Introduction to Financial

Management

Lecture 2b – Obtaining and Managing

Working Capital
Learning Objectives
• To consider the four key elements of working capital in more depth
• To examine the methods of managing and controlling inventories
• To recognise the costs and perils associated with holding inventories
• To recognise the importance of ordering replacement inventories on time
• To examine the methods of managing accounts receivable through good
credit control and risk management
• To recognise the importance of managing payables
• To recognise the importance of managing cash and forecasting/budgeting
• To consider the best means of utilising cash flow surpluses
• To understand the nature of working capital policies employed by firms
Elements of Working Capital
• All of the following must be managed
1. Inventories
2. Accounts Receivable
3. Accounts Payable
4. Cash
1 - Managing Inventories

Manufacturing There needs to

Larger retail firms firms will have to be a balance
Firms have Small firms may
may have control Some firms will between the
different only have
considerable • Raw Materials use ‘scientific costs of
requirements for consumables to
levels of • Work in Progress, and control’ methods • Inventory shortages
inventory control manage
inventory • Finished Goods and
• Inventory holding
Control Methods

Economic Order Quantity (EOQ)
Model
• Used to find the optimum order size
for inventories
• Tries to minimise costs of ordering and
holding
Discounts for Bulk Purchases
• Purchasing large orders may provide
discounts that help reduce costs
Buffer Inventories
• Uncertainty in demand for inventories
and supply lead time may persuade a
firm to hold buffer inventories
• This reduces or eliminates risk of ‘stock
outs’
Inventory Costs

Holding Costs Cost of capital

Warehousing
Handling
Deterioration
Obsolescence
Insurance
Theft
Buying (Procurement) Costs Ordering
Delivery
Stock Out (Shortage) Costs Contribution from lost sales
Extra cost of emergency inventory
Costs of lost production and sales
Cost of Inventory Relevant especially when calculating discounts
Consequences of not ordering on time
If order is placed too late If order is placed too early Getting it right is
important during periods
of uncertainty in demand
Running out or when supply lead time
Too much is uncertain
of inventory
inventory
(stock out)

High holding
Loss of sales
costs

Loss of
Deterioration
production

Risk of perils
is higher
2 - Managing Accounts Receivable

This includes
• Interest charged on overdraft
Increase in profit from
Offering credit comes at a
that funds credit extra sales due to credit
cost
• Interest lost on cash not offsetting costs
received and placed in the bank
Managing Accounts Receivable

Monitoring payment
records constantly
• Needs good sales ledger
administration
• Examination of payment
records required
Using a system of in-house credit
• Creation of ‘accounts
ratings
receivable aged analysis’ is
•Helps to decide on credit limits for each
helpful customer and their credit terms
Example of Credit Utilisation Report
Customer Limit Utilisation

$000s $000s %

Alpha 200 120 60

Beta 80 55 69

Gamma 40 5 12.5

Delta 90 100 111

Epsilon 300 260 87%

710 540 76% average use


This allows the firm
to identify: highlight trends
Customers who may
want more credit
Extent to which the
firm is exposed to
receivables
The tightness of the
policy
•Can the firm make more
profit from offering sales
on credit?
•Does the firm offer credit
too easily?
Helps determine
It can help
extension of credit
but depends on
Level of exposure to
different industries Extra sales that
• Some industries may be
more credit would
more risky than others bring
Level of exposure to Profitability of any
different countries extra sales
Extra length of
average debt
collection period
Required rate of
return on
investment in extra
receivables
Credit Control Policy
Must consider

• Administrative costs of debt collection

• Procedures for controlling credit to individual customers
• Debt collection
• Extra capital needed to finance extension of total credit
• Cost of additional finance required for an increase in the volume of accounts receivable
• e.g. overdraft interest or cost of long term funds
• Any savings or additional expenses in operating policy
• Ways that credit policy could be implemented e.g.
• Giving receivables longer to settle accounts
• Offering discounts for early payment
• Effect of easing credit
Assessing Creditworthiness

Good practice before giving credit

• New customers to give two good references
(one from a bank)
• Credit ratings checked through Credit Rating
Agency
• Credit limit should be low until payment
warrants increase
• File should be kept about the customers and Company may devise its own credit-
reviewed yearly
rating system
• To include annual account and reports
• Extel cards for larger public companies –
details of accounting information
• Take advice from Department for
International Trade (DIT) and ECGD on
overseas firms
• Press comments should be referred to
• Staff member should visit the company
Collecting Amounts Owed
Benefits from collecting debts should exceed costs incurred

Process
• Agree credit terms
• Issue invoice
• Expect payment when due
• Important
• Ensure customer is fully aware of terms
• Have invoice drawn correctly and issued promptly
• Be aware of any possible problems from the customer’s systems
• Resolve queries promptly
• Issue monthly statements promptly
• Chase up overdue payments
• Send reminders to named individuals asking for payment by return
• Send second or third letters
• Send final demand stressing action to be taken e.g. no more supplies or credit
Important (continued)
• Chasing up by telephone is effective but time-consuming
• Personal visits are also time consuming
• Best used for important clients
• Notify debt collection section
• No more credit until amounts due are paid
• Pass debt collection to specialist collection section
• Larger firms will have their own section
• Institute legal action
• Last resort
• Hire external debt agency
• May upset customer
Early Discounts

Average credit This reduces

Discount offered must
periods can be investment in
be financially
shortened by early receivables and
worthwhile
settlement discounts interest costs
Bad Debt Risk

Different credit policies

will incur different bad
debt risk levels

Higher turnover from • Bad debt and

easier credit terms
should bring enough • Extra investment
profit to exceed costs required to achieve
of: higher sales
Credit Insurance

Possible for certain

approved debts to be Specialist insurance Cannot insure all
covered against going firms provide cover losses
bad
Factoring
Arrangement for Factor advances
debts to be collected proportion of money Factor’s role
by a ‘factor’ company due

Administers invoicing, Provides advanced

Provides credit
sales accounting and payments – collects
protection for debts
debt collection debts later

Factor takes the risk

in a non-recourse
agreement

Firm retains the risk

in a with-recourse
agreement
Benefits and Disadvantages of Factoring
• Frees up cashflow

Benefits to •
•
Can use cashflow to take advantage of discounts
Growth comes from sales not from external capital
• Finance is linked to sales
firm • Frees up management time spent on slow payers
• No costs of sales ledger department and internal debt control

• Payment is made to factor (poor customer relations)

Disadvantage • May suggest firm is desperate for cash (financial
stability questions)
Export Credit Insurance

This is insurance against risk

of non-payment by
Benefits Drawbacks
overseas buyers for export
debts
• Avoids lengthy and • Premiums are very high
expensive court cases
• Provides for a variety of
risks in addition to failure
to pay on time
3 Managing Trade Accounts Payable

Process involves: Management involves

• Obtaining credit terms • Obtaining satisfactory

from suppliers credit from suppliers
• Getting credit extended, • Extending credit during
and periods of cash shortage
• Maintaining good • Ensuring good relations
relationships with regular and
important suppliers
4 – Managing Cash
• Why is cash needed?
• Transactions motive
• Cash required for day to day expenses
• Payroll, payment to suppliers etc.
• Finance motive
• Cash for major items
• Repayment of loans
• Purchase of non-current assets
• Precautionary motive
• Held as safety net against unplanned expenditure
• ‘buffer’ inventory
• Speculative motive
• Held to take advantage of market opportunities
• How much cash is needed?
• Consider the problems of:
• Holding too little
• Holding too much
• Need to balance liquidity with profitability
Cash Flow Problems
Making losses

Inflation
• May be profitable but not making enough to replace assets

Growth
• More non-current assets may be needed
• May have to support higher inventories and accounts receivable
Seasonality
• May be times when cash outflow is high but inflow is low

One-off Expenditure
Problems of not holding enough cash

Poor industrial relations

• Industrial action could follow
e.g. late payment of wages
• Damages production in the
short term
Loss of settlement • Damages relationships and
discounts motivation in the longer term

Loss of supplier goodwill Potential liquidation

• Refusal by suppliers to offer • Creditors may petition to wind
further credit up the company if bills are not
• Suppliers may charge higher paid on time
prices or lower their priority in
processing orders
Possible solutions to cash problems
Curtail activities

Find alternative
Take on extra staff
sources of cash
to reduce
e.g. long term
overtime costs
loans; factoring

Reduce pay rates

Speed up debt
in favour of profit
collection
share or bonus

Postpone or Delay payments to

reduce dividends accounts payable
Cash budgets and cash flow forecasts

Cash forecast -
Cash budget -
estimate of cash
commitment to
receipts and
plan for cash
payments for
receipts and
future period
payments for
under existing
future period
conditions
Use of Cash Budgets

Assessing and Planning for cash

Comparing with
integrating shortages and
actual spending
operating budgets surpluses
Cash Flow Forecasts

Forecasts prepared from any of:

Planned receipts and payments
• Based on predictions of sales and cost of sales
and timings of cash flows that come from
these
• Normally used for short term cash forecasts
Balance sheet predictions Working capital ratios
• Based on predictions of future balance sheets • Future cash and funding needs come from
• Comprise all items except cash – this becomes ratios
the balancing figure
• Normally for long term forecasts

Note the difference between the forecast and the budget

Usefulness of Cash Flow Forecasts
• Helps identify potential issues
• Allows managers to take action to avoid them
Cash Position Appropriate Management Action

Short term surplus • Pay accounts payable more quickly to obtain discount
• Try to boost sales by increasing receivables and inventories
• Make short term investments
Short term deficit • Increase payables
• Reduce receivables
• Ask for an overdraft
Long term surplus • Invest long term
• Expand
• Diversify
• Replace or update long term assets
Long term deficit • Obtain long term finance e.g. share issue or debt/bond sale
• Look at shutdown or disinvestment
Dealing with surplus cash
Depends on
• Liquidity needs (short term investments?)
• Profitability (how much return for the risk taken?)
• Safety (avoid a capital loss – check credit rating)

Should investment be
• Fixed or floating interest rates?
• A specific term? (penalties for early withdrawal)

How easy will the investment be realised?

Does a minimum amount need to be invested?

Dealing with Surplus Cash (cont’d)
Can
international
markets be
accessed?

Should cash be Usual One off

returned to annual special
shareholders? dividends? dividend?

Could shares be Raises

bought back and earnings per
cancelled? share figure
Short Term Vehicles

Investment
Deposits
• Short term debt
traded instruments Bank or equivalent
• Certificates of
Deposit
• Treasury Bills Money market lending at LIBOR rates
• Longer term debt (LIBOR to be replaced in 2021 with
traded instruments Secured Overnight Financing Rate – SOFR)
(stock market)
• Shares in listed
Local authority (overnight to one year and over)
companies

Finance house time deposits

Working Capital Requirement

Found by calculating the value of:

• Current assets less (Usually by taking averages over a
• Current liabilities one year period)
Working Capital Policies – Analysis of Assets
Permanent Fluctuating
Fixed assets current assets current assets Matching
principle: long-
term finance used
for long-term
Current assets Why assets, short-term
needed in order finance used for
to continue permanent? short-term assets
operating e.g.
They must be
replaced with
Some stock similar assets

Rapidly depreciating
assets e.g. Computers
Working Capital Policies
– Moderate Policy

Matching principle is
Short-term finance applied with this
used for fluctuating approach to financing
current assets working capital.

Long-term finance
used for permanent
current assets and
fixed assets
Working Capital Policies – Aggressive Policy
Short-term funds Greater use of
used for fluctuating short-term funds
asset and some gives higher risk
permanent current but higher
assets profitability

Long-term funds Choice of policy

used for fixed rests on the
assets and some attitude of the
permanent current company to risk
assets and return.
Working Capital Policies – Conservative Policy

Long-term funds Increased use of

Short-term funds
used for Short-term cash long-term finance
used for part of
permanent and surpluses may lowers risk but
fluctuating
some fluctuating arise decreases
current assets
current assets profitability.
Method of financing

Cumulative Fluctuating current assets

Type of
assets funding

Permanent current assets

Long-
Fixed assets term
funds

Matching policy
Method of financing

Cumulative Fluctuating current assets

Type of
assets funding

Permanent current assets Long-

term
Fixed assets funds

Conservative policy
Method of financing

Cumulative Fluctuating current assets

Type of
assets funding

Permanent current assets Long-

term
Short-term Fixed assets funds
cash surplus

Conservative policy
Method of financing

Cumulative Fluctuating current assets

Type of
assets funding

Permanent current assets

Fixed assets Long-

term
funds
Aggressive policy
Other Influences on Working Capital Management
Management of
Industry Products working capital
norms can depend on

Production
Important for Size of the
process time
management
will have organisation
of receivables
major impact

It’s not easy to Long work-in-

offer shorter progress cycles Degree of
payment terms will extend centralisation
than competitors working capital
cycle

Some Attitude to
industries risk
have longer
period for
certain Previous
products funding
decisions
Summary
• Working capital comprises four key elements that much be managed
effectively, namely inventories, receivables, payables and cash
• Various recognised control methods exist for inventories in order to reduce
or contain the costs associated with holding these
• Credit control is key to managing receivables but care is required in
exercising this control
• Discounts, control of bad debt, factoring and insurance are means of
controlling credit
• Supply chain management and relationship building is key to payables
• Cash is the most important element of the working capital cycle
• Cash surplus must be used effectively
• Different business will adopt different working capital policies (matching,
conservative, aggressive)
Recommended Reading
• Watson and Head (8th Edition) – Corporate Finance - Principles and
Practice – Chapter 3 pp 77-104