Chapter 19

Lecture Objectives
the importance of working capital and short term

finance
the management of stocks, cash and debtors
capital structure and long term finance

What is working capital

On a balance sheet it is usually called net current assets

The component part are;
current assets
stocks
trade debtors
cash, bank balances, and liquid assets
current liabilities
trade creditors
bank overdrafts
other short term claims over assets

The working capital cycle - 1

working capital varies in size between industries

examples
a manufacturing organisation will invest in large amounts of
raw materials, work in progress, and finished goods, and will
often sell product on credit, therefore incurring large debtor
balances
a retail outlet will only hold one form of stock (finished
goods) and will normally sell for cash
working capital represents a net investment in short term
assets

The working capital cycle - 2

Raw materials

Creditors

Work in progress

Cash

Finished goods

Cash sales
Debtors
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Determinants of working capital

external environment

changes in interest rates, market demand, seasonal changes,

the economy

internal environment - an organisation must balance

its liquidity against its profitability

aggressive policy (low working capital, low liquidity) suggests

increased profit focus
conservative policy (high working capital, high liquidity)
suggests lower risk but lower profitability

Cash Operating Cycle - 1

Purchase of
goods on
credit

Payment
for
goods

Sales
of goods
on credit

Cash
received
from debtors

Stockholding period

Cash operating cycle

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Cash Operating Cycle

Average stockholding period
plus
Average settlement period for debtors
minus
Average payment period for creditors
equals
Cash operating cycle

Management of stocks - 1
Nature of the business products /service
Seasonal issues Festive Season Halloween
Stockholding costs (stocks at a high level)
storage, handling
Financing

risk of pilferage and obsolescence

Stocks too low?

loss of sales
loss of goodwill

higher delivery cost

inefficient production runs
high price purchases

The Management of Stock

Just in time (JIT)
Materials requirement planning system (MRP)
Economic order quantity (EOQ)
Data required:
Holding costs
Ordering costs
Demand for inventory item

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Management of stocks - 2

Stock
level

etc..
Time

Economic
order quantity

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Asset and Liability Components

in Practice
Service business:
very little inventory, principally receivables and cash.
Supermarket business:
inventory and cash, and a high level of trade payables
but very low trade receivables.
Pharmaceuticals business:
high levels of receivables, cash and payables.

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Management of debtors
To which customers should we offer credit?

capital, capacity, collateral, conditions, character

What length of credit?

norms, competition, bargaining power, risk, capacity,

marketing strategy

Will discounts be offered for prompt payment?

Discount costs against benefits of reduction in debtors

What collection policies will be adopted?

average settlement period, ageing schedule.

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Management of debtors
Benefits of offering credit terms:
Can increase revenue, especially if the terms are
favorable and attractive to customers.
Drawbacks of offering credit terms:
The risk of non-payment
Administrative costs
Reduction in cash resources available to the business
Loss of potential interest receivable

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The Credit Control Function

Run checks on potential customers.
Set credit limits for each customer.
Regularly review the credit limits for each customer.
Chase up overdue receivables.
Advise on doubtful receivables which may require

adjustment in the financial statements.

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Management of cash
Why hold cash?
transactory, precautionary, speculative
How much cash?
nature of business, opportunities, level of inflation,
availability of liquid assets, availability of borrowing,
cost of borrowing, economic conditions, supplier
relationships
Control - the cash budget (we will in budget later)

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Managing Cash and Overdrafts

Use budget cash flow statement to predict highest

level of demand for short-term borrowing.

If no borrowing required, business can plan shortterm investment to generate interest receivable.

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Management of current liabilities

Managing Trade Payables creditors
Trade payables are a form of free financing, but care must be taken

not to offend the suppliers.

a source of short term finance - cheap, unless abused
Be aware of the conditions of trade, e.g. payables due within 60
days of invoice.
balance discount with costs
Can be helpful to produce age analysis of payables.
control using settlement period
Bank overdrafts
flexible and relatively cheap
suitable for overcoming short term problems
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Sources of external finance

Total
finance

Short term

Long term

Ordinary
shares

Preference
shares

Loans &
Debentures

Bank
Overdraft

Leases

Debt
Factoring

Invoice
Discounting
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Sources of internal
finance
Total
Internal
Finance

Retained
profits

Tighter
credit
control

Reduce
stock
levels

Delay
payment
to creditors

long
term
short term

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Summary
Management of working capital is important in

businesses of all sizes.

Managers must balance all the elements of working
capital to ensure no unexpected shortages in cash.

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The balance of debt and equity

capital -problem
Company A

Company B

Loans - 10%

500,000
500,000

100,000
900,000

Total Capital

1,000,000

1,000,000

Year 1

160,000

160,000

Year 2

80,000

80, 000

Share capital

Operating profits

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Capital balance - solution

Company A

000

Company B

Year 1

Year 2

Year 1

Year 2

160

80

160

80

50

50

90

90

Net profit

110

30

70

(10)

Equity

500

500

100

100

Return
on Equity

22%

6%

70%

Op. profit

Interest

(10%)
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