1.

Working Capital Terms

Working capital: current assets (3 primary assets – inventories, accounts receivable & cash) –
expected to be converted into cash < 1 yr

Net working capital: current assets less current liabilities

Working Capital Policy: basic policy decisions on (1) optimal level of investments in current assets &
(2) optimal financing of current assets

Investment in net working capital affects the risk & return of firm, its cash flows & liquidity as well
as its ability to operate efficiently

Working Capital Management: administration of current assets & current liabilities within the
working capital policy guidelines

Working capital cycle: period that cash is tied-up in working capital of entity

Working Capital Cycle

Ratio Analysis

1 Raw material inventory days: RM inventory / Purchases x 365 days

2 WIP inventory days: WIP inventory / Cost of Production* x 365 days *if not available  use cost of sales

Use avg. inventory for inventory days:

3 FG inventory days: FG inventory / Cost of Sales x 365 days (opening stock + closing stock) / 2

4 Debtors days (credit sales): Debtors / Credit sales* x 365 days *if not available  use sales

Creditors / Credit purchases* x 365 days *if not available  use purchases
5 Creditors days:

Transfer
Purchase raw Finished Credit Cash
material
materials goods sale received
to factory
1 45 2 35 3 50 4 60 Working
capital cycle:
5 90 days 60 days 190 days

Creditors PMT period Debtors collection period

Net working
100 days capital cycle:
190 – 90 =
Period in which financing is required
100 days

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Working Capital Policy

 Appropriate level of investment in current assets & how to finance it

 Obtain balance between return generated & risk entity is exposed to

Return
Inventory, debtors, Want to reduce  capital
cash tied up is costly
Creditors Want to increase as free
financing saves money
Risk
Low investment is risky (shortages, etc)
High investment lowers risk (up to a point) but
rate on return is lower
The higher the levels of finance through
creditors, the higher the risk

Management  shorten working capital cycle to improve cash flows

- Reducing time taken to:

o Convert raw materials into FG
o Sell FG
o Recover cash from debtors
- Reducing time between receiving & transferring raw materials to production
- Lengthening time taken to pay creditors

Conservative vs Moderate vs Aggressive working capital policies

Short-term deposits Short-term financing Least risky, but
lowest return
Conservative  cost of long-
financing term finance >
Long-term financing finance earned
policy
on short-term
Current ratio ≥ 4 deposits

Short-term financing Match maturity

Moderate structure of
financing current assets
Long-term financing policy and liabilities

Current ratio ≥ 2

Most risky, but

Short-term financing highest return.
Aggressive Net current
financing liabilities in SFP.
Risk of inventory
Long-term financing policy & cash shortages
Current ratio ≤ 1.5

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 Current Asset Management & Short-term financing

Management of debtors, inventories & cash

Analyse cost of financing working capital with trade credit, factoring & short-term bank financing

Credit Policy

Market pressure “forces” entity to offer credit facilities  weigh significant costs {cost of bad debts,
cost of financing debtors & administrative costs of managing debtors} against ability to generate
extra sales

Credit policy  creditworthiness & collection policy & settlement discounts

Customer’s attitude
(commitment to paying debts),
credit history, financial positon,
security offered & environment
customer’s operates in
Collection policy, procedure &
age analysis, influences  sales,
collection period, losses from
bad debts, % of customers who
take discount
2/10 net 30  2% if PMT > 10 days,
otherwise full PMT > 30 days
Balance cost of discount against
benefit of cash flow
Would attract more customers &
reduce avg. collection period

Effect of change in credit policy for debtors → if take into account tax, everything except working capital =
AFTER TAX!

If new policy is implemented R R

Increase in gross profit:
R(increase in sales) x GP% XXX
Increase in bad debts:
New policy:
R(new sales) x %(customers who don’t take discount) x %(bad debts) XXX
Old policy:
R(old sales) x %(customers who don’t take discount) x %(bad debts) (XXX) (XXX)
Increase in discount cost:
New policy:
R(new sales) x %(customers who take discount) x %(new discount) XXX
Old policy:
R(old sales) x %(customers who take discount) x %(old discount) (XXX) (XXX)
Change in opportunity cost of investment in debtors:
Can be all working capital! :. (+) ↑

Average investment in debtors:

in creditors ; (-) ↑ in inventories

New policy:
R(new sales) x %(customers who take discount) x (discount days)/365 XXX
R(new sales) x %(customers who don’t take discount) x (net days)/365 XXX
NEW AVERAGE XXX
Old policy
R(old sales) x %(customers who take discount) x (discount days)/365 XXX
R(old sales) x %(customers who don’t take discount) x (net days)/365 XXX
OLD AVERAGE XXX

Net increase in investment XXX

Opportunity cost @ X% (given cost of capital – use that!) (XXX)

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NET ANNUAL BENEFIT (SAVING) / LOSS XXX

Inventory management

Cost to carry inventory vs risk of “out of stock” & lost sales

Balance costs that increase with larger stock holdings & costs that decrease with larger order sizes

Inventory models:

- Economic Order Quantity (EOQ)

- Just-in-time (JIT) Study unit
- Supply Chain Management (SCM) 3.1 -3.4
- ABC (analysis of inventory for control purposes)

Cash Management

Keeping large amounts of unutilised cash on hand  high opportunity cost

4 main reasons to hold cash:

- Transactions  sufficient cash to make PMTs

- As a precaution  cash flows are unpredictable, need reserve for unforeseen transactions
- Speculation  take advantage of bargain purchases that may arise
- Loan covenants  banks might specify amount of liquidity that co. needs to maintain

Financing current assets

1. Accruals
- Continually recurring short-term liabilities  accrued wages, taxes, interest
- Free finance  no interest paid on funds raised through accruals
2. Trade credit
- Spontaneous source of financing
- Free trade credit  during period of discount
- Costly trade credit  forgone discount
3. Factoring of debtors
- Generate cash flow  selling accounts receivable to lender with/ without recourse to
borrower
- Advantages:
o Factor has expertise to assess credit risk of customers & factor’s proficiency in
managing receivables may result in reduction of bad debts
o Co. saves costs of managing accounts receivables, administration, collection & credit
control
o Co. doesn’t have to offer expensive discounts to encourage early PMT
o Management time can be focused elsewhere
- Disadvantages:
o cost of factoring will normally be > bank overdraft rate
o factor would hold a retention % of outstanding accounts receivable
- A credit card is an example (credit card co. pays retailer and collects PMT from card holder)

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 4. Bank overdraft
- Interest on overdraft  calc. effective interest rate
5. Bankers’ acceptances (bank bills)
- Bill of exchange issued by Co. with stated maturity of normally 90/180 days, accepting bank
guarantees PMT to discount house on maturity date, borrower endorses the back of the
bill, which indicates liability to accepting bank on due date
- Minimum of R1million (have to be a very large Co. with a high credit rating)

Short-term financing:

- Advantages:
o Lower cost  usually lower interest rates
o Fast  funds can be available within days
o Lower credit checks & formalities  funds outstanding for shorter period &
administrative formalities are reduced
o No loan covenants & pre-payment penalties  no specifications in relation to
financial ratios
o Flexibility & matching  Co. with seasonal trading patterns require funds for short-
term periods  match financing requirements with right type of financing
instrument
- Disadvantages:
o Volatility of interest rates  ST interest rates are more volatile than LT interest rates
o Risk of non-extension of facility  banks might refuse to offer extensions

Effective cost of trade credit

Cost of lost discount:

K = D/ (100 – D) x 365/ t

K = effective cost (as an annual interest rate)

D = discount rate
t additional days credit if not paid within discount period (if credit period = 45 days & discount period = 10 then t = 35 days)

Compare lost discount rate to bank overdraft rate (if cost of discount > overdraft → take discount!)

Cost of factoring
Sales (all on credit) S
Accounts receivable
(S x avg. debtors days / 365) D
Less: Retention by factoring house (X% x D) (XXX)
Net debtors A
Cost of factoring
- Service facility (X% of S) (XXX)
- Finance facility (X% of A) (XXX)
- Admin cost saving (RXX) XXX
Net cost of factoring B
Advance received (net debtors) A
Net Cost (B)

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Avg. effective cost p.a. (B ÷ A) XX,X%

Concept of overtrading

CO. grows too fast with too little long term capital  long term growth is thus financed with short
term capital

- Significant & fast growth in sales

- Increases in assets financed with creditors & bank overdrafts
- Weaker liquidity ratios

Methods to improve Cash flow

- Defer capital expenditure

- Shorten working capital cycle (quicker collection of debtors)
- Sell financial investments & low return assets
- Defer PMTs (negotiate with suppliers)
- Re-capitalise with new shares issue