Chapter 10 Managing

Working Capital
 Learning Outcomes
• Identify the main elements of working capital.
• Discuss the purpose of working capital and the nature of the working
capital cycle.
• Explain the importance of establishing policies for the control of
working capital and the factors to consider when managing each
element of working capital.
 Outline
• Main elements of working capital
• Purpose of working capital
• Nature of the working capital cycle
• Establishing policies for the control of working capital.
 Main Elements of Working Capital
• Working capital is a daily necessity for businesses, as they require a
regular amount of cash: to make routine payments, to cover
unexpected costs, purchase basic materials used in the production of
goods.

• The major elements of current assets are:

• Inventories, trade receivables, cash (in hand and at bank).
• The major elements of current liabilities are:
• trade payables, bank overdrafts

Learning Outcomes: Identify the main elements of working capital.

 Main Elements of Working Capital
• Changes in the business • Internal changes within the
environment that might change business that could alter working
the level of investment in working capital needs:
capital: • 1) using different production
• 1) changes in interest rates methods (that might hold a lower
• 2) changes in market demand for level of inventories)
the business’s output • 2) changes in the level of risk that
• 3) changes in the seasons managers are prepared to take.
• 4) changes in the state of the
economy
Learning Outcomes: Identify the main elements of working capital.
 Main Elements of Working Capital
• Working capital ratio = current assets / current liabilities

• Interpretation of the result of working capital ratio:

• 1) below one - suggests that a company may be unable to pay its
short-term debts.
• 2) very high suggests that a company is not effectively managing
excess cash flow, which could be better directed towards company
growth.
• 3) Some analysts believe that the ideal working capital ratio is
between 1.5 and 2.0, but this may vary from industry to industry.
 Main Elements of Working Capital
• Two possible reasons why smaller businesses carry more excess
working capital than larger ones:
• 1) Smaller businesses tend to be less well managed than larger ones.
• They often lack the resources to employ people with the same level of
expertise as those employed by larger businesses.
• 2) Economies of scale may be a factor.
• For example, a business with twice the sales revenue of a competitor business
would not normally need twice the level of inventories.
 Purpose of Working Capital
• Working capital management - focuses on ensuring the company can meet day-to-day
operating expenses while using its financial resources in the most productive and
efficient way.

• Goal of working capital management: To maximize operational efficiency.

• Operational efficiency - is the ability of an organization to reduce waste in time, effort
and materials as much as possible, while still producing a high-quality service or product.

• Advantages of Efficient working capital management:

• 1) Maintain smooth operations
• 2) Improve the company's earnings and profitability.

Learning Outcomes: Discuss the purpose of working capital and the nature of the working capital cycle.
 Purpose of Working Capital
• The main objectives of working capital management include:
• 1) maintaining the working capital operating cycle and ensuring its ordered
operation
• 2) minimizing the cost of capital spent on the working capital
• 3) maximizing the return on current asset investments

• The management of working capital is an essential part of the business’s

short-term planning process.
• Management must decide how much of each element should be held.
Learning Outcomes: Discuss the purpose of working capital and the nature of the working capital cycle.
 Nature of the Working Capital Cycle
For a manufacturing business, the working capital cycle can • Cash is used:
be depicted as shown in Figure 10.1. • to pay trade payables for raw
materials, or raw materials are bought
for immediate cash settlement.
• to spend on labour and other items
that turn raw materials into work in
progress and, finally, into finished
goods.
• Cash is received:
• The finished goods are sold to
customers either for cash or on credit.
• In the case of credit customers, there
will be a delay before the cash is
received from the sales. Receipt of
cash completes the cycle.

Learning Outcomes: Discuss the purpose of working capital and the nature of the working capital cycle.
 Nature of the Working Capital Cycle
For a retailing, the working capital cycle can be depicted as
shown in Figure 10.1. • There will be only
inventories of finished
goods.
• There will be no work in
progress or raw materials.

Learning Outcomes: Discuss the purpose of working capital and the nature of the working capital cycle.
 Nature of the Working Capital Cycle
For a purely service business, the working capital cycle can
be depicted as shown in Figure 10.1.
• There may well be work in
progress, since many forms
of service take time to
complete.
• A legal case handled by a
firm of solicitors, for
example, may take several
months.
• During this period, costs will
build up before the client is
billed for them.

Learning Outcomes: Discuss the purpose of working capital and the nature of the working capital cycle.
 Establishing Policies for the Control of
Working Capital
• Management of working capital includes:
• 1) inventory management
• 2) cash management
• 3) management of accounts receivables
• 4) management of accounts payables.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Reasons for holding inventories: To meet the immediate day-to-day
requirements of customers and production.

• Reasons for Holding more inventories:

• 1) future supplies may be interrupted or scarce.
• 2) cost of inventories will increase in the future
• Mining businesses and businesses that trade in commodities, such as precious
metals, oil, coffee and so on, can benefit by holding large amounts of inventories
when commodity prices are rising.
• Disadvantage: When prices are falling, however, large inventories’ holdings can be a
burden

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• For some types of business, inventories held may represent a substantial
proportion of total assets held.
• 1) A car dealership that rents its premises may have nearly all of its total assets in the form of
inventories.
• 2) Manufacturers also tend to invest heavily in inventories: raw materials, work in progress
and finished goods.
• Costs of holding inventories: lost interest, storage cost, insurance cost,
obsolescence.
• Costs of not holding sufficient inventories: loss of sales and customer goodwill,
production dislocation, loss of flexibility – cannot take advantage of
opportunities, reorder costs – low inventories imply more frequent ordering.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 1) Forecasting future demand
• 2) Financial ratios
• 3) Recording and reordering systems
• 4) Levels of inventory control
• 5) Inventory Management Models:
• Economic order quantity
• Enterprise resource planning systems
• Just-in-time inventories management
• XYZ inventories management

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 1) Forecasting future demand – ensures that inventories will be
available to meet future production and sales requirements.
• such as the use of statistical techniques and reliance on the opinions of sales
and marketing staff.
• 2) Financial ratios: average inventories turnover period ratio

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 3) Recording and reordering systems
• Recording System: A sound system of recording inventories movements is a
key element in managing inventories.
• Proper procedures for recording inventories purchases and usages.
• Periodic checks should be made to ensure that physical inventories held corresponds
with what is indicated by the inventories’ records.
• Reordering System:
• Proper authorisation for both the purchase and the issue of inventories.
• Lead Time

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 3) Recording and reordering systems
• Reordering System: Steady Demand – Lead Time
• Reordering System: Uncertainty on the level of demand – buffer or safety
inventories level may be maintained
• The effect of holding a buffer will be to raise the inventories level at which an order for new
inventories is placed (the reorder point).
• The amount of buffer inventories is a matter of judgement. In forming this judgement, the
following should be taken into account:
• the degree of uncertainty concerning the above factors
• the likely costs of running out of the item concerned
• the cost of holding the buffer inventories.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
Lead Time Lead Time + Buffer
• An electrical wholesaler sells a particular type of light switch. • If the business maintains buffer inventories of 300 units. At
The annual demand for the light switch is 10,400 units and what level should the business reorder?
the lead time for orders is 4 weeks.
• Reorder point = expected level of demand during the lead
• Demand for the light switch is steady throughout the year. time plus the level of buffer
• = 800 + 300
• At what level of inventories of the light switch should the • = 1,100 units
business reorder? 1 year = 54 weeks
• Average weekly demand for the switch:
10,400 / 52 = 200 units • Note: Carrying buffer inventories will increase the cost of
• Point at which inventories should be reordered (time between holding inventories.
ordering new switches and receiving them), quantity sold is • This must be weighed against the cost of running out of
• 4 * 200 units = 800 units. inventories, in terms of lost sales, production problems and so
• Lead time x average weekly demand on.
• reorder no later than when the level held reaches 800 units to
avoid running out of inventories.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 4) Levels of inventory control - requires a careful weighing of costs
and benefits.
• Advantages of ABC system:
• A) Helps to direct management effort to the most important areas.
• B) Helps to ensure that the costs of controlling inventories are proportionate to their
value.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Inventory Management
• Procedures & techniques may be employed to manage inventories:
• 5) Inventory Management Models: Decision models may be used to help
manage inventories.
• A) Economic order quantity
• B) Enterprise resource planning systems
• Integrated software: consist of software applications (modules) that record, report, analyse
and interpret data for a range of business operations, including production, marketing,
human resources, accounting and inventories management.
• Common Database: Operated on a real (or near real) time basis and which can be accessed
remotely.
• Disadvantage: Costly
• C) Just-in-time inventories management - may save cost, but it tends to increase risk.
• D) XYZ inventories management

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Receivables
• Care must be taken over the type of customer to whom credit facilities are offered and how much
credit is allowed.
• Risk: Not receiving payment for goods or services supplied.

• Various sources of information are available to help assess the 5 C’s of credit:
• Trade references, Bank references, Published financial statements, The customer, Credit agencies, Other
suppliers

• Costs of allowing credit include: lost interest, lost purchasing power, costs of assessing customer
creditworthiness, administration cost, bad debts, cash discounts (for prompt payment).

• Costs of denying credit: loss of customer goodwill.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Receivables
• When assessing which customers should receive credit, the five Cs of credit can be used:
• 1) Capital - financially sound by examining its financial statements should be examined (future
profitability and liquidity. Also, any major financial commitments (such as outstanding
borrowings, capital expenditure commitments and contracts with suppliers) should be taken into
account.
• 2) Capacity - The customer’s payment record to date should be examined to provide important
clues, the amount of credit required in relation to the customer’s total financial resources should
be taken into account.
• 3) Collateral - security for goods supplied on credit.
• 4) Conditions. The state of the industry and the general economic conditions of the particular
region or country, should be taken into account.
• 5) Character - The willingness to pay will depend on the honesty and integrity of the individual
with whom the business is dealing.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Receivables
• Procedures & techniques may be employed to manage receivables:
• 1) Assess and monitor customer creditworthiness – 5 Cs
• 2) Consider cash discounts - to encourage prompt payment from its
credit customers
• 3) Establish effective administration of receivables: Debt factoring (or
invoice factoring) and invoice discounting
• 4) Credit insurance
• 5) Establish a collection policy

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Receivables
• Procedures & techniques may be employed to manage receivables:
• 4) Credit insurance
• guarantees a lender will be repaid if a borrower is unable to pay his or her
debt due to, for example, death or disability.
• Although credit insurance is solely for the benefit of the lender, it is
purchased and paid for by the borrower.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the
factors to consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Receivables
• Procedures & techniques may be employed to manage receivables:
• 5) Establish a collection policy
• Develop customer relationships
• Credit terms should be openly discussed and an agreement reached.
• Issue invoices (bill) promptly
• Use financial ratios to monitor outstanding receivables - average settlement period for trade
receivables ratio and trade receivables to sales ratio
• In practice, this ratio is normally calculated on a monthly basis and can be used to detect trends. Where,
for example, the ratio is increasing each month, it means that trade receivables are growing faster than
sales revenue.
• Produce an ageing schedule of trade receivables
• Answer queries quickly
• Deal with slow payers - sending out reminders and for adding customers to a ‘stop list’ for
future supplies; Legal action may also be considered against delinquent credit customers.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Cash has been described as the lifeblood of a business.

• Why hold cash? The three reasons are: 1) To meet day-to-day

commitments. 2) For precautionary purposes. 3. To exploit profitable
opportunities.
• Costs of holding cash include lost interest and lost purchasing power.
• Costs of holding insufficient cash include loss of supplier goodwill if unable to
meet commitments on time, loss of opportunities, inability to claim cash
discounts, costs of borrowing (should an obligation need to be met at short
notice)

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• How much cash should be held? Possible factors that might influence the
amount of cash that a business holds:
• 1) nature of the business
• 2) opportunity cost of holding cash
• 3) level of inflation
• 4) availability of near-liquid assets
• 5) availability of borrowing
• 6) cost of borrowing
• 7) Economic conditions
• 8) Relationships with suppliers
Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Procedures & techniques may be employed to manage cash:
• 1) Controlling the cash balance
• 2) Projected cash flow statements
• 3) Operating cash cycle
• 4) Cash transmission
• 5) Bank overdrafts

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Procedures & techniques may be employed to manage cash:
• 1) Controlling the cash balance – by establishing a policy
• Management sets the upper and lower limits for the business’s cash balance.
• When the balance goes beyond either of these limits, unless it is clear that the balance
will return fairly quickly to within the limit, action will need to be taken.
• If the upper limit is breached, some cash will be placed on deposit or used to buy some
marketable securities.
• If the lower limit is breached, the business will need to borrow some cash or sell some
securities.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Procedures & techniques may be employed to manage cash:
• 2) Projected cash flow statements - important tool for both planning and
control purposes.
• A) Planning - will identify periods when cash surpluses and cash deficits are
expected.
• When a cash surplus is expected to arise, managers must decide on the best use of the
surplus funds.
• When a cash deficit is expected, managers must make adequate provision by borrowing,
liquidating assets or rescheduling cash payments or receipts to deal with this.
• B) Control - can help to control the cash held.
• Actual cash flows can be compared with the projected cash flows for the period.
• If there is a significant discrepancy between the projected cash flows and the actual cash
flows, explanations must be sought and corrective action taken where necessary.
Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Procedures & techniques may be employed to manage cash:
• 3) Operating cash cycle
• Objective of working capital management: To limit the length of the operating
cash cycle (OCC), subject to any risks that this may cause.
• The length of the OCC has a significant impact on the amount of funds that
the business needs to apply to working capital.
• It has a significant influence on the financing requirements of the business.
• The longer the cycle, the greater will be the financing requirements and the greater the
financial risks.
• A business with a short OCC is said to have ‘good (or strong) cash flow’.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• OCC is the period between
the payment made to the
supplier, for the goods
concerned, and the cash
received from the credit
customer.
• Figure 10.11 shows that:
• No cash outflow - inventories
acquired on credit
• No cash inflow - credit sales
on customers
Figure 10.11 The operating cash cycle
Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
The financial statements of Freezeqwik Ltd, a distributor of frozen foods, for
the year ended 31 December last year are:
• All purchases and
sales are on
credit.
• There has been
no change in the
level of trade
receivables or
payables over the
period.
• Calculate the
length of the OCC
for the business.
Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
Figure 10.12 Calculating the • To reduce the OCC,
operating cash cycle for businesses it should do one or
that buy and sell on credit. more of the
following:
• 1) reduce the
average inventories
turnover period
• 2) reduce the
average settlement
period for trade
receivables
• 3) increase the
average settlement
period for trade
payables.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Cash
• Procedures & techniques may be employed to manage cash:
• 4) Cash transmission
• receipts from customers at the earliest opportunity: cheque, direct bank
transfer, use of debit card which is referred to as electronic funds transfer at
point of sale (EFTPOS)
• 3) Bank Overdraft
• Make judicious use of bank overdraft finance – it can be cheap and flexible.
• Bank overdrafts are simply bank current accounts that have a negative
balance. They are a type of bank loan.

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Payables
• Trade payables are an important source of finance for most businesses.
• They have been described as a ‘spontaneous’ source, as they tend to increase in line
with the increase in the level of activity achieved by a business.
• Potential costs associated with taking trade credit:
• 1) additional administration and accounting costs, 2) may not be as well treated as
those who pay immediately (given lower priority, less favoured in terms of delivery
dates or in gaining access to technical support), 3) higher price than purchases for
immediate cash settlement, 4) restrictions imposed by seller
• Benefits to be gained from taking credit:
• 1) interest-free loan from suppliers, 2) during a period of inflation, there
• is an economic gain from paying later, 3) more convenient way of paying for goods
and services than paying by cash

Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
 Establishing Policies for the Control of Working Capital:
Managing Trade Payables
• Procedures & techniques may be employed to manage cash:
• 1) Establish a policy
• 2) Taking advantage of cash discounts for prompt payment - business
should be paying within the discount period.
• 3) Controlling trade payables - use accounting ratios (for example, average
settlement period for trade payables ratio)

• Once again, this provides an average figure, which could be misleading.

• A more informative approach would be to produce an ageing schedule for payables.
Learning Outcomes: Explain the importance of establishing policies for the control of working capital and the factors to
consider when managing each element of working capital.
Working Capital
• Group Activity:
• Compute for the working capital
and analyze which one has the
better or efficient working
capital.