CHAPTER 14

WORKING-CAPITAL MANAGEMENT
LECTURER: PROF O.A. ONI
Chapter outline
• Introduction
• What is working capital?
• Why is it important to manage working capital?
• The cash conversion cycle
• Managing cash
• Managing inventory
• Managing accounts receivable (debtors)
• Managing accounts payable (creditors)
• Conclusion
Learning outcomes

By the end of this chapter, you should be able to:

• Explain working capital
• Calculate and interpret the cash conversion cycle
• Prepare a cash budget and comment on it
• Calculate measures to manage inventory
• Explain what a credit policy is
• Calculate the effect of a change in credit policy
• Evaluate whether a discount for early payment of debt
should be accepted or not.
Introduction

• Three financial management decisions

 Capital budgeting
 Capital structure
 Working-capital management
• Short-term capital management
 Management of short-term assets and liabilities
 All assets to be sold or liabilities paid in 12 month
period
 Entity needs to establish and maintain optimal level
of short-term capital to result in highest possible
level of profitability while reducing risk
What is working capital?
• Short-term assets and liabilities that a
business uses to conduct its day-to-day
operations
• Assets and liabilities are continually
transformed
• Management of these assets and liabilities
called short-term capital management
Current assets and liabilities

• Short-term assets (current assets):

 Cash
 Accounts receivable (debtors)
 Inventory
• Short-term liabilities (current liabilities):
 Accounts payable (creditors)
Examples of current assets and
current liabilities
Current assets Current liabilities
Cash and cash equivalents Creditors/accounts payable
Inventory Short-term portion of a long-
term loan
Short-term investments Short-term loans
(overdrafts)
Debtors/accounts Income received in advance
receivable
Prepaid expenses Accrued expenses
Accrued income Dividends payable
Notes receivable Tax payable
Net working capital
• Difference between total current assets and
total current liabilities
• Positive value shows entity has more current
assets than current liabilities – company is able
to pay back its current liabilities as they become
due
 Too low a level of working capital means entity
cannot pay current liabilities
 Too high a level of working capital means cash is tied
up in debtors and inventory instead of being
available for cash
Why is it important to manage
working capital?
• Profits and shareholder wealth maximisation is
only possible if a business is able to conduct its
day-to-day operations successfully
• To operate on a daily basis, working capital
needs to be available and ready for use
 A shortage of working capital means that the level of
customer service can be affected negatively e.g.
inventory shortages
 An oversupply of working capital can also have a
negative effect e.g. spoilage
Why is it important to manage
working capital?
• Elements of working capital needed to conduct
daily business
 Inventory – ready for manufacturing or resale
 Cash – to pay creditors and expenses
 Debtors – customers can purchase on credit which is
convenient for them
 Creditors – entity can purchase on credit which is
convenient
Liquidity

• Ability of an entity to pay its short-term liabilities

• Evaluated by means of current ratio
• Fine balance to be maintained to ensure:
 Expenses and liabilities paid
 Investment in current assets is not too high
• Risks include fraud and theft
The elements of the cash
conversion cycle
• Cash conversion cycle (CCC) way to assess
business’s liquidity
• CCC calculated from inventory, accounts
receivable (debtor) and accounts payable
(creditor) figures
• Result is the number of days that cash is
invested in assets other than cash
• Important because while cash is invested in
other assets it is not available for day-to-day
activities and transactions
Calculating the CCC

• Combined total of the following:

 Average age of inventory
 Average collection period
 Average payment period

• Formula: CCC = AAI+ACP-APP

Where:
AAI = Average age of inventory
ACP = Average collection period
APP = Average payment period
Operating cycle and cash
conversion cycle

Purchase Sell Collect

inventory 20 days inventory 30 days debtors

Pay
creditors 40 days
Example 14.2

RET Ltd has an inventory turnover of 5, an

average collection period of 35 days and an
average payment period of 60 days. You are
required to calculate the cash conversion cycle
(CCC) and the investment in the CCC.
Credit sales are on average R2 500 000 per year
and cost of sales are 70% of sales. Assume that
there is no opening or closing balances for
inventory, debtors or creditors and that there are
365 days per year.
An inventory turnover of 5 means inventory is
used up 5 times per financial period.
Example 14.2

• The average age of inventory is:

AAI = 365/5 = 73 days
 Inventory needs to be replenished every 73 days

• Possible to calculate:
CCC = 73+35-60 = 48 days
 In other words, RET Ltd has to wait average 48 days
from when inventory is purchased on credit to
receive the cash from debtors
Example 14.2

Based on average sales, the investment in the

CCC can be calculated as follows:

Inventory = 73/365 x (R2 500 000 x 0.70) = R350 000

+Debtors = 35/365 x (R2 500 000) = R239 726
-Creditors = 60/365 x (R2 500 000 x 0.70)= R287 671

The total amount of resources invested are:

R302 055
Example 14.2

• If only the average sales figure is available an

approximate investment in the CCC can be
calculated:

• Approximate investment in the CCC:

R2 500 000 x 48/365 = R328 767

• Different from answer on previous slide, but still

gives an idea of the investment of resources
and the availability of cash
Managing cash

• Business needs cash for transactions

 Giving customers change
 Buying supplies
 Paying creditors
 Paying other expenses
 Cash for contingencies
Cash budgeting

• Cash is most liquid of all current assets

 Cash inflow
 Cash outflow
• Careful planning to ensure sufficient cash on
hand for daily transactions and operations
• Cash budget prepared before a financial period
• Based on estimated figures rather than actual
amounts – company can plan its expenditure
and avoid cash deficit
Cash budgeting

• Cash inflows – all the cash expected to come

into a company
 Cash sales
 Receipts from debtors
 Interest received
• Cash outflows – all the cash expected to go out
a company
 Purchases of inventory
 Salaries and wages
 Purchases of assets
Cash budgeting

• From the cash budget it is possible to see if a

company will end a given period with a cash
surplus or a cash deficit
 Cash surplus results from spending less cash than is
available
 Cash deficit results from spending more cash than is
available
Example 14.3

Retail Ltd is a company that supplies a variety of

grocery items in bulk to small supermarkets. The
accountant of the company has prepared
estimations for three months following April.

Feb Mar Apr May Jun Jul

Sales 1 100’ 1 200’ 1 400’ 1 500’ 1 250’ 1 300’
Purchases 500’ 600’ 850’ 800’ 750’ 900’
Example 14.3
•The cash balance of the company on 30 April is
R11 500. It is company policy to keep a
minimum cash balance of R10 000.
•50% of all sales are cash. Credit sales are
collected as follows:
20% in the month of sale
60% in the month following sale
10% in the second month after sale
the remainder is expected to be uncollectible
Example 14.3
• All purchases are on credit and paid for in the
month after purchase
• Water and electricity of R15 600 in May,
expected to increase with 10% per month as
winter approaches
• Salaries and wages are expected to be
R150 000 per month
• Warehouse rent amounts to R7 000 per month
and is not expected to change in the
foreseeable future
Example 14.3
• Office expenses (all cash) are expected to cost
approximately R12 000 per month
• Depreciation is written off using the straight-line
method, R5 000 per month
• A new delivery vehicle of R520 000 will be
purchased in June
• An extension of R200 000 will be built in June to
enlarge the current warehouse
• Interest of R2 500 on an investment will be
received in July
Example 14.3
The expected cash collections from debtors:

May Jun Jul

Total sales (given) 1200’ 1400’ 1 500’ 1 250’ 1 300’
Credit sales (50%) 600’ 700’ 750’ 625’ 650’
Collected in month
of sale (20%) 120’ 140’ 150’ 125’ 130’
Collected one month
after sale (60%) 360’ 420’ 450’ 375’
Collected two months
after sale (10%) 60’ 70’ 75’
630’ 645’ 580’
May June July
Opening balance 11 500 356 900 10 000
Total receipts 1 380 000 1 270 000 1 232 500
Cash sales 750 000 625 000 650 000
Receipts from debtors 630 000 645 000 580 000
Interest 2 500
Total payments 1 034 600 1 706 160 937 876
Creditor payments 850 000 800 000 750 000
Water and electricity 15 600 17 160 18 876
Salaries and wages 150 000 150 000 150 000
Warehouse rent 7 000 7 000 7 000
Office expenses 12 000 12 000 12 000
Vehicle purchase 520 000
Building extension 200 000

Net cash flow 356 900 ( 79 260) 304 624

Minimum closing balance 10 000 10 000 10 000
Cash surplus/(deficit) 346 900 ( 89 260) 294 624
Example 14.3

• It is clear from the cash budget that the company

in the example will experience cash flow problems
in June if they continue to operate according to
their original plan and estimates.
• The example illustrates how useful a cash budget
can be for planning purposes by showing in which
month problems in cash flow may arise and gives
the company the opportunity to make adjusting
changes beforehand to avoid a deficit from arising
or arrange for short-term credit such as a bank
overdraft.
Managing inventory
• Inventory management is important for a
number of reasons:
• Too little
 It can be harmful to the image of a company if they
do not have enough goods to sell to customers
• Too much
 Perishable inventory items can spoil
 All types of inventory can be destroyed in a disaster
 Where there is a lot of development, like technology,
inventory can become obsolete so that customers
won’t want to buy it anymore
Managing inventory
• Inventory causes a number of different costs to
a company:
• Carrying costs
 Costs that a company incurs to keep inventory, like
storage and insurance. The more inventories a
company holds, the higher this cost will be
• Ordering costs
 Costs of placing and receiving an order for inventory,
for example, clerical costs, handling and transport
• Cost of not carrying enough inventory
 Opportunity cost that occurs when a customer
cannot be helped due to a lack of inventory. The lost
sale is then a cost to the company
Methods to manage inventory
• The Economic Order Quantity (EOQ) can be
used to evaluate the best quantity of inventory
to purchase at a time that will reduce the costs
of inventory
• The EOQ calculates the optimal number of units
of inventory that needs to be ordered so that
costs are kept to a minimum
Methods to manage inventory

• The EOQ is calculated by using the following

formula:

Where:
O = Cost of placing an order
D = Annual demand
C = Annual cost of carrying one unit
Methods to manage inventory

• Another useful concept that helps to ensure a company

has the right amount of inventory at the right time is the
reorder point
• It is calculated by using the following equation:

Reorder point = lead time x daily usage

Example 14.4

• The logistics manager of Manufacture Ltd

provides the following information:
 The company uses 15 000 units of Ingredient X in the
product they manufacture
 The cost to place an order for Ingredient X is R150
per order. Storage and insurance costs amount to
R19 per unit
 The lead time for delivery of an order is 5 days
 Assume the factory operates for 240 days per year

• Calculate the EOQ and the reorder point.

Example 14.4
Example 14.4
Accounts receivable management

• Debtors not as liquid as cash – company has to

wait before they receive the cash
• Debtors more liquid than inventory, because
having a debtor means that the inventory has
already been sold
• Debtors need to be managed – too many
debtors cause company to not have enough
cash to meet short-term commitments
• Bad debt is when a debtor cannot pay his debt
• Bad debt is written off as an expense, so it
needs to be avoided as far as possible
Accounts receivable management

•Debtors can be monitored by a debtors’ age

analysis
•It helps to see how much debt is outstanding and
for how long debt has been outstanding
•Example of an age analysis:

0 – 10 days R 82,967.00 24%

11 – 30 days R 154,175.00 44%
31 – 60 days R 66,375.00 19%
61 – 90 days R 31,809.00 9%
91 + days R 11,646.00 3%
Total R 346,972.00 100%
Establishing a credit policy

• To avoid too much cash invested in debtors and

increased bad debt, most companies set a
credit policy that states what is acceptable when
it comes to debtors
 Credit standards put a limit on the amount of credit
allowed to customers
 Credit terms is the period for which credit is allowed
• Credit terms written as: 5/10 net 30
 Debtor receives a 5% discount if the debt is paid
within 10 days
 If debtor does not take discount, debt needs to be
paid in 30 days
Establishing a credit policy

• 5 C’s of creditworthiness to evaluate whether a

customer should be granted credit:
 Character refers to a customer’s reputation for
paying back debt
 Capacity is the customer’s ability to pay its debt from
available funds
 Capital considers any capital the customer can put
toward an investment, which will lessen the chance
for default
 Collateral refers to property or large assets that can
act as security for a loan
 Conditions are the details stating the credit
agreement and are covered in the credit policy
Establishing a credit policy

•A company may change its credit policy

•The table below illustrates the effects of
relaxing credit standards. The opposite will
happen if stricter credit standards are
implemented.

Change that Effect on

Variable will happen profits
Sales volume Increase Increase
Accounts receivable/debtors Increase Decrease
Bad debts Increase Decrease
Example 14.5

ABC Office Furniture sells their main product, a basic

office chair, at R150 per unit. Total credit sales for the
previous financial year was 4 000 units. The variable cost
to manufacture a chair is R60 and total fixed costs for the
year are R80 000.
Example 14.5

• The company’s credit terms are 2/10 net 45 and

wants to tighten it to 3/7 net 30
• This will result in a 5% decrease in sales
• Bad debt will reduce from 2% of credit sales to
1% of credit sales
• The average collection period will reduce from
45 days to 30 days
• 20% of debtors will accept the discount
• The company’s return on risk-free assets is 14%
• Assume 365 days per year
Example 14.5
• To calculate the effect of the tightening of
standards, the company needs to calculate:
 Profit loss/gain from decrease/increase in sales
 Cost of the marginal investment in accounts
receivable
 Cost of marginal bad debts
 Cost of the discount
Example 14.5

• Profit loss/gain from decrease/increase in sales:

 Fixed costs are not included in the calculation, as it is
not affected by a change in credit standards
 Sales will decrease by 5%, which will result in a
decrease of 200 units (4000 x 0.05)
 Profit lost is R18 000 (200 x (150-60))
Example 14.5

• Cost of the marginal investment in accounts

receivable:
 Calculated by multiplying daily sales with the average
collection period
 Daily sales will be R1 644 per day
((4000xR150)/365)
 The average investment in accounts receivable would
be R73 980 (R1644 x 45 days)
 For the new credit policy daily sales will be R1 562
 This will lead to an average investment in accounts
receivable of R46 860
Example 14.5
• Cost of the marginal investment in accounts
receivable (continued):
 The marginal investment in accounts receivable is the
difference between the investment under present and
investment under proposed plans. The difference is
R27 120
 Reducing accounts receivable means the company
will have more cash available for daily transactions
instead of having to borrow the money
 The effect is the marginal investment in accounts
receivable multiplied with the rate of return on risk-
free assets of 14%. This leads to a cost saving of
R3 797
Example 14.5

• Cost of marginal bad debts:

 The amount of expected bad debt under the present
policy is R12 000
 Under the proposed policy, bad debt is expected to
be R5 700
 The difference is R6 300. This is a benefit to the
company since the cost of bad debt is reduced
Example 14.5
• Cost of the discount:
 Under the present plan, the expected cost that arises
as a result of the discount is R2 400
 Under the proposed plan, the cost of the discount is
expected to increase to R3 420
 The difference is a cost increase of R1 020
Example 14.5

The total effect of the tightening of credit

standards is:
Profit loss/gain from change in sales (R18 000)
Marginal investment in acc rec R3 797
Cost of marginal bad debts R6 300
Cost of the discount (R1 020)
Total effect (R8 923)

The proposed tightening of credit standards will

result in a reduction of R8 923 in profits
Managing accounts payable

• Accounts payable or creditors are short-term –

more cash on hand for everyday transactions
• Inventory is often purchased on credit –
favourable impact on the cash conversion cycle
• Accounts payable or creditors must be managed
to ensure company does not have too much debt
• In the same way that a company gives credit
terms to its debtors, creditors also give credit
terms to a company. It is expressed in the same
way, e.g. 2/15 net 60
Managing accounts payable

• A simple calculation makes it possible for a

company to determine if it is better for them to
buy on credit or not
• It determines whether it is cheaper to borrow
from the bank and pay the supplier immediately
or to “borrow” from the supplier by buying on
credit
Managing accounts payable

• The calculation to determine whether it is better

to buy on credit or to borrow from the bank and
pay immediately is:

Where:
CD = The discount in percentage terms
N = The number of days that payment can be
delayed by giving up the cash discount
Example 14.6
Conclusion
• Short-term capital management is important to ensure
that an entity is able to conduct its daily business
successfully.

• Working capital consists of cash, debtors, inventory and

creditors.

• In order to maintain liquidity, an entity needs to manage

and limit its investment in those current assets that are
not as liquid as cash. Having too large an investment in
current assets that are not as liquid as cash means that
cash is not immediately available when it is needed for
day-to-day transactions.
Conclusion (cont.)
• The most important areas of working capital are the
cash conversion cycle, inventory, accounts receivable
and accounts payable. Through the individual and
combined management of each of these areas of
working capital, it is possible to avoid liquidity problems.

• All companies need working capital to conduct their day-

to-day operations and provide services to their
customers.

• Short-term liabilities like creditors give the company the

opportunity to delay payment.