U3.3 Working Capital
About Cash

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Current asset
In hand or At bank
Liquidity
Cash Problems

Lack of cash or working capital more often than lack of
profit lead to:

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Insolvency
Liquidation
Working Capital

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Money available for daily business operation
Also known as Net Current Assets
Shows available funds to pay immediate expenses
Working Capital = Current Assets – Current Liabilities
Current Assets

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Cash
Debtors
Stocks
Current Liabilities

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Overdrafts
Creditors
Tax
Working Capital Cycle
Production
Costs
Cash
Sales
Working Capital Cycle
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Hold enough cash to cover production costs
i.e. stock, wages, debt collection
Without being wasteful by holding too much
i.e. cash could be more profitably invested elsewhere
Current Ratio

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Desired ratio is 1:1
CA significantly higher indicates wastefulness
CA significantly lower indicates liquidity problem
Cash vs. Profit

Simply put
Profit = Revenues – Costs

Revenues are not always cash!
There are sources of cash outside of revenues.
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Profitable companies can be cash poor.
Unprofitable companies can be cash rich.
Cash Flow Forecasts
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Expected movement of cash in and out of a business:
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Cash Inflows
receipts
Cash Outflows
payments, expenses, outgoings
Net Cash Flow
cash inflows – cash outflows
Cash Flow Statements

Depicts the actual flow of cash in and out of a business
over a given period of time.
Reasons for Cash Flow Forecasts


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Persuade banks and other lenders when seeking external
finance.
Aid in the anticipation and preparation for periods of
time where cash flow shortages or surpluses may occur.
Assists in business and strategic planning.
Constructing Cash Flow Forecasts
Jul
Aug
Sept
Oct
Nov
Dec
5,000
3,000
300
(1,400)
(2,600)
600
6,000
5,000
6,500
6,800
7,500
9,500
0
0
0
0
4,000
0
6,000
5,000
6,500
6,800
11,500
9,500
Stocks
2,500
2,200
2,700
2,700
3,000
3,300
Labor costs
3,500
3,500
3,500
3,500
3,500
3,500
Other costs
2,000
2,000
2,000
1,800
1,800
2,200
Total cash
outflows
8,000
7,700
8,200
8,00
8,300
9,000
Net cash flow
(2,000)
(2,700)
(1,700)
(1,200)
3,200
500
Closing balance
3,000
300
(1,400)
(2,600)
600
1,100
Opening Balance
Inflows
Cash sales revenue
Other income
Total cash
inflows
Outflows
Cash Flow Forecast Practice
Cash sales
Stock purchases
Rent
Other costs
Opening cash balance
Net cash flow
Closing balance
Jan ($)
Feb ($)
2,000
2,000
600
600
900
1,200
1,000
0
1,000
0
600
600
800
1,000
1,600
1,900
800
300
1,800
1,600
1,900
1,000
Mar ($)
Apr ($)
4,000
Causes of Cash Flow Problems

Overtrading: quick expansion

Over borrowing: high geared
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Overstocking: poor inventory control
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Poor credit control: lenient credit policies
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Unforeseen changes: demand shifts
Managing Working Capital
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Dealing with liquidity problems:
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Seek alternative sources of finance
Improve cash inflows
Reduce cash outflows
Seeking Alternative Sources of Finance
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Overdrafts
Sale and leaseback
Selling off fixed assets
Debt factoring
Government assistance
Growth strategies
Improving Cash Inflows
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Tighter credit control
Cash payments only
Change pricing policy
Improved product portfolio
Improved marketing planning
Reducing Cash Outflows
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Seek preferential credit terms
Seek alternative suppliers
Better stock control
Reduce expenses
Combining Strategies
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Pareto principle
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80/20 rule
80% time and resources boosting cash inflow
20% on cost cutting
Contingency fund
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Cash set aside for unexpected, emergency use
Alternatives to Dealing with Cash Flow
Problems
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Spread risks with wider customer base
Require partial payments over time from customers of
large or lengthy projects/services
Establish systems to pay bills in regular installments
Establish quality management systems
Limitations of Cash Flow Forecasting
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Marketing
Human resources
Operations management
Competitors
Changing fashion and tastes
Economic changes
External shocks
Working Capital and Business Strategy

“More often than not, businesses fail because of cash flow
problems rather than profitability problems.”

Cash flow “forecasts and calculations are static, i.e. they only
represent the cash flow situation of a firm at one point in time”.
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“Managers face a dilemma in balancing the conflict between the
desire for sufficient working capital and the desire for profits.”

“Working capital is regarded as being more important than profit
in the short run.”
3.3.1 What is meant by working capital?
a.
Working capital (or net current assets) refers to the
money available for the daily running of a business, i.e. it
is used to pay for everyday costs such as wages, utility
bills, and payment so suppliers. Working capital is mainly
generated from the sale of goods and services.
3.3.2 explain the working capital cycle
a.
The working capital cycle refers to the interval between cash paid
by a business for the costs of production and receiving the cash
from customers. For example, if the customers pay by credit then
payment is not received until a later date, although costs are
incurred for the transaction. Due to its revamped menu,
McDonald’s was able to entice more customers thereby helping
to boost its sales by 6 per cent.
However, cash is not the same as profit. The costs of product
research and development for its new menu, for example, would
contribute to higher operation costs and hence lower profits. It is
likely that there is a significant time lag between investment
expenditure (R&D and marketing costs for its revamped menu)
and receiving sufficient sales revenue to recoup the costs. Hence,
it is probably that overall profits declined despite sales revenue
being slightly higher.
Explain the use of cash cards
b.
Credit cards allow customers to ‘buy now and pay later’ through a third
party, i.e. a financial lender. The finance company pays the retailer (and
charges the retailer a small fee for the service) and charges the customer
at a later date.
Since credit improves flexibility (customers do not need to carry so
much cash with them) and allows customers to buy now but to
postpone payment, it can attract a large number of customers to
businesses, including McDonald’s. Hence, sales revenues may increase
since customers have a greater choice of payment systems.
However, retailers and restaurants such as McDonald’s will not receive
their payment instantaneously, i.e. there is a (relatively short) delay in
payment from the credit card company. This therefore extends the
working capital cycle of the business that offers credit to its customers.
In addition, the amount received from the finance company will be
slightly lower since a fee will be charged by the creditor.
A firm faces a liquidity problem ;explain
b.
Definition of liquidity problem, i.e. the extent to which
the firm can meet its short term debts. The firm seems
to be suffering from worsening liquidity as seen by the
closing balance figures. The net cash flow for the first
four months of trading is also negative suggesting the
firm has insufficient working capital.
3.3.5 Answer Key
a.
Profitable firms can experience cash flow problems for
a number of reasons, such as:
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Overtrading
Long working capital cycle
Poor credit control
Long credit periods