AFU 07303: Corporate Finance

WORKING CAPITAL
MANAGEMENT

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 Learning outcomes
◼ Describe WCM objectives and policies
◼ Describe the credit management and policy
◼ Describe the financing of working capital requirements
◼ Describe the concept of overtrading and overcapitalisation
◼ Determine the working capital cycle (cash cycle)
◼ Manage cash by using the Baumol model
◼ Manage inventory by using the EOQ model

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Working Capital Components

◼ Working Capital
◼ Assets and liabilities required to operate a
business on a day-to-day basis
◼ Assets:
◼ Cash
◼ Accounts Receivable
◼ Inventory
◼ Liabilities:
◼ Accounts Payable
◼ Accruals
◼ Bank overdrafts

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 Working Capital Concepts
Net Working Capital
Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The administration of the firm’s current assets and the
financing needed to support Non-current assets.

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Objectives of working capital management

◼ One of the two key objectives of working capital management is

to ensure liquidity. A business with insufficient working capital
will be unable to meet obligations as they fall due, leading to
late payments to employees, suppliers and other providers of
credit. Late payments can result in lost employee loyalty, lost
supplier discounts and a damaged credit rating. Non-payment
(default) can lead to the compulsory liquidation of assets to
repay creditors.
◼ The other key objective is profitability. Funds tied up in
working capital tend to earn little, or no, return. Hence, a
company with a high level of working capital may fail to achieve
the return on capital employed (Operating profit ÷ (Total equity
and long-term liabilities)) expected by its investors.
Working capital management objectives…

◼ Therefore, when determining the appropriate

level of working capital there is a trade-off
between liquidity and profitability:

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 Elements of Working capital

◼ Working capital elements

◼ Inventory

◼ Receivables

◼ Cash

◼ Payables

◼ Accruals

◼ Bank overdrafts

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Elements of Working Capital
Inventory
High Levels Low Levels
Benefit: Cost:
Happy customers – supplied quickly Shortages
Few production delays (parts always on hand) Dissatisfied customers –
Cost: product not available
High financing costs Benefit:
High storage costs Low financing and storage
Shrinkage (theft) costs
Risk of obsolescence Less risk of obsolescence

Cash
High Levels Low Levels
Benefit: Benefit:
Reduces risk of being unable to pay bills Reduces financing costs
Cost: Cost:
Increases financing costs Increases transaction risk
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Elements of Working Capital
Accounts Receivable
High Levels Low Levels
Benefit: Cost:
Happy customers –can pay slowly Customers unhappy with
High credit sales payment terms
Cost: Lower Credit Sales
More bad debts Benefit:
High collection costs Less financing cost
Increased financing costs

Payables and Accruals

High Levels Low Levels
Benefit: Benefit:
Spontaneous financing reduces need to borrow Happy suppliers/employees
Cost: Cost:
Unhappy suppliers because paid slowly Not using spontaneous financing

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The right amount of working capital
◼ Too low level of working capital will
lead to inventory shortages, unpaid
supplier’s invoices and possible “over-
trading” leading to liquidity problems
◼ too high an investment in working
capital will incur unnecessary costs

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Permanent and Temporary
Working Capital
◼ Need for working capital varies with
sales level
◼ Temporary working capital supports
seasonal peaks in business
◼ Working capital is permanent to the
extent that it supports a constant,
minimum level of sales

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Working Capital Needs of
Different Firms

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 Financing strategy in relation to
working capital
◼ play safe and adopt a “matching”
strategy whereby short-term financing
is used only for the fluctuating working
capital investments or
◼ riskier “aggressive” strategy where
short-term financing is used for some
proportion of its permanent current
assets
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 The Working Capital Cycle or the
Cash Cycle
◼ the number of days from when cash is
first spent on current assets (to pay
suppliers) to the receipt of the cash
from customers, who have bought on
credit.
◼ it shows for how long the firm has to
finance purchases before receiving cash
from customers

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Diagram of working capital cycle

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Working capital cycle example:
◼ Sales: £640 per day
◼ Cost of sales: 80% of the value of sales
◼ Raw material purchases: £300 per day

Inventories of raw £36,000 Trade £38,500

materials receivables
Work in progress £10,240 Trade £37,500
payables
Finished goods £12,288

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 Working capital calculation

Days
Raw material Raw materials inventory 36,000 120
holding Daily purchases 300
Less the time to pay Trade payables 37,500 −125
suppliers Daily purchases 300
Production period Work-in-progress inventory 10,240 20
Daily cost of goods sold 512
Time to sell Finished goods inventory 12,288 24
finished goods Daily cost of goods sold 512
Customer credit Trade receivables 38,400 60
period Daily sales 640
Total cycle 99

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Inventory Management

◼ Inventory: product held for sale

◼ Inventory mismanagement can ruin a
company
◼ Finance department has only an
oversight responsibility
◼ Monitor level of lost or obsolete inventory
◼ Supervise periodic physical inventories

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Benefits and Costs of Carrying
Adequate Inventory
Benefits Costs
◼ Reduces stockouts ◼ Interest on funds used to
and backorders acquire inventory
◼ Makes operations ◼ Storage and security
run more smoothly ◼ Insurance
◼ Improves customer ◼ Taxes
relations ◼ Shrinkage - theft
◼ Increases sales ◼ Spoilage
◼ Breakage
◼ Obsolescence

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Inventory Control and Management

◼ Inventory Management - overall way a firm controls

inventory and its cost
◼ Define an acceptable level of operating efficiency

with regard to inventory

◼ Achieve that level with the minimum inventory cost

◼ EOQ – An inventory cost minimization model

H = Annual Carrying Cost per Unit
O = Fixed Cost per Order
D = Annual Demand in Units
Q = Order Quantity

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 Economic Order Quantity
(EOQ) Model
◼ The basic EOQ model sets out to
calculate the optimal ordering quantity
for an item of inventory that will
minimise total costs
◼ i.e. holding and ordering costs.

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The assumptions used in EOQ model
◼ demand is certain, constant and continuous over time
◼ the supply lead time is constant and certain
◼ customer’s orders cannot be held while
replenishment stocks are awaited
◼ no stock-outs are permitted
◼ all prices are constant and certain (e.g., no bulk
purchase discounts available)
◼ the costs of holding stocks are proportional to the
quantities held.

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Graph of EOQ costs

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EOQ model
▪ Given these assumptions, the optimal (i.e.
cost minimising) reorder quantity is:
▪ Q = 2DO/H
▪ Where:
▪ D = usage in units per year (i.e., demand)
◼ O = cost of making an order

◼ H = annual unit holding cost of stock item

◼ Q = reorder quantity,

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 EOQ stock levels and time

• The average level of inventory is Q/2

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 Problem
• A company makes bicycles. It produces 450 bicycles a
month. It buys the tires for bicycles from a supplier at a
cost of $20 per tire. The company’s inventory carrying
cost is estimated to be 15% of cost and the ordering is
$50 per order.
a. Calculate the EOQ
b. What is the number of orders per year?
c. Compute the average annual ordering cost.
d. Compute the average inventory.
e. What is the average annual carrying cost?
f. Compute the total cost.
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 Solution
• a. Calculate the EOQ
• In this problem: D = annual demand = (2 tires per
bicycle) x (450 bicycles per month) x (12 months in a
year) = 10,800 tires
• S = ordering cost = $50 per order
• H = carrying cost = (15%) x ($20 per unit) = $ 3.00 per
unit per year
• EOQ = Square root of {(2 x 10,800 x $50) / $3= 600 tires
• The company should order about 600 tires each time it
places an order.

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 Solution
• b. What is the number of orders per year? Number of orders per
year = D / Q = 10,800 / 600 = 18 orders per year
• c. Compute the average annual ordering cost. Average annual
ordering cost = (18 orders per year) x ($50 per order) = $900 per
year
• d. Compute the average inventory. Average inventory = Q / 2 = 600 /
2 = 300 tires
• e. What is the average annual carrying cost? Average annual
carrying cost = (average inventory) x (H) = (300 tires) x ($3) = $900
per year
• f. Compute the total cost. Total cost = (Average annual ordering
cost) + (average annual carrying) = ($900) + ($900) = $1,800

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Baumol’s Cash Balance model
◼ Trade-off between two types of cost:
◼ Firms keep a cash balance to pay bills when
needed and the main cost associated with
this is the interest lost (cash holding cost).
◼ To replenish the cash balance, the firm will
sell Treasury Bills (or draw cash from an
interest-bearing deposit account) which
involves a fixed charge for each transaction.

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Baumol’s EOQ model
◼ EOQ = Q =  2FT/h
◼ Where:
◼ Q = amount of Treasury bills sold each
time the cash is replenished,
◼ T = annual cash requirements,
◼ F = fixed transaction charge,
◼ h = Treasury bill interest rate

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Cash management example
◼ Ms West has a private income and she pays
for her daily living expenses by transferring
money from an 8% interest deposit account.
◼ Each withdrawal costs her £3 in charges.
◼ Her monthly outgoings are evenly spread and
total £625 [= £7,500 per annum].
◼ What is the optimal amount she should
withdraw from her account in order to
minimise her transfer costs and lost interest?

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Ms West example (contin)
◼ Q =  2x£3x(12monthsx£625)/0.08 = £750
◼ which means there will be 10 transfers of
£750 per year,
◼ At the EOQ, the transfer (order) costs equal
the interest (holding) costs
◼ Transfer costs = 3 x (12 x 625)/750 = £30
◼ Interest costs = 0.08 x £750/2 = £30

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Cash Management
◼ Motivation for Holding Cash
◼ Transactions demand
◼ Precautionary demand
◼ Speculative demand
◼ Compensating balances

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Objective of Cash Management
◼ Business cash balances earn little or no interest
◼ Firms generally borrow to support cash balances

◼ But it is easier to do business with plenty of cash -

Liquidity
◼ Objective: Strike a balance
◼ Operate efficiently at a reasonable cost

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Overtrading and overcapitalisation
◼ Overcapitalisation is where the overall level of
working capital is too high.
The solution is to reduce the level of working capital
by better management of receivables, cash
and inventory.
As a result the company will need less financing, or
alternatively will have more finance available
for profit-earning investment in fixed assets.
Overtrading (or under-capitalisation) is where
the level of working capital is too low.

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Overtrading and overcapitalisation…
◼ Overtrading happens when a business expands too quickly
without having the financial resources to support such a quick
expansion. If suitable sources of finance are not obtained,
overtrading can lead to business failure.
◼ Importantly, overtrading can occur even a business is profitable.
It is an issue of working capital and cash flow.
◼ Overtrading is, therefore, essentially a problem of growth.
◼ It is particularly associated with retail businesses who attempt
to grow too fast.

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Overtrading…
Overtrading is most likely to occur if:
◼ Growth is achieved by making significant capital investment in
production or operations capacity before revenues are
generated
◼ Sales are made on credit and customers take too long to settle
amounts owed
◼ Significant growth in inventories is required in order to trade
from the expanding capacity
◼ A long-term contract requires a business to incur substantial
costs before payments are made by customers under the
contract

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Overtrading…
◼ Classic Symptoms of Overtrading
◼ High revenue growth but low gross and operating
profit margins
◼ Persistent use of a bank overdraft facility
◼ Significant increases in the payables days and
receivables days ratios
◼ Significant increase in the current ratio
◼ Very low inventory turnover ratio
◼ Low levels of capacity utilisation

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Overtrading…
Managing the Risk of Overtrading
◼ The most effective steps to avoid overtrading are essentially
those that would be taken as part of a sensible cash flow and
working capital management. For example:
◼ Reducing inventory levels

◼ Scaling back the pace of revenue growth until profit margins

and cash reserves have improved
◼ Leasing rather than buying capital equipment

◼ Obtaining better payment terms from suppliers

◼ Enforcing better payment terms with customers (e.g. through

prompt-payment discounts)

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Receivable management and policies
◼ The reason for the existence of receivables is that the
business is prepared to sell to customers on credit.
The higher the receivables, the more cost there is for
the company – both in terms of the interest cost and
in terms of the greater risk of losses through bad
debts.
An easy solution would be to stop selling on credit
and to insist on immediate cash payment, but this
would risk the losing of customers if competitors
offer credit.

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Receivable management…
◼ There is no ‘best’ level for receivables – it
depends very much on the type of business
and the credit terms offered by competitors –
but it is in the interest of all companies to
keep the level of receivables as low as
possible in the circumstances.

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management of receivables
(1) Credit checks and credit limits - before granting
credit customers should be assessed as to their
ability to pay, and credit limits set for all accounts
a. use credit rating agencies
b. ask for trade and bank references from new
customers
c. analyse the payment record of existing customers
d. assess the financial statements of large customers
e. review credit limits regularly

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Receivales management…
(2) Credit terms and settlement discounts:
a. these will be greatly influenced by competition and trade
custom
b. the company must quantify the cost of any settlement
discounts and decide whether the benefits outweigh the cost
c. ensure that customers are aware of the terms and
settlement discounts by printing them on orders, invoices and
statements
d. ensure that any discount policy is enforced – most customers
will attempt to take the discount as a matter of course, whether
or not they have paid on time

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Receivables management…
(3) Collection procedures:
a. Set clearly defined procedures to be followed. Set
timings for issuing demand letters,making chasing
telephone calls, and stopping deliveries.
b. Decide when outside assistance is needed (e.g.
the use of collection agencies or lawyers)
c. Compare the cost of taking direct legal action with
that of using outside help.

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Receivables management…
(4) Charge interest on overdue invoices

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Invoice discounting and factoring
◼ Invoice discounting is the selling of an invoice to a third
party (usually a bank) for a lower (discounted) amount. This
way the supplier gets cash immediately and it is the bank who
has to wait for payment (hence the lower or discounted
amount).
Factoring is paying another company to administer all or part
of the receivables ledger.

Depending on the fee paid to the factor, different facilities may

be bought

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Invoice factoring….
◼ The basic level of factoring involves paying the factor
to handle all the administration – maintaining
the sales ledger and collecting the debts.
For a higher fee, the factor will advance money to
the company before the debts have been collected.
For example, the factor may advance 80% of the
value of sales immediately on invoicing.
For a higher fee still, the factor may accept
responsibility for any bad debts – the company is

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Invoive factoring…
effectively insured against bad debts. This is known as
‘non-recourse factoring’. (Normal factoring, where
the company keeps the responsibility for any bad
debts, is known as ‘with-recourse factoring’)

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Payables management
◼ Payables may be used as a source of short-term finance. If a
company delays payment by a further month then they now
have a further months use of the cash.
However, delaying payment may lose the company it’s credit
status with the supplier and could result in supplies being
stopped.
Additionally, the company could lose the benefit of any
settlement discount offered by the supplier for early payment.
In exactly the same way as for receivables, we can calculate the
annual effective cost of refusing any settlement discount
offered, and compare this with the cost of financing working
capital

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