Working Capital Management

Viktoria Solutions

06/02/22 SU - 2011
 Class Plan
CAT 1
8 13-Jan
  Cost of Capital- Practicals
Capital Structure discussion
9 20-Jan Practical's finish
  Review Take Away Question
Presentations
10 27-Jan
  Discuss Dividend policy
 
02-Feb Make up class Working capital Mngt
 
11 03-Feb   Working capital Mngt
CAT - 2
12 10-Feb
  Working capital
13 17-Feb   Corporate Governance - Theory
14 24-Feb   Corporate Governance - Speakers
15 02-Mar   General Revision

10/25/2011 ViKtoria Solutions 2

 Objectives
• Describe the nature of working capital and identify its
different components
• Identify the objectives of working capital management in
terms of liquidity and profitability, and discuss the conflict
between them
• Discuss the role of working capital management in financial
management.
• For each item of working capital
– Identify the tools/techniques used to manage the item
– Use the tools to calculate and analyze the quality of working capital
management in a firm
• Calculate relevant ratios and explain their implications vis a
vis working capital management

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 Content
• Introduction
• Working capital ratios such as cash cycle
• Management of inventory
• Management of receivables
• Management of Cash
• Management of Payables

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ELEMENTS & OBJECTIVESOF WC

• Refers to the management of CA and CL to ensure liquidity

and profitability (Profitability liquidity trade off)
• Gross working capital – Current assets
• Net working capital-CA-CL
• Objectives
– Optimal liquidity
– Optimal Profitability
– Determine optimal mix of various components
– Cost of WC financing management

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 HOW MUCH W.C?
• Size of the firm
• Type of business – supermarket vs construction co.
• Business fluctuation
• Manufacturing Lead time
• Price level expectations esp. on stock
• Credit policy of the firm – high credit sales & longer the credit
period = higher about of debtors and capital tied up in debtors

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 WHY MANAGE WC?
• Amount of W.C in a firm Vs total assets - >50%
• Liquidity of the firm and profitability
• Time devoted to WC management
• Source of funds to small co’s

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 FINANCING W.C
• Three types of assets
– Fixed assets
– Permanent/Fixed C.A : min amt of WC always present
– Temporary/fluctuating C.A
• Financing approaches
– Aggressive approach
• Temporary W.C capital is financed with S.T borrowing
• Permanent W. C is or partially or wholly financed with short term borrowing
• Fixed assets financed with long-term borrowing but may also be financed
with short term funds for very aggressive firms
• Lower interest charges
• Increased risk (to solvency) and return

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 FINANCING WC
• Conservative approach
– Use long term funds to finance F.A ,P.W.C fully & portion of T.C.A
also
– Low liquidity risk (less reliance on ST funding) and profitability
– High gearing & financial risk
• Matching/ Moderate approach
– Middle line between conservative and aggressive
– Match long term funding to Long-term assets (F.A & P.C.A) and short
term funding to T.C.A
– Moderate risk & Profitability
(Page 71 Corporate Finance Principles and Practice – Denzil Watson &
Antony Head)

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 Illustration 1: WCM
• Handout

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 EXTREME W.C POSITIONS
• Overcapitalization- holding excessive W.C also issuing more
debt and/or equity than value of Co.’s assets
( Opp: Undercapitalization – no cash flows or credit to support
operations)
– Low profitability
– Symptoms
• Low sales to NWC ratio
• High liquidity ratios
• Short creditors days
• Lengthy Average Collection Period and Inventory holding period

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 EXTREME W.C POSITIONS
• Overtrading
– High sales with little long term capital, NWC and Cash
– High sales and profits, on credit, accrual accounting
– Increased S.T borrowing
– Unfavorable liquidity ratios
– Increased financial risk

Overtraded companies enter a negative cycle, where increase in interest

 expenses negatively impact net profit leads to lesser working capital
 leads to increase borrowings leads to more interest expense and the
cycles continues

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 Content
• Introduction
• Working capital ratios
• Management of inventory
• Management of receivables
• Management of Cash
• Management of Payables

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 W.C RATIOS

• Made up of;
– RM Conversion Period
– WIP CP Inventory Holding period (CP)
– FG CP
– Receivables/debtors collection period
– Payables/creditors payment Period
– Working capital turnover
– Liquidity ratios

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 FORMULAE

• RM CP= AV RMI X 365/ RMC

• WIP CP=AV WIP X 365/COP
• FGCP= AV FGI X 365/COGS
• Creditors Payment Period=365X AV Creditor
Credit Purchases
• ACP=AV Debtors X 365/Credit Sales

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 FORMULAE
1. Cash Conversion cycle = Raw material conversion period +
WIP CP + Finished goods conversion period + Debtors’ days
– Creditors’ days

Number of days required for a company to convert resources to

cash flows.
Shows the period within which assets are committed to business
processes hence not available for investment – the shorter the
better

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 FORMULAE
2. Operating Cycle = Raw material CP + WIP CP + Finished
goods conversion period + Debtors’ days

Average time period between acquisition of inventory and the

receipt of cash from the inventory's sale.
A short operating cycle means a more prompt return on
investment for the firm's inventory. During an economic
downtown, an operating cycle typically lasts longer than in
periods of economic growth.

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3. Working capital cycle = Debtors’ days + Inventory days –
Creditors’ days

Time it takes to purchase inventory or components to making the

sale and receiving the cash.

The faster the conversion of trading operations into available cash =

increased the liquidity = less reliance on cash from customers,
extended terms from suppliers, overdrafts, and loans.
NB: Sometimes the working capital cycle is used
interchangeably with the cash conversion cycle

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 Formulae
• Working capital turnover ratio indicates the velocity of the
utilization of net working capital.

• The ratio represents the number of times the working capital is

turned over in the course of year and is calculated as follows

• WC Turnover= Cost of Sales /NWC (If COS is not available

Sales revenue figure could be used)

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 Working Capital turnover ratio

• Measures the efficiency with which the working capital is

being used by a firm.

• A high ratio indicates efficient utilization of working capital

and a low ratio indicates otherwise. But a very high working
capital turnover ratio may also mean lack of sufficient
working capital which is not a good situation.

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 Illustration 2: WCM
2011 2010
  Shs. ‘000’ Shs. ‘000’
Purchase of raw materials 6,700 5,000
Usage of raw materials 6,500 5,500
Cost of Production 15,000 12,000
Cost of sales (finished goods) 18,000 15,600
Sale of finished goods (all on credit) 25,000 21,000
Average creditors 1,400 1,000
Average raw materials stock 1,200 700
Average work in progress 1,000 500
Average finished goods stock 2,100 1,800
Average debtors 4,700 3,000

Assuming 365 days in the year compute the Cash Operating Cycle and comment
on it.

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 INTERPRETATION
• High Cash conversion cycle- More WC needed for financing
purposes & vice versa
• Understand the business
• Compare with prior periods and competitors

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WORKING CAPITAL FORECASTING

• Sales to WC ratio
• Use ratios to come up with WC items
• NWC=C.A-C.L

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 Content
• Introduction
• Working capital ratios
• Management of inventory
• Management of receivables
• Management of Cash
• Management of Payables

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 Management of Inventory
• Inventory consists of
– Raw material
– Work in progress
– Finished goods
• Why firms hold stock?
– Quantity discounts
– Stock outs
– Low prices
– Seasonal fluctuations
– Slow moving stock
– Unfavourable inventory management

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 Inventory management
• Balancing act
– Too much stock – tied capital, risk of obsolescence etc
– Too little – Stock outs, opportunity costs etc
• Different models in place for this
– Economic Order Quantity model
– Just in time model

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 Economic Order Quantity - EOQ
• Model based on certainty of variables related to stock in a
company aimed at forecasting the optimal amount of stock to
be held to ensure minimal stock holding costs
• Assumptions
– Annual stock demand or requirement in units is known and constant.
– Ordering cost per order is known and fixed.
– Carrying /holding cost per unit/annum of stock is known and constant.
– No quantity discounts associated with the buying price.
– There is instantaneous replenishment of stock once it is over.

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 EOQ

Usage

Replenishment

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 EOQ

EOQ occurs at point where

Total ordering costs = Total Holding costs
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 EOQ
• Ordering costs
– Insurance on transit costs
– Transport/carriage inward expenses.
– Clerical and administration costs.
• Holding costs
– Interest on capital or foregone profits on capital tied up in stock.
– Storage charges such as rent, lighting, air conditioning etc
– Insurance and security
– Obsolescence of stock

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 Formulae
• EOQ = √2DCo/Ch
• Total Holding costs = ½ X Q X Ch
• Ordering costs = D/Q X Co
• Total relevant costs = ½ X Q X Ch + D/Q X Co
• If discounts are included TRC changes
– It includes cost of purchases less the discount
– Holding costs are usually a percentage of purchase costs and will also
change
• Others
– Reorder level with lead times = Safety stock + D/365 X Lead Time
– Holding costs with safety stock =
(Safety Stock + ½ X Q )Ch

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 Fun Activity

• Given TRC curve let’s derive the EOQ formula

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 Illustration 3: WCM
• Handout

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 JIT
Japanese system aimed at producing required items at highest
quality and at the exact time needed by the customer

Features
1. 100% on time delivery
2. 0 defects – perfect quality
3. Move towards 0 inventory
4. Elimination of non-value adding activities such as storage, raw
material inspection – don’t add to customer’s utility

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5. Production line is run on demand pull basis
6. Production line is stopped if ineffective work is discovered or
parts for production are missing
7. Short machine set up time and manufacturing lead time

• Advantages - Class
• Disadvantages - Class

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 Content
• Introduction
• Working capital ratios
• Management of inventory
• Management of receivables
• Management of Cash
• Management of Payables

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 Introduction

• Consider two things;

– Profitability from credit sales – increased sales
– Cost of the credit allowed – bad debts, alternative source of financing
etc
• The above is influenced by
– Demand for products
– Competitors terms
– Financing costs
– Cost of credit control
 Evaluating a credit policy change
• Consider the following
– Change in profit
– Change in bad debts
– Change in costs of financing working capital due to increase in debtors
and other WC items

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 Illustration
A company is currently making sales of 120,000 units per annum
at KES 10/unit. The variable cost per units is KES6/unit. The
company is thinking of relaxing its credit policy which is
expected to result in an increase in the sales by 15% and an
increase in the average collection period from 30-45days. The
increase in bad debts is expected to shift from 2% to 3% of total
credit sales. Other working capital items apart from the accounts
receivables are 25% of sales under both the current and proposed
policy. The cost of capital is 12%. Determine whether the firm
should change its credit policy (assume a 360 day year)

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 Credit policy Cont’d

• The credit policy is meant to address the following issues

– How credit worthy is debtor?
– What are the credit limits?
– Do we invoice promptly and collect overdue balances
– Monitor and improve
 Components of credit policy
• Credit period
• The discount
• Credit standards - acceptable level of bad debts
• Collection procedure
• Profitability

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 Components of credit policy
1. Credit Period: Total length of time over which credit is
extended to a customer to pay a bill. Customers prefer long
periods – boosting sales but at increased probability of
default.

Example of credit terms: “2/10, net 30” – This implies that a

2% discount is given if the bill is paid within 10 days of the
invoice date. If the discount is not taken then full payment is
due by the 30th day of the invoice date.

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 Components of credit policy
2. Discounts: price reductions given for early payment. They
specify the % reduction and how rapidly payment must be
made to be eligible for a discount.
- Stimulate sales and prompt payments.

3. Credit standards: minimum quality of credit worthiness of a

credit applicant that is acceptable to the firm.

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 Components of credit policy
4. Collection policy/procedure: the degree of toughness in
enforcing the credit terms. Firms need to be somewhat tough
but excessive pressure may lead to loss of business.

5. Profitability: Before adjusting its credit policy a firm needs to

consider the profitability of such an undertaking – E.g. a firm
may lower its credit standards only if the profitability of sales
generated exceeds the additional costs of the receivables.

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 Credit Worthiness

• Evaluate 5C’s
– Capacity-record, business size
– Capital- health of customer, liquidity
– Character- integrity
– Collateral-security
– Conditions- prevailing economic conditions impact on customer
• Assessment of credit worthiness from info from
– Bank references
– Credit bureau
– Trade references
 Invoice promptly and collect

• Credit period begins after invoicing

• To follow up and collect
– Reminder letter
– Telephone calls
– Withhold supplies
– Debt collectors
– Legal action
 Monitor system

• Age analysis – check average time taken to collect

• Ratios – Current ratio, quick ratio, turnover ratios etc
• Statistical data – what is happening in the economy?
 Evaluate credit decision

• High credit
– High sales
– High profits
– Bad debts
– Discounts to encourage early settlement
– Credit administration costs
– Capital tied up due to increased working capital
• pnMock questions
 Illustration 2
ABC ltd has been experiencing a reduction in the volume of sales as a result of which the finance manager
has suggested to the B.O.D that the credit standards should be relaxed. Currently the firm sells in terms of
net 60 and the current total sales amounts to shs.120M p.a75% of which it is in credit.
The firm is expecting to adopt credit terms of 2/10 net 30 which management expects to lead to increase in
total sales by 25%.
Out of the new sales, 80% will be on credit.
Customers who buy in cash under the new policy will be given a 1%discount.It is anticipated that 40% of
the credit customers will take advantage of the 2% discount and pay within the discount period.
The variable cost ratio under the new and old policy is 70%
Bad debts are currently equal to 1.5% of the total credit sales but are expected to increase to 2% of the new
credit sales. Due to increase in credit sales, the firm will need to employ a part time credit controller who
will be paid shs.216, 000p.a
To support the increase in sales, the firm will need additional stock of raw materials and finished goods
valued at shs.3M
The rate of return on investment of this nature is 18%.Assume 360 days p.a
 
REQUIRED: Should the firm change the credit policy?

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 Factoring and Invoice discounting

• Can be recourse (can follow up) on non recourse (cannot

follow up)
• Sell the debtors of the company to a factor
• Functions of a factor
– Debt collection and administration
– Financing
– Credit insurance
• Process
– Enter into factoring agreement
– Before credit, give factor to evaluate
– Give credit
 Factoring Process

• Factor pays company 80% advance for a

– Financing fee
– Administration fee
• Customer pays to factor
• Factor pays to company the remaining 20% less
administration fee and any other cost
 To consider in factoring

• Saving in administration • Costly

costs • May indicate inability to
• Reduced bad debts do credit administration
• Reduced financing costs • Relationship with
• Useful for small and customer
growing companies
• Growth financed
through sales

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 Evaluation of factoring decision

• Cost of existing policy

– Financing cost
– Bad debts
– Credit administration cost
• Cost of Factoring arrangement
– Financing costs
– Administration cost
– Any savings not included above
 Invoice discounting

• Use debtors as security

• Risk of bad debts does not pass to other party
• Collection still done by the company
 Content
• Introduction
• Working capital ratios
• Management of inventory
• Management of receivables
• Management of Payables
• Management of Cash

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 Trade creditors

• Source of finance for the company

• Managing entails balancing act;
– Liquidity-ability access and utilize credit without impairing
relationship by delaying payment
– Profitability- it may be costly credit or cost free trade credit
• If there is opportunity cost of discount then trade credit
become costly
• Calculation of cost of trade credit same for debtors and
creditors
 Cost of Trade Credit
• Terms 2/10 n 30 days (if you pay within 10 days you get a 2%
discount otherwise if you pay afterwards you do not get a
discount but still has to pay by the 30th day.

10 days 30 days
2% Discount No Discount

I get 2% discount I lose 2% discount

I need to get a loan to I need not get a loan to
finance myself between finance myself
day 10 and 30 I incur the cost of foregoing
the discount as a finance cost

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 Cost of Trade Credit

• To evaluate whether to take discount or not company should

– Annualize the cost of the discount
– Compare this with other sources of financing
– If cost of discount is higher then take discount, if that of loan is higher
then take loan
• Procedure for computation
– Discount as % of amount paid
– Get no. of periods (n)=365/Duration of date paid less allowed
payment period
– Annualize cost of discount=[1+(d%/1-d%)]n-1
– If cost of offering discount exceeds cost of O/D then discount should
be taken and vice versa
 Foreign Accounts Receivables

• Additional twists
– Export trade credit risk- risk of unsettlement or delay in settlement
from foreign customers
– Foreign Transaction exposure- foreign currency used for trade may
depreciate or appreciate against local currency between time of
contract and payment date (next topic)
 Export trade credit risk

• Caused by;
– Insolvent customers
– Bank failure
– Unconvertible currencies
– Political risk
• Solutions
– Intermediary banks
– Irrevocable Letters of Credit (ILC’s)
– Guarantees
 Export trade credit risk

• Solutions (Cont’d)
– Export covers
– Good business management
 Content
• Introduction
• Working capital ratios
• Management of inventory
• Management of receivables
• Management of Payables
• Management of Cash

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 Introductions
• Cash held does not earn any interest
• Cash invested earns interest
• If there is no cash for daily settlements company will be at
huge risk due to decault
• Balancing act between
– Liquidity
– Profitability

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 Why hold cash
• Transactions
• Speculate
• Precaution

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 Models for cash management
• Baumol model
• Miller orr model
• Cash budgets

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 Baumol model
• Similar to EOQ
• D – total cash demand per annum
• Holding cost – carrying cost – opportunity cost since cash in
not earning anything
• Ordering costs – Transaction/transfer cost – need to convert
cash from earning form to real cash, sale of marketable
securities

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 Assumptions
• The annual cash requirement is known and constant.
• The firm has steady cash inflows and outflows i.e. cash inflow
and outflows occur at regular intervals in equal amounts.
• The conversion cost is known and fixed.
• The opportunity cost is based on interest rate on short term
marketable securities and is known and constant.

• Total relevant Costs= Transaction cost + Total Opportunity

costs

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 Illustration
• A retail trader requires shs.800, 000 to meet his operational
needs. Any surplus cash held is deposited in a bank account
which yields interest income at 10% p.a. Everytime he
withdraws the cash from the bank to meet his operational
needs, he is charged shs.100
 
• REQUIRED 
• Determine the optimal cash balance to hold and the associated
opportunity costs and withdrawal cost.
• How frequently should the trader should the trader withdraw
cash from the bank?

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 Miller-Orr Cash model
• Model that assumes uncertainty in cash management
developed by Morton Miller and Daniel Orr,
• Model assumes that cash inflows and outflows are allowed to
fluctuate or meander within some set limits over and below the
optimal cash balance or limit.
• Identifies 3 possible cash balances.
– Upper limit (H) H = 3Z - 2L
– Return point (Optimal cash level) (Z)
– Lower limit balance (L)

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 Miller-0rr Cash model
• Firms aims at ensuring cash amount does not go out of the
upper and lower band
• When cash goes to H they buy marketable (H-Z)securities to
go back to Z and if cash goes to L they sell marketable
securities (Z-L) to go to Z
• Otherwise they do not do anything

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 Miller-0rr Cash model
• Optimal balance is determined by
– Transaction cost
– Daily variance fluctuations
– Daily interest rate on short term marketable securities

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 Investment of surplus cash
• Treasury bills
• Commercial paper
• Certificate of deposit
• Long terms loans

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 Sources of short term credit
• Factoring
• Invoice discounting/ pledging
• Trade creditors
• Bank overdrafts
• Line of credit
• Negotiated credit

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