Objectives of Working Capital Management

Objectives of Working Capital Management

1.1       Objectives:

• The objectives of working capital management are profitability and liquidity.
• The objective of profitability supports the primary financial management objective, which is shareholder wealth maximization.
• The objective of liquidity ensures that liabilities can be met as they fall due.

1.2       Conflict between two objectives:

• Liquid assets such as bank accounts earn very little return or no return, so liquid assets decrease profitability.
• Profitability is met by investing over the longer term in order to achieve higher returns.

1.3       Trade-off between two objectives:

• It depends part on the particular circumstances of an organization.
• Liquidity may be more important objective when short-term finance is hard to find.
• Profitability may become a more important objective when cash management has become too conservative.
• Both objectives are important and neither can be neglected.

1.4       Steps to achieve the objectives of working capital management:

• Good credit management effect –
• Aims to minimize the risk of bad debts and expedite the prompt payment of money due from debtors
• Take steps to optimize the level and age of debtors will minimize the cost of financing them, leading to increase in the returns available to shareholders.
• Good inventory management effect –
• Use, for example, EOQ, ABC analysis and buffer stock management can minimize the costs of holding and ordering inventory.
• Apply the JIT inventory procurement can reduce the cost of investing in inventory.
• Improve inventory management can therefore reduce costs and increase shareholder wealth.
• Other examples:
• Cash budgets can help to determine the transaction need for cash.
• Baumol model and Miller-Orr model can help to maintain cash balances close to optimum levels.

Question 1 (a)      Identify the objectives of working capital management and discuss the conflict that may arise between them.                                                                                           (3 marks) (b)      Discuss whether profitability or liquidity is the primary objective of working capital management.                                                                                                      (4 marks) (c)      Outline the advantages to a company of taking steps to improve its working capital management, giving examples of steps that might be taken.                            (7 marks)

2.       Cash Conversion Cycle (Cash Operating Cycle, Working Capital Cycle or Trading Cycle)

2.1	The Cash Operating Cycle
	The cash operating cycle (working capital cycle or trading 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.

2.2       Significance (or factors) in determining the level of investment in working capital:

• The longer the cash conversion cycle, the higher the investment in working capital.
• The length of the cash operating cycle varies between industries, for example –
• Service organization may have no inventory holding period,
• Retail organization will have a stock holding period based almost entirely on finished goods and a very low level of debtors,
• Manufacturing organization will have a stock holding period based on raw materials, WIP and finished goods.
• The length of the cash operating cycle also varies within the same industries, depends on which working capital policies adopted –
• Aggressive policy – characterized by lower levels of inventory and receivables. It can increase profitability but also increase the risk of running out of inventory, or losing potential customers due to better credit terms being offered by competitors.
• Conservative policy – maintain high levels of investment in inventory and receivables, profitability is therefore reduced, but the risk of stock-outs is lower and new credit customers may be attracted by more generous terms.
• Terms of trade:
• More generous terms of trade will need a comparatively higher investment in current assets.

2.3       How to reduce the level of investment in working capital?

• Reduce the inventory holding period, e.g. using JIT.
• Reduce receivables collection period, e.g. improve receivables management.
• Increase payables repayment period, e.g. settle invoices as late as possible.

2.4       Calculation of the cash conversion cycle:

• For manufacturing business

Raw materials holding period	x
Less: Payables’ payment period	(x)
WIP holding period	x
Finished goods holding period	x
Receivables’ collection period	x
	x

 

• For wholesale or retail business

Inventory holding period	x
Less: Payables’ payment period	(x)
Receivables’ collection period	x
	x

• The cycle may be measured in days, weeks or months.

 

Question 2 – Cash Operating Cycle, Working Capital Management and Factoring Extracts from the recent financial statements of Anjo plc are as follows: Income statements 2006 2005   $000 $000 Turnover 15,600 11,100 Cost of sales 9,300 6,600 Gross profit 6,300 4,500 Administration expenses 1,000 750 Profit before interest and tax 5,300 3,750 Interest 100 15 Profit before tax 5,200 3,735     Statement of financial position 2006 2005   $000 $000 $000 $000 Non-current assets   5,750   5,400 Current assets         Inventory 3,000   1,300   Receivables 3,800   1,850   Cash 120   900       6,920   4,050 Current liabilities         Trade payables 2,870   1,600   Overdraft 1,000   150       (3,870)   (1,750) Total assets less current liabilities   8,800   7,700 All sales were on credit. Anjo plc has no long-term debt. Credit purchases in each year were 95% of cost of sales. Anjo plc pays interest on its overdraft at an annual rate of 8%. Current sector averages are as follows: Inventory days: 90 days Receivable days: 60 days Payables days: 80 days Required: (a)     Calculate the following ratios for each year and comment on your findings. (i)      Inventory days (ii)     Receivables days (iii)    Payables days (6 marks) (b)     Calculate the length of the cash operating cycle (working capital cycle) for each year and explain its significance.                                                                                (4 marks) (c)     Discuss the relationship between working capital management and business solvency, and explain the factors that influence the optimum cash level for a business.   (7 marks) (d)     A factor has offered to take over sales ledger administration and debt collection for an annual fee of 0.5% of credit sales. A condition of the offer is that the factor will advance Anjo plc 80% of the face value of its debtors at an interest rate 1% above the current overdraft rate. The factor claims that it would reduce outstanding debtors by 30% and reduce administration expenses by 2% per year if its offer were accepted. Required: Evaluate whether the factor’s offer is financially acceptable, basing your answer on the financial information relating to 2006.                                                               (8 marks) (Total 25 marks)

3.       Working Capital Ratios and Overtrading

3.1       Working capital ratios may help to indicate whether a company is over-capitalized (overtrading).
3.2       Types of working capital ratios

(1)       Current ratio =
(2)       Quick ratio =
(3)       Accounts receivable payment period =
(4)       Finished goods turnover period =
(5)       Raw materials holding period =
(6)       WIP holding period =
(7)       Accounts payable payment period =
(8)       Working capital turnover =
3.3       Overtrading occurs when a business has insufficient finance for working capital to sustain its level of trading.
3.4       Symptoms of overtrading:

• Rapid increase in turnover.
• Rapid increase in the volume of current assets and possibly also non-current assets.
• Inventory turnover and accounts receivable turnover might slow down.
• Accounts payable period is likely to lengthen.
• Bank overdrafts often exists or even exceeds the limit of the facilities agreed by the bank.
• Current ratio and quick ratio fall.
• Debt ratios alter dramatically.
• Liquid deficit may happen, that is, an excess of current liabilities over current assets.

 

Question 3 – Interest Rate Risk, Overtrading and Factoring The following financial information related to Gorwa Co:   2007 2006   $000 $000 Sales (all on credit) 37,400 26,720 Cost of sales 34,408 23,781 Operating profit 2,992 2,939 Finance costs (interest payments) 355 274 Profit before taxation 2,637 2,665 Statement of financial position 2007 2006   $000 $000 $000 $000 Non-current assets   13,632   12,750 Current assets         Inventory 4,600   2,400   Trade receivables 4,600   2,200     9,200   4,600   Current liabilities         Trade payables 4,750   2,000   Overdraft 3,225   1,600     7,975   3,600   Net current assets   1,225   1,000     14,857   13,750 8% Bonds   2,425   2,425     12,432   11,325 Capital and reserves         Share capital   6,000   6,000 Reserves   6,432   5,325     12,432   11,325 The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years’ time. A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%. Required: (a)     Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase in interest rates and advise the company of steps it can take to protect itself against interest rate risk.                                                                                                  (7 marks) (b)     Use the above financial information to discuss, with supporting calculations, whether or not Gorwa Co is overtrading.                                                                            (10 marks) (c)     Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average cost of short-term finance in this part of the question only. (8 marks) (Total 25 marks)

4.      Working Capital Requirement

4.1       Computing the working capital requirement is a matter of calculating the value of current assets less current liabilities, perhaps by taking averages over a one-year period.

Question 4 The following data relate to ABC Co, a manufacturing company. Sales revenue for year: $1,500,000 Costs as percentage of sales:   Direct materials 30% Direct labour 25% Variable overheads 10% Fixed overheads 15% Selling and distribution 5% Average statistics relating to working capital are as follows: (1)     Receivables take 2.5 months to pay (2)     Raw materials are in inventory for three months (3)     WIP represents two months’ half-produced goods (4)     Finished goods represent one month’s production   (5)     Credit it taken: - Materials 2 months - Direct labour 1 week - Variable overheads 1 month - Fixed overheads 1 month - Selling and distribution 1/2 month WIP and finished goods are valued at the cost of material, labour and variable expenses. Required: Compute the working capital requirement of ABC Co assuming that the labour force is paid for 50 working weeks in each year.

 

 

5.       Inventory Management

5.1       Costs and objective of inventory management

5.1.1    Costs of high inventory level:

• Purchase costs
• Holding costs
• Storage
• Stores administration
• Risk of theft/damage/obsolescence

5.1.2    Costs of low inventory level:

• Stockout costs
• Lost contribution
• Production stoppages
• Emergency orders
• High re-order/setup costs
• Lost quantity discounts

5.1.3    Objective of good inventory management is to determine:

• The optimum re-order level – how many items are left in inventory when the next order is placed, and
• The optimum re-order quantity – how many items should be ordered when the order is placed for all material inventory items.

 

5.2       EOQ

5.2.1    Economic order quantity (EOQ) – minimize the total cost of holding and ordering inventory.

EOQ =
C0 = Cost of placing one order
CH = Holding cost per unit of inventory for one period
D = Annual demand
5.2.2    Quantity discounts – discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size needed for discount, should the order size be increased above the EOQ?
5.2.3    Limitations of EOQ:

• Only based on two types of costs: holding costs and ordering costs.
• Demand for stock, holding cost per unit per year and order cost are assumed to be certain and constant.
• Ignore the cost of running out of stock (stockouts)
• Developed on the basis of zero lead time and no buffer stock.

Question 5 – Objectives of working capital management, EOQ, AR management and foreign currency risk management PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information: Inventory management The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0•50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year. Accounts receivable management Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%. Accounts payable management PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the currency risk of this account payable. The following information has been provided by the company’s bank: Spot rate ($ per €): 1.998 ± 0.002 Six months forward rate ($ per €): 1.979 ± 0.004 Money market rates available to PKA Co:   Borrowing Deposit One year euro interest rates: 6.1% 5.4% One year dollar interest rates: 4.0% 3.5% Assume that it is now 1 December and that PKA Co has no surplus cash at the present time. Required: (a)     Identify the objectives of working capital management and discuss the conflict that may arise between them.                                                                                             (3 marks) (b)     Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model.                                           (7 marks) (c)     Discuss ways in which PKA Co could improve the management of domestic accounts receivable.                                                                                                           (7 marks) (d)     Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign account payable.                                        (8 marks) (Total 25 marks)

 

Quantity (bulk purchase) discount

5.3.1    Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size needed for a discount, should the order size be increased above the EOQ?

5.3.2

Example 1

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 order of 60 units or more, and a discount of 5% for orders of 90 units or more. What is the cost minimizing order size? Solution: (a)      The EOQ ignoring discount is: = 50 units   $ Purchases (no discount) 125 × $200 25,000 Holding costs (50/2) 25 units × $30 750 Ordering costs 2.5 orders × $300 750 Total annual costs 26,500 (b)      With a discount of 3% and an order quantity of 60 units costs are as follows.   $ Purchases $25,000 × 97% 24,250 Holding costs 30 units × 15% × 97% × $200 873 Ordering costs 2.08 orders × $300 625 Total annual costs 25,748 (c)      With a discount of 5% and an order quantity of 90 units costs are as follows.   $ Purchases $25,000 × 95% 23,750 Holding costs 45 units × 15% × 95% × $200 1,282.5 Ordering costs 1.39 orders × $300 416.7 Total annual costs 25,449.2 The cheapest option is to order 90 units at a time.

5.4       Re-order level

5.4.1    Re-order level builds in a measure of safety inventory and minimizes the risk of the organization running out of inventory.

5.4.2	Formula
	Re-order level = maximum usage × maximum level Maximum inventory level = re-order level + re-order quantity – (minimum usage × minimum lead time) Minimum inventory level or buffer safety inventory = Re-order level – (average usage × average lead time) Average inventory = minimum level + (re-order level ÷ 2)

5.5       Just-in-time (JIT)

5.5.1    Meaning:

• Seek to eliminate any waste that arises in the manufacturing process as a result of using inventory.
• Under this method, stock levels of raw materials, WIP and finished goods are reduced to a minimum or eliminated altogether by improved work-flow planning and closer relationships with suppliers.

5.5.2    Advantages of JIT:

• Eliminate waste at all stages of the manufacturing process – it can be achieved by improved workflow planning, quality control and long-term contracts between buyer and supplier.
• Stronger relationship with supplier – this offers security to the supplier who benefits from regular orders, continuing future business and more certain production planning. The buyer may also benefit from bulk purchase discounts or lower purchase costs.
• Emphasis on quality control – it can reduce scrap, reworking and set-up costs. The result is a smooth flow of material and work through the production system, with no queues or idle time.

5.5.3    Disadvantages of JIT:

• May not run as smoothly in practice as theory may predict – because there may be little room for manoeuver in the event of unforeseen delays. For example, there is little room for error on delivery time.
• Heavily depend on the supplier for maintaining the quality of delivered materials and components – if the quality is not up to standard, expensive downtime may arise.
• Not easy to find alternative supplier – especially in short-time.

5.5.4    Not all businesses are appropriate to apply JIT, such as restaurant and hospital.

6.       Accounts receivable management

6.1       Key areas of accounts receivable management

6.1.1    Four areas:

• Policy formulation – establish the framework within which management of receivables in an individual company takes place. The elements include:
• Establishing terms of trade, such as credit period and early settlement discounts;
• Deciding whether to charge interest on overdue accounts;
• Determining procedures when granting credit to new customers;
• Establishing procedures when accounts become overdue, etc.
• Credit analysis – assessment of creditworthiness should be applied. The information can be obtained by:
• Bank references,
• Trade references,
• Credit reference agency reports,
• Financial information about the customer,
• Press comments, etc.
• Credit control – review outstanding accounts on a regular basis so overdue accounts can be identified. For example: it can be done by aged receivables analysis.
• Collection of amounts due – have agreed procedures for dealing with overdue accounts. For example:
• Send reminder letter,
• Log telephone calls,
• Refuse to grant further credit,
• Use debt collectors,
• Apply legal action, as a last resort.

6.2       Factors to be considered when formulating working capital policy on the management of trade receivables

6.2.1    Factors can be summarized as follows:

• The level of investment in trade receivables – If the amount is substantial, receivables management policy may be formulated with the intention of reducing the level of investment by tighter control over the credit grant and client creditworthiness.
• The cost of financing trade credit – If the cost is high, there will be pressure to reduce the amount of credit offered and to reduce the period for which credit is offered.
• The terms of trade offered by competitors – a company need to match the terms offered by its competitors, otherwise customers will migrate to competitors, unless there are other factors that will encourage them to be loyal, such as better quality or more valuable after-sales service.
• The level of risk acceptable to the company – The level of risk of bad debts that is acceptable to company.
• The need for liquidity – If the need for liquidity is relatively high, a company may choose to accelerate cash inflow from credit customers by using invoice discounting or by factoring.
• The expertise available within the company – If expertise in the assessment of creditworthiness and the monitoring of customer accounts is not to a sufficiently high standard, a company may choose to outsource its receivables management to a third party, i.e. a factor.

6.3       Early settlement discounts

6.3.1    Advantages and disadvantages of early settlement discounts:

Advantages	Disadvantages
(a)     Early payment reduces the receivables balance and hence the finance costs. (b)     Potential to reduce the irrecoverable debts arising. (c)     Offers a choice to customers of payment terms.	(a)      Difficulty in setting the appropriate terms. (b)      Uncertainty as to when cash receipts will be received, complicating cash budgeting. (c)      Customers pay over normal terms but still take the cash discount.

6.3.2

Example 3

A company is offering a cash discount of 2.5% to receivables if they agree to pay debts within one month. The usual credit period taken is three months. What is the effective annualized cost of offering the discount and should it be offered, if the bank would loan the company at 18% pa? Solution: Discount as a percentage of amount paid = 2.5 / 97.5 = 2.56% Saving is 2 months and there are 12/2 = 6 periods in a year Annualised cost of discount (%) is (1 + 0.0256)6 – 1 = 16.38% The loan rate is 18%. It would be therefore be worthwhile offering the discount.

6.4       Factoring

6.4.1    How to assist in the management of receivables?

• Factoring involves a company turning over administration of its sales ledger to a factor.
• The receivables are effectively sold to a factor (normally by a bank). The factor is responsible for the issuing invoices and collecting debts.
• Factor offer finance to a company, usually up to 80% of the face value of invoices. The finance is repaid from the settled invoices, with the balance being passed to the company after deduction of interest charge.
• If factoring is without recourse, the factor will carry the cost of any bad debts. Of course, the factor’s fee will be higher.

6.4.2    Factoring is most suitable for:

• Small and medium-sized firm which often cannot afford sophisticated credit and sales accounting systems, and
• Firms that are expanding rapidly. Factoring debts can be a more flexible source of financing working capital than an overdraft or bank loan.

6.4.3    Advantages and disadvantages of factoring:

Advantages

Disadvantages

(a)     Saving in administration costs – not incur the costs of running its own sales ledger department. (b) Reduction in the need for management control, i.e. slow paying accounts receivable. (c)     Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume growth. (d)     Growth can be financed through sales rather than by injecting fresh external capital.

(a)      Likely to be more costly than an efficiently run internal credit control department. (b)      Factoring has a bad reputation associated with failing companies; using a factor may suggest your company has money worries. (c)      Customers may not wish to deal with a factor. (d)      Once you start factoring it is difficult to revert easily to an internal credit control system. (e)      The company may give up the opportunity to decide to whom credit may be given (non-recourse factoring).

6.4.4 Determine whether factoring is financially acceptable:

Question 6 – Cash operating cycle and factoring Extracts from the recent financial statements of Bold Co are given below.   $000 $000 Turnover 21,300   Cost of sales 16,400   Gross profit 4,900           $000 $000 Non-current assets   3,000 Current assets     Inventory 4,500   Trade receivables 3,500 8,000 Total assets   11,000       Current liabilities     Trade payables 3,000   Overdraft 3,000 6,000       Equity     Ordinary shares 1,000   Reserves 1,000 2,000       Non-current liabilities     Bonds   3,000     11,000   A factor has offered to manage the trade receivables of Bold Co in a servicing and factor-financing agreement. The factor expects to reduce the average trade receivables period of Bold Co from its current level to 35 days; to reduce bad debts from 0·9% of turnover to 0·6% of turnover; and to save Bold Co $40,000 per year in administration costs. The factor would also make an advance to Bold Co of 80% of the revised book value of trade receivables. The interest rate on the advance would be 2% higher than the 7% that Bold Co currently pays on its overdraft. The factor would charge a fee of 0·75% of turnover on a with-recourse basis, or a fee of 1·25% of turnover on a non-recourse basis. Assume that there are 365 working days in each year and that all sales and supplies are on credit. Required: (a)      Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the cash operating cycle and the level of investment in working capital. Your answer should include a discussion of relevant working capital policy and the nature of business operations.                                                                                           (7 marks) (b)      Calculate the cash operating cycle of Bold Co. (Ignore the factor’s offer in this part of the question).                                                                                                      (4 marks) (c)      Calculate the value of the factor’s offer: (i)      on a with-recourse basis; (ii)     on a non-recourse basis.                                                                           (7 marks) (d)      Comment on the financial acceptability of the factor’s offer and discuss the possible benefits to Bold Co of factoring its trade receivables.                                       (7 marks) (25 marks)

6.5       Invoice discounting

6.5.1    How to assist in the management of receivables?

• It is way of raising finance against the security of invoices raised, rather than employing the credit management and administration services of a factor.
• Good quality of invoices may be discounted, rather than all invoices.

 

 

 

Question 7 – EOQ, JIT, changes in AR management policy and formulating working capital management policy WQZ Co is considering making the following changes in the area of working capital management: Inventory management It has been suggested that the order size for Product KN5 should be determined using the economic order quantity model (EOQ). WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding cost is expected to be $5·12 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be maintained, whether orders are made by the traditional method or using the economic ordering quantity model. Receivables management WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were offered. It is expected that administration and operating cost savings of $753,000 per year will be made after improving operational procedures and introducing the early settlement discount. Credit sales of WQZ Co are currently $87·6 million per year and trade receivables are currently $18 million. Credit sales are not expected to change as a result of the changes in receivables management. The company has a cost of short-term finance of 5·5% per year. Required: (a)      Calculate the cost of the current ordering policy and the change in the costs of inventory management that will arise if the economic order quantity is used to determine the optimum order size for Product KN5.                                                               (6 marks) (b)      Briefly describe the benefits of a just-in-time (JIT) procurement policy.         (5 marks) (c)      Calculate and comment on whether the proposed changes in receivables management will be acceptable. Assuming that only 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered? (6 marks) (d)      Discuss the factors that should be considered in formulating working capital policy on the management of trade receivables.                                                                (8 marks) (25 marks)

7.         Accounts Payables Management

7.1       Normally seen as a free source of finance, but delay too long, it will have the following problems:

•             Loss discount
•             Loss of goodwill
•             Credit rating problem
•             Refuse to supply in future
•             Increase price in future

7.2       Calculation of early settlement discount – same as receivables early settlement discount in 5.3.2 above.

Question 8 – Formulation of working capital policy, early settlement discount and bulk purchase discount ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which ZPS Co meets, and the cost per component is $7.50. The cost of ordering is $200 per order, while the cost of holding components in inventory is $1.00 per component per year. The supplier has offered either a discount of 0.5% for payment in full within 30 days, or a discount of 3.6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $2.20 per component per year due to the need for a larger storage facility. Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 4.5% per year. Required: (a)      Discuss the factors that influence the formulation of working capital policy;  (7 marks) (b)      Calculate if ZPS Co will benefit financially by accepting the offer of: (i)      the early settlement discount; (ii)     the bulk purchase discount.                                                                      (7 marks)

8.      Foreign Trades Management

8.1       Additional two types of risks need to managed:

•             Export credit risk – failure or delay in collecting payments due from foreign customers. It may be caused by:
•        Insolvent customers
•        Bank failure
•        Unconvertible currencies
•        Political risk
•             Foreign exchange risk – is a risk that the value of the currency will change between the date of the contract and the date of settlement.

8.2       Solutions for credit risk:

•             Early payment – by payment in advance, payment on shipment, or cash on delivery (COD).
•             Letters of credit – the customer’s bank guarantees it will pay the invoice.
•             Bills of exchange – IOU (I owe you) signed by customer.
•             Invoice discounting – sale of selected invoices to a debt factor.
•             Insurance – used to cover some of the risks associated with giving credit to foreign customers.
•             Export factoring – provide 3 main services:
•        Invoicing and debt collection
•        Bad debt insurance (non-recourse)
•        Cash advances

Question 9 – Granting credit to foreign customers Discuss how risks arising from granting credit to foreign customers can be managed and reduced.                                                                                                                        (8 marks)

9.       Cash Management

9.1       Reasons for holding cash

9.1.1    Motives for holding cash:

• Transaction motive – cash required to meet day-to-day expenses, e.g. payroll, payment of suppliers, etc.
• Finance motive – cash required to cover major items such as the repayment of loans and the purchase of non-current assets.
• Precautionary motive – cash held to give a cushion against unplanned expenditure (the cash equivalent of buffer inventory).
• Speculative motive – cash kept available to take advantage of market investment opportunities.

9.2       Cash budgets and cash flow forecasts

9.2.1    Usefulness of cash flow forecasts:

• Shows the cash effect,
• Give management an indication of potential problems that could arise and allows them the opportunity to take action to avoid such problems.

9.2.2    Forecasts can be prepared from any of the following:

• Planned receipts and payments
• Statement of financial position predictions
• Working capital ratios

Question 10 – Working Capital Financing Strategies, Cash Budgets and Risks of Granting Credit to Foreign Customers The following financial information relates to HGR Co: Statement of financial position at the current date (extracts)   $000 $000 $000 Non-current assets     48,965 Current assets       Inventory   8,160   Accounts receivable   8,775       16,935   Current liabilities       Overdraft 3,800     Accounts payable 10,200 14,000   Net current assets     2,935 Total assets less current liabilities     51,900 Cash flow forecasts from the current date are as follows:   Month 1 Month 2 Month 3 Cash operating receipts ($000) 4,220 4,350 3,808 Cash operating payments ($000) 3,950 4,100 3,750 Six-monthly interest on trade bonds ($000)   200   Capital investment ($000)     2,000 The finance director has completed a review of accounts receivable management and has proposed staff training and operating procedure improvements, which he believes will reduce accounts receivable days to the average sector value of 53 days. This reduction would take six months to achieve from the current date, with an equal reduction in each month. He has also proposed changes to inventory management methods, which he hopes will reduce inventory days by two days per month each month over a three-month period from the current date. He does not expect any change in the current level of accounts payable. HGR Co has an overdraft limit of $4,000,000. Overdraft interest is payable at an annual rate of 6·17% per year, with payments being made each month based on the opening balance at the start of that month. Credit sales for the year to the current date were $49,275,000 and cost of sales was $37,230,000. These levels of credit sales and cost of sales are expected to be maintained in the coming year. Assume that there are 365 working days in each year. Required: (a)     Discuss the working capital financing strategy of HGR Co.                              (7 marks) (b)     For HGR Co, calculate: (i)      the bank balance in three months’ time if no action is taken; and (ii)     the bank balance in three months’ time if the finance director’s proposals are implemented. Comment on the forecast cash flow position of HGR Co and recommend a suitable course of action.                                                                                                (10 marks) (c)     Discuss how risks arising from granting credit to foreign customers can be managed and reduced.                                                                                                               (8 marks) (Total 25 marks)

 

 

10.    Cash Management Model

10.1     Baumol Model

10.1.1  Similar to inventory levels and based on the EOQ.
10.1.2  Assumptions:

• Cash use is steady and predictable
• Cash inflows are known and regular
• Day-to-day cash needs are funded from current account
• Buffer cash is held in short-term investments

10.1.3  Formulate:

C0 = transaction costs (brokerage, commission, etc.)
D = demand for cash over the period
CH = cost of holding cash
10.1.4  Drawbacks of Baumol model:

• In reality, it is unlikely to be possible to predict amounts required over future periods with much certainty.
• No buffer inventory of cash is allowed for. There may be costs associated with running out of cash.
• There may be other normal costs of holding cash which increase with the average amount held.

10.1.5

Example 3

A company has a fixed cost of $40,000 to obtain new funds. There is a requirement for $240,000 cash over each period of one year for the foreseeable future. The interest cost of new funds is 12% per annum and the interest rate earned on short-term securities is 9% per annum. How much finance should the company raise each time that it raises new finance? Solution: The cost of holding cash is 12% – 9% = 3% The optimum level of reorder quantity = The optimum amount of new funds to raise is $800,000. This amount is raised every: $800,000 ÷ $240,000 = 3.33 years

10.1.6

Example 4

A company requires $480,000 of cash over each period of one year for the foreseeable future and is considering two alternatives: Option 1:    Taking up a bank loan of $480,000 at once for one year period at an interest rate of 12% per annum on the initial balance. Option 2:    Sale of existing securities which will incur a transaction fee of $1,000 based on the Baumol model (the return from the securities investment is currently at 15% per annum). Any fund/cash not in use will be placed in a call deposit at 9% per annum. Which of the two options is financially better to undertake? Solution:       Option 1 Option 2 Annual cash required $480,000 $480,000 Cash to be raised/cycle $480,000 Number of cycle/year 1 $480,000 ÷ $126,491 = 4 Total costs per annum under each option: Option 1 $ Option 2 $ Interest payable ($0.48m × 12%)   57,600 Ordering cost ($1,000 × 4)   4,000 Lost return on investment ($0.48m × 9%)   (21,600) Holding cost ($0.48 ÷ 2) × 15%   36,000     Return on investment ($126,491 ÷ 2) × 9%   (5,692) Total cost 36,000   34,308 Option 2 should be chosen, as its total cost is marginally lower than option 1.

Question 12 – Cash budget, overdrafts and Baumol cash model Thorne Co values, advertises and sells residential property on behalf of its customers. The company has been in business for only a short time and is preparing a cash budget for the first four months of 2006. Expected sales of residential properties are as follows.   2005 2006 2006 2006 2006 Month December January February March April Units sold 10 10 15 25 30 The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the value of each property sold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after sale. The company has nine employees who are paid on a monthly basis. The average salary per employee is £35,000 per year. If more than 20 properties are sold in a given month, each employee is paid in that month a bonus of £140 for each additional property sold. Variable expenses are incurred at the rate of 0·5% of the value of each property sold and these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are paid in the month in which they arise. Thorne Co pays interest every three months on a loan of £200,000 at a rate of 6% per year. The last interest payment in each year is paid in December. An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000. The cash balance at the start of January 2006 is expected to be a deficit of £40,000. Required: (a)     Prepare a monthly cash budget for the period from January to April 2006. Your budget must clearly indicate each item of income and expenditure, and the opening and closing monthly cash balances.                                                                                     (10 marks) (b)     Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecast by its cash budgets.                                                          (5 marks) (c)     Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cash shortages forecast by its cash budgets.                                        (5 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 to Thorne Co for this purpose.                                                           (5 marks) (25 marks)

10.2     Miller-Orr Cash Management Model

10.2.1  It takes account of uncertainty in relation to receipts and payment by setting upper and lower control limits on cash balance.

10.2.2  How it works?

• Lower limit (L) is set by management depending on how much risk of a cash shortfall the firm is willing to accept.
• The model sets higher and lower control limits, H and L, respectively, and a target cash balance, Z.
• When the cash balance reaches H, then (H – Z) dollars are transferred from cash to marketable securities, i.e. the firm buys (H – Z) dollars of securities.
• (c)       Similarly when the cash balance hits L, then (Z – L) dollars are transferred from marketable securities to cash.

10.2.3  Formula:

(a)       Return point = Lower limit + (1/3 × spread)
(b)       Spread =
Variance and interest rates should be expressed in daily terms.

 

Question 13 – Changes of credit policy, Miller-Orr Model, AR management and working capital funding policy Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%. Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay. Required: (a)     Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co.                                                                                                           (6 marks) (b)     Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 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 5.11%. Determine the spread, the upper limit and the return point for the cash account of Renpec 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) (Total 25 marks)

11.     Short-term Investment on Cash Surplus

11.1     Factors to be considered when planning ways to invest any cash surplus:

• Short-term cash surpluses should be invested with no risk of capital loss.
• Length of time the surplus is available for
• The size of the surplus (some instruments have minimum investment levels),
• The yield offered,
• The risk associated with each instrument, and
• Any penalties for early withdrawal.

11.2     Types of short-term investment:

• Deposit with a bank
• Short-term debt instruments, e.g certificates of deposit (CDs) and Treasury bills
• Longer term debt instruments, which can be sold on the market when the company needs cash
• Shares of listed companies

12.     Short-term Borrowing

12.1     Two main sources of bank lending:

• Bank overdraft
• Bank loan

12.2     Advantages and disadvantages of bank overdraft:

Advantages	Disadvantages
Flexible source of finance Only pay for what is used, so cheaper	Repayable on demand May require security, e.g. floating charges or personal guarantee Expose to the risk of an interest rates increase

 

Question 14 Discuss the advantages and disadvantages of using overdraft finance to fund any cash shortages forecast by the cash budgets.                                                                       (5 marks)

 

 

13.     Strategies for Funding Working Capital

13.1     Also named as follows:

• Working capital funding policy
• Working capital financing strategy

13.2     Working capital financing policies can be classified into conservative, moderate (or matching) and aggressive, depending on the extent to which fluctuating current assets and permanent current assets are financed by short-term sources of finance.
13.3     Permanent current assets represent the core level of working capital investment needed to support a given level of sales, for example:

• Buffer inventory
• Receivables during credit period
• Minimum cash balances

13.4     Fluctuating current assets represent the changes in working capital that arise in the normal course of business operations, for example:

• when some accounts receivable are settled later than expected, or
• when inventory moves more slowly than planned.

13.5     Matching principle suggests that long-term finance should be used for long-term assets. Under a matching working capital funding policy, therefore, long-term finance is used for both permanent current assets and non-current assets. Short-term finance is used to cover the short-term changes in current assets represented by fluctuating current assets.
13.6     A conservative working capital funding policy will use a higher proportion of long-term finance than a matching policy, thereby financing some of the fluctuating current assets from a long-term source. This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.
13.7     An aggressive working capital funding policy will use a lower proportion of long-term finance than a matching policy, financing some of the permanent current assets from a short-term source such as an overdraft. This will be more risky and more profitable than a matching policy.
13.8     Other factors that influence a working capital funding policy:

• management attitudes to risk – determine whether there is a preference for a conservative, an aggressive or a matching approach
• previous funding decisions – determine the current position being considered in policy formulation
• organisation size – influence its ability to access different sources of finance

13.9     A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to raise additional long-term finance, whether equity or debt.

Question 15 – Yield curve, financing and cash operating cycle Blin is a company listed on a European stock exchange, with a market capitalisation of €6m, which manufactures household cleaning chemicals. The company has expanded sales quite significantly over the last year and has been following an aggressive approach to working capital financing. As a result, Blin has come to rely heavily on overdraft finance for its short-term needs. On the advice of its finance director, the company intends to take out a long-term bank loan, part of which would be used to repay its overdraft. Required: (a)      Discuss the factors that will influence the rate of interest charged on the new bank loan, making reference in your answer to the yield curve.                                        (9 marks) (b)      Explain and discuss the approaches that Blin could adopt regarding the relative proportions of long- and short-term finance to meet its working capital needs, and comment on the proposed repayment of the overdraft.                                     (9 marks) (c)      Explain the meaning of the term ‘cash operating cycle’ and discuss its significance in determining the level of investment in working capital. Your answer should refer to the working capital needs of different business sectors.                                         (7 marks) (25 Marks)

Additional Examination Style Questions

Question 16 – Cash budget, JIT, financing and working capital management
Jack Geep will set up a new business as a sole trader on 1 January 2003 making decorative glassware. Jack is in the process of planning the initial cash flows of the business. He estimates that there will not be any sales demand in January 2003 so production in that month will be used to build up stocks to satisfy the expected demand in February 2003. Thereafter it is intended to schedule production in order to build up sufficient finished goods stock at the end of each month to satisfy demand during the following month. Production will, however, need to be 5% higher than sales due to expected defects that will have to be scrapped. Defects are only discovered after the goods have been completed. The company will not hold stocks of raw materials or work in progress.

As the business is new, demand is uncertain, but Jack has estimated three possible levels of demand in 2003 as follows:

	High demand	Medium demand	Low demand
	£	£	£
February	22,000	20,000	19,000
March	26,000	24,000	23,000
April	30,000	28,000	27,000
May	29,000	27,000	26,000
June	35,000	33,000	32,000

Demand for July 2003 onwards is expected to be the same as June 2003. The probability of each level of demand occurring each month is as follows:

High 0.05;

Medium 0.85;

Low 0.10.

It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making small purchases. The remaining 90% of sales will be made on two months’ credit. A 2·5% discount will, however, be offered to credit customers settling within one month. It is estimated that customers, representing half of credit sales by value, will take advantage of the discount while the remainder will take the full two months to pay.

Variable production costs (excluding costs of rejects) per £1,000 of sales are as follows:

 

	£
Labour	300
Materials	200
Variable overhead	100

Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears and variable overheads are paid two months in arrears. Fixed production and administration overheads, excluding depreciation, are £7,000 per month and are payable in the same month as the expenditure is incurred.

Jack employed a firm of consultants to give him initial business advice. Their fee of £12,000 will be paid in February 2003. Smelting machinery will be purchased on 1 January 2003 for £200,000 payable in February 2003. Further machinery will be purchased for £50,000 in March 2003 payable in April 2003. This machinery is highly specialized and will have a low net realisable value after purchase.

Jack has redundancy money from his previous employment and savings totalling £150,000, which he intends to pay into his bank account on 1 January 2003 as the initial capital of the business. He realises that this will be insufficient for his business plans, so he is intending to approach his bank for finance in the form of both a fixed term loan and an overdraft. The only asset Jack has is his house that is valued at £200,000, but he has an outstanding mortgage of £80,000 on this property.

The consultants advising Jack have recommended that rather than accumulating sufficient stock to satisfy the following month’s demand he should not maintain any stock levels but merely produce sufficient in each month to meet the expected demand for that month.

Jack’s production manager objected: ‘I need to set up my production schedule based on the expected average demand for the month. I will reduce production in the month if it seems demand is low. However, there is no way production can be increased during the month to accommodate demand if it happens to be at the higher level that month. As a result, under this new system, there would be no stocks to fall back on and the extra sales, when monthly demand is high, would be lost, as customers require immediate delivery.’ In respect of this, an assessment of the impact of the introduction of just-in-time stock management on cash flows has been made that showed the following:

Required:

(a)     Prepare a monthly cash budget for Jack Geep’s business for the six month period ending 30 June 2003. Calculations should be made on the basis of the expected values of sales. The cash budget should show the net cash inflow or outflow in each month and the cumulative cash surplus or deficit at the end of each month. For this purpose ignore bank finance and the suggested use of just-in-time stock management.                                                                                                                            (17 marks)
(b)     Assume now that just-in-time stock management is used in accordance with the recommendations of the consultants. Calculate for EACH of the six months ending 30 June 2003:
(i)      receipts from sales; and
(ii)     payments to labour.                                                                                      (6 marks)
(c)     Evaluate the impact for Jack Geep of introducing just-in-time stock management. This should include an assessment of the wider implications of just-in-time stock management in the particular circumstances of Jack Geep’s business.                                                                                         (10 marks)
(d)     Write a report to Jack Geep which identifies the financing needs of the company. It should consider the following:
(i)      the extent of financing required;
(ii)     the factors that should be considered in determining the most appropriate mix of short-term financing (e.g. overdraft) and long-term financing (e.g. fixed term bank loan); and
(iii)    the extent to which improved working capital management (other than just-in-time stock management) might reduce the company’s financing needs and describe how this might be achieved. Where appropriate, show supporting calculations.
(17 marks)
(50 marks)

 

Question 17 – Overtrading, factoring and lease or buy
At a recent meeting of the Board of Doe Ltd, a supplier of industrial and commercial clothing, it was suggested that the company might be suffering liquidity problems as a result of overtrading, despite encouraging growth in turnover. The Finance Director was instructed to report to the next Board meeting on this matter.

Extracts from the financial statements of Doe Ltd for 2002, and from the forecast financial statements for 2003, are given below.

Income statement extracts for years ending 31 December

Statement of financial position extracts as at 31 December

The Finance Director had reported to the recent board meeting that the bank was insisting the company reduce its overdraft as a matter of urgency. It was suggested that the company could consider factor finance as an alternative source of funds for working capital investment. The Production Director insisted that a new machine would be needed to maintain growth in turnover and the Finance Director agreed to investigate how this might be financed.

Factoring
The Finance Director has found a factor who would take over administration of the company’s debtors on a non-recourse basis for an annual fee of 1·0% of turnover. The factor would advance 80% of the book value of debtors at an annual interest rate 2% above the company’s current overdraft rate. The factor expects to reduce the average debtor period to 90 days. The company estimates that Doe Ltd could save £15,000 per year in administration costs. No redundancy costs are expected.

The New Machine
The new machine wanted by the Production Director would cost £365,000 if purchased. The Finance Director is confident this purchase could be financed by a medium-term bank loan at an annual interest cost of 10% before tax.

Alternatively, the machine could be leased for £77,250 per annum, payable annually in advance. The machine has an expected life of five years, at the end of which it would have zero scrap value.

Sales and Costs of New Machine Output
The Finance Director has commissioned research that shows growth in sales of the output produced by the new machine depends on the sales price, as follows:

Variable costs of production are £42 per unit and incremental fixed production overheads arising from the use of the machine are expected to be £85,000 per annum. The maximum capacity of the new machine is 20,000 units per annum.

Other Information
Doe Ltd pays tax one year in arrears at a rate of 30% and can claim annual writing down allowances (tax-allowable depreciation) on a 25% reducing balance basis. The company pays interest on its overdraft at approximately 6% per annum before tax.

Average ratios for the business sector in which Doe Ltd operates are as follows:

Stock days	210 days	Current ratio	1.35
Debtor days	100 days	Quick ratio	0.55
Creditor days	120 days

Required:
(a)     Write a report to the board of Doe Ltd that analyses and discusses the suggestion that the company is overtrading.                                                                                                         (12 marks)
(b)     (i)      Determine whether Doe Ltd should accept the factor’s offer.                     (7 marks)
(ii)     What are the advantages to Doe Ltd of factoring its debtors?                    (8 marks)
(c)     Discuss three ways (other than factoring) by which Doe Ltd might improve the management of its debtors.                                                                                                                              (8 marks)
(d)     Evaluate whether Doe Ltd should buy or lease the new machine, using an after tax discount rate of 7%. (Assume that payment for the purchase, or the first lease payment, would take place on 1 January 2004.)                                                                                                                              (9 marks)
(e)     Calculate the optimum sales price for the output from the new machine. (Taxation and the time value of money should be ignored.)                                                                                   (6 marks)
(50 marks)

Question 18 – Key Factors for the level of investment in current assets, calculation of OD, Factoring, invoicing discounting and EOQ
FLG 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 rate 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 FLG Co                           1·4
Cost of long-term finance of FLG 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 FLG Co, the net working capital of the company and the total cost of financing its current assets.                                                                              (6 marks)
(d)     FLG Co wishes to minimise its inventory costs. Annual demand for a 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 discount of 1% for orders of 10,000 units or more. If 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 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 raw material.                                                                    (3 marks)
(Total 25 marks)