WorkingCapital

Introductiontothe
Managementof
WorkingCapital
AS&A2BusinessStudies
PowerPointPresentations2005
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Introduction
Allbusinessesneedcashtosurvive
Cashisneededto:
Investinfixedassets
Paysuppliersandemployees
Fundoverheadsandotherfixedcosts
PaytaxduetotheGovernment
Nearlyallbusinessesusemuchoftheircashresources
tofinanceinvestmentinworkingcapital
Managingworkingcapitaleffectivelyis,therefore,a
vitalpartofmakingsurethebusinesshasenoughcash
tocontinue
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WhatisWorkingCapital?
Workingcapitalisthedifference
betweenthecurrentassetsofa
businessanditscurrentliabilities
Workingcapitalisthecashneededto
payforthedaytodayoperationofthe
business
WhatisWorkingCapital?
HowisItCalculated?
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DefinitionofWorkingCapital
Current
Assets
Less
Current
Liabilities
Assetsofthebusiness
heldincashform(e.g.
atthebank)orthatthat
canquicklybeturned
intocash
Moneyowedbya
businesswhichwill
needtobepaidinthe
next12months
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DefinitionofWorkingCapital
Current
Assets
Less
Current
Liabilities
Stocks
Debtors
Cash
Investments
TradeCreditors
Taxation
Dividends
ShorttermLoans
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CalculatingWorkingCapitalExample
Current
Assets
Less
Current
Liabilities
Stocks
TradeDebtors
Cash
Prepayments
TradeCreditors
Taxation
Dividends
ShorttermLoans
250,000
500,000
125,000
25,000
350,000
100,000
50,000
150,000
900,000
650,000
250,000
WorkingCapital=
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TheWorkingCapitalCycle
Notallbusinesseshavethesameneedtoinvestin
workingcapital
Muchdependson
(1)Thenatureoftheproductionprocess(i.e.whatandhowsomething
isbeingproduced),and
(2)Thewayinwhichtheproductisdistributedtocustomers
Theworkingcapitalcycleis:
Theperiodoftimebetweenthepointatwhichcashisfirstspenton
theproductionofaproductandthefinalcollectionofcashfroma
customer
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WorkingCapitalCycleIllustrated
RawMaterialsorderedfrom
suppliersandputintostock
awaitingproduction.Cash
isuseduptofinancestocks
(bypayingthesuppliers)
Morecashisusedtofinance
theproductionprocess
employstaff,runthefactory
andothersupportoperations
Morecashisuseduptostore
finishedproductsanddistribute
themtotheintendedmarkets.
Tradecustomersareallowedto
buynowandpaylaterso
debtorsincrease
Finallytheproductstartsto
generatecashas
customerspaytheamounts
theyowe.Thenthewhole
processstartsagain
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WorkingCapitalRatios(liquidity)
Theliquiditypositionofabusinessreferstoitsability
topayitsdebtsi.e.doesithaveenoughcashtopay
thebills?
Thebalancesheetofabusinessprovidesasnapshot
oftheworkingcapitalpositionataparticularpointin
time
Therearetwokeyratiosthatcanbecalculatedto
provideaguidetotheliquiditypositionofabusiness
Currentratio
Acidtest(quick)ratio
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CurrentRatio
Calculation
Formula
CurrentAssets
CurrentLiabilities
ExampleCalculation
3,525 CurrentAssets
650 Cashbalances
1,750 Tradedebtors
1,260 CurrentLiabilities
235 Othershorttermliabilities
1,025 TradeCreditors
1,125 Stocks
000
3,525
1,260
2.8 =
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AcidTest(Quick)Ratio
Calculation
Formula
CurrentAssets(lessStocks)
CurrentLiabilities
ExampleCalculation
3,525 CurrentAssets
650 Cashbalances
1,750 Tradedebtors
1,260 CurrentLiabilities
235 Othershorttermliabilities
1,025 TradeCreditors
1,125 Stocks
000
1,260
1.9 =
2,400
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InterpretingtheRatios
Abusinessneedstohaveenoughcash(orcashtocome)tobe
abletopayitsdebts
Obviously,acurrentratiocomfortablyinexcessof1shouldbe
expectedbutwhatiscomfortabledependsonthekindof
business
Somebusinessesfindithardtoturnstockanddebtorsintocash
soneedahighcurrentratio
Somebusinesses(e.g.supermarkets)turnstockintocashvery
rapidlyandhavelowdebtorssotheycanhappilyexistwitha
currentratiooflessthan1
Theacidtestratioisoftenconsideredtobeabettertestofliquidity
forbusinesseswithalowstockturnover
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LimitationsofLiquidityRatios
Liquidityratiosshouldbeusedwithcare
Balancesheetvaluesataparticularmomentintime
maynotbetypical
Balancesusedforaseasonalbusinesswillnot
representaveragevalues
Ratioscanbesubjecttowindowdressingor
manipulation(e.g.abigpushtogetcustomerstopay
outstandingbalancesbytheyearend
Ratiosconcernthepast(historic)notthefuture
Workingcapitalmanagementisverymuchabout
ensuringthebusinesshassufficientcashinthefuture
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DangerofOvertrading
Overtradinghappenswhena
businesstriestodotoomuch,too
quicklywithtoolittlelongterm
capital
Warning:aprofitablebusinesscan
failifitrunsoutofcash
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OvertradingIntroduction
Overtradingrepresentsanimbalancebetweenthe
ordersabusinessacceptsandthemeansithastofulfill
them
Overtradinghappenswhenabusinesstakeson
customerorders,butdoesnothaveenoughcurrent
assets,orworkingcapital,tomeetthesedemands
Overtradingisparticularlycommoninyoung,rapidly
expandingbusinesses.Itcanbeextremelyserious,
evenfataltothebusiness
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HowdoesOvertradingHappen?
Thelengthoftheworkingcapitalcyclegetslonger
E.g.tradedebtorsstarttakinglongertopaytheirdebts
E.g.stocksareorderedearlierandneedtobepaidforbeforethey
aresold
E.g.suppliersinsistonbeingpaidearlier
Businessturnover/outputincreases
E.g.morestockisrequired(rawmaterials,greatervalueofworkin
progress)
E.g.thevalueoftradedebtorsgrowsinlinewithhighersales
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SymptomsofOvertrading
Rapidincreaseinsales/turnover
Rapidincreaseinthevalueandvolumeofcurrent
assets(e.g.increaseinstocks)
Reductioninstockturnoverandincreaseinaverage
timetakenbydebtorstopayinvoices
Onlyasmallincreaseinownerscapitalwithmostof
theadditionalfinancecomingfromhighertrade
creditors(borrowingfromsuppliers)andthebank
Significantfallinkeyliquidityratios(currentratio/
quickratio)
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OtherSourcesofLiquidityProblems
Internalcauses
Poormanagementofoperations(e.g.allowingtoomuchstocktobe
boughtandstockpiled)
Productionproblems(e.g.equipmentfailuredelayingtheprocessing
ofrawmaterialsintofinishedgoods,orpoorqualitystandards)
Poormarketingdecisions(e.g.allowingcustomersunsuitablylong
credittermsfailureofpromotionalcampaignsleavingthebusiness
withunexpectedlyhighstocks)
Externalcauses
Economic:e.g.unexpectedlylowerdemandduetofallingcustomer
confidenceorchangeinexchangerates
Financialfailure:e.g.tradedebtorsgoingoutofbusinessleaving
theirdebtsunpaid
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WaystoImproveLiquidity
Anothergoodwayofreleasingcashfromfixedassetsbut
leavesthebusinesswithhighercostsandpaymentobligations
Saleandleasebackofassets
Agoodwaytoobtaincashquicklybutusuallycostly(e.g.
factoringfirmchargesahighcommissionondebtspaid)
Useinvoicediscountingordebtfactoring
toobtaincashfromtradedebtors
Adangerousoptionsuppliersmayrefusetosupplyormay
chargeinterestiftheirpaymenttermsareexceeded
Extendthetimetakentopaycreditors
Mayupsetcustomersorcausethemtoreducetheamount
theybuy
Reducethecreditperiodofferedtotrade
debtorsandchaseamountsduemore
aggressively
Costlytoreorganiseproductionbutmaybeworthitinthe
mediumterm
Improvetheefficiencyoftheproduction
process(e.g.shortenbyusingbetter
productionmethods)
Mayresultinproductiondelaysorshortagesifdemand
increasesunexpectedly
Reducethestockholdingperiodfor
finishedgoodsandrawmaterials
Pitfalls Option
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KeyTerms
Whenabusinesstakesontoomanyobligationswithouthavingthefinancetopayforthem Overtrading
Anotherliquidityratiobettersuitedtoassessbusinessesthathavealowstockturnover Acidtestratio
Measureofliquiditybasedondatafromthebalancesheet.Calculatedascurrentassets
dividedbycurrentliabilities
Currentratio
Theabilityofabusinesstopaywhatitowesasthoseamountsbecomedue.Abusiness
thatdoesnothaveenoughcashisdescribedasilliquid
Liquidity
Moneyowedbyabusinesswhichwillneedtobepaidinthenext12months Currentliabilities
Assetsofthebusinessheldincashform(e.g.atthebank)orthatthatcanquicklybe
turnedintocash
Currentassets
Theperiodoftimebetweenthepointatwhichcashisfirstspentontheproductionofa
productandthefinalcollectionofcashfromacustomer
Workingcapital
cycle
Fundsrequiredbythebusinesstopayforthedaytodayoperationofthebusiness Workingcapital