Chapter 15 Working Capital Management

Topic List 1. 2. 3. !. 5. Objectives of working capital management Cash conversion cycle Working capital ratios and overtrading Working capital re"#irement %nventory management 5.1 Costs and objective of inventory management 5.2 'O( 5.3 (#antity *b#lk p#rchase+ disco#nt 5.! ,e-order level 5.5 .#st-in-time *.%/+ 0cco#nts receivable management .1 1ey areas of acco#nts receivable management .2 2actors considered to form#late policy on receivables .3 'arly settlement disco#nts .! 2actoring .5 %nvoice disco#nting 0cco#nts payables management 2oreign trades management Cash management &.1 ,easons for holding cash &.2 Cash b#dgets and cash flows forecasts Cash management model 1).1 4a#mol model 1).2 5iller-Orr cash management model 6hort-term investment on cash s#rpl#s 6hort-term borrowing 6trategies for f#nding working capital Page 351 352 35 35$ 35& 3 ) 3 2 3 3 3 ! 3 5 3 5 3 3 3 3 & 331 332 333 333 33 3$) 3$2 3$2 3$3

3. $. &.

1).

11. 12. 13.

&!

1.
1.1

Objectives of Working Capital Management

Objectives7 /he objectives of working capital management are profitabilit an! li"#i!it . /he objective of profitabilit s#pports the primar financial management objective8 which is sharehol!er wealth ma$imi%ation. /he objective of li"#i!it ens#res that liabilities can be met as the fall !#e. Conflict between two objectives7 Li"#i! assets s#ch as bank acco#nts earn ver little ret#rn or no ret#rn8 so li"#i! assets !ecrease profitabilit . Profitabilit is met by investing over the longer term in order to achieve higher ret#rns. Tra!e&off between two objectives7 %t !epen!s part on the partic#lar circ#mstances of an organi9ation. Li"#i!it may be more important objective when short&term finance is har! to fin!. Profitabilit may become a more important objective when cash management has become too conservative. 4oth objectives are important and neither can be neglected. 'teps to achieve the objectives of working capital management7 (oo! cre!it management effect : 0ims to minimi%e the risk of ba! !ebts and e$pe!ite the prompt pa ment of money d#e from debtors /ake steps to optimi%e the level an! age of !ebtors will minimi%e the cost of financing them8 lea!ing to increase in the ret#rns available to shareholders. (oo! inventor management effect : ;se8 for e<ample8 )O*+ ,-C anal sis an! b#ffer stock management can minimi%e the costs of hol!ing an! or!ering inventor . 0pply the ./T inventory proc#rement can re!#ce the cost of investing in inventor . %mprove inventory management can therefore re!#ce costs an! increase sharehol!er wealth. Other e<amples7 Cash b#!gets can help to !etermine the transaction nee! for cash. -a#mol mo!el an! Miller&Orr mo!el can help to maintain cash balances close to optim#m levels.
&5

1.2

1.3

1.!

*#estion 1 *a+ %dentify the objectives of working capital management and disc#ss the conflict that may arise between them. *3 marks+ *b+ =isc#ss whether profitability or li"#idity is the primary objective of working capital management. *! marks+ *c+ O#tline the advantages to a company of taking steps to improve its working capital management8 giving e<amples of steps that might be taken. *3 marks+

0.

Cash Conversion C cle 1Cash Operating C cle+ Working Capital C cle or Tra!ing C cle2
The Cash Operating C cle /he cash operating c cle *working capital c cle or tra!ing c cle+ is the length of time between the company>s o#tlay on raw materials8 wages and other e<pendit#res and the inflow of cash from the sale of goods.

2.1

&

2.2

2.3

2.!

'ignificance 1or factors2 in !etermining the level of investment in working capital7 /he longer the cash conversion c cle8 the higher the investment in working capital. /he length of the cash operating cycle varies between in!#stries8 for e<ample : 6ervice organi9ation may have no inventory holding period8 ,etail organi9ation will have a stock holding period based almost entirely on finished goods and a very low level of debtors8 5an#fact#ring organi9ation will have a stock holding period based on raw materials8 W%? and finished goods. /he length of the cash operating cycle also varies within the same in!#stries8 depends on which working capital policies adopted : ,ggressive polic : characteri9ed by lower levels of inventor an! receivables. %t can increase profitabilit b#t also increase the risk of r#nning o#t of inventor 8 or losing potential c#stomers d#e to better credit terms being offered by competitors. Conservative polic : maintain high levels of investment in inventor an! receivables8 profitabilit is therefore re!#ce!8 b#t the risk of stock&o#ts is lower and new cre!it c#stomers ma be attracte! by more genero#s terms. Terms of tra!e7 More genero#s terms of tra!e will need a comparatively higher investment in c#rrent assets. @ow to re!#ce the level of investment in working capitalA 3e!#ce the inventor hol!ing perio!8 e.g. #sing .%/. 3e!#ce receivables collection perio!8 e.g. improve receivables management. /ncrease pa ables repa ment perio!8 e.g. settle invoices as late as possible. Calc#lation of the cash conversion cycle7 2or man#fact#ring b#siness ,aw materials holding period < Bess7 ?ayables> payment period *<+ W%? holding period < 2inished goods holding period < ,eceivables> collection period < <

&3

2or wholesale or retail b#siness %nventory holding period Bess7 ?ayables> payment period ,eceivables> collection period

< *<+ < <

/he cycle may be meas#red in days8 weeks or months.

*#estion 0 4 Cash Operating C cle+ Working Capital Management an! 5actoring '<tracts from the recent financial statements of 0njo plc are as follows7 /ncome statements /#rnover Cost of sales Dross profit 0dministration e<penses ?rofit before interest and ta< %nterest ?rofit before ta< 0667 C))) 158 )) &83)) 83)) 18))) 583)) 1)) 582)) 0665 C))) 1181)) 8 )) !85)) 35) 3835) 15 38335

'tatement of financial position C))) 8on&c#rrent assets C#rrent assets %nventory ,eceivables Cash C#rrent liabilities /rade payables Overdraft

0667 C))) 5835) C)))

0665 C))) 58!))

38))) 38$)) 12) 8&2) 28$3) 18)))

183)) 18$5) &)) !8)5) 18 )) 15)

&$

*38$3)+ /otal assets less c#rrent liabilities $8$))

*1835)+ 383))

0ll sales were on credit. 0njo plc has no long-term debt. Credit p#rchases in each year were &5E of cost of sales. 0njo plc pays interest on its overdraft at an ann#al rate of $E. C#rrent sector averages are as follows7 %nventory days7 &) days ,eceivable days7 ) days ?ayables days7 $) days 3e"#ire!9 *a+ Calc#late the following ratios for each year and comment on yo#r findings. *i+ %nventory days *ii+ ,eceivables days *iii+ ?ayables days * marks+ Calc#late the length of the cash operating cycle *working capital cycle+ for each year and e<plain its significance. *! marks+ =isc#ss the relationship between working capital management and b#siness solvency8 and e<plain the factors that infl#ence the optim#m cash level for a b#siness. *3 marks+ 0 factor has offered to take over sales ledger administration and debt collection for an ann#al fee of ).5E of credit sales. 0 condition of the offer is that the factor will advance 0njo plc $)E of the face val#e of its debtors at an interest rate 1E above the c#rrent overdraft rate. /he factor claims that it wo#ld red#ce o#tstanding debtors by 3)E and red#ce administration e<penses by 2E per year if its offer were accepted. 3e"#ire!9 'val#ate whether the factor>s offer is financially acceptable8 basing yo#r answer on the financial information relating to 2)) . *$ marks+ */otal 25 marks+

*b+ *c+ *d+

&&

:.
3.1 3.2

Working Capital 3atios an! Overtra!ing

Working capital ratios may help to in!icate whether a compan capitali%e! *overtra!ing+. /ypes of working capital ratios
Current assets

is over&

*1+ *2+ *3+

C#rrent ratio F Current liabilitie s (#ick ratio F 0cco#nts

Current assets less inventories Current liabilitie s

receivable

payment

period

Average Trade receivables 3 5 days Credit sales turnover

*!+ *5+ * +

2inished goods t#rnover period F ,aw materials holding period F W%? holding

Average inventory 3 5 days Cost of sales

Average raw materials 3 5 days Annual purchases

period

Average WIP Degree of WIP completion 3 5 days Cost of sales

*3+ *$+ 3.3 3.!

0cco#nts payable payment period F Purchases or cos t of sales 3 5 days Working capital t#rnover F Current assets Current liabilities
Sales revenue

Average Trade payables

Overtra!ing occ#rs when a b#siness has ins#fficient finance for working capital to s#stain its level of tra!ing. ' mptoms of overtra!ing7 ,apid increase in t#rnover. ,apid increase in the vol#me of c#rrent assets and possibly also non-c#rrent assets. %nventory t#rnover and acco#nts receivable t#rnover might slow down. 0cco#nts payable period is likely to lengthen. 4ank overdrafts often e<ists or even e<ceeds the limit of the facilities agreed by the bank. C#rrent ratio and "#ick ratio fall. =ebt ratios alter dramatically. Bi"#id deficit may happen8 that is8 an e<cess of c#rrent liabilities over c#rrent assets.
1))

*#estion : 4 /nterest 3ate 3isk+ Overtra!ing an! 5actoring /he following financial information related to Dorwa Co7 066; <666 338!)) 3!8!)$ 28&&2 355 28 33 066; C))) 8on&c#rrent assets C#rrent assets %nventory /rade receivables C#rrent liabilities /rade payables Overdraft 8et c#rrent assets $E 4onds Capital an! reserves 6hare capital ,eserves C))) 138 32 C))) 0667 <666 2 832) 2383$1 28&3& 23! 28 0667 C))) 12835) 5

6ales *all on credit+ Cost of sales Operating profit 2inance costs *interest payments+ ?rofit before ta<ation 'tatement of financial position

!8 )) !8 )) &82)) !835) 38225 38&35 18225 1!8$53 28!25 128!32 8))) 8!32 128!32

28!)) 282)) !8 )) 28))) 18 )) 38 )) 18))) 13835) 28!25 118325 8))) 58325 118325

/he average variable overdraft interest rate in each year was 5E. /he $E bonds are redeemable in ten years> time. 0 factor has offered to take over the administration of trade receivables on a non-reco#rse
1)1

basis for an ann#al fee of 3E of credit sales. /he factor will maintain a trade receivables collection period of 3) days and Dorwa Co will save C1))8))) per year in administration costs and C35)8))) per year in bad debts. 0 condition of the factoring agreement is that the factor wo#ld advance $)E of the face val#e of receivables at an ann#al interest rate of 3E. 3e"#ire!9 *a+ =isc#ss8 with s#pporting calc#lations8 the possible effects on Dorwa Co of an increase in interest rates and advise the company of steps it can take to protect itself against interest rate risk. *3 marks+ ;se the above financial information to disc#ss8 with s#pporting calc#lations8 whether or not Dorwa Co is overtrading. *1) marks+ 'val#ate whether the proposal to factor trade receivables is financially acceptable. 0ss#me an average cost of short-term finance in this part of the "#estion only. *$ marks+ */otal 25 marks+

*b+ *c+

=.
!.1

Working Capital 3e"#irement

Comp#ting the working capital re"#irement is a matter of calc#lating the val#e of c#rrent assets less c#rrent liabilities8 perhaps by taking averages over a one-year period.

*#estion = /he following data relate to 04C Co8 a man#fact#ring company. 6ales reven#e for year7 Costs as percentage of sales7 =irect materials =irect labo#r Gariable overheads 2i<ed overheads 6elling and distrib#tion 0verage statistics relating to working capital are as follows7 *1+ ,eceivables take 2.5 months to pay *2+ ,aw materials are in inventory for three months
1)2

C185))8))) 3)E 25E 1)E 15E 5E

*3+ *!+

W%? represents two months> half-prod#ced goods 2inished goods represent one month>s prod#ction

*5+

Credit it taken7 - 5aterials - =irect labo#r - Gariable overheads - 2i<ed overheads - 6elling and distrib#tion

2 months 1 week 1 month 1 month 1H2 month

W%? and finished goods are val#ed at the cost of material8 labo#r and variable e<penses. 3e"#ire!9 Comp#te the working capital re"#irement of 04C Co ass#ming that the labo#r force is paid for 5) working weeks in each year.

5.
5.1 5.1.1

/nventor Management
Costs an! objective of inventor management Costs of high inventor level7 ?#rchase costs @olding costs 6torage 6tores administration ,isk of theftHdamageHobsolescence Costs of low inventor level7 6tocko#t costs Bost contrib#tion ?rod#ction stoppages 'mergency orders @igh re-orderHset#p costs Bost "#antity disco#nts Objective of goo! inventor management is to determine7 /he optim#m re&or!er level : how many items are left in inventory when the
1)3

5.1.2

5.1.3

ne<t order is placed8 and /he optim#m re&or!er "#antit : how many items sho#ld be ordered when the order is placed for all material inventory items.

5.0 5.2.1

)O* )conomic or!er "#antit 1)O*2 : minimi9e the total cost of holding and ordering inventory.

'O( F

2C ) D CH

5.2.2

5.2.3

C) F Cost of placing one order C@ F @olding cost per #nit of inventory for one period = F 0nn#al demand (#antity disco#nts : disco#nts may be offered for ordering in large "#antities. %f the 'O( is smaller than the order si9e needed for disco#nt8 sho#ld the order si9e be increased above the 'O(A Limitations of 'O(7 Only base! on two t pes of costs7 holding costs and ordering costs. =emand for stock8 holding cost per #nit per year and order cost are ass#med to be certain an! constant. /gnore the cost of r#nning o#t of stock *stocko#ts+ >evelope! on the basis of %ero lea! time an! no b#ffer stock.

*#estion 5 4 Objectives of working capital management+ )O*+ ,3 management an! foreign c#rrenc risk management ?10 Co is a '#ropean company that sells goods solely within '#rope. /he recentlyappointed financial manager of ?10 Co has been investigating the working capital management of the company and has gathered the following information7 /nventor management /he c#rrent policy is to order 1))8))) #nits when the inventory level falls to 358))) #nits. 2orecast demand to meet prod#ction re"#irements d#ring the ne<t year is 258))) #nits. /he cost of placing and processing an order is I25)8 while the cost of holding a #nit in stores is I)J5) per #nit per year. 4oth costs are e<pected to be constant d#ring the ne<t year. Orders
1)!

are received two weeks after being placed with the s#pplier. Ko# sho#ld ass#me a 5)-week year and that demand is constant thro#gho#t the year. ,cco#nts receivable management =omestic c#stomers are allowed 3) days> credit8 b#t the financial statements of ?10 Co show that the average acco#nts receivable period in the last financial year was 35 days. /he financial manager also noted that bad debts as a percentage of sales8 which are all on credit8 increased in the last financial year from 5E to $E. ,cco#nts pa able management ?10 Co has #sed a foreign s#pplier for the first time and m#st pay C25)8))) to the s#pplier in si< months> time. /he financial manager is concerned that the cost of these s#pplies may rise in e#ro terms and has decided to hedge the c#rrency risk of this acco#nt payable. /he following information has been provided by the company>s bank7 6pot rate *C per I+7 6i< months forward rate *C per I+7 5oney market rates available to ?10 Co7 One year e#ro interest rates7 One year dollar interest rates7 4orrowing .1E !.)E =eposit 5.!E 3.5E 1.&&$ L ).))2 1.&3& L ).))!

0ss#me that it is now 1 =ecember and that ?10 Co has no s#rpl#s cash at the present time. 3e"#ire!9 *a+ %dentify the objectives of working capital management and disc#ss the conflict that may arise between them. *3 marks+ *b+ Calc#late the cost of the c#rrent ordering policy and determine the saving that co#ld be made by #sing the economic order "#antity model. *3 marks+ *c+ =isc#ss ways in which ?10 Co co#ld improve the management of domestic acco#nts receivable. *3 marks+ *d+ 'val#ate whether a money market hedge8 a forward market hedge or a lead payment sho#ld be #sed to hedge the foreign acco#nt payable. *$ marks+ */otal 25 marks+

1)5

1)

5.: 5.3.1

*#antit 1b#lk p#rchase2 !isco#nt =isco#nts may be offered for ordering in large "#antities. %f the 'O( is smaller than the order si9e needed for a disco#nt8 sho#ld the order si9e be increased above the 'O(A )$ample 1 /he ann#al demand for an item of inventory is 125 #nits. /he item costs C2)) a #nit to p#rchase8 the holding cost for one #nit for one year is 15E of the #nit cost and ordering costs are C3)) an order. /he s#pplier offers a 3E disco#nt for order of ) #nits or more8 and a disco#nt of 5E for orders of &) #nits or more. What is the cost minimi9ing order si9eA 'ol#tion9 *a+ /he 'O( ignoring disco#nt is7
2 3)) 125 F 5) #nits 15E 2))

5.3.2

?#rchases *no disco#nt+ 125 M C2)) @olding costs *5)H2+ 25 #nits M C3) Ordering costs 2.5 orders M C3)) /otal ann#al costs *b+

C 258))) 35) 35) 2 85))

With a disco#nt of 3E and an order "#antity of ) #nits costs are as follows. C ?#rchases C258))) M &3E 2!825) @olding costs 3) #nits M 15E M &3E M C2)) $33 Ordering costs 2.)$ orders M C3)) 25 /otal ann#al costs 2583!$

*c+

With a disco#nt of 5E and an order "#antity of &) #nits costs are as follows. C ?#rchases C258))) M &5E 23835) @olding costs !5 #nits M 15E M &5E M C2)) 182$2.5 Ordering costs 1.3& orders M C3)) !1 .3 /otal ann#al costs 258!!&.2

1)3

/he cheapest option is to order &) #nits at a time. 5.= 5.!.1 3e&or!er level 3e&or!er level b#ilds in a meas#re of safet inventor and minimi%es the risk of the organi9ation r#nning o#t of inventor . 5orm#la 3e&or!er level F ma<im#m #sage M ma<im#m level Ma$im#m inventor level F re-order level N re-order "#antity : *minim#m #sage M minim#m lead time+ Minim#m inventor level or b#ffer safet inventor F ,e-order level : *average #sage M average lead time+ ,verage inventor F minim#m level N *re-order level O 2+

5.!.2

1)$

5.5 5.5.1

.#st&in&time 1./T2 5eaning7 6eek to eliminate an waste that arises in the man#fact#ring process as a res#lt of #sing inventory. ;nder this method8 stock levels of raw materials8 W%? and finished goods are re!#ce! to a minim#m or eliminate! altogether b improve! work&flow planning an! closer relationships with s#ppliers. ,!vantages of .%/7 )liminate waste at all stages of the man#fact#ring process : it can be achieve! b improve! workflow planning8 "#alit control an! long&term contracts between b#yer and s#pplier. 'tronger relationship with s#pplier : this offers sec#rit to the s#pplier who benefits from reg#lar or!ers8 contin#ing f#t#re b#siness and more certain prod#ction planning. /he b# er may also benefit from b#lk p#rchase !isco#nts or lower p#rchase costs. )mphasis on "#alit control : it can re!#ce scrap+ reworking an! set&#p costs. /he res#lt is a smooth flow of material and work thro#gh the prod#ction system8 with no "#e#es or idle time. >isa!vantages of .%/7 Ma not r#n as smoothl in practice as theor may predict : beca#se there may be little room for manoe#ver in the event of #nforeseen delays. 2or e<ample8 there is little room for error on delivery time. ?eavil !epen! on the s#pplier for maintaining the "#ality of delivered materials and components : if the "#ality is not #p to standard8 e<pensive downtime may arise. 8ot eas to fin! alternative s#pplier : especially in short-time. 8ot all b#sinesses are appropriate to apply .%/8 s#ch as resta#rant and hospital.

5.5.2

5.5.3

5.5.!

1)&

7.
7.1 .1.1

,cco#nts receivable management

@e areas of acco#nts receivable management 2o#r areas7 Polic form#lation : establish the framework within which management of receivables in an individ#al company takes place. /he elements incl#de7 )stablishing terms of tra!e8 s#ch as credit period and early settlement disco#ntsP >eci!ing whether to charge interest on overd#e acco#ntsP >etermining proce!#res when granting cre!it to new c#stomersP )stablishing proce!#res when acco#nts become over!#e8 etc. Cre!it anal sis : assessment of creditworthiness sho#ld be applied. /he information can be obtained by7 4ank references8 /rade references8 Credit reference agency reports8 2inancial information abo#t the c#stomer8 ?ress comments8 etc. Cre!it control : review o#tstan!ing acco#nts on a reg#lar basis so overd#e acco#nts can be identified. 2or e<ample7 it can be done by age! receivables anal sis. Collection of amo#nts !#e : have agree! proce!#res for dealing with overd#e acco#nts. 2or e<ample7 6end reminder letter8 Bog telephone calls8 ,ef#se to grant f#rther credit8 ;se debt collectors8 0pply legal action8 as a last resort. 5actors to be consi!ere! when form#lating working capital polic management of tra!e receivables on the

7.0

.2.1 2actors can be s#mmari9ed as follows7 The level of investment in tra!e receivables : %f the amo#nt is s#bstantial8 receivables management policy may be form#lated with the intention of red#cing the level of investment by tighter control over the credit grant and client creditworthiness.
11)

The cost of financing tra!e cre!it : %f the cost is high8 there will be press#re to red#ce the amo#nt of credit offered and to red#ce the period for which credit is offered. The terms of tra!e offere! b competitors : a company need to match the terms offered by its competitors8 otherwise c#stomers will migrate to competitors8 #nless there are other factors that will enco#rage them to be loyal8 s#ch as better "#ality or more val#able after-sales service. The level of risk acceptable to the compan : /he level of risk of bad debts that is acceptable to company. The nee! for li"#i!it : %f the need for li"#idity is relatively high8 a company may choose to accelerate cash inflow from credit c#stomers by #sing invoice disco#nting or by factoring. The e$pertise available within the compan : %f e<pertise in the assessment of creditworthiness and the monitoring of c#stomer acco#nts is not to a s#fficiently high standard8 a company may choose to o#tso#rce its receivables management to a third party8 i.e. a factor.

7.: .3.1

)arl settlement !isco#nts 0dvantages and disadvantages of early settlement disco#nts7 ,!vantages *a+ 'arly payment re!#ces the *a+ receivables balance an! hence the finance costs. *b+ ?otential to re!#ce the irrecoverable !ebts arising. Offers a choice to c#stomers of *c+ payment terms. >isa!vantages >iffic#lt in setting the appropriate terms. Ancertaint as to when cash receipts will be received8 complicating cash b#!geting. C#stomers pa over normal terms b#t still take the cash !isco#nt.

*b+ *c+

.3.2

)$ample : 0 company is offering a cash disco#nt of 2.5E to receivables if they agree to pay debts within one month. /he #s#al credit period taken is three months. What is the effective ann#ali9ed cost of offering the disco#nt and sho#ld it be offered8 if the bank wo#ld loan the company at 1$E paA
111

'ol#tion9 =isco#nt as a percentage of amo#nt paid F 2.5 H &3.5 F 2.5 E 6aving is 2 months and there are 12H2 F periods in a year 0nn#alised cost of disco#nt *E+ is *1 N ).)25 + : 1 F 1 .3$E /he loan rate is 1$E. %t wo#ld be therefore be worthwhile offering the disco#nt. 7.= .!.1 5actoring @ow to assist in the management of receivablesA 2actoring involves a company t#rning over a!ministration of its sales le!ger to a factor. /he receivables are effectively sold to a factor *normally by a bank+. /he factor is responsible for the iss#ing invoices an! collecting !ebts. 5actor offer finance to a company8 #s#all #p to B6C of the face val#e of invoices. /he finance is repai! from the settle! invoices8 with the balance being passed to the company after !e!#ction of interest charge. %f factoring is witho#t reco#rse8 the factor will carr the cost of an ba! !ebts. Of co#rse8 the factor>s fee will be higher. 2actoring is most s#itable for7 'mall an! me!i#m&si%e! firm which often cannot afford sophisticated credit and sales acco#nting systems8 and 5irms that are e$pan!ing rapi!l . 2actoring debts can be a more fle<ible so#rce of financing working capital than an overdraft or bank loan. ,!vantages an! !isa!vantages of factoring7 ,!vantages *a+ 'aving in a!ministration costs : *a+ not inc#r the costs of r#nning its own sales ledger department. 3e!#ction in the nee! for *b+ management control8 i.e. slow paying acco#nts receivable. Partic#larl #sef#l for small an! >isa!vantages Likel to be more costl than an efficientl r#n internal credit control department. 2actoring has a bad rep#tation associated with failing companiesP #sing a factor ma s#ggest o#r compan has mone worries.
112

.!.2

.!.3

*b+

*c+

*d+

fast growing b#sinesses where the *c+ credit control department may not be able to keep pace with vol#me *d+ growth. (rowth can be finance! thro#gh sales rather than by injecting *e+ fresh e$ternal capital.

C#stomers may not wish to !eal with a factor. Once yo# start factoring it is !iffic#lt to revert easil to an internal credit control system. /he compan may give #p the opport#nit to !eci!e to whom cre!it ma be given *nonreco#rse factoring+.

.!.! =etermine whether factoring is financiall acceptable7 *#estion 7 4 Cash operating c cle an! factoring '<tracts from the recent financial statements of 4old Co are given below. <666 2183)) 1 8!)) !8&)) C))) Qon-c#rrent assets C#rrent assets %nventory /rade receivables /otal assets C#rrent liabilities /rade payables Overdraft '"#ity Ordinary shares ,eserves Qon-c#rrent liabilities 4onds C))) 38))) <666

/#rnover Cost of sales Dross profit

!85)) 385))

$8))) 118)))

38))) 38)))

8)))

18))) 18)))

28)))

38))) 118)))
113

0 factor has offered to manage the trade receivables of 4old Co in a servicing and factorfinancing agreement. /he factor e<pects to red#ce the average trade receivables period of 4old Co from its c#rrent level to 35 daysP to red#ce bad debts from )R&E of t#rnover to )R E of t#rnoverP and to save 4old Co C!)8))) per year in administration costs. /he factor wo#ld also make an advance to 4old Co of $)E of the revised book val#e of trade receivables. /he interest rate on the advance wo#ld be 2E higher than the 3E that 4old Co c#rrently pays on its overdraft. /he factor wo#ld charge a fee of )R35E of t#rnover on a with-reco#rse basis8 or a fee of 1R25E of t#rnover on a non-reco#rse basis. 0ss#me that there are 3 5 working days in each year and that all sales and s#pplies are on credit. 3e"#ire!9 *a+ '<plain the meaning of the term Scash operating cycle> and disc#ss the relationship between the cash operating cycle and the level of investment in working capital. Ko#r answer sho#ld incl#de a disc#ssion of relevant working capital policy and the nat#re of b#siness operations. *3 marks+ Calc#late the cash operating cycle of 4old Co. *%gnore the factor>s offer in this part of the "#estion+. *! marks+ Calc#late the val#e of the factor>s offer7 *i+ on a with-reco#rse basisP *ii+ on a non-reco#rse basis. *3 marks+ Comment on the financial acceptability of the factor>s offer and disc#ss the possible benefits to 4old Co of factoring its trade receivables. *3 marks+ *25 marks+ /nvoice !isco#nting @ow to assist in the management of receivablesA %t is way of raising finance against the sec#rit of invoices raised8 rather than emplo ing the cre!it management an! a!ministration services of a factor. (oo! "#alit of invoices ma be !isco#nte!8 rather than all invoices.

*b+ *c+

*d+

7.5 .5.1

11!

*#estion ; 4 )O*+ ./T+ changes in ,3 management polic an! form#lating working capital management polic W(T Co is considering making the following changes in the area of working capital management7 /nventor management %t has been s#ggested that the order si9e for ?rod#ct 1Q5 sho#ld be determined #sing the economic order "#antity model *'O(+. W(T Co forecasts that demand for ?rod#ct 1Q5 will be 1 )8))) #nits in the coming year and it has traditionally ordered 1)E of ann#al demand per order. /he ordering cost is e<pected to be C!)) per order while the holding cost is e<pected to be C5R12 per #nit per year. 0 b#ffer inventory of 58))) #nits of ?rod#ct 1Q5 will be maintained8 whether orders are made by the traditional method or #sing the economic ordering "#antity model. 3eceivables management W(T Co co#ld introd#ce an early settlement disco#nt of 1E for c#stomers who pay within 3) days and at the same time8 thro#gh improved operational proced#res8 maintain a ma<im#m average payment period of ) days for credit c#stomers who do not take the disco#nt. %t is e<pected that 25E of credit c#stomers will take the disco#nt if it were offered. %t is e<pected that administration and operating cost savings of C3538))) per year will be made after improving operational proced#res and introd#cing the early settlement disco#nt. Credit sales of W(T Co are c#rrently C$3R million per year and trade receivables are c#rrently C1$ million. Credit sales are not e<pected to change as a res#lt of the changes in receivables management. /he company has a cost of short-term finance of 5R5E per year. 3e"#ire!9 *a+ Calc#late the cost of the c#rrent ordering policy and the change in the costs of inventory management that will arise if the economic order "#antity is #sed to determine the optim#m order si9e for ?rod#ct 1Q5. * marks+ 4riefly describe the benefits of a j#st-in-time *.%/+ proc#rement policy. *5 marks+
115

*b+

*c+

*d+

Calc#late and comment on whether the proposed changes in receivables management will be acceptable. 0ss#ming that only 25E of c#stomers take the early settlement disco#nt8 what is the ma<im#m early settlement disco#nt that co#ld be offeredA * marks+ =isc#ss the factors that sho#ld be considered in form#lating working capital policy on the management of trade receivables. *$ marks+ *25 marks+ ,cco#nts Pa ables Management Qormally seen as a free so#rce of finance8 b#t !ela too long8 it will have the following problems7 Boss disco#nt Boss of goodwill Credit rating problem ,ef#se to s#pply in f#t#re %ncrease price in f#t#re Calc#lation of early settlement disco#nt : same as receivables early settlement disco#nt in 5.3.2 above.

;. 3.1

3.2

*#estion B 4 5orm#lation of working capital polic + earl settlement !isco#nt an! b#lk p#rchase !isco#nt T?6 Co places monthly orders with a s#pplier for 1)8))) components that are #sed in its man#fact#ring processes. 0nn#al demand is 12)8))) components. /he c#rrent terms are payment in f#ll within &) days8 which T?6 Co meets8 and the cost per component is C3.5). /he cost of ordering is C2)) per order8 while the cost of holding components in inventory is C1.)) per component per year. /he s#pplier has offered either a disco#nt of ).5E for payment in f#ll within 3) days8 or a disco#nt of 3. E on orders of 3)8))) or more components. %f the b#lk p#rchase disco#nt is taken8 the cost of holding components in inventory wo#ld increase to C2.2) per component per year d#e to the need for a larger storage facility. 0ss#me that there are 3 5 days in the year and that T?6 Co can borrow short-term at !.5E per year. 3e"#ire!9
11

*a+ *b+

=isc#ss the factors that infl#ence the form#lation of working capital policyP *3 marks+ Calc#late if T?6 Co will benefit financially by accepting the offer of7 *i+ the early settlement disco#ntP *ii+ the b#lk p#rchase disco#nt. *3 marks+

B.
$.1

5oreign Tra!es Management

0dditional two types of risks need to managed7 )$port cre!it risk : fail#re or delay in collecting payments d#e from foreign c#stomers. %t may be ca#sed by7 %nsolvent c#stomers 4ank fail#re ;nconvertible c#rrencies ?olitical risk 5oreign e$change risk : is a risk that the val#e of the c#rrency will change between the date of the contract and the date of settlement. 'ol#tions for cre!it risk7 )arl pa ment : by payment in advance8 payment on shipment8 or cash on delivery *CO=+. Letters of cre!it : the c#stomer>s bank g#arantees it will pay the invoice. -ills of e$change : %O; *% owe yo#+ signed by c#stomer. /nvoice !isco#nting : sale of selected invoices to a debt factor. /ns#rance : #sed to cover some of the risks associated with giving credit to foreign c#stomers. )$port factoring : provide 3 main services7 %nvoicing and debt collection 4ad debt ins#rance *non-reco#rse+ Cash advances

$.2

*#estion D 4 (ranting cre!it to foreign c#stomers =isc#ss how risks arising from granting credit to foreign c#stomers can be managed and red#ced. *$ marks+

113

D.
D.1 &.1.1

Cash Management
3easons for hol!ing cash 5otives for holding cash7 Transaction motive : cash re"#ired to meet day-to-day e<penses8 e.g. payroll8 payment of s#ppliers8 etc. 5inance motive : cash re"#ired to cover major items s#ch as the repayment of loans and the p#rchase of non-c#rrent assets. Preca#tionar motive : cash held to give a c#shion against #nplanned e<pendit#re *the cash e"#ivalent of b#ffer inventory+. 'pec#lative motive : cash kept available to take advantage of market investment opport#nities. Cash b#!gets an! cash flow forecasts Asef#lness of cash flow forecasts7 6hows the cash effect8 Dive management an in!ication of potential problems that co#ld arise and allows them the opport#nit to take action to avoi! s#ch problems. 2orecasts can be prepared from any of the following7 ?lanned receipts and payments 6tatement of financial position predictions Working capital ratios

D.0 &.2.1

&.2.2

*#estion 16 4 Working Capital 5inancing 'trategies+ Cash -#!gets an! 3isks of (ranting Cre!it to 5oreign C#stomers /he following financial information relates to @D, Co7 6tatement of financial position at the c#rrent date *e<tracts+ <666 <666 <666 Qon-c#rrent assets !$8& 5 C#rrent assets %nventory $81 ) 0cco#nts receivable $8335 1 8&35 C#rrent liabilities Overdraft 38$))
11$

0cco#nts payable Qet c#rrent assets /otal assets less c#rrent liabilities

1)82))

1!8))) 28&35 518&))

Cash flow forecasts from the c#rrent date are as follows7 Month 1 Cash operating receipts *C)))+ !822) Cash operating payments *C)))+ 38&5) 6i<-monthly interest on trade bonds *C)))+ Capital investment *C)))+

Month 0 !835) !81)) 2))

Month : 38$)$ 3835) 28)))

/he finance director has completed a review of acco#nts receivable management and has proposed staff training and operating proced#re improvements8 which he believes will red#ce acco#nts receivable days to the average sector val#e of 53 days. /his red#ction wo#ld take si< months to achieve from the c#rrent date8 with an e"#al red#ction in each month. @e has also proposed changes to inventory management methods8 which he hopes will red#ce inventory days by two days per month each month over a three-month period from the c#rrent date. @e does not e<pect any change in the c#rrent level of acco#nts payable. @D, Co has an overdraft limit of C!8)))8))). Overdraft interest is payable at an ann#al rate of R13E per year8 with payments being made each month based on the opening balance at the start of that month. Credit sales for the year to the c#rrent date were C!&82358))) and cost of sales was C33823)8))). /hese levels of credit sales and cost of sales are e<pected to be maintained in the coming year. 0ss#me that there are 3 5 working days in each year. 3e"#ire!9 *a+ *b+ =isc#ss the working capital financing strategy of @D, Co. *3 marks+ 2or @D, Co8 calc#late7 *i+ the bank balance in three months> time if no action is takenP and *ii+ the bank balance in three months> time if the finance director>s proposals are implemented. Comment on the forecast cash flow position of @D, Co and recommend a s#itable co#rse of action. *1) marks+ =isc#ss how risks arising from granting credit to foreign c#stomers can be managed and red#ced. *$ marks+
11&

*c+

*/otal 25 marks+ *#estion 11 4 3ole of 5inancial /nterme!iaries+ 5inancial 'tatement 5orecasts+ Working Capital 5inancing Polic an! 5inancial Performance 5orecasts 0?U Co achieved a t#rnover of C1 million in the year that has j#st ended and e<pects t#rnover growth of $R!E in the ne<t year. Cost of sales in the year that has j#st ended was C1)R$$ million and other e<penses were C1.!! million. /he financial statements of 0?U Co for the year that has j#st ended contain the following statement of financial position7 <m Qon-c#rrent assets C#rrent assets %nventory /rade receivables /otal assets '"#ity finance7 Ordinary shares ,eserves Bong-term bank loan C#rrent liabilities /rade payables Overdraft /otal e"#ity and liabilities <m 22.)

2.! 2.2

!. 2 .

5.) 3.5

12.5 1).) 22.5

1.& 2.2

!.1 2 .

/he long-term bank loan has a fi<ed ann#al interest rate of $E per year. 0?U Co pays ta<ation at an ann#al rate of 3)E per year. /he following acco#nting ratios have been forecast for the ne<t year7 Dross profit margin7 Operating profit margin =ividend payo#t ratio %nventory t#rnover period7 3)E 2)E 5)E 11) days
12)

/rade receivables period7 /rade payables period7

5 days 35 days

Overdraft interest in the ne<t year is forecast to be C1!)8))). Qo change is e<pected in the level of non-c#rrent assets and depreciation sho#ld be ignored. 3e"#ire!9 *a+ *b+ =isc#ss the role of financial intermediaries in providing short-term finance for #se by b#siness organisations. *! marks+ ?repare the following forecast financial statements for 0?U Co #sing the information provided7 *i+ an income statement for the ne<t yearP and *ii+ a statement of financial position at the end of the ne<t year. *& marks+ 0nalyse and disc#ss the working capital financing policy of 0?U Co. * marks+ 0nalyse and disc#ss the forecast financial performance of 0?U Co in terms of working capital management. * marks+ */otal 25 marks+

*c+ *d+

16.
16.1

Cash Management Mo!el

-a#mol Mo!el

1).1.1 6imilar to inventory levels and based on the 'O(. 1).1.2 ,ss#mptions7 Cash #se is steady and predictable Cash inflows are known and reg#lar =ay-to-day cash needs are f#nded from c#rrent acco#nt 4#ffer cash is held in short-term investments 1).1.3 2orm#late7
Q= 2C ) D CH

C) F transaction costs *brokerage8 commission8 etc.+ = F demand for cash over the period C@ F cost of holding cash 1).1.! >rawbacks of 4a#mol model7
121

%n reality8 it is #nlikel to be possible to pre!ict amo#nts re"#ire! over f#t#re perio!s with m#ch certainty. 8o b#ffer inventor of cash is allowe! for. /here may be costs associated with r#nning o#t of cash. /here may be other normal costs of hol!ing cash which increase with the average amo#nt held.

1).1.5 )$ample : 0 company has a fi<ed cost of C!)8))) to obtain new f#nds. /here is a re"#irement for C2!)8))) cash over each period of one year for the foreseeable f#t#re. /he interest cost of new f#nds is 12E per ann#m and the interest rate earned on shortterm sec#rities is &E per ann#m. @ow m#ch finance sho#ld the company raise each time that it raises new financeA 'ol#tion9 /he cost of holding cash is 12E : &E F 3E
2 C!)8))) C2!)8))) = C).$m ).)3

/he optim#m level of reorder "#antity F

/he optim#m amo#nt of new f#nds to raise is C$))8))). /his amo#nt is raised every7 C$))8))) O C2!)8))) F 3.33 years 1).1. )$ample = 0 company re"#ires C!$)8))) of cash over each period of one year for the foreseeable f#t#re and is considering two alternatives7 Option 17 Option 27 /aking #p a bank loan of C!$)8))) at once for one year period at an interest rate of 12E per ann#m on the initial balance. 6ale of e<isting sec#rities which will inc#r a transaction fee of C18))) based on the 4a#mol model *the ret#rn from the sec#rities investment is c#rrently at 15E per ann#m+.

0ny f#ndHcash not in #se will be placed in a call deposit at &E per ann#m. Which of the two options is financially better to #ndertakeA

122

'ol#tion9

Option 1 0nn#al cash re"#ired Cash to be raisedHcycle Q#mber of cycleHyear C!$)8))) C!$)8))) 1

Option 0 C!$)8)))
2 C18))) C!$)8))) = C12 8!&1 ).15 ).)&

C!$)8))) O C12 8!&1 F !

/otal costs per ann#m #nder each option7

Option 1 %nterest payable *C).!$m M 12E+ Bost ret#rn on investment *C).!$m M &E+ *218 ))+ 538 )) < Option 0 Ordering cost *C18))) M !+ @olding cost *C).!$ O 2+ M 15E ,et#rn on investment *C12 8!&1 O 2+ M &E /otal cost 3 8))) *58 &2+ 3!83)$ 3 8))) !8))) <

Option 2 sho#ld be chosen8 as its total cost is marginally lower than option 1. *#estion 10 4 Cash b#!get+ over!rafts an! -a#mol cash mo!el /horne Co val#es8 advertises and sells residential property on behalf of its c#stomers. /he company has been in b#siness for only a short time and is preparing a cash b#dget for the first fo#r months of 2)) . '<pected sales of residential properties are as follows. 2))5 2)) 2)) 2)) 2)) 5onth =ecember .an#ary 2ebr#ary 5arch 0pril ;nits sold 1) 1) 15 25 3) /he average price of each property is V1$)8))) and /horne Co charges a fee of 3E of the val#e of each property sold. /horne Co receives 1E in the month of sale and the remaining 2E in the month after sale. /he company has nine employees who are paid on a monthly basis. /he average salary per employee is V358))) per year. %f more than 2) properties are sold in a given month8 each employee is paid in that month a bon#s of V1!) for each additional property sold.
123

Gariable e<penses are inc#rred at the rate of )R5E of the val#e of each property sold and these e<penses are paid in the month of sale. 2i<ed overheads of V!83)) per month are paid in the month in which they arise. /horne Co pays interest every three months on a loan of V2))8))) at a rate of E per year. /he last interest payment in each year is paid in =ecember. 0n o#tstanding ta< liability of V&58$)) is d#e to be paid in 0pril. %n the same month /horne Co intends to dispose of s#rpl#s vehicles8 with a net book val#e of V158)))8 for V2)8))). /he cash balance at the start of .an#ary 2)) is e<pected to be a deficit of V!)8))). 3e"#ire!9 *a+ ?repare a monthly cash b#dget for the period from .an#ary to 0pril 2)) . Ko#r b#dget m#st clearly indicate each item of income and e<pendit#re8 and the opening and closing monthly cash balances. *1) marks+ =isc#ss the factors to be considered by /horne Co when planning ways to invest any cash s#rpl#s forecast by its cash b#dgets. *5 marks+ =isc#ss the advantages and disadvantages to /horne Co of #sing overdraft finance to f#nd any cash shortages forecast by its cash b#dgets. *5 marks+ '<plain how the 4a#mol model can be employed to red#ce the costs of cash management and disc#ss whether the 4a#mol cash management model may be of assistance to /horne Co for this p#rpose. *5 marks+ *25 marks+

*b+ *c+ *d+

12!

16.0

Miller&Orr Cash Management Mo!el

1).2.1 %t takes acco#nt of #ncertaint in relation to receipts an! pa ment by setting #pper an! lower control limits on cash balance.

1).2.2 @ow it worksA Lower limit 1L2 is set b management depending on how m#ch risk of a cash shortfall the firm is willing to accept. /he mo!el sets higher an! lower control limits8 @ and B8 respectively8 and a target cash balance+ E. When the cash balance reaches ?8 then 1? 4 E2 !ollars are transferre! from cash to marketable sec#rities8 i.e. the firm b#ys *@ : T+ dollars of sec#rities. *c+ 6imilarly when the cash balance hits L8 then 1E 4 L2 !ollars are transferre! from marketable sec#rities to cash. 1).2.3 2orm#la7 *a+ *b+ ,et#rn point F Bower limit N *1H3 M spread+ 6pread F
3 transaction cos t var iance of cash flows 3 ! int erest rate
1H 3

Gariance and interest rates sho#ld be e<pressed in daily terms.

125

*#estion 1: 4 Changes of cre!it polic + Miller&Orr Mo!el+ ,3 management an! working capital f#n!ing polic ;lnad Co has ann#al sales reven#e of C million and all sales are on 3) days> credit8 altho#gh c#stomers on average take ten days more than this to pay. Contrib#tion represents )E of sales and the company c#rrently has no bad debts. 0cco#nts receivable are financed by an overdraft at an ann#al interest rate of 3E. ;lnad Co plans to offer an early settlement disco#nt of 1.5E for payment within 15 days and to e<tend the ma<im#m credit offered to ) days. /he company e<pects that these changes will increase ann#al credit sales by 5E8 while also leading to additional incremental costs e"#al to ).5E of t#rnover. /he disco#nt is e<pected to be taken by 3)E of c#stomers8 with the remaining c#stomers taking an average of ) days to pay. 3e"#ire!9 *a+ *b+ 'val#ate whether the proposed changes in credit policy will increase the profitability of ;lnad Co. * marks+ ,enpec Co8 a s#bsidiary of ;lnad Co8 has set a minim#m cash acco#nt balance of C385)). /he average cost to the company of making deposits or selling investments is C1$ per transaction and the standard deviation of its cash flows was C18))) per day d#ring the last year. /he average interest rate on investments is 5.11E. =etermine the spread8 the #pper limit and the ret#rn point for the cash acco#nt of ,enpec Co #sing the 5iller-Orr model and e<plain the relevance of these val#es for the cash management of the company. * marks+ %dentify and e<plain the key areas of acco#nts receivable management. * marks+ =isc#ss the key factors to be considered when form#lating a working capital f#nding policy. *3 marks+ */otal 25 marks+

*c+ *d+

12

11.
11.1

'hort&term /nvestment on Cash '#rpl#s

5actors to be considered when planning ways to invest any cash s#rpl#s7 6hort-term cash s#rpl#ses sho#ld be invested with no risk of capital loss. Length of time the s#rpl#s is available for /he si%e of the s#rpl#s *some instr#ments have minim#m investment levels+8 /he iel! offered8 /he risk associate! with each instr#ment8 and 0ny penalties for earl with!rawal. T pes of short-term investment7 >eposit with a bank 'hort&term !ebt instr#ments8 e.g certificates of deposit *C=s+ and /reas#ry bills Longer term !ebt instr#ments8 which can be sold on the market when the company needs cash 'hares of liste! companies

11.2

10.
12.1

'hort&term -orrowing
/wo main so#rces of bank lending7 4ank overdraft 4ank loan 0dvantages and disadvantages of bank overdraft7 ,!vantages 2le<ible so#rce of finance Only pay for what is #sed8 so cheaper >isa!vantages ,epayable on demand 5ay re"#ire sec#rity8 e.g. floating charges or personal g#arantee '<pose to the risk of an interest rates increase

12.2

*#estion 1= =isc#ss the advantages and disadvantages of #sing overdraft finance to f#nd any cash shortages forecast by the cash b#dgets. *5 marks+

123

1:.
13.1

'trategies for 5#n!ing Working Capital

0lso named as follows7 Working capital f#nding policy Working capital financing strategy Working capital financing policies can be classified into conservative8 mo!erate *or matching+ and aggressive8 !epen!ing on the e$tent to which fl#ct#ating c#rrent assets an! permanent c#rrent assets are finance! b short&term so#rces of finance. Permanent c#rrent assets represent the core level of working capital investment needed to s#pport a given level of sales8 for e<ample7 4#ffer inventory ,eceivables d#ring credit period 5inim#m cash balances 5l#ct#ating c#rrent assets represent the changes in working capital that arise in the normal co#rse of b#siness operations8 for e<ample7 when some acco#nts receivable are settled later than e<pected8 or when inventory moves more slowly than planned. Matching principle s#ggests that long&term finance sho#l! be #se! for long&term assets. ;nder a matching working capital f#nding policy8 therefore8 long-term finance is #sed for both permanent c#rrent assets and non-c#rrent assets. 6hort-term finance is #sed to cover the short-term changes in c#rrent assets represented by fl#ct#ating c#rrent assets. 0 conservative working capital f#nding policy will #se a higher proportion of long& term finance than a matching polic 8 thereby financing some of the fl#ct#ating c#rrent assets from a long&term so#rce. /his will be less risk an! less profitable than a matching policy8 and will give rise to occasional short&term cash s#rpl#ses. 0n aggressive working capital f#nding policy will #se a lower proportion of long& term finance than a matching policy8 financing some of the permanent c#rrent assets from a short&term so#rce s#ch as an overdraft. /his will be more risk an! more profitable than a matching policy. Other factors that infl#ence a working capital f#nding policy7 management attit#!es to risk : determine whether there is a preference for a conservative8 an aggressive or a matching approach previo#s f#n!ing !ecisions : determine the c#rrent position being considered in policy form#lation organisation si%e : infl#ence its ability to access different so#rces of finance
12$

13.2

13.3

13.!

13.5

13.

13.3

13.$

13.&

0 small compan 8 for e<ample8 may be force! to a!opt an aggressive working capital f#n!ing polic beca#se it is #nable to raise a!!itional long&term finance 8 whether e"#ity or debt.

*#estion 15 4 Fiel! c#rve+ financing an! cash operating c cle 4lin is a company listed on a '#ropean stock e<change8 with a market capitalisation of I m8 which man#fact#res ho#sehold cleaning chemicals. /he company has e<panded sales "#ite significantly over the last year and has been following an aggressive approach to working capital financing. 0s a res#lt8 4lin has come to rely heavily on overdraft finance for its short-term needs. On the advice of its finance director8 the company intends to take o#t a long-term bank loan8 part of which wo#ld be #sed to repay its overdraft. 3e"#ire!9 *a+ *b+ =isc#ss the factors that will infl#ence the rate of interest charged on the new bank loan8 making reference in yo#r answer to the yield c#rve. *& marks+ '<plain and disc#ss the approaches that 4lin co#ld adopt regarding the relative proportions of long- and short-term finance to meet its working capital needs8 and comment on the proposed repayment of the overdraft. *& marks+ '<plain the meaning of the term Scash operating cycle> and disc#ss its significance in determining the level of investment in working capital. Ko#r answer sho#ld refer to the working capital needs of different b#siness sectors. *3 marks+ *25 5arks+

*c+

12&

,!!itional )$amination 't le *#estions

*#estion 17 4 Cash b#!get+ ./T+ financing an! working capital management .ack Deep will set #p a new b#siness as a sole trader on 1 .an#ary 2))3 making decorative glassware. .ack is in the process of planning the initial cash flows of the b#siness. @e estimates that there will not be any sales demand in .an#ary 2))3 so prod#ction in that month will be #sed to b#ild #p stocks to satisfy the e<pected demand in 2ebr#ary 2))3. /hereafter it is intended to sched#le prod#ction in order to b#ild #p s#fficient finished goods stock at the end of each month to satisfy demand d#ring the following month. ?rod#ction will8 however8 need to be 5E higher than sales d#e to e<pected defects that will have to be scrapped. =efects are only discovered after the goods have been completed. /he company will not hold stocks of raw materials or work in progress. 0s the b#siness is new8 demand is #ncertain8 b#t .ack has estimated three possible levels of demand in 2))3 as follows7 @igh demand 5edi#m demand Bow demand V V V 2ebr#ary 228))) 2)8))) 1&8))) 5arch 2 8))) 2!8))) 238))) 0pril 3)8))) 2$8))) 238))) 5ay 2&8))) 238))) 2 8))) .#ne 358))) 338))) 328))) =emand for .#ly 2))3 onwards is e<pected to be the same as .#ne 2))3. /he probability of each level of demand occ#rring each month is as follows7 @igh ).)5P 5edi#m ).$5P Bow ).1).

%t is e<pected that 1)E of the total sales val#e will be cash sales8 mainly being retail c#stomers making small p#rchases. /he remaining &)E of sales will be made on two months> credit. 0 2R5E disco#nt will8 however8 be offered to credit c#stomers settling within one month. %t is estimated that c#stomers8 representing half of credit sales by val#e8 will take advantage of the disco#nt while the remainder will take the f#ll two months to pay. Gariable prod#ction costs *e<cl#ding costs of rejects+ per V18))) of sales are as follows7

13)

Babo#r 5aterials Gariable overhead

V 3)) 2)) 1))

Babo#r is paid in the month in which labo#r costs are inc#rred. 5aterials are paid one month in arrears and variable overheads are paid two months in arrears. 2i<ed prod#ction and administration overheads8 e<cl#ding depreciation8 are V38))) per month and are payable in the same month as the e<pendit#re is inc#rred. .ack employed a firm of cons#ltants to give him initial b#siness advice. /heir fee of V128))) will be paid in 2ebr#ary 2))3. 6melting machinery will be p#rchased on 1 .an#ary 2))3 for V2))8))) payable in 2ebr#ary 2))3. 2#rther machinery will be p#rchased for V5)8))) in 5arch 2))3 payable in 0pril 2))3. /his machinery is highly speciali9ed and will have a low net realisable val#e after p#rchase. .ack has red#ndancy money from his previo#s employment and savings totalling V15)8)))8 which he intends to pay into his bank acco#nt on 1 .an#ary 2))3 as the initial capital of the b#siness. @e realises that this will be ins#fficient for his b#siness plans8 so he is intending to approach his bank for finance in the form of both a fi<ed term loan and an overdraft. /he only asset .ack has is his ho#se that is val#ed at V2))8)))8 b#t he has an o#tstanding mortgage of V$)8))) on this property. /he cons#ltants advising .ack have recommended that rather than acc#m#lating s#fficient stock to satisfy the following month>s demand he sho#ld not maintain any stock levels b#t merely prod#ce s#fficient in each month to meet the e<pected demand for that month. .ack>s prod#ction manager objected7 S% need to set #p my prod#ction sched#le based on the e<pected average demand for the month. % will red#ce prod#ction in the month if it seems demand is low. @owever8 there is no way prod#ction can be increased d#ring the month to accommodate demand if it happens to be at the higher level that month. 0s a res#lt8 #nder this new system8 there wo#ld be no stocks to fall back on and the e<tra sales8 when monthly demand is high8 wo#ld be lost8 as c#stomers re"#ire immediate delivery.> %n respect of this8 an assessment of the impact of the introd#ction of j#st-in-time stock management on cash flows has been made that showed the following7

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3e"#ire!9 *a+ ?repare a monthly cash b#dget for .ack Deep>s b#siness for the si< month period ending 3) .#ne 2))3. Calc#lations sho#ld be made on the basis of the e<pected val#es of sales. /he cash b#dget sho#ld show the net cash inflow or o#tflow in each month and the c#m#lative cash s#rpl#s or deficit at the end of each month. 2or this p#rpose ignore bank finance and the s#ggested #se of j#st-in-time stock management. *13 marks+ 0ss#me now that j#st-in-time stock management is #sed in accordance with the recommendations of the cons#ltants. Calc#late for '0C@ of the si< months ending 3) .#ne 2))37 *i+ receipts from salesP and *ii+ payments to labo#r. * marks+ 'val#ate the impact for .ack Deep of introd#cing j#st-in-time stock management. /his sho#ld incl#de an assessment of the wider implications of j#st-in-time stock management in the partic#lar circ#mstances of .ack Deep>s b#siness. *1) marks+ Write a report to .ack Deep which identifies the financing needs of the company. %t sho#ld consider the following7 *i+ the e<tent of financing re"#iredP *ii+ the factors that sho#ld be considered in determining the most appropriate mi< of short-term financing *e.g. overdraft+ and long-term financing *e.g. fi<ed term bank loan+P and *iii+ the e<tent to which improved working capital management *other than j#st-in-time stock management+ might red#ce the company>s financing needs and describe how this might be achieved. Where appropriate8 show s#pporting calc#lations. *13 marks+ *5) marks+

*b+

*c+

*d+

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*#estion 1; 4 Overtra!ing+ factoring an! lease or b# 0t a recent meeting of the 4oard of =oe Btd8 a s#pplier of ind#strial and commercial clothing8 it was s#ggested that the company might be s#ffering li"#idity problems as a res#lt of overtrading8 despite enco#raging growth in t#rnover. /he 2inance =irector was instr#cted to report to the ne<t 4oard meeting on this matter. '<tracts from the financial statements of =oe Btd for 2))28 and from the forecast financial statements for 2))38 are given below. %ncome statement e<tracts for years ending 31 =ecember

6tatement of financial position e<tracts as at 31 =ecember

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/he 2inance =irector had reported to the recent board meeting that the bank was insisting the company red#ce its overdraft as a matter of #rgency. %t was s#ggested that the company co#ld consider factor finance as an alternative so#rce of f#nds for working capital investment. /he ?rod#ction =irector insisted that a new machine wo#ld be needed to maintain growth in t#rnover and the 2inance =irector agreed to investigate how this might be financed. 5actoring /he 2inance =irector has fo#nd a factor who wo#ld take over administration of the company>s debtors on a non-reco#rse basis for an ann#al fee of 1R)E of t#rnover. /he factor wo#ld advance $)E of the book val#e of debtors at an ann#al interest rate 2E above the company>s c#rrent overdraft rate. /he factor e<pects to red#ce the average debtor period to &) days. /he company estimates that =oe Btd co#ld save V158))) per year in administration costs. Qo red#ndancy costs are e<pected. The 8ew Machine /he new machine wanted by the ?rod#ction =irector wo#ld cost V3 58))) if p#rchased. /he 2inance =irector is confident this p#rchase co#ld be financed by a medi#m-term bank loan at an ann#al interest cost of 1)E before ta<. 0lternatively8 the machine co#ld be leased for V33825) per ann#m8 payable ann#ally in
13!

advance. /he machine has an e<pected life of five years8 at the end of which it wo#ld have 9ero scrap val#e. 'ales an! Costs of 8ew Machine O#tp#t /he 2inance =irector has commissioned research that shows growth in sales of the o#tp#t prod#ced by the new machine depends on the sales price8 as follows7

Gariable costs of prod#ction are V!2 per #nit and incremental fi<ed prod#ction overheads arising from the #se of the machine are e<pected to be V$58))) per ann#m. /he ma<im#m capacity of the new machine is 2)8))) #nits per ann#m. Other /nformation =oe Btd pays ta< one year in arrears at a rate of 3)E and can claim ann#al writing down allowances *ta<-allowable depreciation+ on a 25E red#cing balance basis. /he company pays interest on its overdraft at appro<imately E per ann#m before ta<. 0verage ratios for the b#siness sector in which =oe Btd operates are as follows7 6tock days 21) days C#rrent ratio 1.35 =ebtor days 1)) days (#ick ratio ).55 Creditor days 12) days 3e"#ire!9 *a+ Write a report to the board of =oe Btd that analyses and disc#sses the s#ggestion that the company is overtrading. *12 marks+ *b+ *i+ =etermine whether =oe Btd sho#ld accept the factor>s offer. *3 marks+ *ii+ What are the advantages to =oe Btd of factoring its debtorsA *$ marks+ *c+ =isc#ss three ways *other than factoring+ by which =oe Btd might improve the management of its debtors. *$ marks+ *d+ 'val#ate whether =oe Btd sho#ld b#y or lease the new machine8 #sing an after ta< disco#nt rate of 3E. *0ss#me that payment for the p#rchase8 or the first lease payment8 wo#ld take place on 1 .an#ary 2))!.+ *& marks+ *e+ Calc#late the optim#m sales price for the o#tp#t from the new machine. */a<ation and the time val#e of money sho#ld be ignored.+ * marks+ *5) marks+
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*#estion 1B 4 @e 5actors for the level of investment in c#rrent assets+ calc#lation of O>+ 5actoring+ invoicing !isco#nting an! )O* 2BD Co has ann#al credit sales of C!R2 million and cost of sales of C1R$& million. C#rrent assets consist of inventory and acco#nts receivable. C#rrent liabilities consist of acco#nts payable and an overdraft with an average interest rate of 3E per year. /he company gives two months> credit to its c#stomers and is allowed8 on average8 one month>s credit by trade s#ppliers. %t has an operating cycle of three months. Other relevant information7 C#rrent ratio of 2BD Co Cost of long-term finance of 2BD Co 3e"#ire!9 *a+ *b+ *c+ *d+ =isc#ss the key factors which determine the level of investment in c#rrent assets. * marks+ =isc#ss the ways in which factoring and invoice disco#nting can assist in the management of acco#nts receivable. * marks+ Calc#late the si9e of the overdraft of 2BD Co8 the net working capital of the company and the total cost of financing its c#rrent assets. * marks+ 2BD Co wishes to minimise its inventory costs. 0nn#al demand for a raw material costing C12 per #nit is )8))) #nits per year. %nventory management costs for this raw material are as follows7 Ordering cost7 @olding cost7 C per order C)R5 per #nit per year

1R! 11E

/he s#pplier of this raw material has offered a b#lk p#rchase disco#nt of 1E for orders of 1)8))) #nits or more. %f b#lk p#rchase orders are made reg#larly8 it is e<pected that ann#al holding cost for this raw material will increase to C2 per #nit per year. 3e"#ire!9 *i+ Calc#late the total cost of inventory for the raw material when #sing the economic order "#antity. *! marks+ *ii+ =etermine whether accepting the disco#nt offered by the s#pplier will minimise the total cost of inventory for the raw material. *3 marks+ */otal 25 marks+
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