Working Capital Management by Binam Ghimire
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Transcript of Working Capital Management by Binam Ghimire
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Working Capital Managementby Binam Ghimire
Learning Objectives
Concept and Significance of WC management Cash Conversion Cycle Receivables Management and Credit Policy Inventory Management Cash Management and Cash Budget
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WC:Concept
Is Cash really a King?
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WC:Concept
“My techniques confine itself to the purchase of common stocks at less than their working capital value”
– Benjamin Graham
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WC:Concept
Look at the Balance Sheet given and find out the followingsGross Working CapitalNet Working Capital/ Net Operating Working
Capital
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WC: Classification
Permanent Variable
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Permanent WC
Variable WC
Working Capital (£)
Time
WC Management
Short-term financial management The management of current assets investment
and their financing Zero Working Capital Level of Working Capital: Optimal
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WC Management
PoliciesWorking Capital Investment PolicyWorking Capital Financing Policy
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WC Management
Policies: Aggressive, Moderate and ConservativeLiquidityProfitability
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Current Assets (£)
Conservative
Moderate
Aggressive
Output (units)
WC Management
Policies: Aggressive (Short term funds to finance the permanent CA)
Level ofCA/Sales ratiois ……
Match the Fund requirement to the maturity of assets 10
Assets
Month
Fixed Assets
Permanent current assets or net working capital
Total Funds Short term Funds
WC Management
Policy: Conservative (long term fund for permanent CA)
Level ofCA/ Sales ratiois ……
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Assets
Fixed Assets
Permanent CA
Month
Cash Conversion Cycle (CCC)
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Cash
Purchase
Inventory of Raw Materials
Inventory of Work-in-progress
Inventory of Finished Goods
Sales
Receivables
Payable
CCC
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The time intervals between outflow of cash and its inflow through sales and collection from customers.
CCC also known as trading cycle, Cash cycle, Operating cycle (Operating also includes the Date the order is placed i.e. the date firm purchases the inventory)
CCC, Formula
CCC =
Inventory Turnover Period (Inventory Days)
+ Average Collection Period (Receivable Days)
– Average Payable Period (Payable Days)
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CCC, Formula
Inventory Days: Inventory/Average Daily Cost of Goods Sold
Receivable Days: Receivables /Average Daily Sales
Payable Days:Payables/ Average Daily Costs of Good Sold
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CCC Consider the following information taken from a
company’s statements
Receivable Days = (100,000/ 600,000) x 365 = 61 days Inventory Days = (80,000/400,000) x 365 = 73 days Payable Days = (120,000/400,000) x 365 = 110 days CCC = 24 days
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Income Statement
£ Balance Sheet
£
Sales 600,000 Receivables
100,000
Gross Profit 200,000 Inventory 80,000Payables 120,000
CCC, Example 1
Extracts for A Ltd. (£)Income Statement:
Balance Sheet:
Prepare the operating cycle
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Turnover 250,000Gross Profit 90,000
Inventory 30,000Receivables 60,000Payable 50,000
CCC, Example 2
Extracts for X Ltd. (£ ‘000)
Income Statement:
Balance Sheet:
Prepare the trading cycle
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Turnover 100Cost of Sales 50
Inventory 10Receivables 15Payable 12
CCC, Case - solve and comment Given the following information from Elite PC’s
2006 income statement and balance sheet (numbers are in the $millions), calculate the company’s cash conversion cycle (CCC) and use it to evaluate the company’s efficiency and comment on the results:
Sales 66,467Cost of Goods Sold 54,226Accounts Receivable 5,160Inventory 643Accounts payable 10,234
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Managing Receivables (MR) Offer Credit
Advantages Retain customers More (old and new) customers
Disadvantages Bad Debts Slow Payers that increase WC Higher monitoring expenses
How can we manage credit?
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MR:Aspects to Credit Management Assessing Credit Status Terms of Trade Day to Day Management
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MR:Aspects to Credit Management Assessing Credit Status
Own record of sales Bank Reference Trade Reference Published Accounts Credit Rating Agencies Credit Scoring: subjective guidelines such as 5 Cs
(Character, Capacity, Capital, Collateral, Conditions) Altman Z score (Edward Altman Z Score)
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MR: Aspects to Credit Management, Assessing Credit Status, Altman Z Edward Altman developed a Z Score formula that
was able to identify bankrupt firms approximately 95% of the time.
If Z is < 1.81 likely to become bankrupt, 1.82 – 2.99 may become bankrupt, > 2.99 will not become bankrupt
Interested see – www.jaxworks.com/zscore3.htm 23
Altman Z Score formula
Z = 3.3EBIT
total assets+ 1.0
salestotal assets
+.6market value of equity
total book debt
+ 1.4retained earnings
total assets+ 1.2
working capitaltotal assets
If the Altman Z score of a company is as follows, would we accept the client?
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9.debtbook equitymarket
4.1assets total
sales
12.assets total
EBIT
retained earningstotal assets
working capitaltotal assets
=
=
.
.
4
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MR: Aspects to Credit Management, Assessing Credit Status, Altman Z
Z score is > 2.99
So accept the client
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Firm' s Z Score( . . ) ( . . ) ( . . ) ( . . ) ( . . ) .3 3 12 1 0 1 4 6 9 1 4 4 1 2 12 3 04x x x x x+ + + + =
MR: Aspects to Credit Management, Assessing Credit Status, Altman Z
MR: Aspects to Credit Management Terms of Trade
Credit limit amount Interest on overdue account Discount for early payment Number of Days Credit
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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
If a firm sells goods on terms of 2/30, net 60 This means a 2% discount for payment within 30
days or else must pay in full within 60 days. If the term is only net 60 days then no discount pay by 60 days
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What does it mean: A sells goods, terms 5/10, net 30 Which is wrong? (A or B)
A) 3/20, net 40 B) 4/20, net 10
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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
Suppose that a firm sells goods on terms of 2/10, net 20 On 1st of May you buy goods from the company with an
invoice value of £ 20,000. How much would you need to pay if you took the cash discount? What is the latest date on which the cash discount is available? By what date should you pay for your purchase if you decide not to take the discount?
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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
To get the cash discount, you have to pay the bill within 10 days, that is, by 11th May. With the 2% discount, the amount that needs to be paid by 11th May is £20,000 x 0.98 = £19,600. If you forego the cash discount, you don’t have to pay the bill until 21st May when you pay (£20,000)
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MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
Trade Credit Rates (rate when firm does not accept the discount but makes the payment on the payment date)
What is the effective interest rate in such a case? (After all this is an implicit loan from the supplier)
The formula is then
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1PriceDiscounted
Discount1RateAnnualEffectiveCreditDaysExtra
365
MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
What is the implied interest rate on the trade credit if the discount for early payment is 5/10, 60?
= 0.454 (i.e. this is equivalent to 45.4 % a year)
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1PriceDiscounted
Discount1RateAnnualEffectiveCreditDaysExtra
365
19551RateAnnualEffective
50365
MR: Aspects to Credit Management, Terms of Trade, Discount for early payment
MR: Aspects to Credit Management, Terms of Trade, No. of Days Credit Collection Policy: Procedures to collect and monitor
receivables Aging Schedule - Classification of accounts
receivable by time outstanding
Sample aging schedule for accounts receivable
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Customer' sName
Less than1 month
1 - 2 months 2 - 3 monthsMore than3 months
Total Owed
A 10,000 0 0 0 10,000B 8,000 3,000 0 0 11,000* * * * * ** * * * * ** * * * * *Z 5,000 4,000 6,000 15,000 30,000
Total $200,000 $40,000 $15,000 $43,000 $298,000
MR:Aspects to Credit Management Day to Day Management
Recover the money and keep the customer Communicate frequently
A Process
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Time Line ActionAfter 30 days Send statement of
account+ 7 days Reminder Letter+ 7 days 2nd Reminder+ 7 days Legal action threat+ 7 days Take action
MR:Cost of financing receivables Total cost for a year
How much the receivables are costing in the course of a year
What interest rate to apply?
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MR:Cost of financing receivables, Formulas
Interest Cost =Receivable balance x Interest Rate
Receivable Days =
(Receivable balance/ Sales) x 365
Receivable Balance =
(Receivable Days x Sales)/ 365
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MR, Cost of financing receivables:Example 3 Sales = £10 m, Receivable = £3m. Interest Rate = 6%,
Calculate 1) the receivable days and 2) cost of financing receivables
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MR, Cost of financing receivables:Example 4 Discount for early settlement Same as example above, Now 0.5% discount to
customers who pay after 30 days (i.e. they pay after 30 days after the sale) instead of current average of 109.5 days. Assume 40% of customers are expected to take the offer]
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MR, Cost of financing receivables:Example 4, Solution Step 1: Calculate the receivable balance for those
who continue with the existing terms (60% of customers)
Receivable balance = (10m x 60% x (109.5/ 365)) = £1,800,000
Step 2: Calculate the receivables balance for those who pay after 30 days
Receivable balance = (10m x 40% x (30/365)) = £328,767
Step 3 Calculate the interest cost of these to A ltd(1800,000 x 0.06) + (328,767 x 0.06)= 108,000 + 19,726 =127,726
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MR, Cost of financing receivables:Example 4, Solution
Step 4 Calculate the cost of the discount10m x 40% x 0.5% = £ 20,000 Therefore total cost of finance =£127,726+ £20,000 = £147,726
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MR, Cost of financing receivables:Example 5 Shankley Ltd. has sales of £ 40 m. for the previous year,
receivables at the year end year £8 m. The cost of financing debtors is covered by an overdraft at the interest rate of 14 %.
What are the receivable days for Shankley. Calculate the cost of financing receivables
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MR, Cost of financing receivables:Example 6 Shankley Ltd. As above but discount of 2% is offered for
payment within 10 days. Should the company introduce the discount given that
50% of the customers take up the discount?
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MR, Cost of financing receivables:Example 6, Solution Step 1: Calculate the cost of receivables for those who
continue with the current terms (note that this step and step 2 combines the calculation of the receivables balance with the calculation of the interest on that balance)
£40m x 50% x 73/ 365 x 0.14 = £560,000 Step 2: Calculate the cost of the receivables for those
who take the early settlement discount£40m x 50% x 10/ 365 x 0.14 = £76,712
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MR, Cost of financing receivables:Example 6, Solution Step 3: Calculate the cost of the discount£40m x 50% x 2% = £400,000 Step 4: Calculate the total cost of finance£560,000 + 76,712+ 400,000= £1,036,712This is cheaper than the previous cost of £1,120,000.
therefore the new offer is cost effective
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MR, Factoring Factoring: Outsourcing of credit control department to a
third party The factor takes the responsibility to collect the debt for
a fee
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MR:Factoring, Example 7
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Continue Example 6. Rather than offer a discount, the company has been offered a contract by a factor whereby the factor offers to collect the debt for a fee of 0.75% of turnover. They believe they can collect the debt in 80 days. Admin savings of £ 20,000 are expected.
Should A Ltd. accept the offer?
Inventory Management (IM):Concept
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Minimise Total Inventory Cost Two basic but conflicting issues
How? Neither inadequate nor excessive inventory
IM:Cost components
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TC = OC + CC
IM, Differentiate the following:OC or CC?
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1. Cost of storage2. Cost of preparing specifications 3. Cost of deterioration and obsolescence4. Cost of receiving an order and checking it
against the invoice5. Cost of running a purchasing department6. Cost of writing a purchase order7. Cost of processing the paperwork 8. Insurance and taxes9. Personnel and telephone costs
IM, Carrying Cost: Total Carrying Cost =
TCC = C x Q/2
Where, C = carrying costs per unitQ = order size of inventoryQ/2= average inventory unit
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IM, Ordering Cost: Total Ordering Cost =
TOC = O x R/ Q
Where,O = ordering costs per orderR = total requirement of inventory for the
periodR/Q= number of order to be placed
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IM, Total Cost of Inventory : Total Inventory Cost =
TIC = C x Q/2 + O x R/ Q
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IM, Economic Order Quantity:
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TIC is minimum when CC = OCCosts
EOQ
Total costs
Carrying costs
Ordering costs
Order Size (in units)
IM, Economic Order Quantity: Algebraically
WhereCo = Cost per OrderD = Annual DemandCh = Cost of holding one unit for one year
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ChDxCox2EOQ
IM, Example 8: A company requires 20,000 Kg. of a raw material
per annum. The cost of placing an order is £ 40 regardless of the size of the order. The holding costs are £ 0.5 per unit per month. What is the EOQ?
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Cash Management Reasons for Holding Cash
TransactionPrecautionarySpeculative
How much to hold?Liquidity and Profitability
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Cash Management Baumol Model This is simply the EOQ model to manage the cash Formula
WhereQ = Amount invested per TransactionCo= Transaction cost of investing/ en-cashing a
securityD = Excess cash available to invest in short term
securitiesCh = Opportunity cost of holding cash
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ChDxCox2Q
Cash Management Baumol Example A company generates £5,000 per month excess
cash. The interest rate it can expect to earn on its investment is 6% p.a. The transaction cost associated with its separate investment of funds is constant at £50.
What is the optimum amount of cash to be invested in each transaction. How many transaction will arise each year
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Cash Management Optimum amount of cash to be invested =
= £10,000
Numbers of transactions = D/ Q = 60,000/10,000 = 6
Other models: Miller- ORR
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0.0660,000x50x2Q
Cash Budget A cash budget is a statement of all the inflows
and outflows of cash for a given period Financial Manager can use the Cash Budget to
identify short-term financial needs. The cash budget tells the manager what
borrowing is required or what lending will be possible in the short term.
The firm has a number of possible ways of acquiring funds to meet short-term shortfalls, including unsecured (line of credit from a bank) and secured loans (accounts receivable or inventories).
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Thank You
“Revenue is vanity, Profit is sanity”