Managing working capital

Managing Working Capital

It is estimated that over half of a financial manager's time is spent managing net working capital, which is the difference between a business's current assets and current liabilities.

Current Assets (Working Capital)

These are assets that circulate from one form to another during normal business operations. The main current assets are:

Inventory
Debtors (accounts receivable)
Cash

The goal of a business owner is to convert illiquid current assets into cash as quickly as possible. This involves managing the cash cycle, which is the recurring transition from cash to inventory to debtors and back to cash. Faster transitions lead to more efficient and successful businesses.

Current Liabilities

These are debts that must be settled within a year. It is crucial for financial managers to use current assets to settle current liabilities, to avoid selling off non-current assets like equipment or property to cover short-term debts.

Unpredictability of Working Capital

Managing working capital is challenging due to its unpredictable nature. While cash outlays for current liabilities are relatively predictable, cash inflows from converting inventory and debtors to cash are not.

Predictable Cash Flows: If cash inflows are predictable, a firm needs less net working capital.
Unpredictable Cash Flows: If cash inflows are unpredictable, a business should maintain current assets significantly higher than current liabilities to avoid a liquidity trap.

Generally, a greater margin between current assets and current liabilities makes it easier for a firm to pay its bills.

Profitability vs. Risk

A trade-off exists between a firm's profitability and its risk.

Profitability: The relationship between revenue and costs generated from using the firm's assets. It can be increased by increasing revenues or decreasing costs.
Risk: The probability that a business will be unable to pay its bills as they become due, potentially leading to technical insolvency.

Technical insolvency refers to a state where a firm cannot pay its bills as they become due but may still have positive net worth. This is different from absolute insolvency, where total liabilities exceed total assets.

Working Capital Ratio

The working capital ratio (current assets ÷ current liabilities) indicates a firm's profitability and risk profile. A higher ratio means lower risk of technical insolvency, but it can also indicate lower profitability because current liabilities are often used to finance inventory, which drives turnover and profits.

This reflects a basic investment principle: higher risk equals higher potential reward, and lower risk equals lower potential reward.

Overtrading

Overtrading is a pitfall in working capital management where a business grows too quickly to the detriment of its net working capital. This occurs when a business buys excessive inventory on credit to increase sales but struggles to sell the merchandise or collect cash from debtors in a timely manner. The situation worsens when the debtors' collection period exceeds the creditors' settlement period.

Learning Example 5 A: Constant vs. Increasing Sales

The following example illustrates the dangers of overtrading using two scenarios:

Scenario 1: Constant Sales
Sales remain constant at R 200,000 per month from March to June. The bank balance ends in the black at R 80,000 at the end of June.
Scenario 2: Increasing Sales
Sales increase rapidly from R 200,000 in March to R 460,000 in June. Despite increasing profits, the bank balance ends virtually in the red (zero).

This example demonstrates that rapid sales growth can create additional risk if the business cannot convert inventory to cash promptly to settle increased creditors. Failure to generate cash in time can lead to illiquidity, stressing the need for effective working capital management and highlighting the risks of overtrading. A business should only take on more debt if it can settle these debts on time.

Schedule of Budgeted Receipts from Debtors

It is important to create a schedule of expected collections from debtors and payments to creditors, as payments are not always received or made according to company policy. This schedule helps in setting up a cash flow budget.

Learning Example 5 B: Longile Limited

The budgeted total sales of Longile Limited for the first half of 20.6 are as follows:

January: R 120,000
February: R 140,000
March: R 168,000
April: R 144,000
May: R 128,000
June: R 100,000

Debtors are expected to pay their debts as follows:

70% in the first month following the month of the sale
20% in the second month following the month of the sale
7% in the third month following the month of the sale

3% is irrecoverable, and credit losses are written off at the end of the month in which the last installment is received. Debtors amount to R 179,200 on 1 January 20.6. Total sales for October 20.5, November 20.5, and December 20.5 were R 112,000, R 120,000, and R 132,000 respectively, with credit sales accounting for 50% of total sales.

A schedule is then constructed to show the amounts Longile Limited will receive from debtors each month from January 1, 20.6 to June 30, 20.6.

The Cost of Money (Interest)

If a business cannot finance its working capital through revenue or profits, it often takes on debt, incurring interest. The benchmark interest rate in South Africa is the prime overdraft rate, which is generally 3-3.5% above the repo rate. The repo rate is what the South African Reserve Bank (SARB) charges commercial banks when they borrow money. Increases in the repo rate curb inflation, while decreases aim to spawn economic growth by lowering financing costs for businesses. The prime overdraft rate is also called the 'mortgage rate'.

The 3-3.5% differential between the repo rate and the prime rate is the commercial banks' profit on financing deals. For example, if the SARB lends money to a commercial bank at 10%, and the prime rate is set at 13%, the 3% difference is the bank's interest rate profit.

To determine if a quoted rate is competitive, benchmark it against the prime overdraft rate and compare it with rates quoted on other assets with similar risk. Generally, residential property financing should have lower interest rates than financing a new, unproven product because the bank can repossess and sell the house to recoup losses if the borrower defaults. Loans for businesses are often more expensive due to the higher risk.

Nominal vs. Effective Interest Rates

When making decisions on interest-bearing assets, investors should always use effective interest rates, which reflect annual compounding. Compounding is a powerful tool for wealth creation or depletion.

Example:

If you invest R 1,000 at a 10% per annum interest rate compounded annually, the present value (PV) is R 1,000 on January 1, 20.1.

By December 31, 20.1, you earn $1,000 × 10\% = R 100$ , making the future value (FV) R 1,100.

In the second year (20.2), interest is calculated as $(R 1,000 + 100) × 10\% = R 110$ , bringing the total value to R 1,210 by December 31, 20.2.

The formula for future value, compounded annually is:

$FV = PV × (1 + r)^n$

Where:

$FV$ = Future Value
$PV$ = Present Value
$r$ = interest rate
$n$ = number of years

More examples:

Future Value (FV) on 31 December 20.1: $R 1000 × 1.10 = R1100$
Future Value (FV) on 31 December 20.2: $R 1000 × 1.10 × 1.10 = R1210$
Future Value (FV) on 31 December 20.3: $R 1000 × 1.10 × 1.10 × 1.10 = R1331$
Future Value (FV) on 31 December 20.10: $R 1000 × 1.10^{10} = R 2593.74$

Integration Task 5.2

Starting to save early has a significant impact due to compound interest. For example, saving R 100 a month from age 18 at a 12% effective interest rate would grow to R 2,697.35 by age 20 (total invested: R 2,400). Leaving this amount to earn interest until age 65 would result in substantial growth.

However, inflation erodes the true value of these savings. To ascertain the real value, the future value needs to be discounted by a factor reflecting inflation over the investment period. Calculating the true PV of the maturity value at 65, with 10% and 13% inflation rates applied throughout the 47 years, gives a more accurate picture of the investment's worth in today's terms.

Interest Rate Quotations

The way interest rates are quoted can be confusing, sometimes due to tradition, legislation, or deliberate attempts to mislead borrowers and investors. A rate is not an effective rate when it is not annually compounded but rather daily, weekly, monthly, or semi-annually. For example, a 12% nominal per annum interest rate compounded monthly is not equivalent to a 12% effective rate.

With monthly compounding, an investor receives $12\% ÷ 12 = 1\%$ interest per month. An investment of R 1,000 grows to $R 1,000 × 1.01 = R 1,010$ after one month. By the end of the twelfth month, it becomes $R 1,000 × 1.01^{12} = R 1,126.83$ . This is higher than the $R 1,120$ you would have with annual compounding ( $R 1,000 × 1.12 = R 1,120$ ).

Therefore, effective rates are usually quoted when marketing investments, while nominal rates might be quoted when offering loans, potentially resulting in a higher effective rate for the borrower.

To calculate an effective annual rate (EAR) from a nominal rate, use the formula:

$EAR = [1 + (\text{Quoted nominal rate} ÷ m)]^m - 1$

Where m = number of compounding periods in a year.

Example:

For a 12% nominal rate compounded monthly:

$EAR = [1 + (0.12/12)]^{12} - 1$

Thus: $1.01^{12} - 1 = 12.68\%$ , making an investor indifferent between a 12% interest compounded monthly and a 12.68% interest compounded annually.

Effective Annual Rates and Annual Percentage Rates

Confusion often arises with Annual Percentage Rates (APR), which are effective rates adjusted for loan-specific costs. The APR calculates the total cost of borrowing, making it easier to compare lenders and loan options.

The APR is likely to differ from the advertised rate. The general process involves:

Adding the once-off costs of the loan to the principal amount.
Calculating a monthly payment for the new total at the loan's effective rate (nominal rate compounded annually).
Calculating the interest rate that, when applied to only the face amount of the loan, equals the calculated monthly payment in step 2. This is the APR.

Learning Example 5 C: Letsema Furnishers

Letsema Furnishers purchases a delivery vehicle on hire purchase. The VAT-inclusive purchase price is R 228,000, with a 10% deposit required. The balance is financed over 5 years (monthly installments), with no residual. Initiation costs are R 2,220, and the monthly premium is R 4,934.51, with a quoted nominal interest rate of 15%.

Using MS Excel, the APR can be calculated using the 'Rate' function under the 'Financial' button. Enter the following arguments:

Nper (Total number of payments): 60 (5 years × 12 months)
Pmt (Monthly installment): -4,934.51 (negative because it is an outflow)
Pv (Amount borrowed excluding costs): 205,200 (R 228,000 - 10%)

The formula result is 0.012907402, the rate charged per payment period. To determine the APR, multiply this result by 12: 0.012907402 × 12 = 0.154888824. Multiply by 100 to get the percentage: 15.49%.

Therefore, despite a quoted rate of 15%, the actual rate payable (APR) is 15.49% due to additional initiation costs.