Managing Working Capital Notes

Managing Working Capital

This comprehensive guide covers the essential elements of managing working capital within a business, including definitions, purposes, control policies, and management factors. It emphasizes optimizing investments in working capital components like inventories, receivables, and cash while considering associated costs and benefits.

What is Working Capital?

Working capital is defined as current assets less current liabilities. The key elements are:

Current Assets:
- Inventories
- Trade Receivables
- Cash (in hand and at bank)
Current Liabilities:
- Trade Payables
- Bank Overdrafts and other short-term borrowings

The size and composition vary greatly depending on the industry. For example, manufacturing firms invest heavily in all types of inventories (raw materials, work in progress, finished foods) and receivables whereas retailers primarily have some finished goods inventories, and service businesses have very little inventories.

The composition varies within the industry depending on the management's attitude to risk. It is essential to evaluate if the business has different attitudes towards risk for its important investments.

Working capital represents a net investment in short-term assets that are continuously flowing in and out of the business. The various elements of working capital are interrelated and form a short-term cycle.

Working Capital Cycle for a Manufacturing Business:

Cash is used to pay trade payables for raw materials.
Cash is spent on labor and other items to convert raw materials into work in progress and finished goods.
Finished goods are sold for cash or on credit.
Cash is received from credit sales, completing the cycle.

For a retailer, the cycle is similar, but only involves inventories of finished goods. For a service business, there may be work in progress as some services take time to complete, like a legal case.

Managing Working Capital

An essential part of a business’s short-term planning is the effective management of the individual components of working capital. Management must decide on the scale of each element balancing the costs of holding too much and the costs associated with holding too little. These costs include opportunity costs. A business should then weigh the potential benefits against the likely costs to arrive at an optimal investment.

Changes in the business environment are inevitable and managers must monitor them to ensure the correct level of investment; these can include:

Changes in interest rates, changing demand, seasonal changes, or changes in the economy.

Internal changes in using production methods or changes in risk attitude will also change the business' working capital needs.

The Scale of Working Capital

Despite the scale of investment in non-current assets, investment in working capital can be considerable. Real World 12.1 expresses statement of financial position items as a percentage of the total investment. The statements highlight differences in make-up from one business to another. For example, only certain businesses such as Next, Babcock, and Tesco hold inventories. Tesco's trade payables are also higher than its inventories because Tesco receives cash from groceries well in advance of paying for them.

According to a 2018 PwC survey of listed businesses, companies could release cash by improving inventory, trade receivables, and trade payables management. Improved management of working capital is essential to increase capital investment and avoid additional external funding.

Key Findings from PwC Survey:

Businesses had about $€1.3$ trillion tied up in working capital.
Capital investment could be increased by $50$ % with better management.

Reasons Smaller Businesses Carry More Excess Working Capital:

Less well-managed than larger businesses due to a lack of expertise and resources.
Economies of scale: larger sales revenue does not necessarily mean proportionally higher inventories.

Managing Inventories

Inventories are held to meet both the immediate day-to-day demands of customers and the needs of production. Businesses may hold more inventories than necessary to mitigate the risks of future supply interruption or scarcity. Businesses can also hedge against increasing costs by buying in bulk. For some businesses, such as car dealerships, inventories may also represent a large proportion of total assets held.

Manufacturers tend to invest heavily in inventories because they need to hold three kinds of inventories: raw materials, work in progress, and finished goods.

Businesses with seasonal demand levels may vary inventory levels over the year; others with stable demand may remain unchanged.

Businesses should minimise inventories held when inventories are available to minimise the costs associated with holding inventories:

Storage and handling costs
Financing costs
Pilferage and obsolescence costs
Opportunity costs

Real World 12.3 shows inventory financing costs for 5 businesses. It is based on the cost of capital and average inventory held; significant costs are apparent in Associated British Foods, Kingfisher and Tesco.

To help manage inventories, businesses can:

Budgeting Future Demand

Preparing proper budgets ensures that inventories will be available to meet future production and sales requirements. The budgets are very important as they can determine future ordering and production levels.

Techniques can be statistical, such as Using Time Series Analysis or it may be based on judgements of sales and marketing staff. There is also increasing use of AI to forecast future demand based on previous customer orders and market trends.

Financial Ratios

Average inventories turnover period ratio is a useful tool to help monitor inventory levels. The ratio is calculated as:

$Average\,inventories\,turnover\,period = {Average\,inventories\,held \over Cost\,of\,sales} * 365$

The ratio provides a picture of the average period for which inventories are held. The average inventories turnover period can be calculated for individual product lines, for particular categories of inventories, and for inventories as a whole.

Recording and Reordering Systems

There should be proper procedures for recording inventories purchases and usages, and periodic checks should be made to ensure that the amount of physical inventories held corresponds with what is indicated by the inventories’ records.

To replenish inventories quickly, a business must consider the costs of low inventory levels, including:

Loss of sales
Loss of customer goodwill
Purchasing inventory at a higher price as to replenish inventory quickly
High transport costs
Lost production
Inefficient Production Scheduling

There should also be clear procedures for the reordering of inventories and authorisation should be restricted to specific staff to increase coordination. Businesses must also consider lead time and likely level of demand to determine when inventory should be reordered.

For example, a business with annual demand of $10,400$ and a lead time of 4 weeks, should reorder 800 units to meet demand (calculated as ( $\frac{10,400}{52} * 4 = 800$ ).

Businesses include buffer stock in their inventory reorder point to avoid inventory shortage due to uncertainty. Factors to weigh when adopting buffer inventory include:

The degree of uncertainty with the above factors.
The likely costs of running out for the item considered.
The costs of holding the buffer inventory.

The formula for Reorder point with buffer inventories is:

$Reorder\, point = Expected \,level\, of\, demand \,during\, the\, lead\, time + the\, level\, of\, buffer\, inventories$

Real World describes how political uncertainty had a dramatic effect on business inventories. In early 2019, UK manufacturers stockpiled inventories due to fears of a chaotic exit from the EU. The Manufacturer's index showed concrete evidence of widespread stockpiling particularly in the food and drinks, clothing, chemical and plastics, and electronics sector. Warehouses in the UK reached record levels in take-up due to stockpiling. To guarantee not running out of inventories, businesses must assume a reorder point based on the maximum usage and lead time.

Levels of Control

Different levels of control should be implemented depending on the natures of the inventories held, requiring a careful balancing of costs and benefits. The ABC system of control is based on selective control levels categorized by the value of their inventory held.

Example 12.1: ABC System in Alcan Products plc:

Brass fittings account for $10$ % of physical volume but $65$ % of total value (Category A): Sophisticated recording procedures, tight control, and high security are applied.
Steel fittings account for $30$ % of total volume and $25$ % of total value (Category B): Lower level of recording and management control.
Plastic fittings account for $60$ % of the volume but only $10$ % of the total value (Category C): Lowest level of recording and management control.

Categorising inventories in this way helps to direct management effort to the most important areas, ensuring inventory costs are proportional to their value.

Inventory Management Models

Decision models may be used to help manage inventories. The economic order quantity (EOQ) model is concerned with determining the quantity of a particular inventories item that should be ordered each time. In its simplest form, the EOQ model assumes that demand is constant. This implies that inventories will be depleted evenly over time to be replenished just at the point that they run out.

The formula for EOQ is:

$EOQ = \sqrt{\frac{2DC}{H}}$
Where:

$D$ = the annual demand for the inventories item
$C$ = the cost of placing an order
$H$ = the cost of holding one unit of the inventories item for one year.

Example: HLA Ltd sells $2,000$ bags of cement each year. The cost of holding one bag of cement is $£4$ , and the cost of placing an order is $£250$ . The EOQ is therefore $500$ bags ($\sqrt{\frac{2 * 2000 * 250}{4}} = 500$).

Small inventories levels imply frequent reordering and high annual ordering costs. High inventories levels imply exactly the opposite.

The cost of inventories, which is the price paid to the supplier, does not directly affect the EOQ model. However, more expensive items tend to have greater holding costs, this occurs because of ABC systems of inventories control may be in place.

The basic EOQ model has a number of limiting assumptions:

Demand can be predicted with accuracy.
Demand is constant over the period.
No buffer inventories are required.
There are no discounts for bulk purchasing.

Enterprise Resource Planning Systems

Enterprise resource planning (ERP) systems provide an automated and integrated approach to managing a business. They record, report, analyse, and interpret data for a range of business operations, including production, marketing, human resources, accounting, and inventories management.

an ERP software application for the management of inventories will carry out a wide range of tasks:

Forecasting demand using statistical formulae.
Making re-order decisions based on forecast future demand.
Ordering the transfer of goods between locations.
Tracking and reporting inventories according to type, serial numbers and soon.
Providing real time information concerning shipping costs, trends in inventories holdings, on time deliveries and so on.
Allocating warehouse space for where goods are to be stored.
Helping inventories audits by setting tolerance levels for variations between actual and reported inventories held.
Pricing inventories being shipped, to take account of required profit margins, bulk discounts and so on.

Just-In-Time Inventories Management

In recent years, many businesses have tried to eliminate the need to hold inventories by adopting just-in-time (JIT) inventories management. With JIT, a business informs suppliers of inventories requirements in advance so that scheduling can occur and materials can be delivered at the right quality at the right time. Failure could lead to a disruption of production and could be costly. Successful JIT often requires that suppliers are geographically near to the business.

Adopting JIT will usually require re-engineering a business’s production process in order to avoid the risk that production will be brought to a halt for any reason. To ensure that orders are quickly fulfilled, the production process must be flexible and responsive.

A final point worth making is that successful implementation of a JIT system rests with the workforce. A more streamlined and efficient production flow will only be achieved if workers are well trained and fully committed to the pursuit of quality.

JIT is widely viewed as more than simply an inventories control system. The philosophy underpinning this approach is that of total quality management, it is concerned with eliminating waste and striving for excellence. There is an expectation that suppliers will always deliver inventories on time and that there will be no defects in the items supplied.

XYZ Inventories Management

XYZ inventories management classifies inventories into three categories according to variability of customer demand:

Category X: Little variation in demand, allowing for accurate sales forecasts.
Category Y: Greater variability due to seasonal factors and competition, but sales demand can still be reasonably predicted.
Category Z: High level of variability in demand, making accurate sales forecasting impossible.

By classifying inventories according to their variability in demand, a business can manage them more effectively.

Managing Trade Receivables

Selling goods or services on credit will result in costs being incurred by a business. These costs include the costs of credit administration, of bad debts and of opportunities forgone to use the funds for other purposes. However, these costs must be weighed against the benefits of increased sales revenue resulting from the opportunity for customers to delay payment.

Selling on credit is the norm outside the retail sector. When a business offers to sell its goods or services on credit, it's policies should include:

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

Which Customers Should Receive Credit and How Much Should Be Offered?

A business offering credit runs the risk of not receiving payment for goods or services supplied. Care must be taken over the type of customer to whom credit facilities are offered and how much credit is allowed:

5 C's of Credit:

Capital: The customer must appear to be financially sound.
Capacity: The customer must appear to have the capacity to pay.
Collateral: Some kind of security for goods supplied on credit may be required.
Conditions: Industry conditions and general economic conditions should be taken into account.
Character: An honest customer is more likely to pay amounts owing to a business.

Length of Credit Period

A business must determine what credit terms it is prepared to offer its Customers. Potential competition may be attracted to the offer of a longer credit period, which will increase sales. To illustrate, see Example 12.2, Torrance Ltd.

Other costs of extending credit must also be considered, these may include bad debts and additional collections costs. Real World 12.6 discusses how some large businesses have often been guilty of extending the credit. Some companies reduce their financial expenses by enforcing excessively generous credit terms from their suppliers.

Late in 2017, new regulations came into force in the UK that required large companies to report upon their payment practices. The government's goal is that bad business improve performance, but some are pessimistic.

It is possible to view the credit decision as a capital investment decision. These choices will result in different returns and different levels of risk. NPV investment appraisals may be used, where applicable.

Cash Discounts

To encourage prompt payment from its credit customers, a business may offer a cash discount. The size of any discount could be an important influence on whether a customer decides to pay promptly. From the business’s viewpoint, the cost of offering discounts must be weighed against the likely benefits in the form of a reduction both in the cost of financing trade receivables and in the amount of bad debts.

Note: A business must ensure that receivables are collected as quickly as possible so that non-payment risk is minimised and operating cash flows are maximised. Real World 12.8 outlines the excuses credit managers hear from outstanding debts.

How to Overcome this Issue: Instead of allowing customers to deduct a discount, customers who pay promptly can be rewarded separately, say on a three-monthly basis. The value of the reward would be equal to the cash discounts earned by each customer during the three months.

Managing Cash

Why Hold Cash?

There are three reasons why businesses hold cash:

To meet day-to-day commitments, such as wages, overhead expenses and goods purchased.
For precautionary purposes in times of uncertainty.
To exploit opportunities such as acquiring a competitor business.

Note: The quantity of cash varies between businesses and is very important as it must be monitored over time.

Controlling The Cash Balance

Several models propose the use of upper and lower control limits for cash balances and the use of a target cash balance. The model assumes that the business will invest in marketable investments that can easily be liquidated. These investments will be purchased or sold, as necessary, in order to keep the cash balance within the control limits.

The model relies heavily on management judgement to determine where the control limits are set and the length of the period within which breaches of the control limits are acceptable. Models used include the cash equivalent of the inventory economic order quantity model.

The Operating Cash Cycle (OCC)

For a business that purchases goods on credit for subsequent resale on credit, such as a wholesaler, it represents the period between the outlay of cash for the purchase of inventories and the ultimate receipt of cash from their sale. The OCC for this type of business:

Purchase of goods on credit.
Payment for goods.
Sale of goods credit.
Cash received from credit customers.

The length of the OCC has a significant impact on the amount of funds that the business needs to apply to working capital. The business may therefore wish to reduce the OCC to the minimum period possible. For businesses that buy and sell goods on credit, the OCC can be deduced from their financial statements through the use of certain ratios.

The financial statements of Freezeqwik Ltd, a distributor of frozen foods, are used to determine their balance via the following formula:

$Average\,inventories\,turnover\,period + Average\,settlement\,period\,for\,trade\,receivables - Average\,settlement \,period\, for\,trade\,payables = Operating\,cash\,cycle$

Following the above formula, businesses must reduce the average settlement period for traders to cut expenses while keeping the required stock and investment levels intact.

It seems quite common, in practice, for businesses to try to maintain the OCC at a particular target level. However, not all days in the OCC are of equal value.

Cash Transmission

A business will normally wish to benefit from receipts from customers at the earliest opportunity. Cheques have helped to reduce this delay through the CHAPS (Clearing House Automated Payments) system to help reduce the time spent in the banking system.

Various methods of cash transmission have helped increase banking speeds, transfers, credit, debit and online transfers. Online payment services, such as PayPal, provide a secure internet account where cards can be added for a prompt service.

Bank Overdrafts

Bank overdrafts are simply bank current accounts that have a negative balance, they are a useful tool for managing a business' cashflow requirements. Real World 12.10 shows how Mears Group plc managed to improve its cash flows through better management practices.

Managing Trade Payables

Most businesses buy their goods and services on credit. Trade payables are an important source of finance for most businesses. They have been described as a ‘spontaneous’ source, as they tend to increase in line with the increase in the level of activity achieved by a business.

A customer can purchase goods while paying over time, there is an economic gain in doing that, but there is the case where those who pay quicker are treated with more respect.

Why might a supplier prefer a customer to take a period of credit rather than pay for the goods or services on delivery?

Paying on delivery may not be administratively convenient for the seller.
A credit period can allow any problems with the goods or service supplied to be resolved before payment is made.

Delaying payment might reflect financial problems or an uneven power imbalance between each player.

Taking Advantage of Cash Discounts

Where a supplier offers a discount for prompt payment, the business should give careful consideration to the possibility of paying within the discount period. The annual cost of foregoing the discount will be too high. Therefore you must prioritise and invest in the opportunity even if that means borrowing to do so. This is shown in Example 12.6 Hassan Ltd.

Controlling Trade Payables

To help monitor the level of trade credit taken, management can calculate the average settlement period for trade payables ratio.

Management can then calculate the level of trade credits as seen in the Trade Payables ratio. An alternate approach would be to produce an accounting schedule for payables.

Some techniques of working capital can only improve matters so far, there needs to be a cultural shift within the business. Those decisions affect the amount of cash needed to improve the business. Those daily decisions can affect value. This is because those with high-performance values can avoid tying up cash. Real World 12.11 supports the idea.

To make improvements to those strategies; one can see how that performance is on Real World 12.12. This helps those better control and improve strategies as a whole.