Chapter 4

Working capital
Management

THE TREASURY MANAGEMENT

A function devoted to all aspects of cash within a company.

This includes:

1. Investment
2. Raising finance
3. Banking and exchange
4. Cash and currency management
5. Risk
6. Insurance

Role

‘The treasury management is the corporate handling of all financial matters, the generation of external and internal funds for
business. The management of currencies and cash flows, and complex strategies, policies and procedures of corporate finance’.

The role being summarised under 5 headings:

1. Corporate objectives
2. Liquidity management
3. Investment management
4. Funding management
5. Currency management

Centralisation vs. Decentralisation

In a large organisation there is the opportunity to have a single head office treasury department or to have individual treasury
departments in each of the divisions. Modern practice would suggest the decentralised route where there is little or no head office
intervention in the workings of an autonomous division. This runs contrary to the treasury practice where large companies tend to
have a centralised function.

Advantages of centralisation

1. Avoid duplication of skills of treasury across each division. A centralised team will enable the use of specialist employees in
each of the roles of the department.
2. Borrowing can be made ‘in bulk’ taking advantage of better terms in the form of keener interest rates and less onerous
conditions.
3. Pooled investments will similarly take advantage of higher rates of return than smaller amounts.
4. Pool of cash resources will allow cash-rich parts of the company to fund other parts of the business in need of cash.
5. Closer management of the foreign currency risk of the business.

Advantages of decentralisation

1. Greater autonomy of each action by individual treasury departments to reflect local requirements and problems.
2. Closer attention to the importance of cash by each division.

Profit centre vs. Cost centre

Should the treasury department be run as a cost centre or a profit centre?

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Cost centre – A function to which costs are accumulated.
Profit centre – a function to which both costs and revenues are accounted for.

Advantages of using a profit centre

1. The use of a treasury department is given ‘a value’ which limits the use of the service by the divisions.
2. The prices charged by the treasury department measure the relative efficiency of that internal service and may be compared to
external provision.
3. The treasury department may undertake part of the hedging risk of a trade thereby saving the company as whole money.
4. The department may gain other business if there is surplus capacity within the department.
5. Speculative positions may be taken that net substantial returns to the business.

Disadvantages of using a profit centre

1. Additional costs of monitoring. The treasury function is likely to be different to the rest of the business and hence require
specialist oversight if run as a profit making venture.
2. The treasury function is unlikely to be of sufficient size in most companies to make a profit function viable.
3. The company may be taking a substantial risk by speculating that it cannot readily quantify. In the event of a position going
wrong the company may be dragged down as a result of a single transaction.

Short-term sources of finance

Factoring
The outsourcing of the credit control department to a third party. The factor advances a proportion of the money it is due to
collect. This is usually up to 80% of the face value of invoices raised. The finance is repaid once the invoices have been settled
and the balance is passed to the issuing company after deduction of a fee. This fee is equivalent to an interest charge on the cash
advanced.

The debts of the company are effectively sold to factor. The factor takes on the responsibility to collect the debt for a fee. The
factor offers three services:

1. Debt collection
2. Financing
3. Credit insurance (non-recourse service)

The factor is often more successful at enforcing credit terms leading to a lower level of debt outstanding. Factoring is therefore not
only a source of short-term finance but also an external means of controlling or reducing the level of debtors.

Invoice discounting
A service also provided by a factoring company.
Selected invoices are used as security against which the company may borrow funds. This is a temporary source of finance
repayable when the debt is cleared. The key advantage of invoice discounting is that it is a confidential service, the customer need
not know about it.

The invoice discounter does not take over the administration of the client’s sales ledger.

A client should only want to have some invoices discounted when he has temporary cash shortage, and so invoice discounting
tends to consist of one-off deals.

Trade credit
The delay of payment to the suppliers is effectively a source of finance.
By paying on credit terms the company is able to ‘fund’ its stock of the material at the expense of its suppliers.

Overdrafts
A source of short-term funding which is used to fund fluctuating working capital requirements.

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Its great advantage is that you only pay for that part of the finance you need.
The overdraft facility (total limit) is negotiated with the bank on a regular basis (may be annually). For a company with a healthy
trading record it is normal for the overdraft facility to be ‘rolled over’ from one year to the next although theoretically it is
‘repayable on demand’.

Bank loans
Bank loans or term loans are loans over between one and three years which have become increasingly popular over the past ten to
fifteen years ‘as a bridge’ between overdraft financing and more permanent funding.

Advantages of an overdraft a loan

(i) The customer only pays interest when he is overdrawn.
(ii) The bank has the flexibility to review the customer’s overdraft facility periodically, and perhaps agree to additional
facilities, or insist on a reduction in the facility.
(iii) An overdraft can do the same job as a loan: a facility can simply be renewed every time it comes up for review.
(iv) Being short-term debt, an overdraft will not affect the calculation of the company’s gearing.

Bear in mind, however, that overdrafts are technically repayable on demand, so even though they are cheaper than longer term
sources of debt finance, they are more risky.

Advantages of a long-term loan

(i) Both the customer and the bank know exactly what the repayments of the loan will be and how much interest is payable,
and when. This makes planning (budgeting) simpler.
(ii) The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility before he is in a
position to repay what is owed. There is an element of ‘security’ or ‘peace of mind’ in being able to arrange a loan for an
agreed term. However, long term finance is generally more expensive than short term finance.
(iii) Loans normally carry a facility letter setting out the precise terms of agreement.

Bills of exchange
A means of payment whereby a ‘promissory note’ is exchanged for goods. The bill of exchange is simply an arrangement to pay a
certain amount at a certain date in the future. No interest is payable on the note but is implicit in the terms of the bill.

Asset specific sources of finance

Some sources of finance are used to purchase individual assets using the asset as security against which the funds are borrowed.

Hire purchase
The purchase of an asset by means of a structured financial agreement.

Instead of having to pay the full amount immediately, the company is able to spread the payment over a period of typically
between two and five years. The periodic payments include both an interest element on the initial price and a capital repayment
element. The mechanics of the transaction are as follows.

1. The supplier of the asset sells it to a finance house.

2. The supplier of the asset delivers it to the customer who will be the user and the eventual owner.
3. The hire purchase agreement is made between the finance house and the customer.

Benefits of hire purchase

At the end of the period, ownership of the asset passes to the user, who is also able to claim capital allowances on the basic
purchase cost of the asset.

Finance lease
A type of asset financing that appears initially very similar to hire purchase. Again the asset is paid for over between two and five
years (typically) and again there is a deposit (initial rental) and regular monthly payments or rentals.

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The key difference is that at the end of the lease agreement the title of the asset does not pass to the company (lessee) but is
retained by the leasing company (lessor). This has important tax advantages covered latter in the course.

Key features of a finance lease

(i) The provider of finance is usually a third party finance house and not the original provider of the equipment.
(ii) The lessee is responsible for the upkeep, servicing and maintenance of the asset.
(iii) The lease has a primary period, which covers all or most of the useful economic life of the asset. At the end of the
primary period the lessor will not be able to lease the equipment to someone else because it would be worn out.
(iv) It is common at the end of the primary period to allow the lessee to continue to lease the asset for an indefinite
secondary period, in return for a very low nominal rent, sometimes known as a ‘peppercorn’ rent.
(v) The lessee bears most of the risks and rewards and so the asset is shown on the lessee’s balance sheet.

Operating lease

In this situation the company does not buy the asset (in part or in full) but instead rents the asset.

The operating lease is often used where the asset is only required for a short period of time such as Plant Hire or the company has
no interest in acquiring the asset simply wishing to use it such as a company vehicle or photocopier.

Key features of an operating lease

(i) The lessor supplies the equipment to the lessee.

(ii) The lessor is responsible for the upkeep, servicing and maintenance of the asset.
(iii) The lease period is fairly short, less than the expected economic life of the asset. At the end of one lease agreement the
lessor can either lease the same equipment to someone else and obtain a rent for it or sell it second-hand.
(iv) The asset is not shown on the lessee’s balance sheet.

Sale and leaseback

Sale and leaseback is an arrangement similar to mortgaging. A business which already owns an asset, for example, a building or
an item of equipment, agrees to sell the asset to a financial institution and then immediately lease it back on terms specified in the
agreement. The business has the benefit of the funds from the sale while retaining use of the asset, in return for regular payments
to the financial institution.

Benefits of sale and leaseback

The principal benefit is that the company gains immediate access to liquid funds; however this is at the expense of the ability to
profit from any capital appreciation (potentially significant in the case of property), and the capacity to borrow elsewhere may be
reduced since the balance sheet value of the assets will fall.

WORKING CAPITAL MANAGEMENT – AN OVERVIEW

CURRENT MINUS CURRENT

ASSETS LIABILITIES

Inventory Payables
Receivables
Cash and Bank Bank overdraft

Require funding Provide funding

Aim: Minimise Aim: Maximise
‘current assets current liabilities

Working capital seesaw

Have sufficient working Keep the overall

‘capital to avoid running requirement to a
‘out out of cash minimum to avoid
‘the financing cost

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____________________________________________________________

Level of working capital

1. The nature of business,

2. Certainty in supplier deliveries,
3. The level of activity of the business,
4. The company’s credit policy.

Funding working capital requirement

Short-term sources of Long-term sources of

‘finance finance
Examples
Bank overdraft Equity
Trade creditor’s Long-term debt
Advantages
1. Flexible – only borrow 1. Secure – no need to
‘what is needed constantly replenish
2. Cheaper – liquidity 2. Lower financing risk
‘preference
3. Easier to source 3. Matching funding to need

Fluctuating
Current
Assets assets

Permanent
Current assets

Non-current
assets

Time

Formulating a working capital funding policy

In order to understand working capital financing decisions, assets can be divided into three different types.

Non-current (fixed) assets are long-term assets from which an organisation expects to derive benefits over a number of periods.
For example, buildings or machinery.

Permanent current assets are the amount required to meet long-term minimum needs and sustain normal trading activity. For
example, inventory and the average level of accounts receivable.

Fluctuating current assets are the current assets which vary according to normal business activity. for example due to seasonal
fluctuations.

Fluctuating current assets together with permanent current assets form part of the working capital of the business, which may be
financed by either long-term funding (including equity capital) or by current liabilities (short-term funding).

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Short-term sources of funding are usually cheaper and more flexible than long-term ones. However, short-term sources are
riskier for the borrower as interest rates are more volatile in the short term and they may not be renewed.

The matching principle suggests that long-term finance should be used for long-term assets. A balance between risk and return
must be best achieved by a moderate approach to working capital funding. This is a policy of maturity matching in which
long-term funds finance permanent assets while short-term funds finance non-permanent assets. This means that the maturity of
the funds matches the maturity of the assets.

A conservative approach to financing working capital involves all non-current assets and permanent current assets, as well as
part of the fluctuating current assets, being financed by long-term funding. This is less risky and less profitable than a matching
policy. At times when fluctuating current assets are low, there will be surplus cash which the company will be able to invest in
marketable securities.

Finally, an organisation may adopt an aggressive approach to financing working capital. Not only are fluctuating current assets
all financed out of short-term sources, but so are some of the permanent current assets. This policy represents an increased risk
of liquidity and cash flow problems, although potential returns will be increased if short-term financing can be obtained more
cheaply than long-term finance.

Other factors that influence a working capital funding policy include previous management attitudes to risk; this will
determine whether there is a preference for a conservative, aggressive or moderate approach. Secondly, previous funding
decisions will determine the current position being considered in policy formulation. Finally, the size of the organisation will
influence its ability to access different sources of finance. For example, a small company may have to adopt an aggressive
working capital funding policy because it cannot raise additional long-term finance.

MEAURES OF WORKING CAPITAL MANAGEMENT

Liquidity measures Efficiency measures

Issue Ensuring sufficient funding to Measuring the speed of circulation of

‘avoid running out of cash of cash within the company

Measures Current ratio The operating cycle

Quick ratio

Liquidity ratios

Current assets may be financed by current liabilities or by long-term funds. The “ideal” current ratio is 2: 1. This would mean that
half of the current assets are financed current liabilities and therefore half by long-term funds. Similarly the ideal quick ratio is
1:1.

Current ratio

A simple measure of how much of the total current assets is financed by current liabilities. A safe measure is considered to be 2 : 1
or greater meaning that only a limited amount of the assets are funded by the current liabilities.

Current Ratio = Current Assets

Current liabilities

Quick ratio

A measure of how well current liabilities are covered by liquid assets. A safe measure is considered to be 1: 1 meaning that we are
able to meet our existing liabilities if the all fall due at once.

Quick Ratio = Current Assets minus Stock

(or acid test) current liabilities

Operating cycle
Also known as the cash cycle or trading cycle. The operating cycle is the length of time between the company’s outlay on raw
materials, wages and other expenditures and the inflow of cash from the sale of goods.

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 Purchases Sales Receipt
Inventory Receivables

Payables
Payment Operating cycle

Days

Question 1

Income statement extract $

Turnover 250,000

Gross profit 90,000

Statement of Financial Position extract

$ $
Current assets
Inventory 30,000
Receivables 60,000
180,000

Current Liabilities
Payables 50,000

Required:
Prepare the operating cycle.

Question 2 – Working capital requirements

The following data relate to Corn Co, a manufacturing company.
Revenue for the year $1,500,000
Costs as percentages of sales %
Direct materials 30
Direct labour 25
Variable overheads 10
Fixed overheads 15
Selling and distribution 5

On average:
(a) Accounts receivable take 2.5 months before payment
(b) Raw materials are in inventory for three months.
(c) Work-in-progress represents two months of half produced goods
(d) Finished goods represents one month’s production
(e) Credit is taken as follows:
(i) Direct materials 2 months
(ii) Direct labour 1 week
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 (iii) Variable overheads 1 month
(iv) Fixed overheads 1 month
(v) Selling and distribution 0.5 months

Work-in-progress and finished goods are valued at material, labour and variable cost.

Required:
Compute the working capital requirement of Corn Co assuming the labour force is paid for 50 working weeks a year.

OVERTRADING

Overtrading is a term applied to a company which rapidly increase its turnover without having sufficient capital backing, hence
the alternative term “under-capitalisation”. Output increases are often obtained by more intensive utilisation of existing fixed
assets, and growth tends to be financed by more intensive use of working capital.

Overtrading companies are often unable or unwilling to raise long-term capital and thus tend to rely more heavily on short-term
sources such as overdraft and trade payables. Receivables usually incre3ase sharply as the company follows a more generous trade
credit policy in order to win sales, while inventory tend to increase as the company attempts to produce at a faster rate ahead of
increase in demand. Overtrading is thus characterised by rising borrowings and a declining liquidity position in terms of quick
ratio, if not always according to the current ratio.

Symptoms of overtrading

1. Rapid increase in turnover

2. There is a rapid increase in the volume of current assets and possibly non-current assets.
3. Fall in liquidity ratio or current liabilities exceed current assets
4. Sharp increase in the sales-to-fixed assets ratio
5. Increase in trade payables period
6. Increase in short-term borrowing and a decline in cash balance
7. Fall in profit margins.

Overtrading is risky because short-term finance may be withdrawn relatively quickly if creditors lose confidence in the business,
or if there is general tightening of credit in the economy resulting to liquidity problems and even bankruptcy, even though the firm
is profitable.

The fundament solution to overtrading is to replace short-term finance with long-term finance such as term loan or equity funds.

MANAGING RECEIVABLES

Offering credit encourages Offering credit introduces

‘customers to take up our risk of default, defers inflow
‘goods of cash and needs managing
___________________________________________________________________________________________________

Credit management
There are three aspects to credit management
1. Assessing credit status
2. Terms
3. Day to day management

Assessing credit status

The creditworthiness of all new customers must be assessed before credit is offered; it is a privilege and not a right. Existing
customers must also be re-assessed on a regular basis. The following may be used to assess credit status of a company.

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1. Bank references
2. Trade references
3. Published accounts
4. Credit rating agencies
5. Company’s own Sales Record

Terms
Given that we are will to offer credit to a company, we must consider the limits to the agreement.
This may include:
1. Credit limit value
2. Number of days credit
3. Discount on daily payment
4. Interest on overdue account.

Day to day management

The credit policy is dependent on the credit controllers implementing a set of simple but rigorous procedures. If the system is not
rigorous, those receivables who don’t want to pay will find ways not to pay. A process may be like the following

Time line Action

After 30 days Send statement of account
+ 7 days Reminder letter
+ 7 days 2nd reminder
+ 7 days legal action threat
+ 7 days Take action to recover funds

COST OF FINANCING RECEIVABLES

The receivables balance needs to be financed. Any change to the receivables balance will lead to a change in the financing cost of
the business.

Interest cost = Receivables balance x Interest rate

Receivables balance = Sales x Receivables days

365

Question 3
Agger Limited has sales of $40m for the previous year; receivables at the yearend were $8m. The costs of financing receivables
are covered by an overdraft at the interest rate of 14%.

Required:
(a) What are the receivables days for Agger?
(b) Calculate the cost of financing receivables.

Discounts for early payment

Cash discounts are given to encourage early payment by customers. The cost of the discount is balanced against the savings the
company receives from a lower balance and a shorter average collection period.

Question 4
Agger Limited as above but a discount of 2% is offered for payment within 10 days.
Required:
Should the company introduce the discount given that 50% of the customers take up the discount?

Advantages
1. Early payment reduces the receivables balance and hence the interest charge.
2. May reduce the bad debts arising.

Disadvantages
1. Difficulty in setting the terms.
2. Greater uncertainty as to when cash receipts will be received.
3. May not reduce bad debts in practice.
4. Customers may pay over normal terms but still take the cash discount.

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Factoring
There are three main types of factoring service available.
1. Debt Collection and Insurance
2. Credit Insurance
3. Financing

Question 5
Agger Limited again but a factor has offered a debt collection service which should shorten the receivables collection period on average to 50
days. It charges 1.6% of turnover but should reduce administration costs to the company by $175,000.

Required:
Should the company use the factoring facility?

Advantages
1. Saving in internal administration costs.
2. Reduction in the need for day to day management control.
3. Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume
growth.

Disadvantages
1. Should be more costly than an efficiently run internal credit control department.
2. Factoring has a bad reputation associated with the failing companies, using a factor may suggest your company has money worries.
3. Customers may not wish to deal with a factor.
4. Once you start factoring it is difficult to revert easily to an internal credit control.
5. The company may give up the opportunity to decide to whom credit may be given.

Question 6
A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debts administration has been poor and the average
collection period has been 45 days with 0.5% of the sales resulting in bad debts which were written off.

A factor would take on the task of bad debt administration and credit checking, at an annual fee of 2.5% of credit sales. The company would
save $30,000 a year in administration costs. The payment period would be 30 days.

The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current base rate). The company can
obtain an overdraft facility to finance its accounts receivable at a rate of 2.5% over base rate.

Required:
Should the factor’s services be accepted? Assume a constant monthly turnover.

Question 7
Ewden plc is a medium sized company producing a range of engineering products which it sells to wholesale distributors.
Recently, its sales have begun to rise rapidly following a general recovery in the economy as a whole. However, it is concerned
about its liquidity position and is contemplating ways of improving its cash flow. Ewden’s accounts for the past two years are
summarised below.

Income statement for the year ended 31 December

2012 2013
$000 $000
Sales 12,000 16,000
Cost of sales 7,000 9,150
Operating profit 5,000 6,850
Interest 200 250
Profit before tax 4,800 6,600
Taxation (after capital allowances) 1,000 1,600
Profit after tax 3,800 5,000
Dividends 1,500 2,000
Retained profits 2,300 3,000

Statement of Financial Position 31 December

2012 2013
$000 $000 $000 $000
Non-current assets (net) 9,000 12,000
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Current assets
Inventories 1,400 2,200
Receivables 1,600 2,600
Cash 1,500 100
4,500 4,900
Current liabilities
Overdraft _ 200
Trade payables 1,500 2,000
Other payables 500 200
(2,000) (2,400)
10% loan stock (2,000) (2,000)

Net assets 9,500 12,500

Capital and reserves

Ordinary shares (50p) 3,000 3,000
Profit and loss account 6,500 9,500
9,500 12,500

In order to speed up collection from receivables, Ewden is considering two alternatives polices. One option is to offer a 2 per cent discount to
customers who settle within 10 days of dispatch of invoices rather than the 30 days offered. It is estimated that 50 percent of the customers
would take advantage of this offer. Alternatively Ewden can utilise the services of a factor. The factor will operate on a service-only basis,
administering and collecting payment from Ewden’s customers. This is expected to generate administrative savings of $100,000 per annum and,
it is hoped, will also shorten the receivables days to an average 45. The factor will make a service charge of 1.5 per cent of Ewden's turnover.
Ewden can borrow from its bankers at an interest rate of 18 per cent per annum.

Required:
(a) Identify the reasons for the sharp decline in Ewden’s liquidity and assess the extent to which the company can be said to be
exhibiting the problem of ‘overtrading’.
Illustrate your answer by reference to key performance and liquidity ratios computed from Ewden’s accounts. (15 marks)
(b) Determine the relative costs and benefits of the two methods of reducing receivables, and recommend an appropriate policy.
(10 marks)
(Total = 25 marks)

Extension of credit
To determine whether it would be profitable to extend the level of total credit, it is necessary to assess:
 The extra sales that a more generous credit policy would stimulate
 The profitability of the extra sales
 The extra length of the average debt collection period
 The required rate of return on the investment in additional accounts receivable

Question 8
Russian Beard Co is considering a change in credit policy which will result in an increase in the average collection period from one to two
months. The relaxation in credit is expected to produce an increase in sales in each year amounting to 25% of the current sales volume.

Selling price per unit $10

Variable cost per unit $8.50
Current annual sales $2,400,000

The required rate of return on investments is 20%. Assume that the 25% increase in sales would result in additional inventories of $100,000 and
additional accounts payable of $20,000.

Advise the company on whether or not to extend the credit period offered to customers, if:
(a) All customers take the longer credit of two months.
(b) Existing customers do not change their payment habits, and only the new customers take a full two months credit.

Question 9
Enticement Co currently expects sales of $50,000 a month. Variable costs of sales are $40,000 a month (all payable in the month
of sale). It is estimated that if the credit period allowed to accounts receivable were to be increased from 30 days to 60 days, sales
volume would increase by 20%. All customers would be expected to take advantage of the extended credit.

Required:
If the cost of capital is 12½% a year, is the extension of the credit period justifiable in financial terms?

Working capital management Page 11

Annualised cost of a cash discount
The balance of the difference in the amount of debt collected or paid and the time value of money.

Question 10
We offer a cash discount of 2% for payment over 10 days rather than the normal 60 days.

Required:
(a) What is the annualised cost of the cash discount?
(b) If the overdraft rate is 10% should we take the offer of the discount?

Formulating policy on the management of trade receivables

Factors
1. The level of trade receivables
If substantial – 1.tighter control over the way credit is granted.
2. May need improved methods of assessing creditworthiness.

2. The cost of trade credit

If high, there will be pressure to reduce the amount of credit offered, and to reduce the period of credit offered.

3. Terms of credit offered by competitors

 Match the terms offered by its competitors
 Better quality products
 After sales service these may enhance customer loyalty.

4. Liquidity needs
If high – accelerate cash inflows from credit customers by debt factoring or invoice discounting

5. The level of Risk acceptable to the company

 Relaxed terms – more volume of sales compensates for higher risk of debts
 The level of risk acceptable from bad debts will vary from company to company
 May seek to reduce this risk through a policy of insuring against non-payment by clients.

6. The expertise available within the company

Where the expertise in the assessment of credit worthiness and the monitoring of customer accounts is not of sufficiently high
standard, a company may choose to outsource its receivables management to a third party e.g. a factor.

MANAGING ACCOUNTS PAYABLE

The management of trade accounts payable involves:
 Attempting to obtain satisfactory credit from suppliers
 Attempting to extend credit during periods of cash shortage, without damaging a good business relationship with the supplier
 Maintaining good relations with regular and important suppliers

Trade credit
It is a form of short-term finance because it helps to keep working capital down.

Benefits
It a cheap source of finance, since suppliers rarely charge interest.

Costs of maximum use of trade credit

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 Loss of supplier’s goodwill
 Loss of any available cash discounts for the early payment of debts

Question 11
X Co has been offered credit terms from its major supplier of 2/10, net 45. That is a cash discount of 2% will be given if payment
is made within 10 days of the invoice, and payments must be made within 45 days of the invoice. The company has the choice of
paying 98c per $1 on day 10 (to pay before day 10 would be unnecessary), or to invest 98c for an additional 35 days and
eventually pay the supplier $1 per $1. The decision as to whether the discount should be accepted depends on the opportunity cost
of investing 98c for 35 days.

Required:
What should the company do? Assume the company can invest cash to obtain an annual return of 25%, and that there is
an invoice from the supplier for $1,000.

MANAGING INVENTORY
Holding stock is necessary Holding stock incurs costs,
‘for operations, in terms of in particular there is the
‘finished goods it offers greater opportunity cost of money
‘choice to customers tied up in stock
________________________________________________________________

Material costs
Material costs are a major part of a company’s costs and need to be carefully controlled. There are four types of cost associated
with stock:
1. Ordering costs,
2. Holding costs,
3. Stock out costs,
4. Purchase cost.

Ordering costs
The clerical, administrative and accounting costs of placing an order. They are usually assumed to be independent of the size of
the order.

Holding costs
Holding costs include items such as:
1. Opportunity cost of the investment in stock
2. Storage and handling costs
3. Insurance costs
4. Deterioration.
5. Obsolescence
6. Pilferage

Stock out costs

1. Lost contribution through loss of sale;
2. Lost future contribution through loss of customer;
3. The cost of emergency orders of materials;
4. The cost of production stoppages.

Economic order quantity (EOQ)

The EOQ is the optimal ordering quantity for an item of inventory which will minimise costs.

When the reorder quantity is chosen so that the total cost of holding and ordering is minimised, it is known as the economic order quantity or
EOQ.

As the size of the order increases, the average stock held increases and holding costs will also tend to increase. Similarly as the order size
increases the number of orders needed decreases and so the ordering costs fall. The EOQ determines the optimum combination.

Cost

Working capital management Page 13

 reorder quantity
Question 12
A company requires 10,000 units of material X per month. The cost per order is $30 regardless of the size of the order. The holding
costs are $20 per unit per annum. It is only possible to buy the stock in quantities of 400, 500, 600 or 700 units at one time.

Required:
(a) What is the cheapest option?
(b) Calculate the economic order quantity using the formula given.

Question 13 – Exercise
The demand for a commodity is 40,000 units a year, at a steady rate. It costs $20 to place an order, and 40c to hold a unit for a
year.
Required:
Find
(a) The order size to minimise the inventory costs
(b) The number of orders placed each year
(c) The length of the inventory cycle
(d) The total costs of holding inventory for the year

Bulk purchase discounts

Now there are two possible points of minima. The sum of the holding and ordering costs are minimised at the EOQ. There will however be
savings in the purchase cost when bulk discount volume is taken.

To decide mathematically whether it will be worthwhile taking a discount and ordering and ordering larger quantities, it is necessary to
minimise:

Total purchase costs + Ordering costs + Inventory holding costs.

The total cost will be minimised:
 At the pre-discount EOQ level, so that a discount is not worthwhile, or
 At the minimum order size necessary to earn the discount.

Question 14
Annual demand is 120,000 units. Ordering costs are $30 per order and holding costs are $20/unit/annum. The material can
normally be purchased for $10/unit, but if 1,000 units are bought at one time they can be bought for $9,800. If 5,000 units are
bought at one time, they can be bought for $47,500.

Required:
What reorder quantity would minimise the total cost?

Question 15 –Exercise
The annual demand for an item of inventory is 125 units. The item costs $200 a unit to purchase, the holding cost for one unit for
one year is 15% of the unit cost and ordering costs are $300 an order. The supplier offers a 3% discount for orders of 60 units or
more, and a discount of 5% for orders of 90 units or more.
Required:
What is the cost minimising order size?

Question 16
A company a company uses an item of inventory as follows.
Purchase price: $96 per unit
Annual demand: 4,000 units
Ordering cost: $300
Annual holding cost: 10% of purchase price
Economic order quantity: 500 units

Required:
Should the company order 1,000 units at a time to secure an 8% discount?

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Question 17

Bonus Co has annual credit sales of £4.2 million and cost of sales of £1.89 million. Current assets consist of inventory and
accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest of 7% per year. The
company gives two months credit to its customers and is allowed, on average, one month’s credit by trade suppliers. It has an
operating cycle of three months.

Other relevant information

Current ratio of Bonus Co 1.4
Cost of long-term finance of Bonus Co 11%.
Required:
(a) Discuss the key factors which determine the level of investment in current assets. (6 marks)

(b) Discuss the ways in which factoring and invoice discounting can assist in the management of accounts receivable.
(6 marks)
(c) Calculate the size of the overdraft of Bonus Co, the net working capital of the company and the total cost of financing its current
assets. (6 marks)

(d) Bonus Co wishes to minimise its inventory costs. Annual demand for the raw material costing £12 per unit is 60,000
units per year. Inventory management costs for this raw material are as follows:
Ordering cost £6 per order
Holding cost £0.5 per unit per year.

The supplier of this raw material has offered a bulk purchase of discount of 1% for orders of 10 000 units or more. If the
bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material will increase to £2
per unit per year.

Required:

(i) Calculate the total cost of inventory for the new raw material when using the economic order quantity.
(4 marks)
(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost of inventory
for the new raw material. (3 marks)
(Total: 25 marks)

Uncertainties in demand (A re-order level analysis)

Re-order level = maximum usage x maximum lead time
Maximum inventory level = re-order level + re-order quantity - (minimum usage x minimum lead time)
Buffer safety inventory = re-order level – (average usage x average time)
Average inventory = buffer safety inventory + re-order amount
2

Question 18

A company has an inventory management policy which involves ordering 50,000 units when the inventory held falls to 15,000
units. Forecast demand to meet production requirements during the next year is 310,000 units. You should assume a 50 –week
year and that demand are constant throughout the year. Orders are received two weeks after being placed with supplier.

Required:
What is the average inventory level?

JIT – Supplier Contracts

 A holistic approach (whole factory performance)
 Aim: Eliminate inventory

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JIT – Supply contracts
 Reliability of supply
 Quality measures (quality assurances)
 Single supplier status
 New product development
 Close system links.

Potential benefits of introducing JIT

 Reduction in inventory holding costs
 Reduced manufacturing lead times
 Improved labour productivity
 Reduced scrap/rework/warranty costs

CASH MANAGEMENT

Holding cash is necessary Cash is an idle asset that

‘to be able to pay the bills costs money to fund but
‘and maintain liquidity generates little or no return
_______________________________________________________________________

There are three areas associated with management of cash:

1. The Miller-Orr Model

2. The Baumol Model
3. The cash budget.

The Miller-Orr model

A model that considers the level of cash that should be held by a company in an environment of uncertainty. The decision rules
are simplified to two control levels in order that the management of the cash balance can be delegated to a junior manager.
Maximum level
- -- -- -- -- -- -- -- --- --- --- --- --- --- --- --- --- --- --- --- --- ---- --- --- --- --- -- -

Return point

__________________________________
Minimum level

Working capital management Page 16

 Time

The model allows us to calculate the spread. Given that we spread all key control levels can be calculated.

Minimum level - given in the question

Maximum level = minimum level + spread
Return point = minimum level + ⅓ spread

Question 19

The minimum level of cash is £25,000. The variance of the cash flows is £250,000. The transaction cost for both investing and en-
cashing funds is $50. The interest rate per day is 0.05%.

Required:
Calculate the:
(a) Spread
(b) Maximum level
(c) Return point.

The Baumol model

The use of the EOQ model to manage cash.

Co = Transaction cost of investing / en-cashing a security
D = Excess cash available to invest in short-term securities
Ch = Opportunity cost of holding cash

Question 20
A company generates $5,000 per month excess cash. The interest rate it can expect to earn on its investment is 6% per annum. The
transaction costs associated with each separate investment of funds is constant at $50.

Required:
(a) What is the optimum amount of cash to be invested in each transaction?
(b) How many transactions will arise each year?
(c) What is the cost of making those transactions per annum?

Question 21
Kool Co has annual sales revenue of £7 million and all sales are on 30 days’ credit, although customers on average take fifteen days more than this to pay.
Contribution represents 55% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of
8%.

Kool Co plans to offer an early settlement discount of 1.4% for payment within 20 days and to extend the maximum credit offered to 65 days.

The company expects that these changes will increase annual credit sales by 8%, while also leading to additional variable costs equal to 0.5% of turnover. The
discount is expected to be taken by 35% of customers, with the remaining customers taking an average of 65 days to pay.

Required:
(a) Evaluate whether the proposed changes in credit policy will increase the profitability of Kool Co. (6 marks)

(b) Tiger Co, a subsidiary of Kool Co, has set a minimum cash account balance of $2,000. The average cost to the company of making deposits or selling
investments is $50 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on
investments is 9.125%.

Determine the spread, the upper limit and the return point for the cash account of Tiger Co using the Miller-Orr model and explain the relevance of
these values for the cash management of the company. (6 marks)
(c) Identify and explain the key areas of accounts receivable management. (6 marks)
(d) Discuss the key factors to be considered when formulating a working capital funding policy. (7 marks)

Working capital management Page 17

 (Total = 25 marks)

CASH BUDGET
Why hold cash?
1. Transaction motive – wages, operations, taxation, dividends
2. Precautionary motive – unforeseen contingencies e.g. overdraft facility
3. Speculative motive – rise in interest rates

Cash flow problems

Cash flow problems can arise in various ways.
(a) Making losses
If a business is continually making losses, it will eventually have cash flow problems. If the loss is due to a large depreciation
charge, the cash flow troubles might only begin when the business needs to replace non-current assets.

(b) Inflation
In a period of inflation, a business needs ever-increasing amounts of cash just to replace used-up and worn-out assets. A
business can be making a profit in historical cost accounting terms, but still not be receiving enough cash to buy the
replacement assets it needs.

(c) Growth
When a business is growing, it needs to acquire more non-current assets, and to support higher amounts of inventories
and accounts receivable. These additional assets must be paid for somehow (or financed by accounts payable).

(d) Seasonal business

When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times of the year, when
(i) Cash flows are low, but
(ii) Cash outflows are high, perhaps because the business is building up its inventories for the next period of high sales.

(e) One-off items of expenditure

A single non-recurring item of expenditure may create a cash flow problem. Examples include the repayment of loan capital
on maturity of the debt or the purchase of an exceptionally expensive item, such as freehold property.

Cash flow forecasts

A cash flow forecast is a detailed forecast of cash inflows and outflows incorporating both revenue and capital items.

Uses of cash flow forecasts

 Shows the cash effect of all plans made within the forecasting period.
 Gives management an indication of potential problems that could arise and allows them the opportunity to take action to
avoid such problems.

Cash position Appropriate management action

Short-term surplus  Pay accounts payable early to obtain discount
 Attempt to increase sales by increasing accounts receivable and inventories
 Make short-term investments
Short-term deficit  Increase accounts payable
 Reduce accounts receivable
 Arrange an overdraft
Long-term surplus  Make long-term investments
 Expand
 Diversify
 Replace/update non-current assets
Long-term deficits  Raise long-term finance (such as via issue of share capital)
 Consider shutdown/disinvestment opportunities
Investing surplus cash
 Temporary surpluses can be invested in a variety of financial instruments.
 Long-term surpluses should be returned to shareholders if there is a lack of investment opportunities.

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Factors to consider
1. Liquidity
Money should be available to take advantage of favourable short-term interest rates on bank deposits or grasp a strategic
opportunity e.g. paying cash to take over another company.

2. Profitability
The company should seek to obtain a good return for the risk incurred.

3. Safety
The company should avoid the risk of a capital loss

4. Fixed or floating rate

Floating rate investments are likely to be chosen if interest rates are expected to rise.

5. Term to maturity
Affected by the business’s desire for liquidity and expectations about future rates of interest. Penalties for early settlement
may be meted.

6. Amount
Whether a minimum amount has to be invested in certain investments.

Question 22
Moses Ltd operates a retail business. Purchases are sold at cost plus 33⅓%.

(a) Budgeted sales Labour cost Expenses incurred

In month in month in month
£ £ £
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 160,000 5,000 7,000
April 120,000 4,000 7,000

(b) It is management policy to have sufficient inventory in hand at the end of each month to meet half of next month’s sales.

(c) Payables for materials and expenses are paid in the month after the purchases are made/expenses incurred. Labour is paid in
full by the end of each month. Labour costs and expenses are treated as period costs in the income statement.

(d) Expenses include a monthly depreciation charge of £2,000.

(e) (i) 75% of sales are for cash.

(ii) 25% of sales are on one month’s credit.

(f) The company will buy equipment costing £18,000 for cash in February and will pay a dividend of £20,000 in March. The
opening cash balance is £1,000.

Required:
(a) Prepare a cash budget for February and March. (8 marks)
(b) Prepare an income statement for February and March. (4 marks)
(Total= 12 marks)

Question 23 – cash budget and opening balance sheet

A statement of financial position as at 31 December 2014 has the following details.

Trade receivables £150,000

Trade payables £60,000

You are given the following information.

Working capital management Page 19
(a) Customers are allowed two months to pay.
(b) 1½ month’s credit is taken from suppliers.
(c) Sales and materials purchases were both made at an even monthly rate throughout 2014.
Required:
Ascertain the months of 2015 in which the receivables will eventually pay and the payables will be paid.
(4 marks)

Question 24 – Bad debts and provisions

Binzi Ltd had receivables on 1 January 2014 and 31 December 2014 as follows.

1 Jan 31 Dec
£ £
Receivables in total 36,000 42,000
Less allowance for doubtful debts (6,000) (10,000)
Receivables reported in the statement of financial position 30,000 32,000

During 2014 the value of sales amounted to £200,000 and the allowance for doubtful debts was increased by £4,000 (from £6,000
to £10,000).
Required:
What is the amount of cash received from customers in 2014? (2 marks)

Question 25-amounts to be paid to suppliers

At 31 December 2014 Bob Ltd held inventories which cost £60,000. The period of credit allowed by suppliers is one month and
trade payables at 31 December 2014 amounted to £30,000. It is company policy to hold inventories equal to the cost of sales in the
next two months and, until the end of 2014, the monthly cost of sales was £30,000.

From 1 January 2015 the company expects to increase its monthly sales by 20%. The policy on inventory levels will remain
unchanged, and suppliers will continue to allow one month’s credit.
Required:
Calculate the cash payments to trade payables each month in 2015. (5 marks)

Question 26
George Ltd will begin on 1 January 2015. The following sales revenue is budgeted for January to March 2015.
January February March
£13,000 £17,000 £10,000

Five percent of sales will be for cash. The remainder will be credit sales. A discount of 5% will be offered on all sales. The
payment pattern for credit sales is expected to be as follows.

Invoices paid in the month after sale 75%

Invoices paid in the second month after sale 23%
Bad debts 2%

Invoices are issued on the last day of each month.

Required:
Calculate the amount budgeted to be received from customers in March 2015. (2 marks)

Working capital management Page 20

Question 27:
In the near future a company will purchase a manufacturing business for $315,000, this price to include goodwill ($150,000),
equipment and fittings ($120,000), and stock of raw materials and finished goods ($45,000). A delivery van will be purchased for
$15,000 as soon as the business purchase is completed. The delivery van will be paid for in the second month of operations.

The following forecasts have been made for the business following purchase:

(i) Sales (before discounts) of the business’s single product, at a mark-up of 60% on production cost will be:
Month 1 2 3 4 5 6
(K’000) 96 96 92 96 100 104

25% of sales will be for cash; the remainder will be on credit, for settlement in the month following that of sale. A
discount of 10% will be given to selected credit customers, who represent 25% of gross sales.

(ii) Production cost will be $5.00 per unit. The production cost will be made up of:
Raw materials $2.50
Direct labour $1.50
Fixed overhead $1.00

(iii) Production will be arranged so that closing inventory at the end of any month is sufficient to meet sales requirements
in the following month. A value of $30,000 is placed on the inventory of finished goods which was acquired on
purchase of the business. This valuation is based on the forecast of production cost per unit given in (ii) above.

(iv) The single raw material will be purchased so that inventory at the end of the month is sufficient to meet half of the
following month’s production requirements. Raw material inventory acquired on the purchase of the business
($15,000) is valued at the cost per unit which is forecast as given in (ii) above. Raw materials will be purchased on
one month’s credit.

(v) Costs of direct labour will be met as they are incurred in production.

(vi) The fixed production overhead rate of $1.00 per unit is based upon a forecast of the first year’s production of
150,000 units. This rate includes depreciation of equipment and fittings on a straight-line basis over the next five
years.

(vii) Selling and administration overheads are all fixed, and will be $208,000 in the first year. These overheads include
depreciation of the delivery van at 30% per annum on a reducing balance basis. All fixed overheads will be incurred
on a regular basis, with the exception of rent and rates. $25,000 is payable for the year ahead in month one for rent
and rates.

Required:
(a) Prepare a monthly cash budget. You should include the business purchase and the first four months of
operations following purchase. (12 marks)

(b) Discuss the factors that should be considered when planning ways to invest any surplus forecast by the
cash budget. (4 marks)

(c) Discuss the advantages and disadvantages of using overdraft finance to fund any cash shortages forecast
by a cash budget. (4 marks )

(d) Explain how the Baumol model can be employed to reduce the costs of cash management and discuss
whether the Baumol cash management model may be of assistance in respect to the budget in (a) above.
(5 marks)
(Total: 25 marks)

Working capital management Page 21