FM4013_Working Capital Management
Working capital often defined as the difference between current assets and current liabilities. The
working capital cycle of a business would consist of creditors who supply the stock, the stock is
converted to finished goods and supplied to debtors. The cash received from debtors would be used
to pay creditors. It is described as 'working' because in any one period there is a continuing cycle, or
turnover of these assets and liabilities.
A business needs working capital to finance the continuity of its operations. The working capital must
be 'managed'. Debtors and creditors levels must be constantly monitored and stock control
techniques should be in place. ➔ optimal level of the working capital
Too much working capital may appear to be a sound idea, but valuable resources are being tied up
when they could be used more effectively in the business. There is no correct amount of working
capital although certain ratios may be calculated as a guideline. The actual amount needed will depend
on the type of business and its level of activity. Too little working capital means that current liabilities
may well exceed current assets.
Short term funds may be used not only to finance short term assets but also long-term assets. Bank
overdraft facilities may be withdrawn creating a liquidity crisis. Overtrading may cause a shortage of
liquid funds and it is essential to continually match the trading situation with the need to ensure that
adequate short-term funds are available.
Overtrading
Overtrading occurs when a business tries to do too quickly with too little long - term capital, i.e. it is
trying to support too large a volume of trade with the capital resources at its disposal. The business
may be operating at a profit but run into trouble because of shortage of money.
Causes of Overtrading – credits sales and cash sales → 70% of sales is on credit → increase debtors.
→ effect cash management.
✓ Too ambitious of the management in increasing its turnover too rapidly without an adequate
capital base.
✓ A business may have failed to replace a loan with another long-term funds after repaying it.
✓ In periods of inflation, retained profits are not enough to pay for replacement of fixed assets
and stocks.
Symptoms
✓ Rapid increase in turnover.
✓ Rapid increase in its current assets and possibly also its fixed assets. Stock turnover and
debtor’s turnover may slow down i.e. increase in stocks or debtors greater than increase in
sales.
✓ Small increase in capital (e.g. retained profit). Most of the increase in assets is financed by
short-term funds such as credit.
✓ Rapid decline in current as well as 'acid test' ratios. May even have negative net current assets.
Debtor Management Ranges from the receipt of the order up to payment being received. Just like
other elements of current assets, the objective of debtor management is not just to minimise the
investment but also to optimise the level of debtors by examining the costs and benefits involved.
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FM4013_Working Capital Management
The B.O.D. or senior management should lay down policy guidelines and delegate responsibility and
authority for them to be carried_ out.
The policy formulated will probably be unique to an individual organisation and involve balancing a
number of factors including:
i.
ii.
iii.
iv.
v.
vi.
The ability of the firm to finance the investment in debtors since funds are a scarce resource
for most firms.
Trade practice and the nature of the product. There may be certain credit norms for the
market sector within which the firm competes and failure to
Match the terms of competitors will lead to a serious loss of business. Pricing strategy of the
firm, credit may be viewed as part of the overall price package offered.
The competitive situation in the market - a monopoly can set credit terms in isolation to
maximise profits. In a highly competitive situation the firm has to match or better competitors'
terms.
The acceptable level of bad debts.
The cost benefit trade off - Benefits in terms of the additional contribution from the extra
business generated must be set against the costs of providing credit.
For the policy guidelines to operate, systems and procedures need to be set up to cover the areas of
credit analysis, credit control and debt collection. Credit analysis may be defined as the collection and
analysis of relevant information on an organisation to determine whether credit should be granted.
Credit analysis should not only be applied for new customers but also on existing accounts on a
regular basis as well as when requests are received to raise credit limits.
Credit analysis and the overall debtor management guidelines provide the two central statistics for
credit control:
i.
ii.
iii.
iv.
Credit limit - the maximum amount which may be outstanding at any point of time
Credit terms - the interval between the invoices and the payment becoming due.
The credit term relies upon prompt recording and regular monitoring for enforcement. These
terms must be included in the contract by being notified in writing and it is common for the
credit limit and due date to appear on every invoice set.
Debt collection should not be carried out in isolation. It is important that marketing
department is involved and it is common for ageing reports to be sent to this dept. Collection
procedures must be systematic - first, make a phone call to prompt payment, second send
reminder letter and finally as a last resort, take legal action. A company can also insure
against bad debts.
Bad Debts
As credit periods are extended and credit becomes more accessible, bad debts increase in terms of
the number of accounts who are unable to pay. The most important factor is the profile of a firm's
portfolio of accounts. If debtors comprise a large number of small value accounts, there would not be
a great impact even if a number of accounts goes bad. However, if there are a number of significant
accounts, there is a chance that bad debts might lead to insolvency.
Discount
The main purpose is to attract early payments and therefore from the surface it seems a question of
balancing the cost of the discount with the savings from shorter average collection period and lower
debtors' balances. However, sometimes discounts also reduce bad debts because discounts might
stimulate demand from cash rich firms which seek attractive discounts. The approaches to deciding
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FM4013_Working Capital Management
on discounts: i. Annualise the discount cost and compare this with the firm' s required return on
investments. ii. Comparing costs and benefits.
Creditor Management
Major component of creditors is trade creditors. Trade credit is often seen as a free source of funds
after assessing whether discounts are advantageous, the normal practice is to pay creditors only when
pressed and delay paying creditors when there are temporary cash shortage.
This is short-sighted because it may lead to retaliations from existing suppliers (such as reducing credit
period allowed, insisting on cash with order and raising prices) and difficulties in obtaining credit with
new suppliers. It is better to have a more enlightened policy which appreciates that credit terms are
an integral part of the overall price negotiation. The firm should seek to obtain the lowest overall cost
bearing in mind the opportunity benefit provided by longer credit. Once credit terms are set the firm
should pay in accordance with them.
Another aspect of creditor management is monitoring the financial health of key suppliers. Key
suppliers are those whose failure would have adverse financial and other consequences on the
Company.
Cash management Concentrate upon four elements:
✓ Available cash balances - the bank balance recorded in the bank's books at any point in time
includes amount credited against the account which haven't been cleared through the bank
clearance system
✓ Receipts float - recorded in the company's books, which have either not been credited in the
bank account or credited but uncleared.
✓ Payments float - cheques written and entered in the books of the firm but not yet cleared and
debited to the bank account by the bank.
✓ Unbilled and outstanding debtors - covers invoices not raised, invoices in process and
uncollected debts.
Stock Management (inventory management)
The challenge is not to have excessive stock as cash would be tied down in stock, but at the same time,
there must be adequate stock to ensure that 'stockout would not occur. To optimise the level of stock,
mathematical models such as the Economic Order Quantity (EOQ) may be used. The EOQ is used to
determine the order quantity, which minimises the combined costs of ordering and holding.
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FM4013_Working Capital Management
Example (Cash Budget)
The following information relates to Drizzle Ltd :
Month
Sales
Materials
Overheads
Wages
RM
Purchased
RM
incurred
RM
RM
March
50,000
25,000
12,000
10,000
April
60,000
30,000
10,000
12,000
May
80,000
50,000
15,000
16,000
June
60,000 70%
70,000
10,000
12,000
credit)
July
30,000
50,000
11,000
6,000
August
70,000
50,000
12,000
14,000
September
100,000
80,000
20,000
20,000
October
90,000
60,000
18,000
18,000
i. The wages are paid in the month they are incurred → the same month
ii. Creditors are paid for materials two months after purchase. → after 2 months
iii. 30% of the sales are cash. Customers who buy on credit pay in the following month.(70% is
credit sales)
iv. Overhead expenses are paid in the month they are incurred. → same month.
viii. It is expected that the bank balance on 30th June will be RM15000.
Required :
Prepare a cash budget for the three months ended 30th. September. ➔ July, August & September
Step 1 : calculate the adjustments
July
August
September
9,000
21,000
30,000
70% Credit sales – paid in the following
month
Total Sales (cash inflow)
42,000 – June
21,000 - July
49,000 - Aug
51,000
42,000
79,000
Creditors (2 months after months of
purchase)
50,000 – May
70,000 – June
50,000- July
30% of cash sales
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FM4013_Working Capital Management
Step 2 : prepare the cash budget
July
August
September
Balance b/f
Cash Inflow
15,000
(1,000)
51,000
42,000
(55,000)
79,000
Total cash inflow
66,000
41,000
24,000
Creditors
50,000
70,000
50,000
Overhead
11,000
12,000
20,000
Wages
6,000
14,000
20,000
Total Cash Outflow
(67,000)
(96,000)
(90,000)
Net Cash inflow /
Net cash outflow
(1,000)
(55,000)
(66,000)
Cash Outflow
Question 2
DOW Ltd. Is operating a retail business? Sales are expected to be $140000 per month for the
first three months rising to $210000 per month for the next three months. Sales on credit for
customers are allowed one month’s credit. Cost of sales (materials) are 40% of sales value.
Trade suppliers offer one month’s credit. Other operating cost is $2000 per month and are paid
in the month they are incurred.
Prepare the cash budget for the first 5 months.
Step 1 : calculate the adjustments
Sales: $140,000 first 3 months, $210,000 the next 3 months
Credit sales: one-month credit.
Cost of sales: 40% of sales value → materials
1st 3 months 40% x 140,000 = 56,000
Next 3 months 40% x 210,000 = 84,000
Credit purchase: one-month credit
Other operating cost: $2,000 / month
Sales
Materials
Month 1
0
0
Month 2
140,000
56,000
Month 3
140,000
56,000
Month 4
140,000
56,000
Month 5
210,000
84,000
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FM4013_Working Capital Management
Step 2 : prepare the cash budget
Balance c/f
Cash inflow
Total cash inflow
Cash outflow
Materials
Other cost
Total cash outflow
Net Inflow/Net
Outflow
Month 1
0
0
0
0
0
(2,000)
(2,000)
(2,000)
Month 2
(2,000)
140,000
138,000
Month 3
80,000
140,000
220,000
Month 4
162,000
140,000
302,000
Month 5
244,000
210,000
454,000
(56,000)
(2,000)
(58,000)
80,000
(56,000)
(2,000)
(58,000)
162,000
(56,000)
(2,000)
(58,000)
244,000
(84,000)
(2,000)
(86,000)
368,000
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