tutor2u

WorkingCapital
Introductiontothe Managementof WorkingCapital

AS&A2BusinessStudies
PowerPointPresentations2005

Introduction
Allbusinessesneedcashtosurvive Cashisneededto:
Investinfixedassets Paysuppliersandemployees Fundoverheadsandotherfixedcosts PaytaxduetotheGovernment

Nearlyallbusinessesusemuchoftheircashresources tofinanceinvestmentinworkingcapital Managingworkingcapitaleffectivelyis,therefore,a vitalpartofmakingsurethebusinesshasenoughcash tocontinue

tutor2u

www.tutor2u.net

WhatisWorkingCapital?
WhatisWorkingCapital?

Workingcapitalisthecashneededto payforthedaytodayoperationofthe business

HowisItCalculated?

Workingcapitalisthedifference betweenthecurrentassetsofa businessanditscurrentliabilities

tutor2u

www.tutor2u.net

DefinitionofWorkingCapital

Current Assets
Less

Assetsofthebusiness heldincashform(e.g. atthebank)orthatthat canquicklybeturned intocash

Current Liabilities

Moneyowedbya businesswhichwill needtobepaidinthe next12months

tutor2u

www.tutor2u.net

DefinitionofWorkingCapital
Stocks

Current Assets
Less

Debtors Cash Investments

TradeCreditors

Current Liabilities

Taxation Dividends ShorttermLoans

tutor2u

www.tutor2u.net

CalculatingWorkingCapitalExample
Stocks TradeDebtors Current Assets Cash Prepayments Less 250,000 500,000 900,000 125,000 25,000 250,000

WorkingCapital=
TradeCreditors 350,000 100,000

Current Liabilities

Taxation Dividends ShorttermLoans

650,000 50,000 150,000

tutor2u

www.tutor2u.net

TheWorkingCapitalCycle
Notallbusinesseshavethesameneedtoinvestin workingcapital Muchdependson
(1)Thenatureoftheproductionprocess(i.e.whatandhowsomething isbeingproduced),and (2)Thewayinwhichtheproductisdistributedtocustomers

Theworkingcapitalcycleis:
Theperiodoftimebetweenthepointatwhichcashisfirstspenton theproductionofaproductandthefinalcollectionofcashfroma customer

tutor2u

www.tutor2u.net

WorkingCapitalCycleIllustrated
RawMaterialsorderedfrom suppliersandputintostock awaitingproduction.Cash isuseduptofinancestocks (bypayingthesuppliers)

Finallytheproductstartsto generatecashas customerspaytheamounts theyowe.Thenthewhole processstartsagain

Morecashisusedtofinance theproductionprocess employstaff,runthefactory andothersupportoperations

Morecashisuseduptostore finishedproductsanddistribute themtotheintendedmarkets. Tradecustomersareallowedto buynowandpaylaterso debtorsincrease

tutor2u

www.tutor2u.net

WorkingCapitalRatios(liquidity)
Theliquiditypositionofabusinessreferstoitsability topayitsdebtsi.e.doesithaveenoughcashtopay thebills? Thebalancesheetofabusinessprovidesasnapshot oftheworkingcapitalpositionataparticularpointin time Therearetwokeyratiosthatcanbecalculatedto provideaguidetotheliquiditypositionofabusiness
Currentratio Acidtest(quick)ratio

tutor2u

www.tutor2u.net

CurrentRatio
Calculation Formula ExampleCalculation
000 Stocks Tradedebtors Cashbalances CurrentAssets TradeCreditors Othershorttermliabilities CurrentLiabilities 1,125 1,750 650 3,525 1,025 235 1,260

CurrentAssets CurrentLiabilities

3,525

=
1,260

2.8

tutor2u

www.tutor2u.net

AcidTest(Quick)Ratio
Calculation Formula ExampleCalculation
000 Stocks Tradedebtors Cashbalances CurrentAssets TradeCreditors Othershorttermliabilities CurrentLiabilities
tutor2u

CurrentAssets(lessStocks) CurrentLiabilities

1,125 1,750 650 3,525 1,025 235 1,260

2,400

=
1,260

1.9

www.tutor2u.net

InterpretingtheRatios
Abusinessneedstohaveenoughcash(orcashtocome)tobe abletopayitsdebts Obviously,acurrentratiocomfortablyinexcessof1shouldbe expectedbutwhatiscomfortabledependsonthekindof business Somebusinessesfindithardtoturnstockanddebtorsintocash soneedahighcurrentratio Somebusinesses(e.g.supermarkets)turnstockintocashvery rapidlyandhavelowdebtorssotheycanhappilyexistwitha currentratiooflessthan1 Theacidtestratioisoftenconsideredtobeabettertestofliquidity forbusinesseswithalowstockturnover

tutor2u

www.tutor2u.net

LimitationsofLiquidityRatios
Liquidityratiosshouldbeusedwithcare Balancesheetvaluesataparticularmomentintime maynotbetypical Balancesusedforaseasonalbusinesswillnot representaveragevalues Ratioscanbesubjecttowindowdressingor manipulation(e.g.abigpushtogetcustomerstopay outstandingbalancesbytheyearend Ratiosconcernthepast(historic)notthefuture Workingcapitalmanagementisverymuchabout ensuringthebusinesshassufficientcashinthefuture
tutor2u

www.tutor2u.net

DangerofOvertrading

Overtradinghappenswhena businesstriestodotoomuch,too quicklywithtoolittlelongterm capital Warning:aprofitablebusinesscan failifitrunsoutofcash

tutor2u

www.tutor2u.net

OvertradingIntroduction
Overtradingrepresentsanimbalancebetweenthe ordersabusinessacceptsandthemeansithastofulfill them Overtradinghappenswhenabusinesstakeson customerorders,butdoesnothaveenoughcurrent assets,orworkingcapital,tomeetthesedemands Overtradingisparticularlycommoninyoung,rapidly expandingbusinesses.Itcanbeextremelyserious, evenfataltothebusiness

tutor2u

www.tutor2u.net

HowdoesOvertradingHappen?
Thelengthoftheworkingcapitalcyclegetslonger
E.g.tradedebtorsstarttakinglongertopaytheirdebts E.g.stocksareorderedearlierandneedtobepaidforbeforethey aresold E.g.suppliersinsistonbeingpaidearlier

Businessturnover/outputincreases
E.g.morestockisrequired(rawmaterials,greatervalueofworkin progress) E.g.thevalueoftradedebtorsgrowsinlinewithhighersales

tutor2u

www.tutor2u.net

SymptomsofOvertrading
Rapidincreaseinsales/turnover Rapidincreaseinthevalueandvolumeofcurrent assets(e.g.increaseinstocks) Reductioninstockturnoverandincreaseinaverage timetakenbydebtorstopayinvoices Onlyasmallincreaseinownerscapitalwithmostof theadditionalfinancecomingfromhighertrade creditors(borrowingfromsuppliers)andthebank Significantfallinkeyliquidityratios(currentratio/ quickratio)

tutor2u

www.tutor2u.net

OtherSourcesofLiquidityProblems
Internalcauses
Poormanagementofoperations(e.g.allowingtoomuchstocktobe boughtandstockpiled) Productionproblems(e.g.equipmentfailuredelayingtheprocessing ofrawmaterialsintofinishedgoods,orpoorqualitystandards) Poormarketingdecisions(e.g.allowingcustomersunsuitablylong credittermsfailureofpromotionalcampaignsleavingthebusiness withunexpectedlyhighstocks)

Externalcauses
Economic:e.g.unexpectedlylowerdemandduetofallingcustomer confidenceorchangeinexchangerates Financialfailure:e.g.tradedebtorsgoingoutofbusinessleaving theirdebtsunpaid

tutor2u

www.tutor2u.net

WaystoImproveLiquidity
Option
Reducethestockholdingperiodfor finishedgoodsandrawmaterials Improvetheefficiencyoftheproduction process(e.g.shortenbyusingbetter productionmethods) Reducethecreditperiodofferedtotrade debtorsandchaseamountsduemore aggressively Extendthetimetakentopaycreditors

Pitfalls
Mayresultinproductiondelaysorshortagesifdemand increasesunexpectedly Costlytoreorganiseproductionbutmaybeworthitinthe mediumterm Mayupsetcustomersorcausethemtoreducetheamount theybuy Adangerousoptionsuppliersmayrefusetosupplyormay chargeinterestiftheirpaymenttermsareexceeded

Useinvoicediscountingordebtfactoring Agoodwaytoobtaincashquicklybutusuallycostly(e.g. factoringfirmchargesahighcommissionondebtspaid) toobtaincashfromtradedebtors Saleandleasebackofassets

Anothergoodwayofreleasingcashfromfixedassetsbut leavesthebusinesswithhighercostsandpaymentobligations

tutor2u

www.tutor2u.net

KeyTerms
Workingcapital Fundsrequiredbythebusinesstopayforthedaytodayoperationofthebusiness

Workingcapital cycle Currentassets

Theperiodoftimebetweenthepointatwhichcashisfirstspentontheproductionofa productandthefinalcollectionofcashfromacustomer Assetsofthebusinessheldincashform(e.g.atthebank)orthatthatcanquicklybe turnedintocash Moneyowedbyabusinesswhichwillneedtobepaidinthenext12months Theabilityofabusinesstopaywhatitowesasthoseamountsbecomedue.Abusiness thatdoesnothaveenoughcashisdescribedasilliquid Measureofliquiditybasedondatafromthebalancesheet.Calculatedascurrentassets dividedbycurrentliabilities Anotherliquidityratiobettersuitedtoassessbusinessesthathavealowstockturnover Whenabusinesstakesontoomanyobligationswithouthavingthefinancetopayforthem

Currentliabilities Liquidity

Currentratio

Acidtestratio Overtrading

tutor2u

www.tutor2u.net