Description
This is a presentation highlighting management of working capital.
Management of Working Capital
Nothing long term for a change!!
Working Capital
Working Capital=Current Assets-Current Liabilities ? Denotes the gap that would be financed by bank borrowings and long term funding ? Working Capital can also be negative ie. Current liabilities could be more than current assets
?
Factors affecting level of Working Capital
Nature of industry ? Type/availability of raw material used ? Seasonality of industry ? Policies ? Creditworthiness of the company ? Others….
?
Snapshot of a books publisher
Income Statement: Osiris
? ? ? ? ? ?
?
? ? ? ? ? ? ?
Balance Sheet Osiris
Inventory 15,000 Receivables 17,000 Prepayments: authors 3,000 Prepayments : printers 3,000 Payables (9,000) Customer Prepayments (1,000) Working Capital 28,000
? ? ?
Turnover Cost of Sales Royalties Gross Profit Distribution costs Promotion Write-offs Administration costs Operating Profit
100,000 (57,000) (18,000) 25,000 (5,000) (2,000) (3,000) (10,000) 5,000
Operating cycle
Measures the number of days it takes for raw material to get converted to finished goods to debtors to cash. ? Cash cycle measures the time we pay for the inventory to the receipt of the cash from debtors
?
Components of Operating Cycle
?
RM conversion period : the period for which RM stays put until converted to Work in Progress (next stage) = 360 x Average RM Inventory Raw Material consumed during the year
Components of Operating Cycle
?
WIP conversion period : the period for which WIP stays put until converted to Finished Goods = 360 x Average WIP Inventory Cost of Production
?
Finished Goods Conversion period: the period for which Finished Goods stays put until Sold
= 360 x Average Inventory Cost of Goods Sold
Receivables Turnover: = 360 x Avg. Debtors Credit Sales
?
Payables Turnover: = 360 x Avg. Creditors Credit Purchases
?
Example Information
?
Inventory:
?
?
Beginning = 200,000 Ending = 300,000
Beginning = 160,000 Ending = 200,000 Beginning = 75,000 Ending = 100,000
?
Accounts Receivable:
?
?
?
Accounts Payable:
? ?
? ?
Net sales = 1,150,000 Cost of Goods sold = 820,000
Example – Operating Cycle
?
Inventory period
?
?
?
Average inventory = (200,000+300,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = 112 days
Average receivables = (160,000+200,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 58 days
?
Receivables period
? ? ?
?
Operating cycle = 112 + 58 = 170 days
Example – Cash Cycle
?
Payables Period
?
? ?
Average payables = (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 39 days
Cash Cycle = 170 – 39 = 131 days ? We have to finance our inventory for 131 days ? If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem extensive
?
Tradeoffs in Working Capital Management
In making the investment and financing decision for current assets, face tradeoff between ? Liquidity: Ability to pay bills, keep sales coming in, keep customers happy, play it safe ? Profitability: Size of earnings after taxes
?
Measuring Liquidity and Profitability
Liquidity: NWC = CA - CL ? Liquidity: Current Ratio = CA/CL ? Profitability: Return on Total Assets ? ROA = EAT/TA ? Also use Current Asset Turnover to see how efficiently current assets are used ? CAT = Sales/CA
?
Classifying Current Assets
Permanent Current Assets = minimum level of cash, A/R, and inventory needed to stay in business (PCA) ? Temporary Current Assets = fluctuations in cash, A/R, and inventory corresponding to fluctuations in sales (TCA)
?
Matching Principle of WCM
Match the maturity of the sources of financing (CL, LTD, E) with the maturity of the uses (TCA, PCA, FA) ? Use CL to finance TCA ? Use LTD & E to finance PCA and FA
?
Conservative Approach to WCM
Objective: Improve Liquidity ? Level of Current Assets: ? 1) Cash: Maintains large cash balance.
?
Benefit: Able to pay bills easily. ? Cost: Cash could be earning a higher rate of return if it was invested elsewhere.
?
?
2) A/R: Permits high level of accounts receivable: Liberal Credit Policy (easy to get credit)
Benefit: Keeps sales high, keeps customers happy. ? Cost: High bad debt expense.
?
?
3) Inventory: Maintains high level of inventory.
Benefit: Keeps sales high, keeps customers happy. ? Cost: High carrying costs, funds could earn higher return invested elsewhere
?
Financing of Current Assets: ? Use more long-term financing than the matching principle calls for.
?
Benefit: Have the money raised all at once and available to spend- no frequent refinancings. ? Cost: Long-term debt usually has higher interest rate than short-term debt, pay more interest expense.
?
Summary of Conservative Approach
Level of CA: High cash, A/R, inventory ? Financing of CA: More long-term sources used ? Benefit: Increased liquidity ? Cost: Decreased profitability
?
Measures Indicating Conservative Approach
High Level of Net Working Capital ? High Current Ratio ? Low Return on Total Assets ? Low Current Asset Turnover
?
Aggressive Approach to WCM
Objective: Improve Profitability ? Level of Current Assets: ? 1) Cash: Keep minimum amount needed.
?
Benefit: Cash is not in no or low interest accounts, invested elsewhere earning higher rate of return. ? Cost: May not be able to pay bills, no extra cash for emergencies.
?
?
2) A/R: Keeps receivables low, Tight Credit Policy (hard to get credit from them).
Benefit: Low bad debt expense. ? Cost: Unhappy customers, sales drop.
?
?
3) Inventory: Minimum investment in inventory.
Benefit: Low carrying costs, money invested elsewhere. ? Cost: Unhappy customers, sales drop.
?
Financing of Current Assets: ? Uses more short-term financing than the matching principle calls for.
?
Benefit: Short-term debt usually carries lower interest rate than long-term debt, lower interest expense. ? Cost: Frequent refinancing, may have to borrow at higher rates in future, refinancing risk.
?
Summary of Aggressive Approach
Level of CA: Low cash, A/R, inventory ? Financing of CA: Uses more short-term sources of financing ? Benefit: Increased Profitability ? Cost: Decreased Liquidity
?
Measures Indicating Aggressive Approach
Low level of Net Working Capital ? Low Current Ratio ? High Return on Total Assets ? High Current Asset Turnover
?
Cash Management
?
Need to manage cash:
Transactions ? Speculative ? Precautionary ? Compensatory
?
doc_918881126.ppt
This is a presentation highlighting management of working capital.
Management of Working Capital
Nothing long term for a change!!
Working Capital
Working Capital=Current Assets-Current Liabilities ? Denotes the gap that would be financed by bank borrowings and long term funding ? Working Capital can also be negative ie. Current liabilities could be more than current assets
?
Factors affecting level of Working Capital
Nature of industry ? Type/availability of raw material used ? Seasonality of industry ? Policies ? Creditworthiness of the company ? Others….
?
Snapshot of a books publisher
Income Statement: Osiris
? ? ? ? ? ?
?
? ? ? ? ? ? ?
Balance Sheet Osiris
Inventory 15,000 Receivables 17,000 Prepayments: authors 3,000 Prepayments : printers 3,000 Payables (9,000) Customer Prepayments (1,000) Working Capital 28,000
? ? ?
Turnover Cost of Sales Royalties Gross Profit Distribution costs Promotion Write-offs Administration costs Operating Profit
100,000 (57,000) (18,000) 25,000 (5,000) (2,000) (3,000) (10,000) 5,000
Operating cycle
Measures the number of days it takes for raw material to get converted to finished goods to debtors to cash. ? Cash cycle measures the time we pay for the inventory to the receipt of the cash from debtors
?
Components of Operating Cycle
?
RM conversion period : the period for which RM stays put until converted to Work in Progress (next stage) = 360 x Average RM Inventory Raw Material consumed during the year
Components of Operating Cycle
?
WIP conversion period : the period for which WIP stays put until converted to Finished Goods = 360 x Average WIP Inventory Cost of Production
?
Finished Goods Conversion period: the period for which Finished Goods stays put until Sold
= 360 x Average Inventory Cost of Goods Sold
Receivables Turnover: = 360 x Avg. Debtors Credit Sales
?
Payables Turnover: = 360 x Avg. Creditors Credit Purchases
?
Example Information
?
Inventory:
?
?
Beginning = 200,000 Ending = 300,000
Beginning = 160,000 Ending = 200,000 Beginning = 75,000 Ending = 100,000
?
Accounts Receivable:
?
?
?
Accounts Payable:
? ?
? ?
Net sales = 1,150,000 Cost of Goods sold = 820,000
Example – Operating Cycle
?
Inventory period
?
?
?
Average inventory = (200,000+300,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = 112 days
Average receivables = (160,000+200,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 58 days
?
Receivables period
? ? ?
?
Operating cycle = 112 + 58 = 170 days
Example – Cash Cycle
?
Payables Period
?
? ?
Average payables = (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 39 days
Cash Cycle = 170 – 39 = 131 days ? We have to finance our inventory for 131 days ? If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem extensive
?
Tradeoffs in Working Capital Management
In making the investment and financing decision for current assets, face tradeoff between ? Liquidity: Ability to pay bills, keep sales coming in, keep customers happy, play it safe ? Profitability: Size of earnings after taxes
?
Measuring Liquidity and Profitability
Liquidity: NWC = CA - CL ? Liquidity: Current Ratio = CA/CL ? Profitability: Return on Total Assets ? ROA = EAT/TA ? Also use Current Asset Turnover to see how efficiently current assets are used ? CAT = Sales/CA
?
Classifying Current Assets
Permanent Current Assets = minimum level of cash, A/R, and inventory needed to stay in business (PCA) ? Temporary Current Assets = fluctuations in cash, A/R, and inventory corresponding to fluctuations in sales (TCA)
?
Matching Principle of WCM
Match the maturity of the sources of financing (CL, LTD, E) with the maturity of the uses (TCA, PCA, FA) ? Use CL to finance TCA ? Use LTD & E to finance PCA and FA
?
Conservative Approach to WCM
Objective: Improve Liquidity ? Level of Current Assets: ? 1) Cash: Maintains large cash balance.
?
Benefit: Able to pay bills easily. ? Cost: Cash could be earning a higher rate of return if it was invested elsewhere.
?
?
2) A/R: Permits high level of accounts receivable: Liberal Credit Policy (easy to get credit)
Benefit: Keeps sales high, keeps customers happy. ? Cost: High bad debt expense.
?
?
3) Inventory: Maintains high level of inventory.
Benefit: Keeps sales high, keeps customers happy. ? Cost: High carrying costs, funds could earn higher return invested elsewhere
?
Financing of Current Assets: ? Use more long-term financing than the matching principle calls for.
?
Benefit: Have the money raised all at once and available to spend- no frequent refinancings. ? Cost: Long-term debt usually has higher interest rate than short-term debt, pay more interest expense.
?
Summary of Conservative Approach
Level of CA: High cash, A/R, inventory ? Financing of CA: More long-term sources used ? Benefit: Increased liquidity ? Cost: Decreased profitability
?
Measures Indicating Conservative Approach
High Level of Net Working Capital ? High Current Ratio ? Low Return on Total Assets ? Low Current Asset Turnover
?
Aggressive Approach to WCM
Objective: Improve Profitability ? Level of Current Assets: ? 1) Cash: Keep minimum amount needed.
?
Benefit: Cash is not in no or low interest accounts, invested elsewhere earning higher rate of return. ? Cost: May not be able to pay bills, no extra cash for emergencies.
?
?
2) A/R: Keeps receivables low, Tight Credit Policy (hard to get credit from them).
Benefit: Low bad debt expense. ? Cost: Unhappy customers, sales drop.
?
?
3) Inventory: Minimum investment in inventory.
Benefit: Low carrying costs, money invested elsewhere. ? Cost: Unhappy customers, sales drop.
?
Financing of Current Assets: ? Uses more short-term financing than the matching principle calls for.
?
Benefit: Short-term debt usually carries lower interest rate than long-term debt, lower interest expense. ? Cost: Frequent refinancing, may have to borrow at higher rates in future, refinancing risk.
?
Summary of Aggressive Approach
Level of CA: Low cash, A/R, inventory ? Financing of CA: Uses more short-term sources of financing ? Benefit: Increased Profitability ? Cost: Decreased Liquidity
?
Measures Indicating Aggressive Approach
Low level of Net Working Capital ? Low Current Ratio ? High Return on Total Assets ? High Current Asset Turnover
?
Cash Management
?
Need to manage cash:
Transactions ? Speculative ? Precautionary ? Compensatory
?
doc_918881126.ppt