Working Capital Management Notes

Managing Working Capital

Overview

• Financial managers spend over half their time managing net working capital.
• Net working capital is the difference between current assets and current liabilities.
• Efficient businesses convert illiquid assets into cash quickly.
• Current liabilities must be settled with current assets to avoid selling non-current assets.
• Predictable cash inflows reduce the need for large working capital.
• Higher current assets relative to liabilities make bill payment easier.

Profitability vs. Risk

• Profitability balances revenue and costs using assets.
• Risk is the probability of not meeting short-term obligations.
• A higher working capital ratio (current assets ÷ current liabilities) reduces technical insolvency risk but may decrease profitability.
• Higher risk often correlates with higher potential reward.

Overtrading

• Overtrading is growing too quickly, harming net working capital.
• It worsens when debtors take longer to pay than the business takes to settle creditors.
• Increasing sales without timely cash collection can strain cash flow.
• Businesses should only take on debt if they can settle debts on time.

Schedule of Budgeted Receipts from Debtors

• Businesses should forecast debtor collections before budgeting cash flow.
• The same applies to scheduling expected payments to creditors.

The Cost of Money

• Interest is the cost of borrowing money.
• The prime overdraft rate (benchmark in South Africa) is usually 3-3.5% above the repo rate.
• The SARB uses the repo rate to manage inflation and economic growth.
• Lower rates encourage business expansion by reducing financing costs.
• Loans for businesses usually have higher interest rates than mortgage loans.
• Important to consider whether interest rates quoted are effective, nominal, or APR.

Nominal vs. Effective Interest Rates

• Effective interest rate: actual interest rate earned with annual compounding.
• Nominal interest rate: stated rate.
• Compounding: reinvesting earnings to generate additional earnings.
• $Future Value (FV) = Present Value (PV) \times (1 + interest rate)^n$ where n is the number of years.
• The concept of compounding is similar to the calculating VAT inclusive amount from a given exclusive amount.
• $EAR = [1 + (\frac{Quoted nominal rate}{m})]^m - 1$ where m = number of compounding periods in a year.

Effective Annual Rates and Annual Percentage Rates

• APR is the effective rate adjusted for loan-specific costs.
• APR helps compare total borrowing costs across different lenders.

Calculating APR:

1. Add one-off loan costs to the principal.
2. Calculate the monthly payment using the loan's effective rate.
3. Determine the interest rate applicable to the face amount of the loan to match the monthly payment from step 2, as:

Where:

• Nper: Total number of payments.
• Pmt: Monthly installment.
• Pv: Amount borrowed, excluding initiation costs.