Chapter Ten: Managing Working Capital

Arab Open University

Department of Business Administration

Chapter Ten: Managing Working Capital

Working Capital is defined as current assets less current liabilities

Working Capital = CA – CL

The Management of Working Capital

The major elements of current assets are:

1) Stocks (inventory)

2) Trade debtors (accounts receivable)

3) Cash (in hand and at bank)

The major elements of current liabilities are:

1) Trade creditors (accounts payable)

2) Bank overdrafts

The Management of Working Capital

 The management of working capital is an essential part of the business's short-term planning process.

 There are costs associated with holding either too much or too little of each element.

 The working capital needs to change over time as a result of changes in business environment such as different production, level of risk and state of the economy).

The scale of Working Capital

The balance between the components of the Working Capital differs from one industry to another according to the nature of its activities

Managing Working Capital

Accordingly, all the following need to be managed in order to manage the working capital.

1) The Management of Stocks

2) The Management of debtors

3) The Management of cash

4) The Management of trade creditors

(1) The Management of Stocks

Costs incurred as a result of holding low levels of stock:

1) Loss of Sales: from bring unable to provide the goods required immediately

2) Loss of goodwill from customers: for being unable to satisfy customer demand.

3) High transport costs: incurred to ensure that stocks are replenished quickly.

4) Lost production: due to shortage of raw Materials.

5) Inefficient production scheduling due to shortages of raw materials.

6) Purchasing stocks at a high price than might otherwise have been possible in order to replenish stocks quickly.

The Management of Stocks

A number of procedures and techniques may be used to ensure:

(1) Budgeting of future demand

 One of the best means of business to ensure stock available is to make appropriate plans. These budgets should deal with each product that the business makes and/or sells.

 The budgets may be developed by using statistical techniques such as time series analysis or the judgement of the sales and marketing staff.

(2) Financial ratios

 One ratio that can be used to help monitor stock levels is the stock turnover period.

 Stock turnover period = Average stock held/ cost of sales × 365.

 This will provide a picture of the average period or which stocks are held, and can be useful as a basis for comparison.

(3) Recording and Reordering Systems

• The management of stocks in a business of any size requires a sound system of recording stock movement.
• There should also be clear procedures for the recording of stocks.
• There will be some uncertainty about the level of stock so a buffer or safety stock level may be maintained in case problems occur. The amount of safety depends on the degree of uncertainty.

(4) Levels of control

 The ABC system of stock control is based on the idea of selective levels of control and can divide its stock into three broad categories A, B, and C.

 Category A contains stocks that are few in quantity and a large proportion of the total value of stocks.

 Category B stock are those items that are less valuable, but more numerous.

 Category C comprises those stock items that are very numerous, but relatively low in value.

 Only Category A stocks would attract the more expensive and sophisticated control

(5) Stock Management Models

• The Economic Order Quantity (EOQ) model is concerned with answering the question "How much stock should be ordered? “.
• EOQ model assumes that demand is constant, so that stocks will be depleted evenly over time, and replenished just at the point that the stock runs out.
• The models can be used to calculate the optimum size of a purchase order by taking account of both of these cost elements.

Activity
 HLA Ltd sells 2000 bags of cement each year. It has been estimated that the cost of holding one bag of cement for a year is $4. The cost of placing an order for stock is estimated at $250
 Calculate the Economic Order Quantity (EOQ) for the bags
EOQ= 500 bags
Number of orders= 2000÷ 500= 4 orders

(6) Materials Requirements Planning (MRP) Systems

• It takes forecasts of sales demand as its starting point and uses computer technology to help schedule the timing of deliveries to coincide with production requirements.
• It is a co-ordinate approach that links materials and parts deliveries to their scheduled input to the production process.
• The approach also takes account of other manufacturing resources such as labor and machine capacity.

7) Just-in-time (JIT) stock management

• It was first used to the U.S defense industry during the Second World War and it has been widely used by Japanese businesses.
• JIT suggests that having supplies delivered to a business just in time for them to be used in the production process.
• For JIT to be successful, business should inform suppliers of its production plans and suppliers deliver materials of the right quality at the agreed times.
• Failure to do so could lead to a dislocation of production and could be very costly.

(2) The Management of debtors

Which Customer Should Receive Credit?

 The five C's items to check the customer’s credit

(1) Character

 It is important for a business to make some assessment of the character of the customer.

 The willingness to pay will depend on the honest and integrity of the individual with whom the business is dealing.

 The business must feel satisfied that the customer will make every effort to pay any amounts owing.

(2) Capital

 The customer must appear to be financially sound before any credit is extended.

 If the customer is a business its financial statements should be examined with focusing on profitability and liquidity of the customer as well as the customer’s financial commitment

(3) Capacity

 The customer must appear to have the capacity to pay amounts owing where possible

 If the customer is a business the type of business operated will be relevant.

 The value of goods that the customer wishes to buy on credit must be related to the total financial resources of the customer

(4) Collateral

 On occasions, it may be necessary to ask for some kind of security for goods supplied on credit.

 When this occurs, the business must be convinced that the customer is able to offer a satisfactory form of security.

5) Conditions

The state of the industry in which the customer operates, and the general economic conditions on the particular region or country, may have an important influence on the ability of a customer to pay the amounts outstanding on the due date.

Activity
What kind of corrective action might the manager of business decide to take if they found that debtors were paying more slowly than anticipated? Managers might decide to do one or more of the following:

1) Offer cash discounts to encourage rapid payments.

2) Change the collection periods.

3) Improve the accounting systems to ensure that customers are billed more quickly; reminders are sent out rapidly and so on.

4)  Change the eligibility criteria for customers who receive credit.

(3) The Management of cash

Cash is held for:

1) Transactionary motives

 To meet day-to-day commitments, a business requires a certain amount of cash, payments for wages m overhead expenses, goods purchased and so on must be made at the due dates.

(2) Precautionary motives

 If future cash flows are uncertain for any reason, it would be prudent to hold a balance of cash.

 For example, a major customer that owes a large sum to the business may be in financial difficulties.

 Given this situation, the business can retain its capacity to meet its obligations by holding a cash balance.

 Similarly, if there is some uncertainty concerning future outlays, a cash balance will be required.

(3) Speculative motives

 A business may decide to hold cash to put itself in a position to exploit profitable opportunities as and when they arise.

 For example, by holding cash, a business may be able to acquire a competitor business that suddenly becomes available at an attractive price.

 The amount of cash held is according to:

(1) The Nature of the Business

 Some businesses such as utilities (for example, water, and electricity) may have cash flows that are both predictable and reasonably certain.

 This will enable them to hold lower cash balances.

 For some businesses, cash balances may vary greatly according to the time of year.

 An essential business may accumulate cash during the high season to enable it to meet commitments during the low season.

(2) The opportunity cost of holding cash: if there are profitable opportunities it may not be wise to hold a large cash balance.

(3) The level of inflation: Holding cash during a period of rising prices will lead to a loss of purchasing power. The higher the level of inflation, the greater will be this loss.

(4) The availability of near-liquid assets: If a business has marketable securities or stocks that may easily be liquidated, the amount of cash held may be reduced.

(5) The availability of borrowing: if a business can borrow easily (a quickly) there is less need to hold cash.

(6) The cost of borrowing: When interest rates are high, the options of borrowing become less attractive.

(7) Economic Conditions: When the economic is in recession, business may prefer to hold cash so that they can be well placed to invest when the economy improved. In addition, during a recession, business may experience difficulties in collecting debts. They may therefore hold higher cash balances than usual n order to meet commitments.

(8) Relationship with suppliers: Too little cash may hinder the ability of the business to pay suppliers promptly. This can lead to a loss of goodwill. It may also lead to discounts being forgone.

How to control the cash balance

 These are determined through a model. These develop upper and lower limits and the use of target cash balance.

 These models assume that the business will invest in marketable investments that can easily be liquidated.

The Management of trade creditors

 Trade credit is regarded as an important source of finance by many businesses. Described as a spontaneous or free source of finance.

 The average settlement period is a method to monitor the level of trade creditors. An ageing schedule for creditors may sometimes be more appropriate.