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Lecture 6 - Working Capital Management 1

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37 views19 pages

Lecture 6 - Working Capital Management 1

Uploaded by

Gaba Riele
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Topic 6

Working Capital Management (I)

1
Key concepts
• What is working capital?
• The Cash Conversion Cycle (CCC)
• Working Capital Policies: investment/level
• Working Capital Policies: financing
• Overtrading
• Management of Inventory
• The Economic Order Quantity (EOQ) method
Core reading: Watson & Head Ch 3:pp.78-89
2
Working capital management
• Working capital is concerned with short-term
resources and short-term funding
• Net working capital =
Current Assets less Current Liabilities
i.e. Inventory plus Trade Receivables
less Trade Payables
• The need for liquidity must be balanced against
the need for profitability
3
Cash conversion cycle

• Cash conversion cycle: time between paying for


inputs and receiving cash from sales
• Length of cash conversion cycle is a factor in
determining the level of working capital
• Level of working capital also depends upon
working capital policy

4
Cash conversion cycle

• The cash conversion cycle (CCC) is given by the


formula:
ICP + RCP - PDP (days)
ICP= Inventory conversion period
RCP= Receivables collection period
PDP= Payables deferral period
• The longer the period the more WC is required.
5
Working capital policies
INVESTMENT POLICY
• An aggressive working capital investment
policy will have lower levels of investment than
a conservative policy
• An aggressive policy will have higher risk and
higher profitability
• A conservative policy will have lower risk and
lower profitability

6
Working capital policies
Level of investment Conservative

Moderate

Aggressive

Level of sales
7
Working capital policies
FINANCING POLICY
• Current assets are divided into permanent
current assets and fluctuating current assets
• Short-term finance is cheaper than long-term
finance
• Short-term finance is riskier than long-term
finance
• Choice of financing policy depends on
company’s attitude to risk

8
Working capital policies
1. Moderate/matching financing policy
– Short-term funds for fluctuating current assets
– Long-term funds for permanent current assets and non-
current assets
2. Conservative financing policy
– Long-term funds used for permanent and some
fluctuating current assets
3. Aggressive financing policy
– Short-term funds for fluctuating and some permanent
current assets
– Long-term funds for non-current assets and some
permanent current assets
9
Working capital policies
Fluctuating Current Assets
Cumulative Type of
Assets Funding

Permanent Current Assets


Long-
Non-current Assets term
Funds

MATCHING POLICY
10
Working capital policies
Fluctuating Current Assets
Cumulative Type of
Assets Funding

Permanent Current Assets Long-


term
Non-current Assets Funds

CONSERVATIVE POLICY
= surplus funds for re-investment 11
Working capital policies
Fluctuating Current Assets
Cumulative Type of
Assets Funding

Permanent Current Assets

Non-current Assets Long-


term
Funds
AGGRESSIVE POLICY
12
Overtrading
 Overtrading occurs when capital base is too
small to support volume of trade
 Caused by too rapid an increase in turnover or
erosion of capital base
 Overtrading can be indicated by:
• deterioration in key financial ratios
• decreasing liquid resources
• increasing reliance on short-term finance

13
Overtrading
• Solutions seek to bring capital base and volume
of trade back into balance
– Introduction of new capital
– Consolidation of business activity
– Better working capital management
• Note that overtrading can result from
aggressive working capital policies

14
Management of Inventory
• Inventory management seeks to minimise cost of holding stock for production or sale
• The Economic Order Quantity model calculates the optimum order size if Annual demand (S), Holding cost (H) and
Ordering cost (F) are known:

• The EOQ is a deterministic model based on certainty of demand and costs

15
Management of Inventory: EOQ

Total Cost
Cost £ Holding costs

Ordering costs

0 Order size
EOQ

16
Management of Inventory
Advantages:
– EOQ is simple to understand and apply
Disadvantages:
– Assumes needs are known with certainty
– Assumes constant usage
– Assumes constant ordering/storage costs
– Ignores buffer stock*
– Assumes zero lead time*
* this refers to the simplest form of the EOQ – it can be
modified to accommodate both these elements 17
EOQ: an example
Question:
The demand for toggits is 300,000 over the year.
Orders incur a flat rate fixed cost of £200 per order. It
costs £3 per annum to store a toggit. Assuming
smooth usage throughout the year, what is the EOQ?

Answer:
Here, using the EOQ:
•S = 300,000
•F = £200
•H = £3

•EOQ = 6,325
•Orders per annum = 300,000/6,325 = 47.4  48
18
Just-in-time (JIT)
• methodology aimed at reducing inventory levels
to zero
• requires close relationship between supplier and
purchaser
• need for suppliers to be close by and/or can
supply inventory quickly and a short notice
• development in Japan in the 60s/70s mainly by
car manufacturer, Toyota
• Hewlett-Packard was one of the earliest JIT
implementers in the west
19

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