Managing working capital

5
Introduction

• Almost every company carries inventories of some sort, even if

they are only inventories of consumables such as stationery. For a
manufacturing business, inventories in the form of raw materials,
work in progress and finished goods may amount to a substantial
proportion of the total assets of the business.
Introduction

• Some businesses attempt to control inventories on a scientific

basis by balancing the costs of inventory shortages against those of
inventory holding. These approaches are divided into three major
parts.

• Economic Order Quantity

• Discount for bulk purchases
• Buffer inventories
1) EOQ

• The economic order quantity (EOQ) is the optimal ordering quantity for an item of
inventory which will minimise costs.

• The costs included are; Holding costs and carrying costs.

• Note: Deriving the above mentioned formula will provide more clarity.
1) EOQ

• The demand for a commodity is 40,000 units a year, at a steady

rate. It costs $20 to place an order, and 40c to hold a unit for a
year. Find the order size to minimise inventory costs, the number
of orders placed each year, the length of the inventory cycle and
the total costs of holding inventory for the year.
1) EOQ
Uncertainties in demand and lead times: a re-order level system

• Uncertainties in demand and lead times taken to fulfil orders

mean that inventory will be ordered once it reaches a re-order
level (maximum usage * maximum lead time).

• ‘The re-order level is the measure of inventory at which a

replenishment order should be made.’

• What will happen if the stock is ordered too soon or too late?
Maximum and buffer safety inventory levels.

• Use of a re-order level builds in a measure of safety inventory and

minimises the risk of the organisation running out of inventory.

• Maximum inventory level = re-order level + re-order quantity –

(minimum usage * minimum lead time)

• ‘The maximum level acts as a warning signal to management that

inventories are reaching a potentially wasteful level.’
Maximum and buffer safety inventory levels.

• Minimum inventory or buffer safety inventory = re-order level

– (average usage * average lead time)

• ‘The buffer safety level acts as a warning to management that

inventories are approaching a dangerously low level and that
stock-outs are possible.’
Maximum and buffer safety inventory levels.

• Average inventory = buffer safety inventory + (re-order amount/ 2)

• ‘This formula assumes that inventory levels fluctuate evenly between

the buffer safety (or minimum) inventory level and the highest possible
inventory level.’
Maximum and buffer safety inventory levels.
Maximum and buffer safety inventory levels.
2) Discounts

• EOQ calculation provides an optimum quantity at which the costs will be

minimized. The EOQ model does not include purchase cost directly in the
model. Therefore, to make the model more comparison friendly
‘purchase cost’ can be ascertain and further added to the other costs to
calculate the total cost, which can then be compared with ease with
other possible options for purchase.
• The basic format followed when comparison with different discount rates
is ;

• Purchase cost xxxx

• Holding cost (carrying cost). xxxx
• Ordering cost xxxx
2) Discounts
2) Discounts
2) Discounts
2) Discounts
2) Discounts
2) Discounts
3) Just in time (JIT)

• Some manufacturing companies have sought to reduce their

inventories of raw materials and components to as low a level as
possible.

• Just-in-time procurement is a term which describes a policy of

obtaining goods from suppliers at the latest possible time (ie when
they are needed) and so avoiding the need to carry any materials or
components inventory.
3) Just in time (JIT)

• As orders are received, manufacturing is triggered to fulfil those

orders. Hence this process is described as manufacturing to order
process.

• Benefits of JIT

• Reduction in inventory holding costs  

• Reduced manufacturing lead times
• Improved labour productivity
• Reduced scrap/rework/warranty costs
4) Managing accounts receivable.

• Giving credit has a cost: the value of the interest charged on an

overdraft to fund the period of credit, or the interest lost on the cash
not received and deposited in the bank. An increase in profit from
extra sales resulting from offering credit could offset this cost.

• The level of total credit can then have a significant effect on

profitability. That said, if credit considerations are included in pricing
calculations, extending credit can, in fact, increase profitability.
4) Managing accounts receivable.

• If offering credit generates extra sales, then those extra sales will
have additional repercussions on:

(a) The amount of inventory maintained in the warehouse, to ensure that

the extra demand must be satisfied.

(b)  The amount of money the company owes to its accounts payable (as
it will be increasing its supply of raw materials).
4.1) Managing accounts receivable – Credit
control policy.

• The administrative costs of debt collection.

• The amount of extra capital required to finance an extension of
total credit – there might be an increase in accounts receivable,
inventories and accounts payable, and the net increase in working
capital must be financed.
• The ways in which the credit policy could be implemented – for
example:
• (i)  Credit could be eased by giving accounts receivable a longer period in
which to settle their accounts – the cost would be the resulting increase in
accounts receivable.
• (ii)  A discount could be offered for early payment – the cost would be the
amount of the discounts taken.
4.2) Managing accounts receivable – Assessing
credit worthiness.

• In managing accounts receivable, the creditworthiness of customers

needs to be assessed. The risks and costs of a customer defaulting
will need to be balanced against the profitability of the business
provided by that customer.

• Credit control involves the initial investigation of potential credit

customers.
4.2) Managing accounts receivable – Assessing
credit worthiness.

• The main point for consideration are as follows;

• New customers should give two good references, including one from a
bank, before being granted credit.
• Credit ratings might be checked through a credit rating/reference agency.
• A new customer's credit limit should be fixed at a low level and only
increased if their payment record subsequently warrants it.
• For large value customers, a file should be maintained of any available
financial information about the customer. This file should be reviewed
regularly. Information is available from the company's annual report and
accounts.
• Government departments can sometimes advise on overseas companies.
4.2) Managing accounts receivable – Assessing
credit worthiness.
4.2) Managing accounts receivable – Assessing
credit worthiness.
4.2) Managing accounts receivable – Assessing
credit worthiness.
Chapter questions.
Chapter questions.
Early settlement discount

Early settlement discount is employed to;

1) Shorten the average credit period. (Customer will try to save

money, hence they will avail the discount.)
2) Reduce the Investment in accounts receivable. (If the credit period
is not reduced, the company will have to finance working capital for
which interest has to be paid.)

The benefit of interest cost + any other cost saved should exceed the
cost of discount allowed.
Early settlement discount
Early settlement discount
Bad debt risk

Sometimes, offering different credit terms might affect:

• Sales (eg longer credit would attract customers)

• Bad debts (usually longer credit increases bad debts)
Bad debt risk- Q

A company has annual credit sales of $12,000,000. Current credit terms =

one month, and bad debts are 2% of sales.
Proposed credit terms = two months and this should increase sales by
25%. Bad debts would then be 3% of sales.
Contribution to sales ratio = 30%
Cost of finance = 15%
Is the change in credit terms worthwhile?
Bad debt risk - Q

$
Increase in sales = $12,000,000 × 25% 3,000,000
Increase in contribution = $3,000,000 × 30% 900,000
Increase in bad debts expense: (15,000,000 × 3%) – 210,000
(12,000,000 × 2%)
Net annual increase in profit 690,000
Proposed receivables: $15,000,000 × 2/12 2,500,000
Current receivables: $12,000,000 × 1/12 1,000,000
Increase in receivables 1,500,000
Annual cost of funding the increase in receivables = 225,000
$1,500,000 × 15%
The proposal is worthwhile as $690,000>$225,000
Factoring

Factoring: An arrangement to have debts collected by a factor

company, which advances a proportion of the money it is due to collect.
Invoice discounting: The purchase of individual trade debts at a
discount to raise working capital.
Note. Factors often administer their client's receivables ledger; invoice
discounters do not.
Aspects of factoring

The main aspects of factoring include the following.

• (a)  Administration of the client's invoicing, sales accounting and
debt collection service
• (b)  Credit protection for the client's debts, whereby the factor
takes over the risk of loss from bad debts and so 'insures' the client
against such losses. This is known as a non-recourse service. However,
if a non-recourse service is provided, the factor, not the firm, will
decide what action to take against non-payers.
• (c)  Making payments to the client in advance of collecting the
debts. This is sometimes referred to as 'factor finance' because the
factor is providing cash to the client against outstanding debts.)
Factoring

Annual sales = $12,000,000 and customers currently pay as follows: 20%

after one month, 40% after two months, 40% after three months.
A factor would pay 100% after one month and charge 3% of turnover.
Savings in credit control costs = $50,000 per year.
The company's bank overdraft rate is 9% per year.

Should the company employ the factor?

 $
Current receivables = (12,000,000 × 20% × 1/12)+ 2,200,000
(12,000,000 × 40% × 2/12) + (12,000,000 × 40% × 3/12 )
Receivables using factor = 12,000,000/12 1,000,000
Decrease in receivables/increase in cash 1,200,000
Saving in finance cost 1,200,000 × 9% 108,000
Cost of factor 3% × 12,000,000 (360,000)
Add: savings in administration costs
Net cost 50,000
Therefore, factoring should not be chosen (202,000)
Invoice discounting.
Invoice discounting.

Invoice discounting is the purchase (by the provider of the discounting

service) of trade debts at a discount. Invoice discounting enables the
company from which the debts are purchased to raise working capital.

The invoice discounter does not take over the administration of the
client's sales ledger.

A client should only want to have some invoices discounted when he has
a temporary cash shortage.
Managing foreign accounts receivable
Reducing investment in foreign accounts receivable

There are several ways in which this might be done;

Advances against collections. Where the exporter asks their bank to
handle the collection of payment (of a bill of exchange or a cheque) on
their behalf, the bank may be prepared to make an advance to the
exporter.
Discounting bills of exchange. This is where the customer agrees to
accept a bill of exchange drawn on the customer by the exporter. The
exporter's bank may buy the bill before it is due for payment (at a
discount to face value)
Documentary credits (‘letters of credit’) [similar to escrow] provide
a method of payment in international trade, which gives the exporter a
secure risk-free method of obtaining payment. This arrangement is a
guarantee from the importers bank.
Reducing investment in foreign accounts receivable

• Forfaiting is a method of export finance whereby a bank purchases

from a company a number of sales invoices, usually obtaining a
guarantee of payment of the invoices. Similar to invoice discounting
but for international invoices.
• Countertrade is a means of financing trade in which goods are
exchanged for other goods. Three parties might be involved in a
'triangular' deal. Countertrade is thus a form of barter and can involve
complex negotiations and logistics. One of the main problems with
countertrade is that the value of the goods received in exchange may
be uncertain.
Managing accounts payable
The management of trade accounts payable involves:
• Obtaining satisfactory credit from suppliers
• Attempting to extend credit during periods of cash shortage
• Maintaining good relations with important suppliers
Over-trading

$ $ Assume that turnover doubles and that

Non-current assets 10,000 this will cause receivables, inventory
and payables to double to keep pace.
Current assets
Inventory 5,000 No capital is raised and no non-current
Receivables 4,000 assets are bought.

Cash 1000 Draft the new SOFP

10,000
Current liabilities, (2000)
payables
8000
18000
 Over-trading
$ $ $ $
Non-current assets 10,000 10,000 Assume that
turnover doubles and
Current assets that this will cause
Inventory 5,000 ×2 10,000 receivables,
Receivables 4,000 ×2 8,000 inventory and
payables to double
Cash 1000 to keep pace.

10,000 18,000 No capital is raised

Current liabilities payables ( 2000 ) ×2 (4,000) and no non-current
Overdraft (balancing (6000) assets are bought.
figure)
Draft the new SOFP
8000 8000
18000 18000
Overtrading
Overtrading happens when a business tries to do too much, too quickly
with too little long-term capital.
• Liquidity troubles arise because inventory and receivables grow and
the firm does not have enough capital to provide the cash to pay its
debts as they fall due.
• Successful, rapidly growing, inexperienced companies often have this
problem.
• The problem is cured by injecting more long-term capital and/or
slowing growth to a more manageable pace.
• Overtrading is also known as under-capitalisation.
Overcapitalisation
Overcapitalisation means that the company has excessive inventory,
receivables and cash compared to its accounts payable.
• Cash is not being used productively and this hurts profits.
• For example, a current ratio of 5 would indicate a very large amount of
current assets compared to current liabilities.
• Perhaps some cash should be invested in new equipment to increase
productivity.
• Customers may be paying late, inventory may be excessive and credit
taken from suppliers too low – all are poor for performance.