Working Capital Management

Working Capital

• Working capital is the capital used in day-to-day trading operations.
• Calculated as: Current Assets - Current Liabilities

Trade Receivables & Payables

• Trade Receivable (Debtor): Someone who owes you money (resulting from a sale on credit).
• Trade Payable (Creditor): Someone you owe money to (resulting from a purchase on credit).

Accounting Impact:

• Sale on Credit: Credit Sales, Debit Trade Receivables.
• Sale on Cash: Credit Sales, Debit Bank.
• Purchase on Credit: Credit Trade Payables, Debit Purchases.
• Purchase on Cash: Credit Bank, Debit Purchases.

Working Capital Cycle

• Time between cash outlay for inventory and cash receipt from sales.
• A shorter cycle reduces financing needs and financial risks.
• Monitoring working capital helps avoid overtrading and negative working capital.
• Over Trading: High sales, high profits but…cash crisis?
• Negative Working Capital: Current liabilities exceed current assets.

Impact on Working Capital

• Paying suppliers in cash: Current Liabilities (CL) decreases, Current Assets (CA) decreases; Working Capital (WC) unchanged.
• Customers paying in cash: CA decreases (trade receivables), CA increases (bank); WC unaffected.

Working Capital Cycle Ratios

• Current Ratio: $\frac{Current Assets}{Current Liabilities}$
• Quick Ratio: $\frac{Current Assets - Stock}{Current Liabilities}$

Elements of Working Capital

• Cash
• Inventory (Stock)
• Trade Receivables (Accounts Receivable or Debtors)
• Trade Payables (Accounts Payable or Creditors)

Cash Management

• Use budgets to manage cash levels, identify shortages, and predict surpluses.

Inventory Management

• Carry inventory to facilitate production, meet orders, and take advantage of discounts.
• Manage inventory through recording systems, periodic checks, and clear reordering procedures.
• Inventory Turnover Period: $\frac{Closing Inventory}{Cost of Sales} * 365$

Inventory Costs:

• Ordering costs (processing orders, receiving goods).
• Holding costs (storage, insurance, handling, obsolescence).

Economic Order Quantity (EOQ)

• EOQ: Order size that minimizes total variable costs to order and hold inventory.

EOQ Assumptions:

• Demand is known and steady.
• Holding and ordering costs are known and constant.
• No discounts for bulk purchasing.
• Orders arrive in one batch with known lead time.

EOQ Implications:

• Holding costs increase as quantity ordered increases.
• Ordering costs decrease as frequency of ordering increases.
• EOQ is at the lowest point on the total cost curve.

EOQ Formula:

• $EOQ = \sqrt{\frac{2QP}{C}}$, where Q = annual quantity used, P = cost per order, C = annual cost per unit of inventory

Just-In-Time (JIT)

• Eliminate raw materials and in-process stockpiles.
• Continuous production flow.
• High quality and assured delivery.
• Eliminate finished goods inventories (if producing to order).

Trade Receivables

• Benefits of credit: Increased sales, higher profits.
• Costs of credit: Administration, bad debts, forgone opportunities.

Managing Trade Receivables:

• Terms of Sale: Cash or credit, period of credit.
• Credit Decisions/Control: Credit limits, risk assessment (Five C’s - Capital, Capacity, Collateral, Conditions, Character).
• Cash Discounts: Discount for early settlement.
• Collection Policy: Procedures for pursuing debts.

Cash Discount Example Considerations:

• Cost of Discount: Total sales * % customers taking discount * discount rate
• Benefit: Interest earned on cash released from trade receivables, decrease in bad debts

Managing Current Liabilities

• Overdraft: Managed via cash budgets and bank relationship.
• Trade Payables: Delay payment vs. taking advantage of discounts.