WORKING CAPITAL MANAGEMENT – II

Working Capital
Investment Policy:

Receivables Management

Inventory Management
 Accounts Receivable Management
 Credit policy decisions influence both return and
risk - tightening credit improves return but
increases risk of losing market share.
 Easing credit policy has the following effects:
o Sales will increase
 Cost of sales will increase correspondingly
 Cost of carrying receivables will go up
 Credit management & collection expenses will go up
 Bad debt losses may go up
 Discount costs may go up
 Financial Manager has to assess whether sales
revenues will rise more than costs.
COMPONENTS OF CREDIT POLICY
Credit Standards – type & quality of customer
Credit Terms – terms of sale: credit period and
early payment discount
Collection Policy and Procedures

CREDIT STANDARDS
Customers must possess minimum qualities to
qualify for credit – credit scoring
Financial statement analysis
Credit ratings/reports, bank/trade references
Reports from sales/collection staff
COLLECTION POLICY & PROCEDURES
 Regular review – aged debtor analysis
 Frequency and tone of reminders
 Withholding of supplies
 Use of collection agencies

CREDIT TERMS
 Credit terms are typically 30 days but vary
according to:
conditions in industry
bargaining power of parties
 Discounts less popular in UK than USA
 Managing Trade Credit:
Cost of Early Payment Discount
E.g. 2% discount if paid in 10 days, otherwise pay in 30 days:
Using a 365-day count for the year, the effective cost (EAR) of
taking 30 days to pay (without compounding) would be:

The credit period is only 20 days , meaning there are

365/20 = 18.25 compounding periods in the year –with
compound interest, the cost would be even higher:
Interest for 20 days is 2/98 = 2.04%. Effective annual interest rate:
FINANCING THE INVESTMENT
IN DEBTORS
BILL FINANCE
o Usually 60 to 180 days
o Liquid asset - can be discounted
o Contingent rather than direct liability
o Discount front-ended - higher effective cost
FACILITATING BILL DISCOUNTING
Bankers’ acceptances
Letters of credit
Forfaiting
INVOICE DISCOUNTING
 Advances against percentage of value of
invoices raised

FACTORING
Sales ledger administration
Credit management/insurance
Finance provision
With recourse & without recourse
Confidential invoice factoring
 ADVANTAGES OF FACTORING
o Working capital blocked in book debts gets
released.
o Administration costs are reduced - debts are
collected more efficiently and promptly by
factor (who has advantages of specialisation
and economies of scale).
o Bad debt losses are curtailed.
o Factoring fees (1% to 2½% of turnover
handled) can be cost-effective in relation to the
above advantages.
 DISADVANTAGES OF FACTORING
 Loss of customer goodwill is possible.
 Financial standing can be affected.
 Factors are particular about about what debts
they buy.
 Smaller companies may find charges
prohibitive.
 Although administrative and collection fees
may be cost-effective, interest on finance
provision is not cheap.
 ECONOMIC ORDER QUANTITY (EOQ)
• Carrying too little stock can be costly in terms of lost
sales and high reordering costs.
• But carrying too much stock also has costs - the EOQ
model is a method of ordering stocks which seeks to
minimise these costs. It requires identification of the
following for each item of stock:
– Holding costs (H): Cost of carrying stock (cost of
capital, storage, obsolescence, theft, spoilage,
insurance, etc.)
– Cost of Ordering (C): Cost of placing and collecting
one order (transaction costs)
– Annual usage of stock (A): Expected annual supply
of the item of stock that will be needed
 Annual Costs (£)

Total Costs

Carrying Costs

Ordering Costs

EOQ Order Quantity (units)

Using differentiation, the minimum point of the Total Costs curve is:
 ORDER POINT
EOQ tells us how to find out the best quantity to order - but when
should the order be placed? Stock consumption during the time
taken for delivery - lead time - has to be allowed for:

Order Point= Lead Time x Daily usage

Stock (units)

Order Point

Days
Lead Lead Lead
Time Time Time
 SAFETY STOCKS
It is difficult to be exactly sure of the lead time - there may be
unexpected delays; it therefore becomes necessary to hold a certain
amount of safety stock to provide for unforeseen contingencies:
Order point = (Lead Time x Daiy Usage) + Safety Stock

Stock (units)

Order
Point
Safety
Stock

Days
 ABC SYSTEM (PARETO ANALYSIS)
Cumulative value of stock items (%)
Cumulative value of
stock items

A B C
Volume of stock items held (%)
JUST-IN-TIME INVENTORY CONTROL

• Minimising inventory by minimising

the EOQ, mainly through reducing
ordering costs.
• Requires timely and reliable supply
with very small lead times – needs
close liaison with suppliers.
• Achieved by long-term contracts with
smaller number of suppliers –
emphasis on quality and reliability.