TREASURY MANAGEMENT:

WORKING CAPITAL MANAGEMENT

MR J MACHINGAMBI
 Working capital is defined as a company’s current assets
minus its current liabilities
 the primary components of working capital are cash,
accounts receivable, inventory, and accounts payable.
1. Credit Management
 There are no receivables unless a company elects to extend credit to
its customers through a credit policy.
 Thus, proper credit management is key to the amount of funds that a
company must invest in its accounts receivable.
Loose Credit policy
 A company has a specific reason for extending an inordinate amount
of credit, even though it knows there will be above - average credit
defaults.
 High product margins, such as in the software industry, and so have
little to lose if a customer defaults on payment.
 May be intent on gaining market share, and so will “ buy ” sales with
a loose credit policy, which essentially means they give liberal credit
to everyone.
 A company may be eliminating a product line or exiting an industry,
and so is willing to take some losses on credit defaults in exchange
for selling off its inventory as expeditiously as possible.
Tight credit policy
 Product margins are small, or
 the industry is an old one with little room to gain market
share.
 a recessionary environment may require a fi rm to restrict its
credit policy, on the assumption that customers will have
less money available to make timely payments.
Changes in Credit Policy
 Any change in a company’s credit policy can have a profound effect
on the funding requirements that a treasurer must deal with.
 Example:
 For example, if a $48 million (revenues) company has receivables
with an average age of 30 days, and its wants to enact a looser credit
policy that will increase the average receivable days to 45 days, then
the company ’ s investment in receivables is going to increase by 50
percent, from $4 million to $6 million. Consequently, the treasurer
must be prepared to find $2 million to fund this increase in working
capital
 In many companies, the treasurer has direct control over the
credit policy and, indeed, over the entire credit granting
function.
 This is a wise placement of responsibility, since the
treasurer can now see both sides of the credit policy — both
the resulting change in sales and the offsetting change in
required working capital funds.
 The treasurer can set up a considerable number of credit
controls to reduce the probability of default by customers.
 Credit Controls
1. Issue credit based on credit scoring. There are several credit -
monitoring services, Financial Clearing Bureau (FCB).
The treasury staff can create a credit - granting model that is based on a
mix of the credit scores of these services, the company ’ s history with each
customer, and the amount of credit requested.
2. Alter payment terms. If a customer requests an inordinate amount of
credit, it may be possible to alter the payment terms to accommodate the
customer while still reducing the level of credit risk.
For example, one - half of a sale can be made with 15 - day payment terms,
with the remainder of the order to be shipped upon receipt of payment for
the first half of the order. This results in payment of the total order in 30
days, but with half the risk.
3. Offer financing by a third party. If the treasury department is
unwilling to extend credit, then perhaps a third party is willing
to do so. This can be a leasing company or perhaps even a
distributor with a loose credit policy.
4. Require guarantees. There is a variety of possible payment
guarantees that can be extracted from a customer, such as a
personal guarantee by an owner, a guarantee by a corporate
parent, or a letter of credit from a bank.
5. Perfect a security interest in goods sold. It may be possible to
create a security agreement with a customer in which the
goods being sold are listed, which the company then files in
the jurisdiction where the goods reside. This gives the
company a senior position ahead of general creditors in the
event of default by the customer.
6. Obtain credit insurance. Credit insurance is a guarantee by a
third party against nonpayment by a customer. It can be used
for both domestic and international receivables. The cost of
credit insurance can exceed one - half percent of the invoiced
amount, with higher costs for riskier customers and
substantially lower rates for customers who are considered to
be in excellent financial condition.
7. Require a credit reexamination upon an initiating event.
 The treasury staff should review customer credit at regular
intervals to see if they still deserve existing credit limits. These
reviews can be triggered when the current credit limit is
exceeded, if a customer places an order after a long interval of
inactivity, if there is an unjustified late payment, or if a
customer stops taking early payment discounts.
2. RECEIVABLES MANAGEMENT
 Once credit has been granted to a customer, responsibility for
billing and collecting from the customer usually passes to the
accounting department.
 The ability of the accounting staff to reliably invoice and collect
in a timely manner has a major impact on the amount of working
capital invested in accounts receivable.
 Source of delays
i. Invoicing delay. Invoices should be issued immediately after the related
goods or services have been provided. If the accounting staff is billing
only at stated intervals, then receivables are being extended just
because of an internal accounting work policy.
ii. Invoicing errors. If invoices are being continually reissued due to errors,
then additional controls are needed to increase the accuracy of initial
invoices. This can be a serious issue, since invoicing errors are usually
found by the customer, which may be several weeks after they were
originally issued.
iii. Invoice transmission. There is a multiday mailing delay when invoices
are delivered through the postal service. Instead, the accounting system
should be configured to issue invoices by email or electronic data
interchange, or the accounting staff should manually email invoices.
iv. Lockbox receipt: Customers should send all checks to a
lockbox, so that checks are deposited in the minimum
amount of time, thereby increasing the availability of funds.
Where checks are received at the company location and then
sent to the bank, this creates a delay of potentially several
days before the checks are processed internally, deposited,
and then clear the bank.
v. Collection management: There should be a well - trained
collection staff that assigns responsibility for specific
accounts, focuses on the largest overdue account balances
first, begins talking to customers immediately after payment
due dates are reached, and is supported by collection
software systems.
vi. Internal error follow - up.
Treasurer’s role in Receivables Management

 The treasurer can periodically inquire of the controller if these

collection issues are being managed properly.
 Another approach is to obtain an accounts receivable aging report
and determine the reasons why overdue receivables have not yet
been paid.
 At a minimum, the treasurer should track the days receivables
outstanding on a timeline, and follow up with the controller or
chief financial officer if the metric increases over time.
3. INVENTORY MANAGEMENT
 Of all the components of working capital, inventory management
is the most critical because it is the least liquid and therefore
tends to be a cash trap.
 Once funds have been spent on inventory, the time period
required to convert it back into cash can be quite long, so it is
extremely important to invest in the smallest possible amount of
inventory.
Inventory Purchasing
 Lead time: Foreign source VS local source
 Manual processing of purchase orders to suppliers VS material
requirements planning system
 Gaining direct access to the inventory planning systems of key
customers to reduce estimation error
 Shifting raw material ownership to suppliers so that they own the
inventory located on the company ’ s premises.
 Bulk purchase of inventory: temptation to proclaim large per - unit
cost reductions, not realizing that this calls for much more up - front
cash and a considerable storage cost and risk of obsolescence.
Receiving Inventory
 Rejecting all inbound deliveries that do not have a purchase
order authorization.
 Immediate entry of all receiving information into the
company ’ s warehouse management system
Inventory Storage
 Drop shipping. Under this system, a company receives an order
from a customer and contacts its supplier with the shipping
information, who in turn ships the product directly to the
customer.
 This is a somewhat cumbersome process and may result in longer
delivery times, but it completely eliminates the company ’ s
investment in inventory and therefore all associated funding needs.
This option is available only to inventory resellers.
Inventory Storage

 Cross - docking . Under cross - docking, when an item arrives at

the receiving dock, it is immediately moved to a shipping dock for
delivery to the customer in a different truck. There is no put -
away or picking transaction, and no long - term storage, which
also reduces the risk of damage to the inventory.
 Cross - docking only works when there is excellent control over
the timing of in - bound deliveries, so the warehouse management
system knows when items will arrive.
Production Issues Impacting Inventory

1. Just - in time (JIT) manufacturing system

2. Avoid volume - based incentive pay systems
3. Acquisition of smaller, simpler machines having lower
maintenance costs .
4. Use smaller container sizes for reducing work in progress
5. reduce machine setup times
6. Cellular manufacturing , where a small cluster of machines are set
up in close proximity to one another, each one performing a
sequential task in completing a specific type or common set of
products.
Product Design Effect
1. Number of product options offered
 If there are a multitude of options, then a company may find it
necessary to stock every variation on the product, which calls
for a substantial inventory investment. If, however, it is possible
to limit the number of options, then inventory volumes can be
substantially reduced.
2. Number of products offered
 If there is an enormous range of product offerings, it is quite
likely that only a small proportion of the total generate a profit;
the remainder requires large inventory holdings in return for
minimal sales volume.
3. Payables Management
 The processing and payment policies of the accounts payable
function can have a resounding impact on the amount of funds
invested in working capital.
 Payables processing is managed by the accounting department,
and payment terms by the purchasing department.
 The treasurer does not have control over either function but
should be aware of the following issues that can impact funding
requirements.
 Payment Terms
 Payment Processing
 Intercompany Netting for intercompany payments
 Supply Chain Finance
 Under supply chain financing, a company sends its approved
payables list to its bank, specifying the dates on which invoice
payments are to be made. The bank makes these payments on
behalf of the company. However, in addition to this basic
payables function, the bank contacts the company ’ s
suppliers with an offer of early payment, in exchange for a
financing charge for the period until maturity.
WORKING CAPITAL METRICS
Average Receivable Collection Period

 This measurement expresses the average number of days that

accounts receivable are outstanding.
Inventory Turnover
 Conversion of Inventory into sales

 Number of days inventory is at hand.

Accounts Payable Days
 A calculation of the days of accounts payable gives a fair
indication of a company ’ s ability to pay its bills on time.
 If the accounts payable days are inordinately long, this is
probably a sign that the company does not have sufficient cash
flow to pay its bills.
 Alternatively, a small amount of accounts payable days indicates
that a company is either taking advantage of early payment
discounts or is simply paying its bills earlier than it has to.
Accounts Payable Days
Cash Conversion Cycle

 
The cash conversion cycle (CCC) is a metric that expresses the time
(measured in days) it takes for a company to convert its investments in
inventory and other resources into cash flows from sales.
 Attempts to measure how long each net input dollar is tied up in the
production and sales process before it gets converted into cash
received.
Days of Working Capital
 The days of working capital measure, when tracked on a trend line, is
a good indicator of changes in the efficient use of working capital.
 A low number of days of working capital indicates a highly efficient
use of working capital.
WORKING CAPITAL INVESTMENT POLICY
 Organisations have to decide what the most important risks
relating to working capital are, and therefore whether to
adopt a conservative, aggressive or moderate approach to
investment in working capital.
A CONSERVATIVE APPROACH
 A conservative working capital investment policy aims to reduce the risk of system
breakdown by holding high levels of working capital.
 Customers are allowed generous payment terms to stimulate demand, finished goods
inventories are high to ensure availability for customers, and raw materials and work in
progress are high to minimise the risk of running out of inventory and consequent
downtime in the manufacturing process.
 Suppliers are paid promptly to ensure their goodwill, again to minimise the chance of
stock-outs.
 However, the cumulative effect on these policies can be that the firm carries a high
burden of unproductive assets, resulting in a financing cost that can destroy profitability.
 A period of rapid expansion may also cause severe cash flow problems, as working
capital requirements outstrip available finance.
 Further problems may arise from inventory obsolescence and lack of flexibility to
customer demands.
AN AGGRESSIVE APPROACH
 An aggressive working capital investment policy aims to reduce this
financing cost and increase profitability by cutting inventories, speeding
up collections from customers and delaying payments to suppliers.
 The potential disadvantage of this policy is an increase in the chances of
system breakdown through running out of inventory or loss of goodwill
with customers and suppliers.
 However, modern manufacturing techniques encourage inventory and
work in progress reductions through just-in-time policies, flexible
production facilities and improved quality management.
 Improved customer satisfaction through a quality and effective response
to customer demand can also mean that credit periods are shortened.
A MODERATE APPROACH
 A moderate working capital investment policy is a middle way
between the aggressive and conservative approaches.
 These characteristics are useful for comparing and analysing

the different ways that individual organisations deal with

working capital and the trade-off between risk and return.
Note
 From the above lecture notes you must be able to do the
following:
1. Describe measures that can be used to improve the company’s
working capital management.
2. Distinguish between the three working capital investment policies