UNIT 7 - MANAGING WORKING CAPITAL

 THE NATURE AND PURPOSE OF WORKING CAPITAL

•       Usually defined as current assets less current liabilities

•       The main elements of current assets are:

-       Inventory

-       Accounts receivable (trade debtors)

-       Cash (in hand and at bank)

•       The main elements of current liabilities are:

-       Accounts payable (trade creditors)

-       Bank overdrafts

•       Represents a net investment in short-term assets

•       The management of working capital is an essential part of the short-term planning process

•       There are costs incurred by holding too much and too little of each element

•       Costs include opportunity cost of using these elements elsewhere

•       Needs are likely to change over time

•       Change may be externally driven or result from changes to the internal environment

STOCK / INVENTORY MANAGEMENT MODELS:

ECONOMIC ORDER QUANTITY (EOQ):

•       Recognises that total cost includes holding and ordering costs

•       Calculates the optimum size of the order, taking these two components into account

•       Decreasing inventory held means an increase in order costs as the number of orders rises in the period

•       EOQ seeks to identify the size of the order that will minimise the total costs

SOME LIMITING ASSUMPTIONS APPLY TO THE MODEL:

•       That demand for the product can be predicted with accuracy

•       Demand is even over the period with no fluctuations

•       No ‘buffer’ inventory is required

•       There are no discounts for bulk purchasing        

 MATERIALS REQUIREMENTS PLANNING (MRP) SYSTEMS:

•       Begins with forecasting sales demand

•       Technology schedules delivery of bought-in parts to coincide with production requirements

•       By ordering those items of inventory necessary for production, inventory holding costs may be reduced

•       Recognises that ordering decisions cannot be made independent of production decisions

•       Newer systems also take account of other resources such as labour and machine capacity

JUST-IN-TIME (JIT) STOCK / INVENTORY MANAGEMENT:

•       Aims to have materials delivered to production ‘just in time’ for their required use

•       Limits holding time and investment in raw materials

•       Suppliers are informed of production requirements in advance

 SOME DISADVANTAGES:

•       May mean inventory is more expensive

•       Risk of non-supply

 THE MANAGEMENT OF DEBTORS

•       Selling goods or services on credit incurs costs

•       Costs include administration, bad debts and opportunity costs

•       When a business offers to sell on credit, it must have clear policy concerning:

•       Which customers should receive credit

•       How much credit should be offered

•       What length of credit it is prepared to offer

•       Whether discounts will be offered for prompt payment

•       What collection policies should be adopted

•       How the risk of non-payment can be reduced

 Which customers should receive credit?

The ‘five Cs’ of credit:

1.     CAPITAL - must appear to be financially sound (liquidity risk) before credit is offered

2.     CAPACITY - must seem able to pay amounts owing (examine payment record / history)

3.     COLLATERAL - can the customer offer satisfactory security if required

4.     CONDITIONS - how the industry and general economic environment the customer operates in affects their ability to pay amounts owing

5.     CHARACTER - a subjective assessment made by the business of factors such as honesty, integrity etc.

 LENGTH OF CREDIT PERIOD:

            The length of credit offered varies and may be influenced by factors such as:

•       The typical credit terms operating in the industry

•       The degree of competition in the industry

•       The bargaining power of particular customers

•       The risk of non-payment

•       The capacity of the business to offer credit

•       The marketing strategy of the business

•       An alternative approach is to view the credit decision as a capital investment decision, using the NPV investment appraisal method

 CASH DISCOUNTS (EARLY SETTLEMENT):

•       The cost must be weighed against the benefits

•       Danger that customers will be slow to pay and still take the discount offered

•       The benefit represents a reduction in the cost of financing debtors and bad debts

COLLECTION POLICIES:

Steps to ensure amounts owing are paid promptly may include:

•       Develop customer relationships

•       Publicise credit terms

•       Issue invoices promptly

•       Monitor outstanding debts

•       Produce a schedule of aged debtors (refer example below)

•       Answer queries quickly

•       Deal with slow payers

•       Identify the monthly pattern of receipts from credit sales