period

• We can see immediately
• The Debtor Period
• The Creditor Period

42
The Working Capital Cycle- essential events

• There are two more important time periods

• The Stockholding Period (where is this?)
• The Operating Cash Cycle (what is this?)

43
The Stockholding Period

• The Stockholding period is the time from the
  purchase of goods to the sale of goods

purchase of goods on credit
Cash received from debtors
payment to creditors for goods
Sale of goods on credit
44
The Operating Cash Cycle

• The Operating Cash Cycle is defined as the time
  between the outlay of cash necessary for the
  purchase of stocks to the ultimate receipt of
  cash from the sale of goods.

purchase of goods on credit
Cash received from debtors
payment to creditors for goods
Sale of goods on credit
45
Operating Cash Cycle

• The Operating Cash Cycle can be calculated using
  the following equation

• Long Operating Cash Cycles have a significant
  influence on the financing of the business.
• Most business will wish to reduce this to a
  minimum.

46
Calculating the Operating Cash Cycle
47
Example of Operating Cash Cycle

• Using the amounts calculated previously

Stock Turnover Days
Debtor Days
Creditor Days
29.41 days

• In this case, the average time between the cash
  laid out and cash returned is less than one month.

48
(No Transcript)
49
41.26 Days
68.34 Days
80.19 Days
41.26 68.34 80.19 29.41 Days
50
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.

51
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.

52
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

53
Reducing the OCC
SAQ 8.4

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

54
SAQ 8.4

• In the lecture example from week 7, (m N
  Manufacturing) we calculated the following
  ratios.

• Calculate the OCC for 2002 2003,
  and comment on the differences.

Solution
55
SAQ 8.4 Solution

• OCC for 2002
• 58.7 39.2 -38.7 59.2 days
• OCC for 2003
• 51.3 31.7 44.1 38.9 days
• Comments
• The OCC has been reduced by 20 days, about a
  third of the original time. This is a vast
  improvement
• In terms of cash flow, this means that M N are
  now utilising their cash with much greater
  efficiency than they did before.
• NB This, by itself will not mean that they are
  more profitable they may be spending it in the
  wrong things! See week 7.

56
Section D

• Controlling the Cash

57
Controlling Working Capital through the Cash
Balance

• We have seen that three important elements of
  Working Capital are Stocks, Debtors and
  Creditors.
• Another element is the Cash Balance at the Bank.
• This is important because sooner or later, we
  need to get money from our Debtors, and pay our
  creditors.
• In order to manage this process, we need to
  monitor our current cash flow situation, and our
  current bank balance.

SAQ 8.5
58
SAQ 8.5

• Why might a business want to hold some of its
  assets in the form of cash?

Solution
59
SAQ 8.5 Solution

• Why might a business want to hold some of its
  assets in the form of cash?
• For day-to-day trading purposes Some of this may
  need to be in cash we need to pay rent, rates,
  fuel bills, tax interest.
• As an insurance against cash-flow problems we
  may need a cash buffer to ensure that we do not
  exceed our overdraft limit at particular times in
  the year.
• To take advantage of opportunities that arise
  there may be bargains that we spot, or we may
  wish to secure short-term investments which offer
  high profitability.

60
Controlling the Cash Balance

• The Cash element of Working Capital now becomes
  of crucial importance.
• If we have too high a Bank Balance, then the
  money might be gaining interest, but hopefully,
  we would obtaining a better ROCE employing it in
  the business.
• If we have too low a Bank Balance (or an
  overdraft), then we are in danger of incurring
  penalties in the form of overdraft interest
  payments

61
Controlling the Cash Balance

• There are many techniques for controlling the
  cash element of Working Capital
• One model proposes
• A Target Balance
• Inner Limits (/-) (close to the target)
• Outer Limits (/- ) (further away)

62
Controlling the cash balance
63
Controlling the cash balance
Outer Limit breeched Managers must decide
whether this will return to inside inner limit
with a few days, if not, take action to generate
cash inflow.
64
Controlling the cash balance
SAQ 8.6
Return to within Inner Limit After action taken
(selling of assets for cash), the cash balance
has returned to acceptable levels.
65
SAQ 8.6

• When deciding what is a suitable Target level
  of cash to hold, what factors would we need to
  take into consideration?

Solution
66
SAQ 8.6

• When deciding what is a suitable Target level
  of cash to hold, what factors would we need to
  take into consideration?
• The type of business businesses such as
  gas/electricity suppliers have cash flows which
  are steady predictable. Xmas tree producers
  have cash flows which are seasonal and
  unpredictable).
• The cost of holding cash borrowing this
  includes factors such as the the current interest
  rate, overdraft conditions etc.
• The general economic climate Following 9/11
  there was a downturn in many areas some business
  responded by holding more cash, some less,
  depending upon the sector.

67
Section E

• Two Real-Life Examples

68
Two Large Comapnies

• Two different examples have been selected to
  highlight the difference in practice in relation
  to Working Capital.
• TESCO PLC is a large retailer which has very
  negligible amounts of Debtors, and works on a
  fast stock Turnaround time high volumes,
  minimum stock levels.
• FORD Motor Co. is a global corporation, carrying
  billions of dollars worth stock and other current
  assets (franchises, trade debt, leases, lendings
  etc.)

69
Example of a Retail CompanyTESCO PLC
Note that there is a net deficit of Working
Capital. The Current Ratio is stable at 0.43 for
both 2002 2003
70
Example of a Manufacturing CompanyFORD Motor
Co. (amounts in 000)
In 2000 there was a one off adjustment for a
previous financial practice
Note that there is a net surplus of Working
Capital.
The Current Ratios in 2001 2002 were 1.1
and 1.3
71
Seminar Eight - Activities

• Preparation read M A Chapter 16
• Describe key concepts
• Working Capital
• Operating Cash Cycle
• Working Capital Example
• M A Exercise 16.1 (answers in M A)
• NB Seminar 8 mainly consists of answers to the
  example, followed by Test 2, which will last the
  rest of the time.