BUSINESS & MANAGEMENT

BUSINESS & MANAGEMENT Unit 3.3 Working Capital 1/37

KEY TOPICS Standard Level • Working capital and the working capital cycle • Cash flow forecasts • Causes of cash flow problems • Managing working capital (dealing with liquidity problems) 2/37

Working Capital • Cash is the life blood of a business. Businesses need cash or money on hand to keep a business running. • Cash is a form of Current Assets. • Working Capital is money a business receives. It is usually used to pay for everyday things a business needs (i.e. Revenue Expenditure). • Working Capital is boosted by Sales of Goods and/or Services, Interest Income, Loans Received, Grants Received, Donations, Sponsorships, Overdraft, Debt Factoring, Selling Company’s Assets and etc. 3/37

Types of Current Assets • Cash - Money at hand or in the bank • Debtors – Money that is owed by a customer of the business. (Someone who bought on credit) • Stocks/Inventories - Raw materials, Semi-finished goods or Finished goods. • Shares – Shares of listed companies obtained in the stock exchange. (The closer to the market something is, the more liquid it is considered). 4/37

Current Assets • Money held in a bank (Cash at Bank) or in hand (Cash in Hand) are two types of current assets. • Stocks and money owed by debtors (Trade Debtors) are also two other types of current assets. • Current Assets = Cash at Bank + Cash in Hand + Stocks + Trade Debtors • Current Assets are used to pay for costs within a year (i.e. Revenue Expenditure). Current Assets are also known as liquid assets. 5/37

Net Current Assets • Working Capital can also be referred to as net current assets. • Working Capital = Current assets – Current liabilities 6/37

Liquidity • Liquidity –means how easily an asset can be turned into cash. • Money at a bank is highly liquid. • Stocks and Shares are also highly liquid. • An asset is highly liquid if it can be turned into cash usually within 3 working days. • A load of lumber used to build a house is not very liquid. 7/37

Illiquidity and Insolvency • Businesses that do not keep up with cash flow issues can become insolventand may go out of business. • As soon as a business has this problem it can cause a spiral effect that will cause a business to not operate the way it should. Why? • Lots of unnecessary time will be spent getting cash instead of generating more revenue! • When this happens, a vicious cyclestarts to happen and finally, a liquidation of the business assets will occur. • This can happen to businesses that have been profitable for years but failed to get through short-term cash flow problems. Isn’t it a pity? 8/37

Current Liabilities • Money that is owed and needs to be paid back within a year. • Types of liabilities: • Overdrafts& Credit Cards – short term loans that need to be paid very quickly • Trade Creditors – suppliers who sold a business something on credit • Tax – Money that is owed to the tax authorities 9/37

Working Capital Cycle • Most businesses will have a delay in-between spending money and receiving money back. NOTE: This is the major reason why businesses work so hard to manage their working capital. Cash flow forecast helps manage this. • Cash • Production Costs Understanding of the Working Capital Cycle (Pg. 363 in 1st Edition or Pg. 321 in 2nd Edition) keeps you out of trouble! • Sales The Working Capital Cycle 10/37

Liquidity vs. Leverage • Most businesses don’t want to have too much liquid assets on hand because they feel that money should be working for the company instead of being very liquid. • Money in the form of cash depreciates in times of inflation. Hence, lower liquidity and higher leverage is more advantageous • However, it is also very important to have cash during the financial crisis. Cash is very scarce during hard times. NOTE: Lack of ready cash was damaging to many companies during the financial crisis. Higher liquidity is required during crisis. 11/37

Current Ratio • Current ratio – a measure of liquidity of a firm. • Shown as a ratio • Current Assets: Current liabilities. • Any firm under 1:1 (e.g. 0.8:1) has liquidity problems that can cause liquidation. That is, there are not enough current assets to cover the current liabilities of the business. 12/37

Cash vs. Profits • Profit = Revenue – Cost • When a firm makes enough to reach the breakeven point then all other money is considered profit. • Customers have several options when making purchases. • They can pay using: Cash in hand, check, direct debit, credit card or trade credit. 13/37

The difference between Cash and Profit • If a business sells on trade credit, the sale will count as profit but it will not be considered cashuntil the actual payment is made. • When credit sales happens, the accounting entries are: Cr. Sales Db. Trade Debtors At this point, the company makes the profit from the sales transaction since there is sales recorded in its Profit & Loss Statement. However, since the customer has not paid; the money is not yet in the company’s bank or cash in hand. • Because of this, profit is not considered cash! • When the customer finally pays, the accounting entries are: Cr. Trade Debtors Db. Bank or Cash in Hand • Only now, the profits has turned into cashas the money has finally landed into the company! 14/37

Sales Revenues vs. Cash Inflows • Sales revenue is always from making a sale to a customer but cash inflows can be from any number of sources of finance that bring money into a business. Examples are: loans, grants, interest income and selling assets. • Sales revenue is a subset of Cash Inflows Cash Inflows Loans Interest Income Sales Revenue Sales of Assets Grants 15/37

Cash Flow Forecasts • Cash inflows/receipts - money that usually comes in from sales revenue from customers. Predicting sales forecasts is very difficult but very important for a business. Also payment from debtors, loans, interest income, sale of assets and rental income all go in cash inflows. • Cash outflows/payments/ expenses/ outgoings – money that leaves a firm from bills such as labor, purchase of stocks (material) rent, taxes, payment to creditors, advertising, interest repayments and dividends. • Net cash flow = Cash Inflows – Cash Outflows. It is very important to keep this positive. 16/37

Two other parts to the cash flow forecast • Opening balance is the amount of cash at the beginning of the trading period. It’s the same amount as the closing balance of the preceding month. • Closing balance is the amount of money in an account at the end of a trading period. • Closing balance = Opening balance + Net cash flow 17/37

Reasons for cash flow forecasts • Lenders want to see cash flow forecasts before they give a business external finance. • Businesses can anticipate times when they might have a cash flow problem and make adjustments to timing of cash coming in and cash going out. • Businesses can plan better for the future when they have reliable predictions about their cash flow needs. Comparing actual results to forecasts help • Turn to page 366/323 18/37

Importance of Cash Flow Forecasts • All businesses need to have good cash inflow in order to have working capital to pay expenses (i.e. revenue expenditure). • Businesses that wait to bring in working capital need to worry about having enough money so they do not have a liquidity problem. Example: Businesses that sell on credit to their customers. • Businesses that don’t worry about these problems can have trouble paying suppliers and employees • It is also a problem for businesses to not use the money they have coming in to expand into areas that they may need to for survival. • Cash flow forecast tend to operate according to the previous year; although new customers may be anticipated. • Having lots of cash in hand doesn’t mean you’re profitable! 19/37

Some businesses that have lots of cash on hand may not actually be profitable. 20/37

There is a difference between liquidity and profitability! 21/37

Causes of cash flow problems • Overtrading – businesses try to expand too quickly. They take orders that they can not possibly fulfill and do not have enough working capital to spend on operating costs. • Over borrowing – businesses that are highly geared will spend lots of their outflow money on paying back loans. Extremely dangerous in times of rising interest rates and financial crisis. • Overstocking – keeping too much product around. This is a waste of resource as money could be used elsewhere. Overstocking is probably only justified to buffer against stock shortage. 22/37

Causes of cash flow problems • Poor credit control – giving too long for debtors to pay back loans as well as giving credit to businesses that are a risk and don’t pay off their debt. • Unforeseen changes – things that happen that cannot be known to happen ahead of time. Example: Act of God. • Note some business that deal in cash and low inventory carrying periods will not need to worry about working capital nearly as much as a business that carries inventory for a much longer period of time. Example: A SHIP PRODUCER COMPARED TO A grocery store. • Other cash flow problems for businesses stem from the fact that some businesses are seasonal. 23/37

Businesses need to make sure current assets can always cover their current liabilities. 24/37

Working capital combat strategies • There are many different ways to deal with working capital problems. • Option 1: Seek other sources of finance • Option 2: Improving cash inflows • Option 3: Reducing cash outflows 25/37

Option 1: Seek other sources of finance • Overdrafts – temporarily take more money out of and account than a business has. Downside are the exorbitant fees and it can be hard if a business is known as a credit risk. • Credit Cards– spend money that the business doesn’t even have in the account! Interest is very high and a host of other finance charges apply if you’re late in paying the minimum required amount. Many people and businesses never got out of this debt!!! • Sale and Leaseback – involves selling off fixed assets and then leasing them back. • Selling off fixed assets - in case of a real emergency a business can sell its assets. Dangerous because they may need these to do business. Example of such assets are machinery and computers. 26/37

Option 1: Seek other sources of finance • Debt factoring – passing on debt to a collection agency so they can have immediate access to the funds. Fees are associated. • Government assistance – governments will sometimes help a businesses that is trouble because they do not want to see a business fail and with that have job loss • Growth strategies - strategic alliances, joint ventures, mergers and takeovers happen many times because a business is in trouble. 27/37

Option 2:Improving cash inflows • Tighter credit control – sometimes businesses may need to reduce the amount customers can buy on credit. Reducing the length of time for payment is also implementing tighter credit control. • Cash payments only - eliminate trade credit all together! Both options will bring in money faster but it may lead to customers switching businesses. It will negatively affect those businesses’ cash flow. 28/37

Option 2:Improving cash inflows • Change pricing policy – if you lower prices it can increase sales on some products making it easer to convert stock to cash. • Broaden product portfolio – offering a greater range of goods can help to increase sales. The downside is that this could increase costs and risks without increasing net cash flows. • Improved marketing planning – more market research can help to understand customers needs and increase cash inflows. 29/37

Option 3:Reducing cash outflows • Seek preferential (good) credit terms– negotiating better terms with current or potential suppliers. Downside is it can have administrate costs with no benefit. • Seek cheaper suppliers – Can lower costs but run the risk of inferior supplies. Inferior supplies will lead to inferior product quality and this may invariably lead to loss of customers. • Better stock control - Some businesses will wait for orders to come in before they make whatever they are selling. Example: Dell Computers got advance payment on all Internet orders before they assemble the computer!!! • Reduce expenses – businesses will spend lots of time figuring out how they can save money by reducing non essential costs. 30/37

Cash flow combat strategies • Most firms will do some combination of these methods to help increase the working capital. Following the Pareto principle, many businesses will spend 80% of their time figuring out how to increase cash inflows and 20% of their time on how to cut costs. • A contingency or emergency fund will usually set aside money for unexpected expenses. The greater the level of uncertainty faced by a business, the higher its contingency fund tends to be. • Refer to Page 372 (1st Edition) or Page 328 (2nd Edition) for the table on alternative sources, raising cash inflows, and lower cash outflows. 31/37

How to prevent cash flow problems from happening • Having a broader range of customers can help by reducing risk. Seasonal and cyclical factors can affect certain groups of customers. Having a broader scope of customers spreads your risk. • For large projects that take a long time, some businesses ask for partial payments to help cash flow problems. This also integrates the customer’s financial interest in the project. • Paying large bills in installments can help cash flow problems. Paying some interests in exchange for the much needed liquidity is financially justified. • Ensure quality management systems and customer service systems are in place to help keep customers happy. 32/37

Limitations of Cash Flow Forecasting • Marketing – Bad market research may give improper sales forecasts. Also a bad marketing campaign will sometimes make customers not like a product. • Human Resources – If a workforce does not get along or if they are unhappy with management then more and more customers may complain or use other businesses. • Operations Management – Some things that go wrong with production can really hurt cash flow when businesses can not produce their products on time or according to the specifications of the customers. 33/37

Limitations of Cash Flow Forecasting • Competitors – Market leaders can be unpredictable and can effect other businesses very negatively. • Changing fashion and tastes– People change what they want and what they like all the time. Because of this making predictions can be very hard. • Economic changes– Low interest rates tend to increase spending because people will borrow more which will boost the overall economy. The opposite happens with higher interest rates. Because of this making predictions become very hard. • External shocks– war, stock market crashes and natural disasters. Make making predictions very hard. 34/37

Common business pitfalls • Predictions are never set in stone. They need to be revised constantly. Because we live in a dynamically changing environment, things can change pretty fast. As such, most businesses try to not make predictions for the very long term. • Managing cash flow is very important. It is important not to mistake cash with profits. More businesses fail because of bad cash flow management rather than a lack of profitability. 35/37

Working capital and Business Strategy • Human Resource – Staff needs to be paid on time or there can be serious trouble. If a firm is profitable but does not have the capital to pay their staff then employees will be unhappy. • Marketing – letting people know about a product and doing research requires large amounts of cash. • Production – businesses that build things for a long time need to make sure that they will have enough working capital to finish their projects. 36/37

Dilemma between liquidity and profitability • Businesses need to be careful about how much they rely on cash flow analysis. It is important to understand where that information is coming from and its reliability. • Businesses need to make sure to have a balance between giving their customers credit and making sure they have working capital. • In the short term working capital is more important than profits for a business because without working capital a business will not survive. However, a business cannot survive very long without profitability. Hence, a balance must be struck. 37/37

BUSINESS & MANAGEMENT