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Working Capital ManagementWorking Capital Management

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PROGRAMMEPROGRAMME

The nature of working capitalThe cash operating cycleFunding the cash operating cycleThe objectives of working capital Inventory managementManaging trade receivablesRelationship with suppliersManaging Cash

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The Nature ofThe Nature ofWorking CapitalWorking Capital

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Definition of Working CapitalDefinition of Working Capital

Current Assets less Current Liabilities

Inventories Trade PayablesRaw Materials AccrualsWork-in-Progress Taxation/DividendsFinished Goods Short-Term Borrowings

Trade ReceivablesPrepaymentsBank/Cash

Current Assets Current Liabilities

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Why Invest in Current AssetsWhy Invest in Current Assets

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Example: Raw MaterialsExample: Raw Materials

Despite running at full capacity, steel suppliers in Japan and elsewhere in Asia struggled to satisfy Japan’s booming exporters

Nissan had to cut down its production by an estimated 40,000 vehicles to meet demand in March (March is the month where demand for cars in Japan hits a peak)Source FT Dec 2004

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Funding Current AssetsFunding Current Assets

The Cheapest way to finance current assets is to use free credit from suppliers

This may lead to LIQUIDITY PROBLEMS. This risk can be illustrated using aCash Operating Cycle

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The The Cash Operating CycleCash Operating Cycle

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Cash Operating Cycle Cash Operating Cycle

Inventory Turnover Period

Raw Materials holding period

Production Period

Finished Goods holding

period

x 365

x 365

x 365

Cost of ProductionAverage Work-in-Progress

Average InventoryCost of Sales

Avg Raw MaterialsCredit Purchases

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Cash Operating Cycle Cash Operating Cycle cont.cont.

x 365Average Trade ReceivablesCredit Sales

The accounts receivable payment period

How long our customers take, on average, to settle their bills

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Cash Operating Cycle Cash Operating Cycle cont.cont.

Accounts payable payment period

x 365Average Trade PayablesCredit Purchases

How long, on average, we take to pay our customers

FREE CREDIT DAYS!!

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Ratios are not perfectRatios are not perfect

Ratios have limitations particularly when comparing P/L items with Balance Sheet Figures

Example: In December retailers normally have below average stock levels and therefore an average based on December figures may not reflect the annual average

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Beware Averages Beware Averages

If you are 6 feet tall and you don’t know how to swim, would you wade across a pool with an average depth of 3 feet?

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Cash Operating CycleCash Operating Cycle

Trade Payables

Raw Materials W-I-P Finished Goods Debtors

Cash Outflow

Cash Inflow

Financing current assets entirely from trade payables will keep the cost of interest down

BUT this may lead to liquidity problems

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Liquidity Risk?Liquidity Risk?

Deferral of Cash InflowsStock becoming obsolete or out-of-fashion

Disruptions in production processes

Debtors failing to meet credit deadlines

Foregone Cash InflowsBad Debts

Other Cash Outflows - Overheads

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The need for working capital The need for working capital

The duration of the trade payables period is normally dictated by suppliers or the market in general. Therefore it may not match the current asset turnover period

In addition the conversion of current assets into cash may be deferred or at worse foregone (Bad Debts)

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Cash Operating CycleCash Operating Cycle

Trade Payables

Raw Materials W-I-P Finished Goods Debtors

Funding the cash operating cycle

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Funding the Funding the Cash Operating CycleCash Operating Cycle

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Funding the Cash Operating CycleFunding the Cash Operating Cycle

Short-Term Borrowings Bank Overdraft Commercial Paper Invoice or Bills of Exchange Discounting

Long-Term Capital Employed Debt / Equity

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Funding the Cash Operating CycleFunding the Cash Operating Cycle

AGRESSIVE CONSERVATIVE

SHORT-TERM FUNDING LONG-TERM FUNDING

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Funding the Cash Operating CycleFunding the Cash Operating Cycle

MATCHINGCurrent assets are assets which are either cash or expected to be converted into cash with one year

For funding purposes these can be classified into:

Permanent Fluctuating

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Funding the Cash Operating CycleFunding the Cash Operating Cycle

Permanent Inventory

Inventory required to stock the shops plus to keep some buffer stock in warehouse/s

Fluctuating

Inventory levels before the Easter, Summer and Christmas holidays will normally be above average

Example: Toy Shop

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Funding the Cash Operating CycleFunding the Cash Operating Cycle

0

2

4

6

8

10

12

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16

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Permanent Current Assets

financed by Long-term Capital

Fluctuating

Current Assets

financed by

Short-Term

Funding

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The Objective of The Objective of Working Capital ManagementWorking Capital Management

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Aim of Working Capital ManagementAim of Working Capital Management

A business needs to invest in current assets to sustain its business operations

The aim of working capital management is to strike off a balance between FINANCIAL STABILITY and PROFITABILITY

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Over-Capitalization -Working CapitalOver-Capitalization -Working Capital

Too much working capital will impinge on profitability

Higher interest rate burden

Opportunity Cost – long-term capital tied in current assets can be used to finance feasible projects

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Inadequate Working CapitalInadequate Working Capital

Inadequate Working Capital may lead to liquidity problems

Overtrading

Rapid expansion in business without having adequate working capital.

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Inadequate Working CapitalInadequate Working Capital cont.cont.

Symptoms of Overtrading

Accounts Payable period will increase

Development of hard core element in bank overdraft plus encroachments

Profit margins will start to decline as raising cash will be given priority to profitability

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Optimum Working CapitalOptimum Working Capital

Over-Capitalised Under-Capitalised

Current Ratio > 2 : 1 < 2 : 1Quick Ratio > 1 : 1 < 1 : 1Cash Operating Cycle Long Short

Some textbooks suggest that:

However Working Capital needs depend on a number of factors. For example:

type of industry accessibility to financial markets

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Optimum Working Capital Optimum Working Capital cont.cont.

Trade Payables (48.7 days)

Inventory (13.8 days)

J SAINSBURY – FOOD RETAIL INDUSTRY

Negative Working Capital

Source: Fitch Ratings figures as at 24-Mar-07

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Optimum Working Capital Optimum Working Capital cont.cont.

Trade Payables (30.7 days)

Inventory processing period (31.2 days) Debtors (27.4 days)

Cash Operating Cycle (27.9 days)

SABMILLER – BREWERY

Source: Fitch Ratings figures as at 31-Mar-07

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Conclusion on OptimalityConclusion on Optimality

Working Capital Needs differ among industries

Optimality depends on the management of the constituents of Working Capital

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Managing Managing Working CapitalWorking Capital

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Inventory ManagementInventory Management

INVENTORY COSTSHOLDING COSTS funding

storage insurance

PROCUREMENT ordering delivery

SHORTAGE COSTS lost contribution from missed sales

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Economic Order QuantityEconomic Order Quantity

EOQ = 2 Co D 1/2

Ch

Where:EOQ (Q) economic order quantityCo Ordering CostD Annual DemandCh Cost of holding 1 unit

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Economic Order Quantity Economic Order Quantity cont.cont.

Example:The expected annual demand is 500,000. Purchase price is $100. It costs $ 500 to place an order and the cost of holding one unit in stock is 20%.

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Economic Order Quantity Economic Order Quantity cont.cont.

-

50

100

150

200

250

300

Q

$' 000s Ch

Co

TC

EOQ

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Economic Order Quantity Economic Order Quantity cont.cont.

Assumptions – Practical ImplicationsGoods are delivered when they are

ordered i.e. no lead timesDemand is constantPrice is constant and no bulk

purchases discounts

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Just-in-Time JITJust-in-Time JIT

Toyota was the first company to develop JIT

Toyota needed to reduce costs of production and JIT was the solution

Kanban System – pull system of production i.e. items are only produced when they are needed

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Just-in-Time JIT Just-in-Time JIT cont.cont.

Companies thinking of introducing JIT will first have to:

Find reliable suppliers

Train employees to minimize wastages and idle time

Improve quality

Minimize lead times

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Trade ReceivablesTrade Receivables

A company which is selling on credit is actually lending money

It must have a debtors policy, composed of a:Credit Analysis SystemCredit Control SystemDebt Collection procedure

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Trade ReceivablesTrade Receivables

The objective of selling on credit is to increase sales, however:

Sales Growth is vanity

Profit is sanity

Cash is king

Ultimate objective should be profitability without jeopardizing liquidity

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Increasing Trade ReceivablesIncreasing Trade Receivables

Main benefit – increase in contribution

Costs

Increase in debtors administration costs

Increase in the likelihood of bad debts

Increase in funding costs

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FactoringFactoring

Three-tiered service

Administration

Credit Protection

Invoice or Bills of Exchange Discounting

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Factoring Factoring cont.cont.

Saving in administration costs

Invoice discounting: alternative source of funds

Credit protection

Can be expensive

Loss of goodwill if too aggressive at chasing for payment

Can be deemed as a signal of liquidity problems

Advantages Disadvantages

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Trade PayablesTrade Payables

Factors to consider in choosing Suppliers:Credit TermsReliability Price

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Management of CashManagement of Cash

3 reasons for holding cash

Transactions motive

Precautionary motive

Speculative motive(John Maynard Keynes)

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Cash Flow ForecastCash Flow Forecast

Simple and Effective Cash Management tool

Objective is to estimate futurecash shortagescash surpluses

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Cash Flow Forecast Cash Flow Forecast cont.cont.

Temporary Surpluses Benefit from early settlement discountsIncrease current assetsMake short-term investments

Temporary DeficitsArrange for short-term fundingGive early settlement discounts

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Cash Flow Forecast Cash Flow Forecast cont.cont.

Permanent Deficits

Raise long-term finance

Permanent Surpluses

Look for feasible long-term projects

Reduce gearing

Expand/Diversify

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Large OrganizationsLarge Organizations

Cash management in large organizations tends to be more complex

Most organizations have centralized treasuries and apply more sophisticated models to manage cash

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Baumol ModelBaumol Model

The Baumol model is the same one which is used to estimate EOQ

Cash is considered as inventory and two related costs are:

Money Procurement costs

Opportunity cost

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Baumol Model exampleBaumol Model example

Treasury

Division A

Division DDivision C

Division B

Cash flowsCash flows

Cash flowsCash flows

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Baumol Model example Baumol Model example cont.cont.

According to the cash flow forecast, Division B’s annual cash requirement is $ 1 million

Procurement Costs - $ 700

Opportunity Cost - 3.5%

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Baumol Model example Baumol Model example cont.cont.

EOQ = 2 Co D 1/2

Ch

Using the same formula for inventories, the optimal amount to be raised and transferred is U$ 200,000.

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ConclusionConclusion

Current Assets are essential in sustaining the operations of a business.

Working Capital Management deals with how current assets are managed and financed.

The objective of working capital management is to maximize profitability without jeopardizing liquidity.

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QUESTION TIME