Working Capital Management (1)

1 Introduction

The purpose of this chapter is to explain the nature of working capital and the importance of it to the financial manager. We will also consider various ratios and measures which may be useful to the financial manager in assessing how well working capital is being controlled.

2 What is working capital?

Working capital is the name given to net current assets which are available for day-to-day operating activities.

It normally includes inventories, receivables, cash (and cash equivalents), less payables.

Working capital = receivables + cash + inventory – payables

Think of working capital as operating in a cycle: goods are bought by a business (but usually not paid for immediately), the goods are stored in inventory, they are sold (but often on credit, not for cash), suppliers are paid then money is received from customers....and the cycle is repeated.

3 Investment in working capital

Working capital needs financing, just as does the investment in machines.

However, it is the investment in non-current assets such as machinery that (hopefully!) earns profits for the company. Investment in working capital does not directly earn profits.

If this were the only consideration, then it would be better to invest all the finance available in non-current assets and to keep working capital to an absolute minimum.

On the other hand, all companies need some working capital in order to keep the business running

• they need to allow customers to buy on credit (and therefore have receivables) otherwise they would lose business to competitors.
  

• they need to carry inventories of finished goods in order to be able to fulfil demand
  

• they need to have a short-term cash balance in order to be able to pay their bills.
  

The company therefore faces a trade-off between profitability and liquidity, and it is up to the financial manager to decide on the optimal level of working capital and to ensure that it is managed properly.

4 The financing of working capital

Whatever level of working capital the business decides to hold, it has to be financed from somewhere.

The business must decide whether to use short-term or long-term finance.

Long-term finance is either raised from equity in the form of share issues etc., or from long-term borrowing.

Short-term finance generally involves overdraft borrowing and/or delaying payment to payables.

Short-term finance is often cheaper (although not always – interest rates on overdrafts can be very high, and delaying payment to payables can involve the loss of discounts).

However, short-term finance is risky as it is repayable on demand.

In the past it was generally thought that since working capital involved short-term assets it should be financed by short-term finance, whereas non-current assets – being long-term – should be financed by long-term finance.

A more modern view is that in fact the overall level of working capital remains fixed in the long-term (permanent working capital) and that there are day-to-day fluctuations above this permanent level (temporary working capital).

Permanent working capital, being long-term, should be financed by long-term sources of finance.

Temporary working capital (for example, if a shop is increasing its inventory in preparation for a holiday period) should be financed by short-term sources of finance.

5 Working capital ratios

5.1 Liquidity ratios:

We would normally expect this to be > 1.

A current ratio of less than 1 could indicate liquidity problems. For example, it will be difficult to keep suppliers who are owed $10,000 happy if the business has only $1,000 in the bank or coming in from customers

The same idea as the current ratio, but without inventory on the basis that it is inventory that will take the longest time to turn into cash.

Clearly the Quick Ratio will be lower than (or equal to!) the Current Ratio, and a Quick Ratio of slightly less than 1 is not necessarily dangerous – it very much depends on the type of business.

5.2 Efficiency ratios:

  This shows how quickly inventory is being sold

  This shows how quickly debts are being collected

  This shows how quickly payables are being paid

These ratios can be 'turned around' to show the number of days of receivables, payables and inventory.

  This shows how many days' supply of inventory there is.

  This shows how many days of credit customers are taking on average.

  This shows how long it takes us to pay suppliers on average.

Problems with the use of ratios:

1. The use of statement of financial position is dangerous in that they represent only one point in time which may be unusual (due to, for example, seasonal factors)
   

2. There may be window-dressing
   

3. They only look at the past – not the future
   

4. They are of little value unless used in comparisons.
   

Note that if opening balances are not available, instead of using average amounts year-end balances are used.

5.3 Inventory and sales

• Inventory rising faster than sales can indicate slow-moving goods or overstocking: storage costs and cash tied up increase. Falling inventory relative to sales may mean better control, or a stock-out risk.

• A planned build-up before seasonal sales can be sensible. Compare like seasons and calculate inventory days/turnover before concluding that inventory is excessive.

6 The Operating Cycle

The operating cycle (or cash operating cycle or working capital cycle) of a business is the length of time between the payment for materials entering into inventory and the receipt of the proceeds of sales.

Purchases are made, goods stay in inventory for some time, sales are made and eventually credit customers pay us. At some point we have to pay our suppliers for our purchases. So, if we have to pay suppliers quickly but it takes some time for goods to sell and for customers to pay us then we will have to find additional cash for the working capital. If, however, our customers pay cash and our inventory sells quickly, then we might not have to pay suppliers until after we have received money for our sales. Financing working capital will then be much easier.

The working capital cycle length is:

Receivables days + Inventory days - Payables days

It is useful to compare the operating cycle of a company from year to year, or with similar companies – a lengthening operating cycle will normally be cause for concern.

Note that different business sectors can have very different working capital cycle lengths. For example, supermarkets receive almost instant payment from customers, hold inventory for only a short time yet take weeks to pay suppliers. Their working capital cycle length will be short. Engineering and building firms can, however, have very large amounts of inventory and might have to wait some time for payment. Their working capital cycle length will be long.

7 Over-capitalisation and over-trading

Over-capitalisation is where the overall level of working capital is too high.

For example, too much inventory or cash are being held. Although this will tend to mean that the business can always easily supply customers and has lots of cash for emergencies, there are risks. Inventory can go out of fashion or deteriorate so that sales become difficult. Cash sitting needlessly in a bank account is wasteful and better use could probably be made of it eg by updating machinery to make the business more efficient. 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 non-current assets.

Over-trading (or under-capitalisation) is where the level of working capital is too low.

7.1 Recognising over-trading and over-capitalisation

Use trends together: rapid sales growth with longer inventory/receivables days, stretched payables and a growing overdraft can indicate over-trading. High liquidity ratios with low sales relative to working capital can indicate over-capitalisation.

• Here sales grow by 50%, but working capital halves and liquidity ratios weaken: growth may be outrunning finance. Check collection times, inventory quality and the cash forecast. Ratios alone do not prove the cause.

• For comparison, $400,000 sales with current assets $300,000, inventory $40,000 and current liabilities $80,000 gives working capital $220,000, current ratio 3.75, quick ratio 3.25 and sales/working capital 1.82 times. High liquidity but low turnover of working capital may signal over-capitalisation: investigate idle resources.

8 Chapter 1 questions

Question 2

What is the working capital cycle length of a company with the following data?

Debt collection period 45 days; supplier payment period 35 days; inventory holding 23 days.

Question 3

An excerpt from a company's financial statements shows the following:

What are the following measures?

A   Quick ratio

B   Current ratio

C   Receivables collection period in days