Managing Finance and Budgets

Presentation 8

Working Capital (1)

Session 3 - Financial Statements (2)

Learning outcomes:Understand what is meant by the term ‘Working Capital’, and be able to describe some of the elements of which it comprises.

Understand what is meant by the Operating Cash Cycle and how it might affect a business.

Manipulate and use financial statements to inform decision-making specifically related to Working Capital.

Key concepts:Cash Flow Statement Working Capital

What is Working Capital?

Working Capital is usually defined as:

Current Assets

Less Current Liabilities

The major elements are: Stocks, Debtors, Cash (Assets) Creditors, Tax payable, Overdraft (Liabilities)

The Elements of Working Capital

a summary

Major elements Major element

Stocks

Trade debtors

Cash (in hand and at bank)

Trade creditors

lessequals

Current liabilitiesWorking capital Current assets

Why do we need to Manage Working Capital?

A shortage of Working Capital may lead to operating difficulties - shortage of stock, inability to offer credit to clients, slow payment to creditors, missed opportunities

An excess of Working Capital also represents money “locked up” in stocks and debtors - investment may not produce an appropriate return

Working capital, therefore, needs careful management

The Problem of “Overtrading”

This is where the working capital is insufficient to finance the increasing volume of trade

Expansion means more money is required to finance higher stock levels, and higher levels of debt

Organisations try to achieve this by increasing amount of time taken to pay suppliers, or increasing overdraft up to or beyond limit

A minor difficulty in any element of the working capital (e.g. late client payment) can then cause catastrophe

The Working Capital Cycle

Purchase materials, which we Use for Work-in-Progress, then we Pay employees, who Develop Finished goods, which we Sell for cash or on credit, so we can Pay creditors, and then Retain the Surplus, which we use to…

This is essentially just a a simplified version of the how the operating activities link together and affect one other:

The Working Capital Cycle

Summary diagram

Cash sales

Trade creditors

Trade debtors

Finished goods

Cash/bank overdraft

Work-in-progress

Raw materials

Key Elements of Working Capital

There are three key elements to Working Capital:

Stock (absorbs working capital) Trade Debtors (absorbs working capital) Trade Creditors (releases working capital)

Each one of these needs to be monitored effectively.

Key Elements of Working Capital:Stock

The higher the levels of stock, the more money the business has tied up in goods.

There may be very good reasons why some businesses need to carry high stock levels (Tesco, for example needs to carry a huge range of items; it will also need to have some basic items such as bread, milk and potatoes in large quantities)

Normally, holding large volumes of stock is not a good idea; if stock is held for long periods, the money is ‘dead’, and not being used effectively.

Typically, the highest profitability occurs when stock levels are at the minimum levels to supply customer needs.

Key Elements of Working Capital:Trade Debtors

Carrying higher levels of Trade Debtors means that the business has a lot of money tied up, which it is not able to use to generate profit.

The businesses that owe us money, are effectively using it to invest in their business, and so create profits for them.

There may be good reasons why some businesses need to carry high levels of Trade debtors. (Builders, for example typically work on contracts for several months before getting paid.)

In the normal ‘cut & thrust’ of trade, most businesses would typically expect payment within one calendar month.

Key Elements of Working Capital:Trade Creditors

Carrying high levels of Trade Creditors means that the business has access to a lot of resources (such as stock, rent, fuel etc.), but for which it has not paid.

This means that other businesses have effectively provided us (until we pay) with free resources, that we can use to create create profits for us.

Before we get carried away, there are good reasons why we should not carry high levels of Trade Credit.

In the normal ‘cut & thrust’ of trade, most businesses would typically expect payment within one calendar month; if this does not happen, we may incur penalties, and ultimately suppliers may refuse to trade with us.

The Working Capital Cycle- revisited

The diagram below is a simplified version of the Working Capital Cycle:

purchase of goods on credit

Cash received from debtors

payment to creditors for

goods

Sale of goods on credit

The cycle gives rise to two important time periods: The Stockholding Period The Operating Cash Cycle

The Operating Cash Cycle

The Operating Cash Cycle is defined as the time between the outlay of cash necessary for the purchase of stocks to the ultimate receipt of cash from the sale of goods.

purchase of goods on credit

Cash received from debtors

payment to creditors for

goods

Sale of goods on credit

Operating Cash Cycle

The Operating Cash Cycle can be calculated using the following equation:

Operating Cash Cycle =

Average Settlement period for Creditors

Average Settlement period for

debtors

Average Stockholding

Period

+ -

Long Operating Cash Cycles have a significant influence on the financing of the business.

Most business will wish to reduce this to a minimum.

Example of Operating Cash Cycle

Using the amounts calculated previously :

Operating Cash Cycle

= 80.1968.3441.26 + -

= 29.41 days

In this case, the average time between the cash laid out and cash returned is less than one month.

Stock Turnover Days

Stock Turnover Days

Debtor Days

Debtor Days

Creditor Days

Creditor Days

Purchase of goods on credit

Payment for goods

Sale of goods on

credit

Cash received

from debtors

Stockholding period

Operating cash cycle

Creditor Period

Debtor Period41.26 Days41.26 Days

68.34 Days68.34 Days

80.19 Days80.19 Days

41.26+ 68.34 –80.19 = 29.41 Days41.26+ 68.34 –80.19 = 29.41 Days

Why is the OCC important?

Effectively the OCC is the time it takes for cash to circulate around the Operating Activities of the business.

On every pass through the cycle, profit will be generated.

The shorter the cycle, the faster cash goes around, and the more profit will be generated over the accounting period.

How can we reduce the OCC?

The Operating Cash Cycle is calculated by:

OCC = Stock + Debtors – Creditors

So we try to: Reduce Stock Reduce Debtors Increase Creditors

Reducing the OCC

Example: OCC = Stock + Debtors – Creditors

OCC = 41.26 + 68.34 – 80.19 = 29.41 days Suppose we: Reduce Stock to 40.26 ; OCC = 28.41 days Reduce Debtors to 63.34; OCC = 23.41 days Increase Creditors to 82.19; OCC = 21.41 days

Effectively we have reduced the time between payout & payback by 8 days. This means that we can re-invest our money sooner, and generate more turnover in the same year.

Controlling Working Capital through the Cash Balance

We have seen that three important elements of Working Capital are Stocks, Debtors and Creditors.

Another element is the Cash Balance at the Bank. This is important because sooner or later, we need to

get money from our Debtors, and pay our creditors. In order to manage this process, we need to monitor

our current cash flow situation, and our current bank balance.

Controlling the Cash Balance

There are many techniques for controlling the cash element of Working Capital:

One model proposes: A Target Balance Inner Limits (+/-) (close to the target) Outer Limits (+/- ) (further away)

Inner limit

Outer limit

Target cash balance

Inner limitCash

balance (£)

Outer limit

Time (days)

2 864 9531 7 11 12100

Controlling the cash balance

Seminar Eight - Activities

Preparation: read M & A Chapter 16 Describe key concepts:

Working Capital

Operating Cash Cycle Working Capital Example M & A Exercise 16.1 (answers in M & A)

NB Seminar 8 mainly consists of answers to the example, followed by Test 2, which will last the rest of the time.