3.

WORKING CAPITAL MANAGEMENT

3.1. Definition and Terms
Working capital management concerned with administration of firm’s current assets and the
financing needed to support the investment in current asset.

Working Capital Management: Is a managerial accounting strategy focusing on

maintaining efficient levels of both components of working capital, current assets and
current liabilities, in respect to each other. Working capital management ensures a
company has sufficient cash flow in order to meet its short-term debt obligations and
operating expenses.

Working Capital Concept:

 Gross working capital: Investment in current assets
 Net working capital: Difference between current assets and current liabilities

NWC = CA – CL

 Net working capital is one of the measures of liquidity.

 When dealing with working capital, the term Gross Working Capital is mostly used.

3.2. Importance of Studying Working Capital Management

 In many firms, current assets form significant portion of the total investment

 The level of working capital of a firm change from time to time due to
variations in the level of activities, therefore working capital policy has impact
on the day to day operations.

 Excessive holding of current assets is likely to lead to loss of income, at the

same time inadequate working capital may affect the firm operations.

 Working capital decision have impact on the firm risk, return and share price

 Working capital management is of particular important to small firms which

are expected to invest much in current assets and to employ more short term
debt (current liabilities).

3.3. Classification of Working Capital (Current Assets)

Working capital can be classified by either components or by time:

i. Classification by components:
- Cash
- Amount receivable
- Inventories

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ii. Classification by time:

- Permanent working capital (current asset)
- Temporary working capital (current asset)

(i) Permanent Current Asset

Minimum level of current assets that a firm must maintain throughout. The investment here is
similar to investment in fixed asset as:
- It is long term in nature.
- As a firm expands, invest more in fixed assets, same in current assets.

(ii) Temporary Current Asset

The amount of current assets that vary with seasonal requirements. Temporary current asset
fluctuate from time to time depending on the level of production and sales resulting from
changes in the market condition.

3.4. Working Capital Policies

Are the firm basic guidelines on investment in current assets and the financing used to support
the investment. It involves decision in two major issues:

i. Optimal investment in current assets, and

ii. How to finance the investment
- Short term funds
- Long term funds

These two decisions are influenced by the tradeoff between Return and Risk.

3.4.1 Current Assets Investment Policies

There are in general three current assets investment policies:

i. Relaxed Current Asset Policy

Involves holding relatively large amount of current assets. The policy implication
is
- reduced return
- exposed to less risk

ii. Restricted Current Asset Policy

Investment in current assets is minimized. Implication is
- greater return
- exposed to greater risk

iii. Moderate Current Asset Policy

Moderate investment in current asset (implication: moderate return, moderate risk)
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3.4.2 Current Assets Financing Policies

This refers to a mode in which the investment in temporary current asset and permanent
current asset is financed. There are two major sources of financing

a) Long term sources of finance (long term debt and equity)

- Common stock (common shares)
- Preferred stocks
- Debt
- Retained earnings

b) Short term sources of financing

- Bank loans / overdraft
- Spontaneous financing (short term funds that are automatically
generated in the normal course of the business e.g payables, accrued
expenses)

Approaches to Financing Policies:

1) Matching Approach Policy

Involves matching the expected life of the assets with the expected life of the source of
fund used to finance the asset. Exactly matching is not possible as one may not be able
to establish the life of the asset and equity has no life.

Under this policy, fixed assets and permanent current assets are financed by long term
funds. Temporary current assets are financed by short term funds.

2) Conservative Approach Policy

Fixed assets, permanent current assets and part of the temporary current assets are
financed with long term funds. It relies on the use of long term funds.

3) Aggressive Approach Policy

Fixed assets and part of the permanent current assets are financed with long term funds
and part of the permanent current assets and all of the temporary current assets are
financed with short term funds.

3.5. Factors to Consider When Making Financing Decision

Short term funds v/s long term funds
1. Cost of financing
2. Risk – short term debt is risky than long term debt
Reasons: - Fluctuation in interest rate
- Short period of time to repay debt
3. Flexibility – short term debt more flexible than long term debt
4. Speed – short term debt can be obtained much faster than long term debt
5. Risk return trade

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3.6 Determinant of Working Capital requirements

1. Nature of the business – manufacturing firm invest much in current asset
2. Size of the business – larger firms require larger working capital than small firm
3. Production or manufacturing cycle
4. Firm’s credit policy
5. Growth of the business – as firm expand need more investment in current assets
6. Access to money market
7. Dividend policy
8. Tax policy

3.7 Receivables Management

Receivables arise as a result of credit sales of goods and services.

Credit or receivables management is concerned with administration of credit to customers so

as to maximize the wealth of the shareholders. It begins from the point when a decision is to
be made on whether or not to sale goods or services on credit to when cash is actually
collected from the customer.

The main reason for extending credit to customer is to promote sales and therefore to increase
a firm profit.

Extension of credit and holding of receivables is accompanied by increased cost. These costs
are:

1. Cost of capital / opportunity cost

Tied up funds could have been invested elsewhere to result to income.

2. Collection cost:
Administrative cost incurred in the process of extending credit and collecting from the
customers cash.

3. Delinquency cost
Arise as a result of the failure of the customer to make payment within a credit period.

4. Default Cost
Bad debts losses which arise when the firm is unable to collect cash from the customer

Receivable management involves tradeoff between benefit and cost.

The goal of receivable management is to determine the optimal level of investment in

receivable. The decision on investment on receivables will depend on incremental profit and
cost that will be involved.

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3.8 Factoring:
Is a process by which a factoring company will take over the management of the company
trade debt in return for a commission.

There are three types of factoring:

1. Debt Collection and administration

Company involved in management of sales ledger account and invoicing

2. Credit insurance
Factor Company will guarantee against bad debt

3. Finance provision
Factor Company advances some amount to the business and charge interest e.g
Factor Company can advance 80% of debt and the 20% is assumed to be funded by
overdraft.

Advantages of Factoring:
a. Provide faster and more predictable cash flow
b. Finance provided is linked to sales
c. Growth can be financed through sales rather than through external funds
d. Business can pay suppliers promptly
e. Management of company can concentrate on managing rather than chasing debt
f. Cost of running sales ledger department is saved.

Disadvantages of Factoring:
a. Interest charge cost more than other short term debt
b. Administration fee can be higher depending on number of debtors and complexity of
accounts as well as nature of debtors
c. Paying direct to factor company, customers will lose some contact with suppliers
d. Use of Factor Company is viewed on negative way especially in periods of financial
difficulties.

Question of whether to use Factor Company or not depend on the cost involved. To decide,
compare cost of using and not using a Factor Company.

Example:

SN Enterprises has annual credit sales of TZS 2M. Recently, the business has witnessed
increased problems in its credit control department. The average collection period for debtors
has risen to 50 days, even though the stated policy of business is for payment within 30 days.
Moreover, 1% of sales are annually written off as bad debt. The company has entered into

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negotiation with a factor who is prepared to make an advance to the company equivalent to
80% of trade debtors, based on the assumption that in the future customers will adhere to 30
days payment period. The interest rate for the advance is 11% per annum. Trade debtors are
currently financed at 12% through a bank overdraft. The factor will take over the credit
control procedure of the company. This will not only lead to an annual saving of TZS 15,000,
but also eliminate all bad debts. The factor will, however. Make 2% charge of sales revenue
for the provision of this service.

Should SN Enterprises take advantage of the opportunity to factor its trade debt? Why?

3.9. Credit Policy

Refers to basic guideline which form the basis of a firm decision to extend credit to customer

Credit policy includes the following variables:

1. Credit Standards
Basic criteria for extension of credit to customer, it is a minimum quality of credit
worthiness that a potential customer must possess to qualify for a credit from the firm.

A firm may adopt strictly or relaxed credit standard.

2. Credit Analysis
Procedures that are used to evaluate whether a potential credit customer meet th
prescribed credit standard

There are three major steps:

a. Gathering information on a potential credit customer
Sources of information include
- Financial statements
- Reports from banks
- Reports from other firms
- Report on the customer’s past payment pattern
- Report from credit rating agencies
- Other sources (news papers, trade journals etc)

b. Analysis of the credit information. Involve analysis of 5 C’s of the credit

i. Credit character
ii. Capacity – ability to pay / ability to earn
iii. Capital – firm’s financial position
iv. Collateral – assets pledged in case of default

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v. Conditions – other factors within and outside the firm that are likely to
affect customer ability to pay

c. Decision to extend or not extend credit

3. Credit Terms
Specify the length of time over which credit is extended to a customer and the discount
(if any), given for early payment

4. Collection Policy
These are procedures and measures adopted by a firm to collect overdue receivables
when customer fails to pay within credit period. Procedures and measures may
include writing letters, making phone calls, personal visits and legal action.

Example:

Sengerama Company is considering changing its credit terms from 1/10, net 30 to 2/10, net
40, relaxing its credit standards, and putting less pressure on slow paying customers. The
change is expected to increase sales and lower credit analysis and collection costs, but
discounts and several other costs would rise.

Sengerema Company’s sales are currently projected at Tshs. 36 million. Under its current
credit policy, 50% of those customers who pay do so on day 10 and take the discount, 40%
pay on day 30, and 10% pay late on day 40. Even though Sengerema Company spends Tsh.
546,300 per annum on analyzing accounts and collections, 4.5% of sales will never be
recovered.

The company’s variable cost ratio is 75% and its cost of funds invested in receivables is 20%.

The Co believe that these changes will lead to a Tshs. 7.2million increase in sales per year.
Analysing and collection of accounts receivable will cost Tshs. 336,300 per annum under the
new credit terms.

Management of the Co believes also that 60% of the customers who pay will take the 2%
discount and bad debt losses will total 7% of sales. Half of the remaining paying customers
will pay on day 40 and the remainder on day 55.

Required:
Find the expected change in Net Income if the Co implements the proposed changes.
Comment on the proposed changes in Sengerema’s credit terms. Assume
applicable corporate tax rate is 40% and 360 day year.

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3.10. Inventory Management

Inventories are goods held by a firm and owned by a firm for sale in ordinary course of the
business.

 Types of inventories:
i. Materials
ii. Work In Progress (WIP)
iii. Finished Goods

 Inventory may form significant portion of current asset in manufacturing firm

 Reasons for holding inventories

i. To ensure even production and sales operations
ii. To meet unexpected increase in demand of product
iii. To secure quantity discount
iv. Anticipation of future increase in price

 Role of Finance Manager in respect of inventory is on establishing optimal level of

investment in inventory.

ABC System of Inventory Management

Is an inventory control technique that calls for greater control of expensive and important
items than on less expensive items. The system divides inventories into three groups, A, B and
C;

Group A: Most expensive items

Group B: Next expensive items
Group C: Least expensive items

Cost of holding inventories:

Excluding the price paid to buy for items, cost of inventory is divided into two components:

i. Ordering or set up cost

Clerical costs that are incurred in the process of placing and receiving
orders

ii. Carrying cost

Incurred in the process of maintaining inventories
 Cost relating to storage
 Opportunity cost

Total Inventory Cost = Ordering Cost + Carrying Cost

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Objective of financial manager is to minimize total inventory cost.

Economic Ordering Quantity (EOQ) Model

Is a tool used to determine optimal order quantity for an item of inventory.

Assumptions:
- Firm knows with certainty the requirement of item of inventory
- Inventory consumed at a constant rate
- Orders are received immediately on placement thus no safety stock maintained
- Ordering and carrying costs are constant over the range of possible inventory
levels under consideration

EOQ = 2CoD
Ch

EOQ = Economic (optimal) order quantity

D = Demand (total inventory requirement)
Co = Ordering cost per unit
Ch = Carrying (holding) cost per unit

Total Cost (TC) = Ordering Cost + Carrying Cost

TC = D.Co + QCh
Q 2

Re-order Point (ROP)

Is the level of inventory at which an order should be placed to replenish existing inventory

ROP = Lead Time x Daily Usage + Safety Stock

Limitations of EOQ Model

- Annual demand of inventory cannot be determined with certainty
- It ignores safety stock, in practice firm maintain safety stock
- Inventory may not be received immediately when orders are placed
- Daily usage may not be constant over time

Example:
A company is trying to improve inventory control system. Expected sales volume is
252,000 units per year. Ordering cost is 8/= per order, carrying cost is 4/= per unit. It
maintains safety stock of 200 units which is on hand. Compute
a. Optimal order quantity
b. Number of orders during the year
c. Average inventory in units
d. Total inventory cost including the safety stock

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e. Reorder point, assume lead time of 5 days and number of days in a year
252

3.11 Cash Management

Cash management is concerned with the managing of cash inflows, cash outflows and cash
balances held by a firm.

Cash
Money that a firm can immediately use to affect payments. Cash include coins, currency,
cheques, balances in current account and sometimes near cash assets like marketable
securities and short-term investment.

Importance of Cash Management:

 Cash is used to meet obligations.
 Cash is a non-earning asset.
 It is not possible to predict cash flow accurately.
 There is cost resulting from keeping cash on hand (opportunity costs).

Reasons (motives) for holding cash

i. Transaction motive:
Cash balances held to meet payments in the ordinary course of the business.

ii. Precautionary motive:

Cash balances held to meet unexpected future cash needs.

iii. Speculative motive:

Cash balance held to enable a firm to exploit profit making opportunities that may
arise in the future.

iv. Compensating balances:

Minimum balance that should be maintained in the bank.

Cash Management Strategies

The goal of cash management is to hold sufficient cash balance to meet obligations and the
same time to minimize the amount of idle cash.

Strategies:

1. Forecasting cash surplus or deficit over a given period of time in the future by the use
of Cash Budget or Proforma Financial Statement

2. Synchronization of cash flows i.e. matching cash receipt and cash payments.

3. Slowing down disbursements

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Delaying payment of accounts payables and accrued expenses by:
 Paying on the last day of credit period
 Centralizing the payment

4. Accelerating collection of receivables

Speeding up collection of cash from customers
- Early dispatch of invoices,
- Offer discount to customers who pay within specified time
- Reducing mailing, processing and deposit time by use of:

o Concentration banking – used by large firm with scattered

customers to collect cash. Customers in particular geographical area
are instructed to send cheques to local collection centre’s where
they will be deposited. Funds in excess of minimum required
amount are then transferred to the central or concentration bank
generally maintained at the company head office. The system
reduces mail and deposit.

o Local box system – a firm hires a postal office box at important

collection centers and customers are required to send their cheques
to such boxes. The local banks of the firm are authorized to collect
cheques from the customers in boxes. They deposit the cheques in
the firm account then send deposit slip and other details to the firm.

5. Determining Optimal Cash Balance:

Involve trade-off between the opportunity cost of holding too much cash and the
trading or transaction cost of holding too little cash (Baumol Model)

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Exercise: Describe the following terms:

1. Capitalization

2. Over capitalization

3. Under capitalization

4. Over trading

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Circulating Working Capital

FA
Sundry Credits Bank O/D

Taxes

Utilities Bad debts

Suppliers

Wages LTD

CASH

Debtors

Raw Mats
Labor
FOH
Equity Capital

WIP Sales

Finished Profit

Goods Losses

Example on Calculating Optimal Cash and Cash Budgeting

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