MANAGEMENT

OF WORKING CAPITAL

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 Working capital - definition
l Working capital – the amount of capital that covers
current assets
l Net working capital – current assets minus current
liabilities
l Current assets – circulating assets as opposed to
long-term (fixed) assets; the same true with current
liabilities (circulating sources of cash)
l Current liabilities are appropriate source of finance
for current assets. Total investment in the company
then is divided into investment in operations and
investment in fixed assets.

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 Operating cycle
Interrelationship of the investment in operations may be
represented in the operating cycle that includes:
l acquisition of raw materials and packaging,
l use of materials and packaging in manufacturing process to
create work in progress (semi-finished goods),
l use of materials, packaging and work in progress to complete
finished goods,
l despatch of finished goods from warehouses and delivery to
customers,
l recording as sales by the company its deliveries to customers,
l use of cash resources to pay overheads, salaries,
l use of cash resources to pay trade creditors and other expenses.

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 Current assets

l Current assets – part of assets that

have the form of cash or that convert into
cash within one year (see the structure
of the assets side of the balance sheet!)
l Characteristics of current assets:
- short-term character,
- rather high liquidity

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 Functions of current assets
l Internal function – to secure uninterrupted
circulation of assets and capital
l Liquidity function – to secure solvency
l Reserve function – some current assets are
a reserve against different risks
l Security function – some assets can be
collateral to be pledged when applying for
loans
l External function – entering economical and
financial relations with business environment
by means of current assets

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 Working capital requirements
l Important – to determine the entire working capital
requirement (i.e. the entire requirement of current
assets); the main purpose – to determine the optimal
amount of sources employed in current assets
l Current assets – do not bring any financial benefits,
therefore good management of the working capital
requirement is of vital importance for the sustained
success of any business
l Managing the short-term resources – major impact on
the relationship between risk and return, riskiness here
attributed to its impact on liquidity
l The size and composition of working capital varies
between industries and businesses.

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 Composition of working capital
l Permanent working capital
l Temporary current assets

Groups of current assets (depending on form)

l stock (production stock, work-in-process, finished
goods)
l trade debtors (accounts receivable),
l cash (cash, current bank accounts, short-term
securities)
→ working capital management consists of management
of stock, management of receivables, cash
management

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 MANAGEMENT OF STOCK

l Proper stock management – important to

the financial health of the firm – WHY?
l Stock – difficult to manage because it
crosses so many lines of responsibility –
WHICH ONES?
l There are significant costs associated
with holding stock as well as with holding
too low level of stock – WHAT COSTS?

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 Types of stock

l Production supply (raw materials) – the

initial input into the production process
l Work-in-process (semi-finished goods)
– items beyond the raw material stage
but not yet at the completed product
stage
l Finished goods – completed goods

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 Procedures and techniques of stock
management

1.Determining the average stock value

(the average production supply value,
the average work-in-process value, the
average finished goods value)
2.Stock management models (EOQ)
3.Complex systems of stock
management
4.Stock ratios

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 1. Determining the average stock value

l Simply method (determining stock

standards) that enables to quantify the
average capital need to be tied in stock.
The average stock value depends on:
- the average daily consumption of each
type of stock given in monetary units,
- the average days in stock for each type
of stock in days.

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 The average production supply value

l The average production supply (raw materials) value

Zv=S*Dv
Dv=DC/2 + P + T

Zv ... the average production supply value in Sk

S ... the average daily consumption of raw materials in Sk
Dv ... the average days in raw materials
DC... the length of delivery cycle in days
P ... the safety stock
T ... the technological stock

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 The average work-in-process value

l The average work-in-process value

ZNV = Nd * DNV
DNV = VC * k

ZNV ... the average work-in-process value in Sk

Nd ... the average daily production costs in Sk
DNV... the average days in work-in-process
VC ... the length of production cycle in days
k ... the cost increase coefficient

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 The average finished goods value

l The average finished goods value

ZHV = NHV * DHV

DHV = OC/2 + E + P

ZHV ... the average finished goods value

NHV ... the average daily costs of sold products
DHV ... the average days in the finished goods
OC ... the length of sales cycle in days
E ... despatch in days
P ... the safety supply of finished goods if any

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 2. Stock management models (EOQ)

l Economic Order Quantity (EOQ) –

minimizes the total cost of managing stock
(ordering and holding costs assumed as key
costs)
l The cost of holding stock can be substantial –
managers try to minimise the average amount
of stock held. However, reducing the level of
stock held increases a need to increase a
number of orders during the period, so
ordering costs will rise.
l Question: How much stock should be
ordered?

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 EOQ - continued

l The EOQ level can be derived by

differentiating the total cost equation
f(Q) = N = (No*S)/Q + (Ns*Q)/2
2 * No * S
Qopt = Ns

Then: vopt = S/Qopt

DCopt = Qopt/(S:360)
Nopt = 2 * S * No * Ns

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 EOQ - continued

Qopt ... economic order quantity

No ... the cost of placing an order
S ... the annual demand for the item
of stock
Ns ... the cost of holding one unit of
stock for one year

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 EOQ - continued
l EOQ – that quantity of stock items that should
be ordered each time an order is placed. It is
the order quantity which minimizes the total
cost of managing the firm´s stock
l Limiting assumptions of basic EOQ model:
demand of the product can be predicted with
accuracy and is even over the period; no
safety stock is required; the amount can be
purchased in single units that correspond
exactly to the EOQ – for ex. 158 units and not
in multiples of 50 or 100; no discounts are
available for bulk purchases

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 3. Complex systems of stock management

l Complex systems of stock management represent

integrated management of wide areas of activities:
- stock records keeping,
- predictions of stock needs,
- order calculations,
- monitoring of orders,
- system of control over stock values etc.
They are associated with utilizing PCs and different
types of software, mainly used in large and medium-
sized enterprises (Material Requirement Planning –
MRP, Optimised Production Technology – OPT,etc).

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 4. Stock ratios

l Stock turnover ratio

R = sales (or costs of goods sold)/average stock held

l Stock operating ratio

K = average stock held/sales (or costs of goods sold)

l Average stock days

D = average stock held/daily sales (or costs of goods sold)

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 MANAGEMENT OF RECEIVABLES

l In literature also referred to as credit management,

management of debtors
l CF is greatly affected by the policies established by a
company with regard to:
- the choice of customers,
- the way in which sales are made,
- the sales invoicing system,
- the speedy correction of errors and resolution of
disputes,
- the means of settlement,
- the monitoring of customer settlement performance,
- the overdue accounts collection system.

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 Policies of trade credit

l When offering to sell on credit, the business

must have policies concerning:
• which customers should receive credit,
• how much credit should be offered,
• what length of credit it is prepared to offer,
• whether discounts will be offered for prompt
payment,
• what collection policies should be adopted,
• how the risk of non-payment can be reduced.

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 Phases of decision-making in management
of receivables

1. Decision on offering trade credit – initial

phase of management of receivables (who to
grant credit to, how much, for how long) –
establishing credit policy containing general
guidelines then used by various managers
2. Management and monitoring the
receivables balance – phase containing
methods, procedures, steps to ensure that
amounts owing are collected as quickly as
possible

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 1. Decision on offering trade credit

l Establishing credit policy and

procedures (basic strategy establishing
framework or guidelines)
l The credit-granting decision (whether
to grant a credit – credit analysis; if yes,
character and credit terms must be
determined – type, advance payments,
length of credit period, cash discount,
credit limits)

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 2. Management and monitoring of the
receivables

Methods, procedures and steps to achieve

that amounts owing are collected as quickly as
possible:
l Publicise credit terms
l Issue invoices promptly
l Monitor outstanding debts
l Produce an ageing schedule of debtors
l Identify the pattern of receipts
l Answer queries quickly
l Deal with slow payers

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 Reducing the risk of non-payment

l advance payments,
l the offset amounts owed against amounts due,
l requiring a third-party guarantee,
l legal title of the goods is not passed to the
customer until they are paid for,
l insurance to cover the costs of any legal
expenses incurred in recovering debt,
l insurance against the risk of non-payment

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 MANAGEMENT OF CASH

Motives for holding cash according to

economic theory:
l transactionary motive – to meet day-to-day
commitments
l precautionary motive – holding a balance of
cash as future cash flows may be uncertain for
any reason
l speculative motive – holding cash in order to
be in a position to exploit profitable
opportunities as and when they arise

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 Controlling the cash balance

l If a business is able to borrow quickly at

a favourable rate, the amount of held
cash can be reduced.
l Several models have been proposed
(Baumol model, Miller-Orr model)
l It is useful to prepare a projected CF
statement identifying periods when cash
surpluses and deficits are expected

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