What Does Free Cash Flow - FCF Mean?

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF)
represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset
base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:

It can also be calculated by taking operating cash flow and subtracting capital expenditures.
Investopedia explains Free Cash Flow - FCF
some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings
can often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe
that FCF gives a much clearer view of the ability to generate cash (and thus profits).
It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a
company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in
the long run.

Chapter 6: Working Capital Management

Working Capital is the money used to make goods and attract sales. The less Working Capital
used to attract sales, the higher is likely to be the return on investment. Working Capital
management is about the commercial and financial aspects of Inventory, credit, purchasing,
marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to
be the level of Working Capital tied up in creating and selling titles. The faster that we create and
sell the books the higher is likely to be the return on investment. Thus when we have been using
the word investment in the chapter on pricing, we have been discussing Working Capital.

In the earlier chapter on Accounting concepts we showed a sample Balance Sheet. The Balance
Sheet comprises Long term Assets (real estate, motor vehicles, machinery) and Net Current
Assets. The word Working Capital is often used for Net Current Assets. In this chapter we will
exclude Cash in Bank from our definition. Thus our Balance Sheet appears as follows:

Long Term Assets 6,000

Working Capital 28,000
Cash in Bank 1,000
Total Capital 35,000

We defined Net Current Assets as Total Current Assets less Total Current Liabilities. In this book
we shall subtract current liabilities items from current assets as follows:

Young
Inventory 15,000
Receivables 17,000
Prepayments 6,000
Payables (9,000)
Customer Prepayments (1,000)
Working Capital 28,000

Using this format we can state than any reduction in the Working Capital figure, other than for
provisions for write-offs and write-downs, will generate the same amount of cash. Thus if a
customer pays US$ 500 that he owes to the organisation, the Working Capital figure will fall be
US$ 500, and the cash figure will be increased by the same figure. This revised format is useful
when designing spreadsheet financial planning models for business plans or for internal reporting.

The Working Capital cycle, or Cash Conversion cycle as it is also called is usually expressed in
terms of the number of days. This figure is the average time that it takes to turn investment in
books into cash and profit. We studied Payback in the previous chapter. Payback expresses the
number of days required to recoup the original investment on a single title. In the organisation’s
Balance Sheet there will be the costs of paper, titles still under development, author advances of
books already and not yet published. In addition there will be the cost of stocks of unsold books,
Accounts Receivable, and Accounts Payable.
Example: Osiris publishers

In order to illustrate the concept I have adapted slightly the example used in the chapter on
Accounting concepts. The Young scenario has the same Income Statement but I have adapted
the Prepayments figure within the Balance Sheet in order to illustrate more elements of

Working Capital. I have divided the Prepayments figure of 6,000 into Prepayments to authors and
Prepayments to printers. The totals are the same.

Income Statement Osiris

Turnover 100,00
0
Cost of Sales (57,000
)
Royalties (18,000
)
Gross Profit 25,000
Distribution costs (5,000)
Promotion (2,000)
Write-offs (3,000)
Administration costs (10,000
)
Operating Profit 5,000
Analysis
Balance Sheet Osiris Working Capital / 28.00%
Sales %
Inventory 15,000 Inventory in days 96
Receivables 17,000 Receivables in days 62
Prepayments: authors 3,000 Prepayments in 61
days: authors
Prepayments : printers 3,000 Prepayments in 19
days : printers
Payables (9,000) Payables (36)
Customer Prepayments (1,000) Customer (4)
Prepayments
Working Capital 28,000 Working Capital 198
Cycle in days

Explanation of the calculations

 Working Capital Explanation
figure
Inventory in days (Inventory / Cost of Sales) x 365 = 96 days.
More correctly the purchases figure, if available
should be used, in this case excluding royalties.
Thus the publisher holds approximately 2
months of unsold inventory
Accounts receivable in (Receivables / Turnover) x 365 = 62 days.
days Assuming the turnover is phased evenly
throughout the year, this means the on
average customers take 62 days to pay
Prepayments in days – (Prepayment: authors / Royalties) x 365 = 61
authors days. In practice royalties will be earned that
reduce this figure while new advances are also
paid to other authors.
Prepayments in days – (Prepayment: printers / Cost of sales) x 365 =
printers 19 days. In practice part of the Cost of Sales
figure would be new title pre-press costs not
carried out at the printer. This item relates to
cases where advance payments are made to
printers as a deposit or for paper. The
purchases figure if available would give a more
accurate figure.
Accounts Payable in (Payables /(All purchases) x 365
days
(9,000 / (57,000 + 18,000 + 5,000 + 2,000 +
10,000) x 365 = 36 days

The purchases (investment) rather than the

cost of sales figure should be used if available. I
have assumed that this figure includes money
owed to authors (see prepayment: authors)
Customer (Customer Prepayments / Turnover) * 365 = 4
Prepayments days
Working Capital cycle 96 + 62 + 61 + 19 - 36 - 4 = 198
in days
Working Capital / Sales 28,000 / 100,000 = 28%
%

Explanation of the figures

• On average it takes Osiris 198 days to turn an investment into cash and profit.
• New tiles will use more Working Capital than reprints
• On average Working Capital equates to 28% of turnover
• The percentage of Working Capital to turnover varies according to the type of publishing
• Trade publishing in developed countries may have a figure of between 35- 45 % of
turnover. Academic publishing is higher. Professional publishing uses a lower Working
Capital % figure
• Working Capital is also a measure of risk

This figure may include new titles, reprints, foreign language coeditions, licence sales. The figure
would be different for each of these. Within the total Balance Sheet, the Working Capital figure
will vary throughout the year according to the phasing of new titles and the sales cycle.
Publishers should know the typical Working Capital cycle and the level of Working Capital as a %
of turnover for each market or distributor, for each category of book.

The relevance of Working Capital to publishing in young economies

In the FSU Working Capital levels were controlled at government rather than factory level.
Invoices were settled on standard credit terms. Non or slow payment was not a major problem for
printers and publishers. Risk was a government problem. Authors were paid standard royalty
rates and terms. Inventory levels and print runs were according to a formula: in textbook
publishing, 150% of the textbook requirement would be printed in year 1, the remaining 50%
would be used for replacement copies in subsequent years. Publishers, printers and distributors
would negotiate for annual cash budgets but did not have to concern themselves about Working
Capital questions except where budget moneys were delayed.

Printing capacity was sufficient to produce local and other agreed requirements. Thus textbook
printing would commence in November for the following September. In a competitive open
economy printers would have to offer discounts and credit to persuade publishers to take the risk
of early ordering. Schools would demand the latest up-to-date editions. Publishers would have to
borrow money from the bank or shareholders to pay for the inventory.

For young economies, the implications are as follows.

1. In young economies the first industries to develop are those with low or negative Working
Capital % to sales. Negative Working Capital is where the organisation uses supplier credit
or customer Prepayments to fund their day to day needs.
E.G. banks and financial services, retailers, distribution, industries with cash sales or
advance payments on signature of contract (e.g. printers). Organisations with negative
Working Capital use the money from their customers with which to invest and to pay
suppliers.
2. Competition is fiercest among industries with low or negative Working Capital / sales %
figures. Financial entry barriers are lower and these industries are easier to expand.
However profit margins are often lower because of the competition (but not always!) and
the failure rate among such industries among developed countries is usually higher.
3. Banks are attracted to industries with low or negative Working Capital / sales % figures as
cash and profits are earned more quickly
4. Entrepreneurs are attracted to industries with low or negative Working Capital % figures
5. Most marketing innovations in book publishing have come about through the application of
the above Working Capital concepts to creating additional sales and expanding the
market. Most of the innovations introduced at the end of the previous chapter were
created by reduced the level of Working Capital and the time schedule of creating and
selling books.
6. The customers, suppliers and authors of book publishers also want to operate to a low or
negative Working Capital / sales %. Thus printers ask for advance payments e.g. for paper,
distributors will try to withhold payment until they have received money from their
customers.
7. Printers are loath to change from their dominant position where they could dictate prices
and schedules according to price scales formulated at state level. These price scales were
geared to maximum production output, not to satisfying publishers and their customers
under national or international competition. 4-colour printing would cost 4-times the cost
of single colour printing, despite the introduction of modern 4-colour sheet-fed presses.
Printers will change their attitude to pricing and print-runs only in a crisis. In many young
economies printers have not co-operated with publishers (partly the fault of the
publishers) and faced near collapse as publishers have purchased printing overseas.
8. In developed countries publishers have sometimes allowed retail groups extra credit (=
higher Working Capital for publishers) in order to encourage them to expand into new
 outlets or sell more books. It is essential to distinguish between genuine expansion cases
and opportunistic entrepreneurs. The more a publisher is actively engaged in marketing
and distribution, the less likely is the publisher to have to rely on offering credit as an
incentive.
9. The concept applies equally to state enterprises and non-profit making organisations. If
cash and profits are generated more quickly, new titles can be commissioned sooner, staff
and suppliers paid promptly. Bank interest is reduced.
10. Where producers are dominant, their customers will have to accept higher levels of
Working Capital. Where customers are dominant, the producers have to accept a greater
burden. In some young economies, the government may have a policy of holding key
organisations in the state sector or as majority owned state enterprises rather than
encouraging a “free-for-all enterprise policy. This may affect printers, publishers and
distributors. This policy will affect the evolution of the Working Capital cycle and may tilt it
more in favour of producers.

Working Capital levels in book publishing in developed countries

Working Capital is a major problem in book publishing. Most publishers solve the question on a
temporary basis by negotiating credit with printers and other suppliers. Their own customers
solve the problem by negotiating credit with publishers or demanding “sale or return” terms.
“Sale or return” terms make planning and cash forecasting much more difficult. Most publishers
rightly prefer to offer a slightly higher discount for a firm sale. Retailers will argue that they would
not purchase many new titles without their risk being mitigated by a “sale-or-return” policy”

The central issues, which must be solved, are:

• Investment decisions rely too heavily on economies of scale e.g. in printing prices, by
amortising first edition costs against larger print runs
• Publishers produce too many titles, which receive too little promotional effort and thus sell
slowly or not at all.

These can be solved only through long term changes in publishing strategy and greater attention
to the “value chain” where suppliers, publishers, wholesalers and retailers co-operate to mutual
benefit and shared risk. On demand publishing may reduce inventory levels but does not solve
the marketing aspects.

Many publishers have studied the publishing of music CD’s and cassettes, and of greeting cards
with a view to finding solutions. While lessons can be learned, there are major differences:

CD’s, cassettes and greeting cards

• Are all high margin projects

• Carry much heavier promotion budgets and commitment to marketing
• Are standardised in format
• Enjoy few economies of scale so short run and on-demand manufacture are the norm
• Sell to a more wide variety of retailers
• Sell on a less seasonal basis

Paperback publishers have adopted some of these aspects and have fought successfully to
overcome the low price perception of paperbacks. Paperbacks can now sell in many cases at the
same price as a hardback edition. The creation of “hit-parades” or “Top 10” listings has been
adopted for books of different categories and has attracted significant media attention thus
making books more fashionable. As a result books may sell faster, perhaps at higher prices and
thus reduce Working Capital levels.
“Book Packagers”

Book packagers create books under contract to publishers, bookclubs or foreign distributors. They
evolve as part of the specialisation process especially when publishers become larger and more
bureaucratic. Publishers buy the rights for a territory for a period of years or number of printings
(provided that the title stays in print). The financial attraction to publishers is that they can buy
smaller print runs at economic cost. Most publishers will make advance payments to the
packagers but may be able to approve the content and design. Most packagers prefer to sell
finished books rather than licence titles on a film and royalty basis.

Packagers buy at low prices from printers because they create only a small number of titles but
each title will have a large print run. Packagers often stay loyal to printers who reward them with
long credit and, in many cases, lower printing prices than those paid by their publisher customers.

In the TV world many program companies will create programs for several networks while TV
companies concentrate on distributing the programs. The production companies will retain the
rights and earn fees for repeat-shown programs. A similar situation exists in the multimedia field.

Thus packagers are specialists who are not involved in marketing and distribution. Subsequently a
small number of them have decided to become publishers and done so very successfully after re-
financing. Most stay as packagers. Compared with publishers, these packagers have little market
value in acquisition terms.

Thus packagers are very similar to many private publishers in young economies but with
important differences as the table below shows:

Book Packagers Private publishers in young

- Founders are creatively
rather than market driven;
enjoy “freedom”
- International printers offer
them low prices and credit;
printers have often offered
credit to allow packagers to
start up, sometimes with dire
results for the printer
- Packagers usually allow
publishers to approve content
- Receive advance payments
from publishers
- Hold no Inventory but reprints - Will often sell the total print run to a
make high profits
- Purchase rights from authors - Sell books with no transfer of rights
and designers, and sell
territorial or other rights to a
number of customers
economies
- Founders are creatively rather than
market driven; enjoy “freedom”
- Printers tend to give better prices to
established publishers
-
Some publishers may be closely linked
with a printer. The printer may
demand advance payment
- Publishers will not involve customers
in the book content except in special
cases e.g. textbooks and Ministry of
Education, University Publishing
Houses
- Are paid after delivery
single or small number of distributors
The Working Capital cycle in both cases is similar in both cases. The reason is perhaps the same.
Neither the book packager nor the young private publisher is adequately financed; both enjoy the
creative aspects but do not want to expand if it means losing control. There are few potential
buyers for book packagers.

The cost of starting such organisations is much lower. Working Capital is lower because they are
involved only in creating the books. They influence distributors, retailers and consumers only so
long as they generate saleable new ideas. While book packagers can of course sell foreign rights,
their potential to sell reprints is lower.

Making more efficient use of Working Capital

The table below lists items, which influence Working Capital levels favourably and adversely

Items that reduce Working Items that increase Working

Capital levels for publishers Capital levels for publishers
- Increased profit margins - Lower profit margins
- Customers who pay promptly - Long print runs except where all
- Advance payments by customers the books are required on
publication e.g. School and
university textbooks
- Inventory which is sold and paid - Slow authors who deliver late
for quickly by customers after and whose manuscripts require
publication substantial editing
- Lower Inventory levels by - Holding paper stock unless
reducing print quantities and market conditions demand and
working with printers who will the savings are large
deliver quickly and produce low - Slow schedules for the
print runs economically development of new titles
- Successful promotion that speeds - Making advance payments to
up the rate of sale printers
- Seasonal sales except where the
publishers prints only for the
season
- Licensing (but problematic in
young economies)
- Paying suppliers on completion
with credit
- Authors who deliver manuscripts
on disk ready for computer make-
up
- Incentives to staff , authors ,
suppliers, customers , sales staff
and agents to speed up the rate of
sale and of developing new books,
delivering manuscripts on
schedule

The attention of readers is again drawn to the examples at the end of the previous chapter, which
illustrate ways in which publishers have produced affordable books through a marketing initiative.
The concepts of this chapter apply in each example.
The danger of averaging Working Capital levels

Osiris has a Working Capital to Sales figure of 28%. However the figure will be the average of the
organisations different activities. Let us assume that there are three divisions that produce
different types of books for different markets and use different methods of distribution. The table
below shows how each division generates much Net Contribution and also how much Working
Capital is used in each division. The cost of sales, royalty, distribution, promotion costs and write-
off figures differ in each case as a percentage of sales although not all the costs are necessarily
variable. The term Net Contribution is the amount of money that each division generates towards
the central administration cost of the company and hence to profit. Items below Net Contribution
is not relevant to our analysis unless administration cost vary according to each market. Interest
on bank loans could however be usefully charged against each division to give an even more
meaningful figure. Although a Balance Sheet item, Working Capital is shown under Net
Contribution to highlight the relevance of comparing Net Contribution and Working Capital levels
by division.

Income Statement Division A Division B Division C Total

Turnover 60,000 30,000 10,000 100,000
Cost of Sales (33,000) (18,000) (6,000) (57,000)
Royalties (10,800) (6,200) (1,000) (18,000)
Gross Profit 16,200 5,800 3,000 25,000
Distribution costs (3,900) (1,000) (100) (5,000)
Promotion (1,100) (900) 0 (2,000)
Write-offs (1,700) (1,100) (200) (3,000)
Net Contribution** 9,500 2,800 2,700 15,000
Working Capital 19,200 7,800 1,000 28,000

** Gross Profit less distribution, promotion and write-offs. The contribution to administration costs
and profit from publishing activities

The analysis of the above sheds useful light on profitability and use of Working Capital by division.
This is discussed in detail below.

Analysis of the net contribution

The table below shows each cost item included in the Net Contribution calculation expressed as a
percentage of turnover.

Division Division Division Averag

A B C e
Cost of Sales % to Turnover 55.0% 60.0% 60.0% 57.0%
Royalty % to turnover 18.0% 20.7% 10.0% 18.0%
Gross profit margin % 27.0% 19.3% 30.0% 25.0%
Distribution % to turnover 6.5% 3.3% 1.0% 5.0%
Promotion % to turnover 1.8% 3.0% 0.0% 2.0%
Write-off % to turnover 2.8% 3.7% 2.0% 3.0%
 Net Contribution % to 15.8% 9.3% 27.0% 15.0%
turnover
Working Capital / Turnover 32.0% 26.0% 10.0% 28.0%
%

Turnover

The turnover figure is the sum of the sales invoices issued during the year by division. Any returns
or invoice queries would be shown separately under write-offs in order to highlight to
management the extent of returns and invoices queries. The company will invoice either by
charging an agreed discount off the recommended retail price, or by using an agreed unit price. If
transport is included in the invoice price, the charge for transport will be shown as an expense
under distribution. Free samples or extra jackets may also be included in the invoice price.

Cost of sales

The percentage to turnover is influenced by the sales mix, the balance of new and reprint titles,
and the length of print runs. A larger print run might increase the gross margin % but also
increase Working Capital levels and hence reduce the cash in bank figure.

Some organisations will charge new title costs in different percentages to each market. The aim is
to demonstrate that certain markets are profitable, but only on a marginal costing basis. If an
organisation has to increase prices to local bookshops as a result of charging all new title costs
against the home market, the organisation runs the risk of losing market share and profitability in
the home bookshop market

Other publishers, often the more progressive, may therefore regard new title costs as research
and development, and charge e.g. 1/12th each month following publication against the Income
Statement. This policy means that inventory is valued at a cost excluding new title costs and
reduces the need for write-offs. This policy also gives a better view of trends in gross margins, as
the figure is not distorted by changes in the new title / reprint mix. The Net Income will fall.
Countries may have specific policies for writing off first edition costs against profits, as they are
similar in concept to research and development expenditure.

Royalty figures

The royalty figures differ because in the case of division A and B, the royalty is charged on the
basis of the retail price, while in the case of division C, the royalty payable is based on net
receipts, i.e. the unit price charged net of discounts. As markets expand, the need to negotiate
royalty terms based on net receipts will grow in order that publishers exploit new markets.
Without such author contractual terms, publishers might have to reject otherwise profitable deals.
Thus the author might lose also. It is common for net receipts royalty rates to be agreed for deals
above a certain discount rate, e.g. bookclub, export deals, coeditions, and licences.

Gross margin

Definition: Turnover minus cost of sales and royalties payable.

Gross margin, the percentage of gross profit to turnover is widely used in book publishing as a
parameter for book pricing. Where an organisation produces books with a similar cost profile, in
similar print runs, and with a constant sales mix, gross profit may be a useful criterion. Here the
figures highlight also that the use of gross margin as a criterion is not always useful and can be
misleading although the division C, with the highest gross margin, also has the highest net
contribution. Use of gross margin ignores distribution, promotion and write-offs, which will usually
differ by division or type of book.
Distribution costs
Distribution costs will include the following:
• Cost of own warehouse in handling the year’s sales
• Cost of using someone else’s warehouse for the same purpose
• Using a contractor who handles your organisation’s distribution on a percentage of turnover basis for
warehousing, transport, packing, invoicing but not selling.
• Transport and postage costs
• Packing materials
• Handling returned copies
• Sales invoicing and credit collection (in some developed countries)
The percentage cost will vary according to the method of market distribution used. If the books are sold to a distributor
who buys the books on a firm-sale basis and who will sell, warehouse and transport the books to customers, then
distribution costs will be low or nil. The publisher’s influence and control over the market will also however be low or zero
also. In the case of a bookclub, the bookclub will demand delivery to their warehouse in bulk and distribution costs for the
publisher will thus be limited to transport costs to the bookclub’s warehouse.
Promotion costs
This includes the costs of promotion and selling whether carried out by the publishers or by other companies who carry out
the publisher’s instructions.
The following will be included:
• Publisher’s own sales force
• Sales commission to agents who sales on a commission basis only or to sales staff who are paid partly by salary,
partly on commission
• Advertising agency costs
• Some publishers may include samples under this heading
Write-offs
Write-offs are provisions against things that are likely to go wrong. The rule is that bad news has to be charged to the
Income Statement as soon as known whereas good news e.g. a large sales order for future delivery is not shown as a profit
until “realised”
The following would be included
• Doubtful debt provisions
• Bad debts
• Inventory that will not recover the cost of producing it
• Sales invoice queries
• Returned books (these are often shown separately as part of the turnover figures e.g.
Gross turnover 105,000
Returns provision 5,000
Sales turnover 100,000
• Currency losses (or gains) on sales and purchase invoices
• Royality advance write-offs
Net Contribution
Definition: Gross profit minus distribution and promotion costs, and write-offs
The Net Contribution shows the contribution from publishing activities of each division or market. While the figure is
immensely useful, the percentage figure must be used with caution as both fixed and variable costs have been deducted
from turnover.
Licensing Income would also be shown, if significant, as a separate item and not necessarily as part of turnover. While
licensing can be risky in young countries, it is a significant part of publishing in developed countries where the legal
system or local publishing association will be active in protecting publishers ‘ rights. Showing licensing Income as part of
turnover has misled publishers for years over the value of rights income to profitability and to an acceptable return on
capital %.
Net Contribution from Book Sales 15,000
Licensing Income (net of royalties payable) say 500
Total Net Contribution from publishing activities 15,500

Analysis of Working Capital levels by division

After a rather long diversion we now revert to Working Capital using the same example. The table below shows how
efficient each division is in using Working Capital.
 Division A Division B Division C Average
% Sales Turnover 60.0% 30.0% 10.0% 100.0%
% Net Contribution /total Net 63.3% 18.7% 18.0% 15.0%
contribution
% Working Capital 68.6% 27.9% 3.6% 100.0%
Net Contribution / Working Capital % 49.5% 35.9% 270.0% 53.6%
Net Contribution per 1 USD Working 49.48 35.90 270.00 53.57
Capital
Explanation using division C as an example
While generating only 10% of total turnover, but 18% of total Net Contribution, Division C uses only 3.6% of the total
Working Capital tied up in the company. Division C makes US$ 2.70 Net Contribution for every 1 US$ of Working
Capital used in Division C.
For both entrepreneurs and for publishers unable to borrow more money from the bank or shareholders, the Net
Contribution per 1 US$ of Working Capital is vital. If we were to add the Working Capital cycle (198 days in the case of
Osiris earlier in the chapter) for each division, the report that we have just studied would be even more useful.

Growth opportunities
The following analysis of the same data shows the importance of Working Capital levels in generating cash as well as
profit. Using the above data we can extract the following

Impact of USD 1,000 increase in Division A Division B Division C Average

sales volume
Increase in Contribution 158 93 270 150
Increase in Working Capital 320 260 100 280
For every additional US$ 1,000 of turnover, US$ 320 of Working Capital is required in Division A, US$ 260 in division B,
and only US$ 100. It is rare that the division with the lowest Working Capital requirement will also have the highest net
contribution % but that is what division C offers. Division C might perhaps consist of reprints or foreign language editions
only.

Calculating cashflow using Working Capital

We can project future cashflows using the Working Capital data. We are assuming that there are no additional purchases of
long term assets involved. Any other additional items of expenditure that are required to support the change would also be
included e.g. an additional editor, a new personal computer.
(a) using the Osiris average net contribution and Working Capital / turnover percentages
In the first case we will calculate the future cashflows over a three-year period using the average net contribution
percentage and average Working Capital % for Osiris. It shows the impact on cashflows starting with sales of US$ 1,000 in
the first year.

Assumption
Turnover growth % 10% 10%
Net Contribution % 15% 15% 15%
Working Capital % to turnover 28% 28% 28%

Osiris Analysis xxxx1 xxxx2 xxxx3

Turnover 1,000 1,100 1,210
Net Contribution 150 165 182
Working Capital 280 308 339
Cashflow (130) 137 151
Bank figure (130) 7 158
As we are studying the cashflow on an incremental basis, the opening Working Capital figure, as for a new project, would
be zero. The calculation for cashflow in the first year is as follows:
Cashflow: year 1 = Net Profit Contribution** plus increase in Working Capital **
= 150 +0 – 280 = (130)
Cashflow: year 2 = 165 +280 – 308 = 137
Cashflow: year 3 = 182 + 308 – 339 = 151
** Plus any purchases of long term assets and additional administration expenses required as a result of the decision. Net
profit contribution is used instead of profit because we are studying the impact on cashflow of increasing sales turnover.
Only incremental costs and sales are included.
(b) using the net contribution and Working Capital / turnover percentages for Division C which has both the
highest net contribution % and the lowest Working Capital / turnover %

Assumption
Turnover growth % 10% 10%
Net Contribution % 27% 27% 27%
Working Capital % to turnover 10% 10% 10%

Division C Analysis xxxx1 xxxx2 xxxx3

Turnover 1,000 1,100 1,210
Net Contribution 270 297 327
Working Capital 100 110 121
Cashflow 170 287 316
Bank figure 170 457 773
Thus an expansion in Division C of USD 1,000 in turnover, and thereafter an increase of 10% per year cumulative,
generates USD 773 of additional cash as compared with USD 158 in the average scenario for Osiris. The difference is
explained as follows:
Increase in Bank figure: Osiris average 158
Additional net contribution from division C 397
Cash improvement due to lower Working Capital % in division C 218
Closing Bank figure for division C : year 3 773
Most of the increase in the bank position is the resulting of higher profits but the lower level of Working Capital in division
C also results in an additional cashflow improvement of US$ 218.
Notes on the Cashflow calculations
In practice we would add back to the net contribution figures that part of write-offs that was included for future problems.
This is because such provisions do not affect cashflow.
We can apply the same concepts for the preparing of spreadsheet-generated Business Plan forecasts. In such cases all
Income Statement and Balance Sheet items would be included. Cashflow can be forecast using the Balance Sheet rather
than through a tale of Receipts and payments. The resulting cashflow figure will be the same under either method. Using
the Balance Sheet figure above, different scenarios can be studied, as the spreadsheet model can be “parameter” driven.
Thus changes in credit terms, inventory levels, margins can be studied quickly.
Pareto's Law - the 80/20 rule
This “rule” states that invariably time, sales, costs, or problem areas occupy a disproportionately high percentage of time or
money. In publishing we might use the rule as follows:
• 80% of inventory held is for only 20% of the titles published
• 80% of our profits are made by 20% of the titles we publish
• 80% of our turnover is made from 20% of our customers
• 80% of our slow payments are caused by 20% of our customers
• 80% of our Working Capital relates to 20% of our list or 20% of sales turnover.
• 80% of out time is spent on 20% of our titles
This general rule can be applied in so many ways to financial management in book publishing.

A detailed Look at the elements of Working Capital

Inventory
Inventory will consist of:
• Un-printed paper
• Flat printed sheets
• New books and reprints under development
 • Finished Inventory
• Publishing plant (discussed in chapters 4 and )
Unprinted paper In young economies paper may represent 40-50% of the price of a book while in developed countries the
percentage may be 10 – 15% of the selling price. Thus in young economies, economic purchase of paper is a major issue.
In some countries paper is a scarce commodity with prices at a premium.
In developed countries publishers will uses several printers in different countries. The normal procedure for book
publishers, except for publishers of standard format paperbacks is to negotiate prices with printers, which include an agreed
paper specification. Newspaper and magazine publishers, who print to a single format using reels will normally purchase
paper in order to secure the lowest possible prices and in order to guarantees supplies.
Paper is a commodity, but, unlike most commodities, is not traded on commodities' exchanges across the world. Attempts
are being made to develop a Futures Market for pulp. As a result there is no “market price” for each paper grade. Large
users will negotiate significant discounts on published price lists. but such data is not published. Only for newsprint is there
an open discussion on prices. Countries with strong economies and currencies will negotiate the best prices, while
countries with no local pulp industries will distort price levels by panic buying.
Young ambitious economies will require increasing levels of paper, as education, packaging and advertising become high
priorities. Where a country has an indigenous pulp and papermaking industry, this increase in demand causes paper
shortages and leads to higher prices. Consumers become more demanding and require higher quality papers, which are not
available locally. Controlled paper distribution means that local users may pay a higher price for local paper than their
counterparts in developed countries. Unless subject to special trade agreements or supported by their local governments
e.g. for credit risk, foreign pulp and paper mills may charge higher prices to young economies because of the credit risk
and because they do not always represent a major market to the mills. Local distributors are unlikely to inform publishers
that world paper prices are falling. Local distributors will often seek to limit alternate sources of supply. There is thus often
a large difference between prices charged by local distributors and those charged by the foreign paper mills who are
prepared to supply direct.
Many publishers in young economies will not purchase paper through the printer for two key reasons. Printers will often
make a surcharge of up to 25% as well as demanding advance payment. In addition printers may give priority to customers
prepared to pay higher prices for printing and paper and thus jeopardise printing schedules.
Thus publishers in young economies face three problems:
• Paying no more than market prices for paper (with guaranteed quality)
• Guaranteeing supplies of paper and thus books. Printers may give priority to publishers with paper stocks.
• Finding cash or loans to pay for the paper
Much of the comment on book inventory applies also to paper stocks. It is cheaper and less risky to hold an inventory of
paper than of books.
Flat printed sheets These are flat printed sheets, which can be bound as hardback, paperback or other editions at a later
date. By not binding immediately the publisher also delays the cost of binding but will usually have to pay the printer for
storage. Wastage rates are higher when the binding is not carried out as a single run.
Many publishers of short run editions will print extra 4-colour covers for later printings. A further use is where 4-colour
illustration sheets are printed for later over-printing in other languages.
New books and reprints under development (Work-in-Progress or WIP)
This represents all the costs of creating new titles and reprints up to the stage where the books ready for sale. Editorial and
design salaries will be included. As competition among publishers increases, publishers are forced to create more added
value to manuscripts and this increases the amount of new title costs and also WIP levels.
Faster schedules will reduce WIP levels. This can be achieved by better scheduling, use of in-house DTP and scanning
equipment, offering incentives to authors (for supplying manuscript on disk) or to staff and supplier for shorter lead-times.
One publishing survey indicated that those publishers who worked to short schedules also had the lowest levels of
typesetting corrections. Seeing the finished book on which they have worked motivates certainly many publishing staff.

Finished Inventory Entrepreneurs and bankers are not attracted to many types of publishing
because of the high Inventory levels. In developed countries these are still high, but falling, for
the following reasons:

• Profit margins in publishing are not high

• Printers offer significant economies of scale for longer print runs. Publishers are persuaded
to print too many copies for too long a sales period. Publishers believe that book prices
must rise if they pay a higher unit cost for printing. Most publishers in the FSU also share
this view
 • Publishers will not always look at the Cashflow and Balance Sheet implications when
making decisions on print runs
• Publishers price books on the basis of a single printing
• Publishers are optimists
• Publishers do not invest heavily in promotion
• Most publishing courses teach full-cost costing for the pricing of investment decisions
• Book sales are highly seasonal
• Production staff are chosen for their design and technical rather commercial skills. The
trend in most industries is for professional buyers, not (printbuying) specialists in a
particular industry

In younger economies publishers face a different scenario. Publishers in developed economies will
print in several countries either for financial reasons or in order to print at a source close to
customers e.g. North America; Asia for the Australasian markets.

Printers in young economies will seek to export printing to developed countries to earn hard
currency In order to break into these markets they will quote low prices on short print-runs in
order to enter the market. However, their local publishers are often forced to operate to the
printer’s terms of trade and pay higher prices. In order not to lose sales by being out-of-stock,
publishers may print excessively large print runs. In addition, the culture of printing for 3 or 5
years as was the norm in the FSU, prolongs these attitudes especially among state publishers.

The subject of inventory levels and optimum print runs is so central to book publishing that it is
discussed in great detail in chapter 7

The following will assist in reducing inventory levels:

Ways of reducing Explanation

Inventory
Closer co-operation with Publishers co-operate closely with one or 2
“partnership” printers printers; contract on an annual basis;
forward plan together. A partnership but
with no final investment in the other
partner.
Market Research and Pre-selling before books are printing allows
advance selling publishers to fix more exact print runs
Increased promotional Promotion and greater sales effort in less
activity promotion obvious areas e.g. smaller towns, may cost
less than interest payments to banks
Use of series and The use of standard (or a small number of)
standard formats formats means that capacity can be booked
with printers, paper purchased in bulk. The
exact print quantities per title are fixed later
on a monthly basis.

This is used for standard format paperbacks.

This policy is as much about purchasing
policy as printing machinery constraints.
Selling stock firm to an This was the procedure in the FSU. Today
exclusive distributor most of these state distributors have
collapsed or split up. Distributors will
demand large discounts for carrying the risk.
 In many cases they will sell in the capital city
and large towns only. The distributor is
needed for expanding sales into smaller
towns and rural areas. The use of more than
a single channel of distribution encourages
competition and improved sales
Sales Incentives, It may be appropriate to offer larger
discounts discounts or incentives to customers and
distributors
Printing contracts The negotiation of price schedules with
equal emphasis on low make-ready costs

Accounts Receivable Obtaining money promptly from customers is a major problem in

publishing (and all industries) worldwide. Market leaders and dominant organisations will be paid
more promptly as their customers fear losing the profits that they earn from such sales.

In many countries over 10,000 new titles are published each year. Bookshops will sell several
thousand titles. The rate of sale of books is slow.

In order to encourage booksellers to stock titles credit is offered. With newspapers and magazines
the product has a short shelf life but the cash cycle is short. In addition there are only a small
number of magazines or newspapers relative to the number of books published. Customers ask
for their regular magazine or newspaper.

When selling to more distant customers e.g. in another country, credit is offered to take account
of the time required to transport and distribute the books.

In some countries the supplier has the statutory right to demand interest on overdue invoices.
These schemes are in practice less useful than they appear as customers may use suppliers as a
bank.

Another key reason is that most customers in the book trade are under-financed. Rather than
raise additional share capital or bank loans, they use trade credit with their suppliers, the
publishers. This is partly because many customers may be privately owned but also because the
low return on capital from bookselling does not attract investment easily.

In order to encourage booksellers to buy new books, publishers will often offer to sell on a “sale-
or-return” or “sale and exchange” basis.

Under sale-or-return basis the bookseller may send back stock not sold after an agreed number of
months. The bookseller must settle the invoice on the agreed date and will subtract returns from
subsequent invoices. In the case of “sale-or-exchange” the bookseller may return unsold titles in
exchange for purchasing the same number of similar new titles. This is used widely for
paperbacks and is particularly prevalent in North America for hardback editions also. The
Accounts Receivable figure must take account of the fact that the amount invoiced may exceed
the amount that will later be paid. This makes cashflow forecasting difficult. Most publishers
prefer to agree larger discounts but sell firm.

Booksellers who pay late are in fact taking a larger discount. If the publisher earns a 25% Return
on Capital, or approximately 2% a month, the bookseller is thus taking an additional 2% discount
for every month that payment is delayed.

Incentives are frequently offered for prompt or early payment. Many customers will pay late and
take the discount, however!
The value of such discounts can be assessed either by using the IRR or NPV function on a
spreadsheet or by the following formula:

The supplier offers credit terms of 30 days from delivery and acceptance. The supplier will accept
a 2.5% discount of the invoice amount if the invoice is settled in 7 days.

The following ways of reducing Receivables are used in book publishing and other industries in
developed countries

Method Comment
High Margin products If Retailers make a large profit from selling a
supplier’s goods, they may lose that profit if
they do not pay on time
Market leadership As for high margin products
Credit checking before This checks the credentials of the customer.
the contract is Many Associations of Publishers operate a
accepted credit committee for their members. Banks
offer a credit reference service also
Frequent and prompt If customers know that they can obtain books
delivery quickly and reliably, they can hold lower levels
of inventory. Many publishers focus on selling
books into rather than out of the bookshops
Formal methods of Bank drafts, Bills of Exchange, Letters of
payment Credit, guarantees. Bonds

Retention of In some countries ownership does not pass to

ownership the customer until the goods have been paid
for.
The accounts Invariably the accounts department will be
department expected to chase customer payments. Private
publishers will give it high priority and owners
will do it personally. It is quite different to most
financial accounting work and is a key priority
for firms. Firm persuasion is needed rather
than accounting skills.
Joint promotions, These may expand the market and cost less
merchandising than bank interest payments

Methods of payment Banks, suppliers and their customers are forced to find more complex
payment methods in order to gain competitive advantage. These are needed to expand trade and
to give confidence to encourage suppliers to enter into contracts. In order to stimulate credit
trade, banks created more formal payment methods. These are only as good as the financial
standing and reputation of each bank, supplier and customer.

The aims of these payments methods include the following:

• To protect the supplier

• To encourage the supplier to offer credit and more attractive prices
• To convince the supplier that he will be paid once the customer has taken delivery
• To act as collateral to the supplier in particular to obtain bank overdrafts or lower rates of
interests
• To reinforce the legal contract between supplier and customer
• To encourage foreign trade; to obtain governmental credit insurance

In practice young publishers are more likely to encounter formal methods of payment when
negotiating with foreign printers.

Typical documents include the following:

Method of Explanation
Payment
Bills of Checks drawn on the customer by the supplier for
Exchange payment at a future date. The supplier will hand over
delivery and customs documents once the Bill of
Exchange has been signed by the customer (for new
customers) or perhaps immediately with trusted
customers. The Bill may be deposited with the
supplier’s bank and allow a lower rate of overdraft
interest. Alternatively Bills may be endorsed in order
to pay a supplier.

Bills normally assure prompt payment but do not

guarantee payment

The use of Bills of Exchange must be agreed by both

parties during negotiations
Letters of The customer signs these at contract stage. The
Credit customer undertakes to pay in full provided certain
listed conditions are fulfilled. The conditions must be
capable of clear non-subjective interpretation by
courts.

They are widely used in North America. In other parts

of the world they tend to be used for larger and longer
contracts than Bills of Exchange. They are usually
regarded as more reliable than Bills of Exchange.
Bankers A bank, after debiting the customer’s account, will
checks issue a check to the supplier drawn on the same date.

The situation in young economies is quite different. Many of the items in the first table concerning
the collection of Receivables may not apply. Banks may not offer financial instruments such as
Bills of Exchange. Cash or deposits may be demanded wherever possible but distributors survive
on supplier credit. Often government departments will be slow payers. Publishers must therefore
take carefully researched risks and enter into alliances of mutual benefit.

Author royalties Authors receive advances against future royalty earnings. They serve also to
pay the author while writing. In most cases they are non-returnable. Thus if sales are low or slow
to emerge, the advance may be in excess of earned royalties and perhaps paid 2 years before the
total sum is earned from sales. In developed countries, trade publishers and paperback publishers
will expect to write-off large amounts of unearned royalty advances each year. The payment of
high royalty advances, as publishers bid for market share, is cyclical. The advance will be against
earnings over the term of the contract which will be for several years and several printings and
editions.

In many types of publishing, the publisher will find an author who will be contracted to write to a
specification; Artists, photographers and photo agencies will be contracted to provide illustrations
and photographs. The publisher than provides more added value by the author. In such cases the
level of advances and royalty rates will be lower. In other fields, e.g. academic publishing, authors
may write for no or minimal advance as the incentive is to increase their academic reputation.

Publishers should regularly e.g. quarterly or twice a year, review those titles where advances
have not been earned. Reprints may require the payment of no further royalties in cashflow
terms.

In young economies the local Society of Authors may insist on standard royalty terms and
advances regardless of the type of book or print run. The terms appropriate to approved
textbooks (print-run 100,000 plus) are quite different to those suitable for university publishing
(print-run 500-2000) or to authors of original novels. Established authors benefit hugely but resist
competition from new authors. Subject to the laws of the country and the availability of good
authors, most countries will need to study variations on standard author contracts if authors,
publishers distributors are to benefit from expanded book markets.

Computer programs exist for the monitoring and payment of author royalties. These are suitable
for publishers with large number of titles with complex contracts. However for most young
publishers a spreadsheet can be used to calculate the royalties earned, and payments due.

Prepayments to supplier In developed economies publishers may buy coeditions for the
exclusive licence to publish in a language from foreign publishers or book “packagers”. Packagers
concentrate on creating multi-language titles but sell the language rights to foreign and local
publishers; they do not involve themselves in the marketing or distribution of books. Typical
contractual terms for packager and coedition contracts involve stage payments, on signature, on
approval for press and on delivery. Publishers who buy from coeditions or packager products can
publish smaller print runs more economically and without using their own editors. For rights deals,
the publisher will purchase film and pay a royalty advance.

In FSU countries, many printers still demand payment in advance whereas in developed countries
60-90 days credit would be given to publishers. These are also Prepayments.

Payables In developed countries where printers compete aggressively on an international basis,

credit of 30 - 120 days is used to encourage publishers. Private publishers will remain loyal to one
or more printers who offer substantial credit. This credit reduces Working Capital levels and
replaces loan capital in many cases. Private publishers will often negotiate lower printing prices
than larger publishers will.
Customer payments in advance Coeditions have already been discussed under Prepayments.
Where publishers sell coeditions to foreign publishers they will receive advance payments which
will be “owed” to their customers until the books are delivered and accepted.

Summary

In developed economies, companies are forced to find innovative ways of reducing Working
Capital levels in order to maintain an acceptable Return on Capital Employed and in order to
survive. In most cases those companies, which are most market, oriented and involved in market
distribution e.g. retail groups will dictate terms to the producers. Where such compa-nies are
successful in expanding the market, the suppliers may benefit also.

EXAMPLE

In developed countries retailers of high priced items and items with slow stock turn, may refuse to
purchase inventory and will accept only merchandising deals where the inventory belongs to the
supplier until the products are purchased by a consumer. The retailer is this acting as a
commission sales agent only. The supplier is paid once the goods have been sold.

Investors, banks and suppliers support such companies provided that they are successful and
expanding. In many countries professional retailers are taking an increasing market share of
bookselling proving that bookselling is attractive to entrepreneurs. Booksellers compete against
other successful booksellers, against supermarkets, bookclubs. Printers, publishers, wholesalers
and retailers operate in a value chain.

However in young economies there is little understanding of the value chain or teamwork.
Printers, publishers, distributors and bookshops operate independently for survival. In the FSU,
printers, publishers and distributors operated like watertight compartments with no overlap of
responsibilities and reporting to different ministries. Working Capital was not a significant problem
for individual enterprises

Printers are accustomed to operating large factories and have to possess management,
commercial and accounting skills. Their long-term assets may be used as collateral for loans. At
the other end of the chain many state distributors have collapsed, as their vast inventories
became unsaleable; many book retailers deserted bookselling to sell higher margin goods. The
publisher is the least experienced business member of the chain: printers have business skills,
distributors have a short Working Capital cycle and collect cash. Publishers’ Balance Sheets offer
little potential for bank collateral. As a result publishers in young economies may feel initially at a
disadvantage to their printers and distributors.

Working Capital characteristics of different types of publishing

Publisher Developed country Young economy

School Medium. High WIP but for a
textbooks small number of titles; low
but seasonal Receivables;
Author advances low;
Payables average and
seasonal
High WIP; Low Inventory if
books are successful;
Receivables low and
seasonal. Printer
advances high as print
runs are often long.
 However printers are
attracted to the long runs
and the guaranteed
market and will start to
offer credit
University Medium. Similar to school High. Publishers will print
textbooks textbooks; larger lists. for several years.
Pricing competitive Receivables low as many
books are sold for cash in
university bookshops.
Professional Low. High WIP but small High WIP and Inventory.
books lists; Receivables low as Professional may pay a
many books are sold direct high price for imported
books but not for local
books
Trade High perhaps 35 – 40% of Medium if books are sold
Publishers turnover. Large inventory to distributors on
due to need to sell to a publication: high WIP as
wide market and due to use many titles; high author
of colour; High author advances. Low
advances and Receivables Receivables.
compensated by high
Payables
Academic Very high. This is making Very high. Similar
publishers the Internet and other characteristics to
electronic medium university textbooks but
attractive to Academic Working Capital levels
publishers and their higher
customers

Factors that reduce Working Capital levels From the table above we can infer the following
checklist of reducing Working Capital level in developed countries

• Small numbers of titles

• Need to buy rather than want to buy titles with unique information
• Use of standard formats for paper printing and binding
• Direct marketing
• Closer involvement in market distribution
• Publishing for clearly identifiable markets e.g. schools, doctors, accountants, lawyers
• Short run printing
• Book packaging
• Titles where printing costs are a low % of the selling price

Whether the same list will apply to young economies will depend on average wages levels and
other economic data such as the percentage of urban population to rural population. In developed
countries profitability for such publishers is linked to their ability to charge a premium price for
need-to-buy books. Computer books are a typical example: a typical PC will cost in excess of
US$1,000. Thus the selling price of a book that assists the user to make better use of the
computer and its software is linked to the benefit. In many young economies that may not yet be
the case.

The Value Chain - Supply and Marketing Decisions This chapter concludes by applying these
concepts to the Value Chain – printers, publishers, distributors and retailers and concludes by
studying in detail the title investment decision.

Most market innovations have arisen through co-operation between suppliers in the Value Chain,
and by the application of Return on Capital pricing. In general the supplier taking the greater risk
will be relieved of much of the Working Capital burden in order that the risk taker can invest in
selling and promotion costs to enlarge the market.

Company Comment Implications for publisher

Printers Fixed costs are high. Even if a printer adds only a
Profit Contribution % is 10% profit margin, the return
high if labour is regarded on capital may be high. Fast
as a fixed cost. Working jobs are very profitable when
Capital % of turnover measured in terms of return
low. (assumes that on Working Capital. Because
publishers supplies of the large fixed costs,
paper). Printers now printers can vary prices if
compete on an they need to attract more
international basis using work to fill their factories.
similar machinery. Many Book printing is regarded as
reproduction prices have one of the more profitable
fallen by over 1000% in parts of the printing industry
the last 15 years.
Distributor Profit Contribution % Distributors will concentrate
(who stores, low. Working Capital as on selling the more saleable
transports and % of turnover also low. titles into the largest towns.
sells) Payback period short. Therefore many titles are
never seen in many parts of
Distributors will usually the market unless the
have a very low territory is divided up
capitalisation. If they do between distributors.
not sell enough books,
they cannot pay
publishers or buy new
stock
Commission Low profit per 1USD of Only one profit margin is
Sales Agents turnover but almost no added as the publisher sells
Working Capital directly to the retailer rather
involved than to distributors. The
publisher carries the total
Working Capital burden.
Retailers Contribution % quite The prices and profit margin
high, Working Capital % on books are both low.
of turnover medium if
the shop is reasonably
successful.
Bookclubs Low Receivables; high Bookclubs create and
Inventory; Very high maintain a customer base
entry costs before
bookclubs make a profit
and generate cash.
Advertising costs high
Publisher’s Higher fixed costs as Publishers can sell direct to
 own sales salary costs have to be the larger shops in large
force paid but faster turnover towns
of inventory follows if
sales turnover increases
Direct Higher fixed and Higher contribution and
marketing variable costs but, if reduced Working Capital
successful, this is amply levels. Higher Break-even
compensated by the point
absence of a discount to
distributors of retailers

Possible Solutions In financial terms there are three main choices:

• To raise more finance in order to be able to take a longer term view of publishing
• To develop innovative solutions involving the use of Working Capital to make books more
affordable to more people and hence expand the market. This has to be linked to a
marketing campaign carried out jointly with distributors, bookshops and other sales
agents.
• To change publishing policy and publish for different more attractive markets; develop
teamwork with partners who have common needs

It is interesting to note that many publishers in young economies have chosen to diversify into
trade book, often in colour and with long print runs, in order to pay for overheads. As the table
above shows, trade publishing, based on the developed country model, usually has the highest
level of Working Capital.