1 Working Capital Management Week 11. 2 Working Capital You will recall the elements of Working...
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Transcript of 1 Working Capital Management Week 11. 2 Working Capital You will recall the elements of Working...
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Working Capital Management
Week 11
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Working Capital
You will recall the elements of Working Capital Stock Debtors Cash Creditors
The liquidity ratios examine the elements of working capital
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Significance of working capital management
In a typical manufacturing firm, current assets exceed one-half of total assets
Excessive levels can result in a substandard Return on Investment (ROI)
Current liabilities are the principal source of external financing for small firms
Requires continuous, day-to-day managerial supervision
Working capital management affects the company’s risk, return, and share price
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Key elements of Working Capital Invest in current assets, so long as
the return from such investment exceeds the cost of the capital used to fund them
Make use of short term funding, so long as it has a lower cost than other sources of funding and can be used to make profitable investments, after allowing for the cost of the funding
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The Working Capital Cycle
Cash Conversion Period = Inventory Transformation Period
+ Debtor Collection Period – Creditor Deferral Period Eg the quicker you turnover stock
and collect debtors and the longer you leave creditors, the better
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Stock
Stock is the least liquid of current assets
Companies will often hold more stock than they need and
This can be costly in terms of Capital tied up Costs of holding stock
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So why hold stock, then? Transactions Motive
to meet anticipated production/sales and service delivery requirements
Precautionary Motive to maintain a cushion or buffer so that
they can cope with any underestimates of demand that may have been made
Speculative Motive to take advantage of temporary
opportunities to buy items of stock at less expensive purchase prices
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The two elements of stock
The more stock held the greater the holding (storage) costs BUT
The less the order costs And vice versa The art is to balance the two
for optimal cost effectiveness
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Economic Order Quantity (EOQ)
EOQ represents the minimum point in total stock costs.
Carrying Costs
Ordering Costs
Order Size (Q)
Co
sts
Total stock costs
EOQ
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Formula for EOQ
O = Cost of placing an order S = Annual demand C = Holding cost of one unit
EOQ =2 (O) (S)
C
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An Example Assume a company has an annual
demand for a stock item of 150,000 The cost of placing an order is £40
per order It is calculated that the cost of
holding 1 unit of the stock item is £2 The item can only be ordered in
batches of 1,500, 2,500, 3,500 or 4,500
Which batch size (all other things being equal) would optimise costs?
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By tabulation BatchNo. of Av holding Order Size Orders Costs Costs Total
1,500100 1,500 4,0005,500 2,50060 2,500 2,4004,900 *** 3,50043 3,500 1,7205,220 4,50033 4,500 1,3205,820
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By formula
EOQ = 2,449 Therefore, 2,500 is
optimum batch size
EOQ =2 (40) (150,000)
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Pros & Cons of EOQ
It is quite effective in situations of regular demand
It can focus management thinking on cost reduction
BUT it is inflexible It assumes zero lead time in
ordering (Sawtooth pattern)
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Zero lead time with EOQ
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Materials Requirement Planning (MRP)
The system starts by seeing what production is planned and then develops a timetable for orders so the materials arrive in time for their use.
Thus the resulting stock of materials depends directly on the known demand.
Advantages of MRP Reduced stock levels. Stock is related to demand, therefore there should be fewer
shortages of materials and consumer satisfaction should be higher.
The stock turnover will be higher, which should have positive implications for the quality of the materials present in the final product.
Delivery of finished goods should be more reliable. There will be improved plant efficiency, because facilities will be
utilised when required, as the materials will be ready for immediate use.
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Disadvantages of MRP The successful implementation of MRP requires the
construction of a detailed master schedule of all the parts that will be required in the production process. If this master schedule has not been drawn up, the system can't operate.
Even if there is a master schedule, it may not be accurate and hence there may be shortages or surpluses of stock.
Plans are frequently changed and/or not made far enough in advance causing problems in accurate scheduling.
If the master schedule is to be accurate, information about current stocks, orders outstanding and the reliability of stock surpluses will be required.
It will be necessary to have information on the length of time it takes to acquire deliveries of stock in time for use.
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Just in Time Stock Control Instead of holding stock at the factory only order
stock on a Just in Time basis (raw materials are ordered only as they are needed).
Advantages of Just in Time There is less stock in the factory, so costs are
lower. This results in a lower unit cost.
Disadvantages of Just in Time If supplies are disrupted for some reason, the
business will have no stock to fall back on. This will affect their production rates very quickly.
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Control of Debtors Key aspects of debtor management
A clear statement of the general terms on which it is prepared to grant credit to customers
Credit rating procedures A credit management system
Terms of credit - need to consider Custom and practice in the relevant
industrial/commercial sector Cash settlement discounts The likely/acceptable level of bad debts
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Control of Debtors Costs of relaxing credit standards
A larger credit department Additional clerical work Servicing additional accounts Bad-debt losses Opportunity costs
Analysing the credit applicant Obtaining information on the credit
applicant Analysing this information to determine
the applicant’s creditworthiness Making the credit decision
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Encouragement to pay Offering Discounts Everything costs so if you have
debtors there will be a cost attached to that income deferred
Either through loss of alternate use Or by having an overdraft because
you haven’t got the money
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Offering Discounts – An example
Vole Ltd has an overdraft and pays 17% p.a. on it
Annual sales are £365,000 and debtors run at present at £90,000
If a 2.5% discount for settlement in 10 days was taken up by 1/3rd of customers
What would the saving be, if any? What is the maximum discount that
could be given and not dent profit?
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Vole Ltd - 1 Annual cost of debtors = £90,000 X 17% =
£15,300 Annual sales are £365,000 (ie £1,000 per day) Existing debtors = £90,000 (ie 90 days) Expected reduction = 1/3rd (ie £30,000) A reduction from 90 to 10 days = 8/9 8/9 X £30,000 = £26,667 Annual interest saved = 17% X £26,667 = £4,533 Annual cost of discount on 1/3rd of annual sales = £121,667 X 2.5% = £3,042 Therefore, there would be a saving
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Vole Ltd - 2 If 2.5% wasn’t enough to
tempt customers Then maximum discount
without affecting profits would be up to interest saved (ie £4,533)
Therefore, interest saved as a percentage of 1/3rd annual sales = 3.726%
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Managing Creditors The basic rule is Defer as long as possible Remember the cash conversion
period is reduced the longer the creditor deferral period
The downside is potential harm to supplier relations
Not good if say operating Just in Time system
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You say creditor, I say debtor
To all of your creditors You are a debtor, so They will be trying to get you
to pay promptly If they offer discounts is it
worth taking them?
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Calculation of “annualised interest rate”
Most small companies, because of cashflow considerations, cannot take advantage of discounts.
But “annualising” the effective interest rate shows the true cost of ignoring discounts
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Formula to calculate “annualised” interest rate
Cost = Discount% X 365 (100-discount%) Final due date –
discount period)
Assume a company is offered 2.5% to pay within 10 days on
28 day invoice Effective interest rate is 2.5/97.5 X 365/(28-10) = 46.15
%
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Maintaining control of creditors Keep records of what is owed and how long
you have to pay Train whoever pays invoices to pay these
when it suits your cashflow Agree clear terms of payment with all your
suppliers Consider paying for non-current assets
over a longer period Decide whether or not you need to always
pay on delivery Pay as late as possible – without incurring
penalties or losing goodwill.
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Management of Cash Balances
The financial manager wants to keep cash balances to a minimum
The goal is to speed up the inflow of cash and slow down the outflow of cash
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Management of Cash Balances
Speeding Up Cash Inflow Expedite preparing and mailing invoices Accelerate mailing of payments from
customers Reduce the time during which payments
received by the firm remain uncollected Use Electronic Funds Transfer
Slowing Down Cash Payouts Control of disbursements Remote and controlled disbursing
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Management of Cash Balances
Source of short-term finance available to commercial entities: Trade credit. Bank borrowing Instalment credit Financial instruments Factoring