Managing Finance and Budgets

1. Managing Finance and Budgets Presentation 8 Working Capital (1)

2. Session 3 - Financial Statements (2) • Learning outcomes: Understand what is meant by the term ‘Working Capital’, and be able to describe some of the elements of which it comprises. • Understand what is meant by the Operating Cash Cycle and how it might affect a business. • Manipulate and use financial statements to inform decision-making specifically related to Working Capital. • Key concepts: Cash Flow Statement Working Capital

3. Structure of the Presentation • A : What do we mean by Working Capital? • B : The Key Elements of Working Capital • C : The Operating Cash Cycle • D : Controlling the Cash • E : Two examples • F : Seminar 8

4. Section A: What do we mean by Working Capital?

5. What is Working Capital? Working Capital is usually defined as: Current Assets Less Current Liabilities The major elements are: • Stocks, Debtors, Cash (Assets) • Creditors, Tax payable, Overdraft (Liabilities)

6. Example For 2002, Current Assets Total = £574,300 For 2002, Current Liabilities Total = £233,360 Working Capital for 2002: £574,300 - £233,360 £340,940

7. Stocks Trade creditors Trade debtors Cash (in hand and at bank) The Elements of Working Capital a summary Major elements Major element Current assets Working capital Current liabilities equals less

8. Why is Working Capital Important? Working Capital… • is money which is used to keep the organisation running on a day to day basis • represents a net investment in short term assets. • defines the Liquidity of the business (whether or not the business is solvent in the short term) • is directly related to the Cash Flow from Operating Activities.

9. Example Revisited Current Assets Total = £574,300 Current Liabilities Total = £233,360 Working Capital for 2002: £574,300 - £233,360 £340,940 Here we can see that although we have a large amount of Working Capital, it is all locked up in Stock & Debtors. The amount of actual cash (£33,500) is low in comparison; this may not be sufficient for needs.

10. Why do we need to Manage Working Capital? • A shortage of Working Capital may lead to operating difficulties - shortage of stock, inability to offer credit to clients, slow payment to creditors, missed opportunities • An excess of Working Capital also represents money “locked up” in stocks and debtors - investment may not produce an appropriate return • Working capital, therefore, needs careful management

11. Further Example For 2001, Current Assets Total = £175,750 For 2001, Current Liabilities Total = £225,900 Working Capital for 2001 is negative £175,750 - £225,900 - £50,150 Here we can see that the business has a deficit of Working Capital; it owes more money to creditors than it has in Stocks & Debtors. It could be Overtrading.

12. The Problem of “Overtrading” • This is where the working capital is insufficient to finance the increasing volume of trade • Expansion means more money is required to finance higher stock levels, and higher levels of debt • Organisations try to achieve this by increasing amount of time taken to pay suppliers, or increasing overdraft up to or beyond limit • A minor difficulty in any element of the working capital (e.g. late client payment) can then cause catastrophe

13. How exactly do we Manage Working Capital? In order to be able to Manage Working Capital effectively, we need to know: • The elements of Working Capital (stocks, debtors, creditors) • Detailed information about these elements; whether the levels are high or low, and whether we are are using them efficiently. • What actions can be taken to affect the situation. All of the above relies on an knowledge how each of these elements affects the Working Capital Cycle

14. The Working Capital Cycle This is essentially just a a simplified version of the how the operating activities link together and affect one other: • Purchase materials, which we • Use for Work-in-Progress, then we • Pay employees, who • Develop Finished goods, which we • Sell for cash or on credit, so we can • Pay creditors, and then • Retain the Surplus, which we use to…

15. Working Capital in Summary • Working Capital is the ‘lubricant’ which allows the business to run smoothly • Requirements vary between different types of industry (e.g. high in manufacturing, low in retail) & according to the fluctuations in the trading position • An increase in business may well require a parallel increase in working capital SAQ 8.1

16. SAQ 8.1 a. Why would the requirements for a greengrocer’s working capital be very different from that of a builder? b. What changes in the general business environment might lead a company to change the level of their Working Capital investment? Solution Solution

17. SAQ 8.1a Solution • Why would the requirements for a greengrocer’s working capital be very different from that of a builder? • Greengrocer: stock has very short shelf-life -often a matter of a day or two; Amount of stock is kept to the minimum possible, otherwise large wastage. In the retail trade, there are virtually no trade debtors, but may be some trade creditors. All this suggests very low levels of Working Capital: hundreds of pounds. • Builder: Often needs to outlay lots of expense: building materials, hire of equipment etc. Often this is on credit. Stock here is the ‘half-completed’ job. Often people take a long time to pay . All of this suggests that Working Capital will involve much larger sums of money – thousands of pounds even for a small builder.

18. SAQ 8.1b Solution b. What changes in the general business environment might lead a company to change the level of their Working Capital investment? Some possibilities: • Interest Rate Change • Seasonal demand patterns • Economic climate • Changes in the Market • Competition

19. Section B: The Key Elements of Working Capital

20. Cash sales Finished goods Cash/bank overdraft Trade debtors Trade creditors Raw materials Work-in-progress The Working Capital Cycle Summary Diagram

21. Key Elements of Working Capital There are three key elements to Working Capital: • Stock (absorbs working capital) • Trade Debtors (absorbs working capital) • Trade Creditors (releases working capital) Each one of these needs to be monitored effectively. SAQ 8.2

22. SAQ 8.2 Discuss the following: • Why do you think it is important to keep careful track of working capital requirements? Solution

23. SAQ 8.2 solution The need to keep track of working capital requirements: Failure to do so could lead to: • Debts not being collected on time, possibly with customers defaulting on payments. • Suppliers refusing credit, or even refusing to supply. • Stock not being available for manufacturing and other processes. • Payments to employees being delayed or impossible. • Possible Bankruptcy.

24. Key Elements of Working Capital:Stock • The higher the levels of stock, the more money the business has tied up in goods. • There may be very good reasons why some businesses need to carry high stock levels (Tesco, for example needs to carry a huge range of items; it will also need to have some basic items such as bread, milk and potatoes in large quantities) • Normally, holding large volumes of stock is not a good idea; if stock is held for long periods, the money is ‘dead’, and not being used effectively. • Typically, the highest profitability occurs when stock levels are at the minimum levels to supply customer needs.

25. Key Elements of Working Capital:Stock Remember from last week: Stock Turnover period: Stock holding (days) = Average Stock Value x 365 Cost of Sales • This provides an indication of the average length of time that stock is held before it is sold.

26. Stock Turnover Period Example calculation of the Stock Turnover Period: • A company has opening and closing stock levels for 2003 of £36,000 and £42,000. • The Cost of the Sales in 2003 was £345,000 Stock holding (days) = (36000+42000)/2 x 365 345000 = 41.26 days

27. Stock Control • One of the important issues here is how we can monitor and control stock levels. • There are several standard techniques for doing this. • Some require simple arithmetical calculations. • Others require a complete redesign of production processes or retail layout • We will explore some of these issues next week.

28. Key Elements of Working Capital:Trade Debtors • Carrying higher levels of Trade Debtors means that the business has a lot of money tied up, which it is not able to use to generate profit. • The businesses that owe us money, are effectively using it to invest in their business, and so create profits for them. • There may be good reasons why some businesses need to carry high levels of Trade debtors. (Builders, for example typically work on contracts for several months before getting paid.) • In the normal ‘cut & thrust’ of trade, most businesses would typically expect payment within one calendar month.

29. Key Elements of Working Capital:Trade Debtors Remember from last week: Average settlement period for Debtors: Debtors (days) = Trade Debtors x 365 Credit Sales • This indicates how long, on average the business has to wait before it gets its money from its customers.

30. Average Settlement Period (Debtors) Example of Debt Settlement period: A Company has the following totals for 2003: • Total amount of Trade Debt is £45,500 • Total for Credit Sales is £243,000 Debtors (days) = 45500 x 365 243000 = 68.34 days

31. Management of Debtors • Just as with stock, an important issue is how we can monitor and control the levels of trade debtors. • There are several standard techniques for doing this. • Organisational policies required regarding offering credit; credit terms etc. • Debt Collection Policies and their management. • Cash Discounts offered for early payment. • We will explore some of these issues next week.

32. Key Elements of Working Capital:Trade Creditors • Carrying high levels of Trade Creditors means that the business has access to a lot of resources (such as stock, rent, fuel etc.), but for which it has not paid. • This means that other businesses have effectively provided us (until we pay) with free resources, that we can use to create create profits for us. • Before we get carried away, there are good reasons why we should not carry high levels of Trade Credit. • In the normal ‘cut & thrust’ of trade, most businesses would typically expect payment within one calendar month; if this does not happen, we may incur penalties, and ultimately suppliers may refuse to trade with us.

33. Key elements of working capital Remember from last week: Average settlement period for Creditors: Creditors (days) = Trade Creditors x 365 Credit purchases • This indicates how long, on average, the business takes to pay what it owes.

34. Average Settlement Period (Creditors) Example of Credit Settlement Period: A company’s accounts for 2003 shows that: • The amount currently owing is £43,500 • The total amount of credit purchases is £198,000 Creditors (days) = 43500 x 365 198000 = 80.19 days

35. Management of Creditors • Just as with stock and trade debtors, an important issue is how we can monitor and control the levels of trade creditors. • There are several issues here. • Discounts may be offered for paying early and may be more valuable than the trade credit • Paying late may have disadvantages: lower priority, higher prices, refusal to supply • We will explore some of these issues next week. SAQ 8.3

36. SAQ 8.3 Tina’s Dressmaking Fabrics & Accessories Ltd. prides itself on stocking a wide range of fabrics in all colours, sizes and materials as well as a huge collection of trimmings, buttons, and ornamentations. It plies its business with specialist dressmakers, who buy mainly on credit, and takes its supplies directly from manufacturers, buying in bulk at a discount, on credit, but in order to qualify for the discount, payment must be made within seven days. • What level of working capital do you think Tina needs? • Do you think that this is an efficient way to run the business? Solution

37. SAQ 8.3 • Tina carries very high levels of stock (probably in the hundreds of thousands of pounds); unless she has a credit policy, it is likely that there would be huge amounts of trade debtors, certainly in the tens of thousands • On the other hand, given the 7-day discount, it is likely that she will keep the amounts owed to trade creditors very low, certainly much lower than the trade debtors. • All this suggests that the Working Capital requirements would be enormous; a huge proportion of this being tied up in stock which may not actually be needed in the short term. • It might be more profitable to hold lower levels of the less popular stocks, and run the risk of running out. If suppliers require payment within 7 days, then it is likely that they offer delivery within that time; hence customer service would not be affected greatly.

38. Section C: The Operating Cash Cycle

39. Cash sales Finished goods Cash/bank overdraft Trade debtors Trade creditors Raw materials Work-in-progress The working capital cycle Summary Diagram

40. purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit The Working Capital Cycle- essential events The diagram below is an even more simplified version of the Working Capital Cycle: Assuming all trade is done on credit, this shows the four essential events, in the normal order in which things occur.

41. The Working Capital Cycle- essential events From the simplified diagram, purchase of goods on credit Creditor Period Cash received from debtors payment to creditors for goods Sale of goods on credit Debtor Period • We can see immediately: • The Debtor Period • The Creditor Period

42. purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit The Working Capital Cycle- essential events There are two more important time periods: • The Stockholding Period (where is this?) • The Operating Cash Cycle (what is this?)

43. The Stockholding Period • The Stockholding period is the time from the purchase of goods to the sale of goods: purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit

44. The Operating Cash Cycle • The Operating Cash Cycle is defined as the time between the outlay of cash necessary for the purchase of stocks to the ultimate receipt of cash from the sale of goods. purchase of goods on credit Cash received from debtors payment to creditors for goods Sale of goods on credit

45. Average Stockholding Period Average Settlement period for debtors Average Settlement period for Creditors Operating Cash Cycle = + - Operating Cash Cycle • The Operating Cash Cycle can be calculated using the following equation: • Long Operating Cash Cycles have a significant influence on the financing of the business. • Most business will wish to reduce this to a minimum.

46. Average stockholding period plus Average settlement period for debtors minus Average payment period for creditors equals Operating cash cycle Calculating the Operating Cash Cycle

47. Operating Cash Cycle = + - 41.26 68.34 80.19 Example of Operating Cash Cycle • Using the amounts calculated previously : Stock Turnover Days Debtor Days Creditor Days = 29.41 days • In this case, the average time between the cash laid out and cash returned is less than one month.

48. Cash received from debtors Purchase of goods on credit Sale of goods on credit Payment for goods Stockholding period Creditor Period Debtor Period Operating cash cycle

49. Cash received from debtors Purchase of goods on credit Sale of goods on credit Payment for goods Stockholding period Creditor Period Debtor Period Operating cash cycle 41.26 Days 68.34 Days 80.19 Days 41.26+ 68.34 –80.19 = 29.41 Days

50. Why is the OCC important? • Effectively the OCC is the time it takes for cash to circulate around the Operating Activities of the business. • On every pass through the cycle, profit will be generated. • The shorter the cycle, the faster cash goes around, and the more profit will be generated over the accounting period.