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WORKING CAPITAL

• i.e a business’s current assets, less its


liabilities
• current assets- cash, stocks of raw
materials, WIP and finished goods, and
debtors
• current liabilities-trade creditors,
tax(VAT, PAYE, & CT), dividends, loans,
overdraft etc.
• every business must have sufficient
liquid resources (cash) to maintain day
to day trading
• sufficient liquidity must be maintained in
order to ensure both the short and long-
term future of a business
WORKING CAPITAL MANAGEMENT
• i.e ensuring that the business has and
will have sufficient liquid resources
• involves balancing the needs of ensuring
the solvency of the business with making
sure that the business achieves
maximum return from its assets
• holding too much cash is as much of a
problem as not holding enough- the
business misses out on making a return
on the assets that the cash could have
bought

• current assets can be financed either by


long term funds or by current liabilities
• current liabilities are a cheap source of
finance, and some companies may
consider that in the interest of higher
profit (i.e no interest to pay) it is worth
accepting some risk of insolvency by
increasing current liabilities and taking
the maximum credit possible from
suppliers
• the volume of current assets required
depends on the nature of the business
e.g a manufacturing company needs to
hold more stock that a company in a
service industry
• OVER-CAPITALISATION
• if there are excessive stocks, debtors

and cash, and very few creditors there


will be an over-investment by the
company in current assets
• working capital will be excessive and the

company will be described as over


-capitalised
• over-capitalisation means that the return
on investment will be lower than it
should be, and long term funds will be
unnecessarily tied up when they could
be invested elsewhere
• the ratios that might indicate over-
capitalisation are
• sales/working capital
• liquidity ratios
• turnover periods
WORKING CAPITAL AND CASH FLOW
• the operating cycle i.e the period
between paying creditors and receiving
cash from debtors
• purchase raw materials
• pay creditors
• produce goods
• hold onto stock before selling
• cash received from debtors

• a company must have adequate cash


inflows to survive, so management
should plan and control cash flows as
well as profitability
• cash budgeting is a very important part
of this process, because as shortfalls are
anticipated , measures can be put into
place to avoid any crises
• managing the timing of cash flows is
therefore very important, and this
involves controlling the component parts
of ‘working capital’
THE MANAGEMENT OF CASH
• how much should be kept as ‘cash in
hand’ or ‘on short call’?- must balance
liquidity with profitability
• methods of easing cash shortages:
• postpone capital expenditure-
but what if urgent?
• press debtors- but risk loss of
goodwill
• sell assets
• take longer credit
• re-negotiate loan repayments
• agree deferral of CT with IR
• reduce dividends- but what
about shareholder expectations?
• surplus cash- what to do?
• if surplus long term could
consider:
• invest in long term high
return asset
• redeem some debt
• pay dividend
• if surplus not permanent could
put on short term deposit, but
must consider rates and notice
periods
THE MANAGEMENT OF DEBTORS
• the efficient management of debtors is

concerned with achieving an optimum


level which involves
• a trade-off between extending
credit and therefore increasing
sales and profits; and the interest
and administrative cost of
carrying debtors and suffering
bad debts
• analysis of individual customers

is instrumental in deciding the


level of risk a company is
prepared to take in extending
credit
• debt collection management is
also important in determining the
volume of debtors and bad debts
• formulating a credit control policy
involves considering:
• the administrative costs of debt
collection
• procedures for controlling the
credit given to individual
customers
• the amount of extra capital
required to finance an extension
of credit e.g overdraft interest
• any additional costs e.g extra
work needed
• the way credit policy is to be
implemented- are discounts to be
offered to encourage early
payment (the cost will be the
amount of the discount)
• what the effect of easing credit
might be e.g it might encourage
increased bad debts
• if the increased contribution from the
additional sales exceeds the additional
costs then extending credit will be
worthwhile
• credit control: individual accounts
• new customers should give at
least two good references,
including one from a bank
• their credit rating should be
checked through a credit agency
• the credit offered should be set
at a low level , and only extended
when the payment record of the
customer warrants it
• any additional information on
customers should be kept if
available e.g statutory accounts,
press cuttings etc
• aged debtor listings should be

produced and reviewed regularly


• credit limits should be looked at

before an order is allowed to


proceed
• debt collection- main areas to consider:
• paperwork
• debt collection

• paperwork
• invoices to be sent out

immediately after delivery


• checks should be carried out to
ensure that the invoices are
correct
• investigation of queries etc
should be carried out promptly
• regular statements of account
should be sent out

• debt collection- possible procedure


• request payment by telephone
• letter
• personal visit
• withdraw credit
• involve debt collection agency
• instigate legal proceedings
THE MANAGEMENT OF CREDITORS AND
SHORT TERM FINANCE
• this involves
• attempting to obtain
satisfactory credit from suppliers
• attempting to extend credit
during periods of cash shortage
• maintaining good relations with
regular and important suppliers

• sources of short term finance


• trade credit
• bank overdraft
• factoring/ invoice discounting

• trade credit is a very important source of


finance, but the costs include
• loss of early payment discounts
• loss of supplier goodwill
THE MANAGEMENT OF STOCKS
• for a manufacturing or retailing
business stock can often amount to a
substantial proportion of the total assets
of the business
• it is important that stocks are kept at the
optimum level-if too low stock-outs will
occur, if too high , unnecessary costs will
be incurred
• stock ‘costs’ include:
• holding costs- cost of capital

tied up, warehousing and


handling costs, deterioration,
obsolescence, insurance and
pilfering
• procuring costs- costs of

ordering and delivery


• shortage costs- i.e not having

the item in stock when ordered-


they include the loss of sale &
contribution of the lost sale; the
extra cost of buying in
emergency stock (often at a high
price);the cost of lost production
and sales , where stock-out
brings whole process to a halt
• cost of stock itself- this will
need to be considered if the
supplier offers a discount for bulk
buying
• stock control levels
• there are 4 critical control levels
that can be used to maintain stock at
their optimum level
• re-order level- this is often

predetermined and considers


the maximum rate of
consumption and length of
lead time(time between
placing order & receiving
stock)
• maximum & minimum levels
-stock levels must not exceed
or fall below these limits
• re-order quantity- a
predetermined quantity that
is ordered when the stock
reaches the re-order level
• some businesses attempt to control
stock on a scientific basis e.g EOQ-
economic order quantity), but this
depends on various assumptions e.g that
demand and lead times are constant.
This is often unrealistic, and businesses
therefore have to work out when to re-
order - to ensure that they don’t run out
of stock in the re-order period many
business hold a buffer stock
• other businesses operate a JIT (just in
time) system which involves ordering
goods at the very last minute, so
avoiding the need to carry stock -this
can save on holding costs but is
unsuitable for some businesses e.g
hospitals, and is considered too risky by
many

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