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Corp Fin 1 Working Capital Management
Corp Fin 1 Working Capital Management
Corp Fin 1 Working Capital Management
• Working capital represents the funds that have been invested in the net
current assets of the business in order to facilitate its day to day operations.
The net current assets of the business are made up of current assets less
current liabilities.
• The following are some of the current assets that you may find in the balance
sheet of a firm: stock (inventory ), debtors ( accounts receivable ), short-term
investments, cash and bank balances, and pre-paid expenses. The current
liabilities may include some of the following items: trade creditors ( accounts
payable ) and other creditors (including accrued expenses, dividends to
shareholders, and taxation.
• The difference between the total current assets and the total of the current
liabilities is the net working capital. At this point, I will not go further with
the actual analysis of each item of working capital.
Importance of Working Capital Management
• The funds that have been invested in net working capital are tied up during the period in
which those assets are in existence. In other words, these funds are not available for any
other purpose until those assets have been liquidated ( converted into cash ). You can
immediately realize from this that the holding of current assets within the business
represents a cost to the business. This cost is an opportunity cost. An opportunity cost is the
cost of an alternative foregone. This means that if the funds are released by liquidating the
asset, they can be put in alternative investments. It is the return that has been foregone on
these alternative investments that represents the cost of holding the assets.
• Working capital is, however, essential for the day to day operations of the business. It is
therefore important to strike a balance between the cost of carrying the working capital and
the smooth operation of the business. It may not be prudent to have "too much" working
capital as this represents a cost to the business, but it may equally be imprudent to have too
little as this may hamper the proper management of the business as well. The proper
management of working capital determines the short-term liquidity of the business.
Liquidity is the ability of the business to meet its short-term financial obligations when they
fall due. The way in which liquidity is managed depends on the firm's working capital
financing policy.
Classes of Current Assets
• Current assets can be temporary (seasonal) or
permanent.
• Permanent current assets can be defined as the base
level of cash, accounts receivable , and inventory and
are determined by their low point through several
sales cycles.
• Temporary current assets are sudden increases in
account receivables and inventory due to seasonal
fluctuations in sales.
Working Capital Financing Policy.
• Several strategies are available to a firm for financing its capital requirements.
1. Maturity Matching Financing Strategy
• This strategy finances permanent current assets and fixed assets with long-term
sources and temporary current assets with short-term sources.
• The firm would rather sell for cash than on credit because selling on credit involves three
elements of costs: the cost of carrying the debtors, the administration cost of managing the
debtors and the cost of bad debts.
• For the firm to manage these costs, it must come up with three policies. These are: the
credit selection policy the credit collection policy and the discount policy.
• The credit selection policy involves decisions about whether to grand credit to a customer,
and if so, how much should be granted. In this regard, the firm should be careful not to
grand credit to customers who will fail to pay or to customers who will delay payment and
pay after the agreed date. If customers fail to pay, the amount that they have been granted
would have to be written off as a bad debt. This is an outright expense to the business,
which is deducted from the revenues. If the customer delays payment, but eventually pays,
the cost is the opportunity cost of carrying the debtors which arises when the average
collection period is extended.
• However, the firm should not avoid granting credit altogether, especially in a competitive
environment, as it would lose sales to competition. In the granting of credit, there are five
factors which are normally considered ( known as the five C's ). These are: capital, collateral,
character, capacity and conditions.
Management of Debtors
• The applicant must have Capital. The firm must analyse the financial position of the
customer. In the case of a firm, this data can be obtained from the financial statements
using appropriate liquidity ratios.
• The customer has to have Collateral. The firm must ascertain whether the customer has
collateral to secure the debt. The firm must ensure that the collateral being offered by the
customer has not already been offered as collateral for other existing debts.
• You must check the Character of the customer. The firm must try to assess the willingness
of the customer to pay the debt. This can be done using the payment history of the
customer, either with the firm, or with other firms. There is a need to find out whether the
customer has defaulted payments with other creditors before.
• You must ascertain the capacity or the ability of the customer to pay by the agreed date.
The customer must supply evidence of this. For example, using bank statements and
audited financial statements.
• Finally, you must consider the conditions or economic environment we are operating in. The
political and economic environment within which the customer is operating also need to be
assessed. For example, the competition within the industry of the customer's business.
Credit Collection Policy.
• Once the decision to grand credit has been made, we must then
decide on the collection policy. The collection policy involves
decisions on the sending out of invoices, following up customers, and
handing over to debt collectors, if necessary.
• The collection policy has an big impact on the cost of administration
and the cost of bad debts. A strict policy reduce the average collection
period as well as the cost of bad debts written off. However, this must
be balanced against the cost. A strict collection policy is more
expensive administratively than a relaxed one. It may also lead to loss
of sales.
Debt Management
• The credit policy of the firm may include a discount to the customer to
induce them to pay early. For example, if the policy is " 2 / 10, Net 30" , this
means that the customer has been given 30 days to pay. However, if they
pay within 10 days, they would be given a discount of 2%.
• The effect of the discount is to induce sales, if customers perceive the
discount as a reduction in the selling price. The other effect is to reduce the
average collection period, if the customers take the discount. Let us look at
the following example:
• Example. The credit policy of the firm is "3 / 15, net 45". What is the average
collection period if 40% of the customers take the discount and the rest pay
in 45 days?
• The average collection period will be:
• ( 0.40 x 15 days ) + ( 0.60 x 45 days ) = 33 days.
MANAGEMENT OF INVENTORY
(b)Providing finance–since stock is money, there is the cost of financing it, which
may be taken as the weighted average cost of capital. There is also an opportunity
cost of capital to consider, as funds tied up in stocks cannot be used for other, more
profitable investments and so potential income will be forgone.
(c)Stock handling–included under this heading will be the costs of the stores
installation, which may include racks, bins, paperwork systems, insurance and
maintenance cost, security and so forth.
• EOQ = √ 2Cd/h
• h = cost of holding one unit of stock per annum (or other relevant
period)
• C = cost of ordering a consignment from a supplier
• d = annual demand (or other period)
• Q = reorder quantity
Management of Cash
• There are several reasons why a business may encounter problems with its cash
flow, including:
• Overtrading, Growth
• Loss-making, Inflation
• Payment delays
• Bad debts,Large items of expenditure
• Seasonal trading
Cash management models are aimed at minimizing the total costs associated with movements
between a company's current account (very liquid but not earning interest) and their short-
term investments (less liquid but earning interest).
• The models are devised to answer the questions:
• at what point should funds be moved?
• how much should be moved in one go?
• The Baumol Cash Management Model
Baumol noted that cash balances are very similar to inventory levels, and developed a model
based on the economic order quantity (EOQ).
Assumptions:
• cash use is steady and predictable
• cash inflows are known and regular
• day-to-day cash needs are funded from current account
• buffer cash is held in short-term investments.
Baumol Equation
• The formula calculates the amount of funds to inject into the current account or to
transfer into short-term investments at one time:
• where:
• CO = transaction costs (brokerage, commission, etc.)
• D = demand for cash over the period
• CH = cost of holding cash.
• The model suggests that when interest rates are high, the cash balance held in non-
interest-bearing current accounts should be low. However its weakness is the
unrealistic nature of the assumptions on which it is based.
Example
Example using the Baumol model
Required:
Solution: