Management of Working Capital

Management of Working Capital

Introduction

Quite properly a great deal of attention is given in financial management to the decisions involved in the purchase of fixed assets. It must not be overlooked, however, that a high proportion of any business resources are tied up in working capital. Although the number of decisions affecting working capital is large and individually each has a small effect, the overall importance of working capital is considerable importance.

There are three main elements of working capital and each gives rise to rather different problems. I will refer to them in the order in which they will usually appear on the balance sheet.

(a) Stock. One concern will be to strike a proper balance between a shortage of stocks and delays in production which this will cause, and excessive stocks which will tie up resources and involve heavy storage costs. Another concern will be the general process of stock control where by losses due to pilferage and wasteful use are minimized.

(b) Debtors. The granting of credit to customers is an important service which can help to improve and maintain sales in a competitive situation. The process must be carefully controlled so as to avoid losses from bad debts and to minimize the value tied up in debtors. Questions are often arise on the different forms of credit control. For example giving of cash discounts.

c) Cash. An important technique in this area is the preparation of cash budget. Such a statement will be invaluable to a financial manager in identifying in advance the periods of cash surplus and cash shortages so that prior arrangements can be made ro deal with this situation on a favorable terms as possible.

Practical Working Capital Management issues.

Example 1

The 14 million annual sales receipts of company M are spread evenly over each of the 50 weeks of the working year. However the pattern within each week is that the daily rate of receipts on Monday and Tuesday is twice that experienced on Wednesday, Thursday and Friday.

Receipts for the whole week are usually banked on the Friday each week but this practice is re-considered. It is suggested that banking should be carried out either daily or twice a week, on Tuesday and Friday. The incremental cash cost to company M of each banking is 40. Company M always operates on bank overdraft and the current overdraft rate is 14% per year – this interest charge is applied by the bank on a simple daily basis.

What is the best policy company M choosing amongst three alternatives for the bank receipts? Indicate the yearly amount by which company M will be worse off it it pursues the worst, rather than the best, of the three policies for the banking receipts ignoring taxation.

Solution 1

Step 1: Determine the pattern of sales receipts. Total receipts in one year 14000000. There fore per week assuming 50 weeks in an year is 1400000/50 = 280000.

Pattern of receipts

Monday 80000

Tuesday 80000

Wednesday 40000

Thursday 40000

Friday 40000

Step 2: Calculate the change is costs and savings if company M changes to daily banking.

Currently there is one banking per week. Daily banking would require 5 banking per week. That is an increase of 4 more banking. The cost is 4*40 = 160 pwe week. The yearly cost is 160*50 = 8000 per year.

The savings on the interest charges on the sums involved and is calculated as follows:

80000 for 4 days ( 80000*4/365*14%* 50 = 6137

80000 for 3 days ( 80000*3/365*14%* 50)= 4603

40000 for 2 days ( 40000*2/365*14%*50) = 1534

40000 for 1 day ( 40000*1/365*14%*50) = 767

Total savings = 13041

The net improvement = 13041 -8000 = 5401.

Step 3

Calculate the change in costs and savings if company M changes to banking on Tuesday and Friday.

There will be one extra banking per week. The cost per year is 40*50 = 2000. The banking on Tuesday will consist of the receipts on Monday and Tuesday of 160000.

The interest saving is : 160000*3/365*14%*50 = 9205.

Net improvement = 9205 – 2000 = 7205.

Step 4

The best policy is banking twice per week as it has the maximum saving. The worst is the one currently operated to bank the receipts on Friday.

Example 2

Company B has produced the budgeted profit and loss appearing below immmediately in advanceof the financial period to which it relates.

Budgeted profit and loss Account for the year ended 31st December 1992.

Sales (100000 units at 5 each) 500000

Less cost of sales Material 150000

Labor 90000

Variable

overhead 90000 330000

Operating profit 170000

Less Fixed overhead 45000

Depreciation 60000 105000

Net profit 65000

Less Dividends 50000

Retained profits 15000

Balance Sheet as at 31st December 1991

Share capital and reserves 500000

Represented by:

Fixed assets 361570

Current assets: Stocks -material 37500

Stocks -finished goods 49500

Debtors (1) 56250

Cash 24680

Total 167930

Less Current liabilities Creditors (2) 29500 138430

Net assets 500000

1. Debtors

   Half of previous quarters sales(11/2 months) 45000

   prepayments of one quarter’s fixed overhead 11250

   Total 56250

   (2) Creditors;

   2/3 of previous quarters purchases ( 2 months) 25000

   Accrual of variable overhead (1 month) 4500

Total 29500

The sales are planned as follows:

1st quarter 75000

2nd quarter 125000

3rd quarter 200000

4th quarter 100000

In each case the corresponding sales value for 1991 were 10% less than the sales for the 1992 quarters. The sales for the year 1992 is 10% more than the corresponding quarter in 1991.

Company B plans to hold stocks of finished stocks and raw materials equal to three months requirements. Creditors allow for 2 months credit and debtors pay one and half months after the goods and services are delivered. Variable overhead is paid one moth in accrual and fixed overhead is paid 1 month in advance. The planned dividend is scheduled to be paid on 30th June and 30th December. Expenditure of 75000 on fixed assets is planned to be in 30th September. The depreciation in already included in the budgeted profit and loss account.

Prepare based on the information the cash Budget for the year ended 31st December 1992?

Solution

Step 1

Prepare a schedule of receipts from debtors

Jan – March

Half -sales of previous month 45000

Half sales of current month

( 75000*1/2) 37500

Total 82500

April -June

Half sales of previous month 37500

Half sales of current month

(125000*1/2) 62500

Total 100000

July – September

Half sales of previous month 62500

Half-sales of current month 100000

( 200000*1/2)

Total 162500

October – December

Half sales of previous month 100000

Half sales of current month

(100000*1/2) 50000

Total 150000

Step 2

Schedule of production to work out the payments made for purchases, variable overhead and labor.

Production is seasonally variable as given in the question. Three of stocks of finished goods is maintained. That is, production is three months in advance to sales.

Jan -March Production in sales value = sales of April -June = 125000.

April -June production in sales value = sales July -September = 200000

July – September production in sales value = sales of October – December = 100000

October – December production in sales value = 10% of the corresponding sales added to the quarter = 75000 + 10% *75000 = 82500

Jan-March of the year 1993 = production of corresponding year to 31st December 1992= 125000+10%*125000 = 137500.

Step 3

Schedule of purchases

The raw material is holded for 3 months. That is material purchased based on one quarter sales before that quarter of production in sales value.

October to December 1991 is the balance sheet value = 37500

January to March 1992 = production in sales value * 150/500 as per profit and loss ratio of materials to sales. The April -June 1992 production = 200000. There fore the material purchase is as follows: 150/500* 200000 = 60000.

Like that April – June 1992 Material purchased = 150/500* 100000 = 30000.

July -September 1992 material purchased = 150/500* 82500 = 24750

October- December = 150/500* 137500 = 41250.

Step 4

Set up a schedule of payment to creditors.

January – March 1992

2/3 previous year purchase ( 2/3* 37500) = 25000

1/3 of Current quarter ( 1/3* 60000) = 20000

Total 45000

April – June 1992

2/3 of previous purchases (2/3* 60000) = 40000

1/3 of current quarter purchase (1/3*30000) = 10000

Total 50000

July – September 1992

2/3 of previous quarter purchases ( 2/3* 30000) = 20000

1/3 of current quarter purchases ( 1/3* 24750) = 8250

Total 28250

October – December 1992

2/3 of previous quarter purchases (2/3* 24750) = 16500

1/3 of current quarter purchases 91/3* 41250) = 13750

Total 30250

The remainder of the quarters purchase is the creditors balance = 2/3* 41250 = 27500. This is the creditors balance in the balance sheet.

Step 5

Set up the schedule of variable overhad payments.

Like the creditors payments 1.3 of previous variable overhead and 2/3 of the current quarter variable overhead is paid in the quarter concerned.

January – March 1992

1/3 of previous production value or balance sheet variable liability = 4500 as given

2/3 of current production sales value*90/500 =15000

Total 19500

April -June 1992

1/3 of previous quarter production value* 90/500 = 7500

2/3 of current quarter production value*90/500 =24000

Total 31500

July – September 1992

1/3 of previous production sales value * 90/500 = 12000

2/3 of current production value *90/ 500 = 12000

Total 24000

October – December 1992

1/3 of previous production sales value*90/500 = 6000

2/3 of current year production sales value*90/500 = 9900

Total 15900

That is 4950( 1/3 of the current production value*90/500) is shown in the creditos as a current liability in the balance sheet.

Step 6

Prepare the cash budget from the receipts and payments as follows.

January -March 1992

Balance at begging 24850

Receipts from Debtors (step 1) 82500

Total 107180

Payment to creditors(step 4) 45000

Payment for variable over head

(step 5) 19500

Wages (90/500*Production) 22500

Fixed overhead as per

balance sheet 11250

Total 98250

Closing Balance 8930

April – June 1992

balance at beginning 8930

Receipts from Debtors (step 1) 100000

Total 108930

Payment to creditors (step 4) 50000

Payment for variable overhead

(step 5) 31500

Wages 90/150* production} 36000

Fixed overhead as per balance sheet 11250

Dividends 25000

Total 153750

Closing balance (44820)

July -September 1992

Balance at beginning (44820)

Receipts from debtors (step 1) 162500

Total 117680

Payment to creditors (step 4) 28250

Payment for variable overhead (step 5) 24000

Wages 90/500* production) 18000

Fixed overhead as per balance sheet 11250

Purchase of fixed assets 75000

Total 156500

Closing balance (38820)

October – December 1992

Balance at the beginning (38820)

Receipts from debtors (step 1) 150000

Total 111180

Payment to creditors (step 4) 30250

Payments for variable overhead (step 5) 15900

Wages 90/500* production) 14850

Fixed over head as per balance sheet 11250

Dividends 25000

Total 97250

Closing balance at 31st December 1992 13930

Step 7

Balance sheet as at 31st December 1992

Share capital and reserves 515000 (note 1)

Represented by:

Fixed Assets 376500 (note 2)

Current assets: Stocks -Raw materials 41250

stocks – finished goods 54450

Debtors ( step 1) 50000

Fixed overhead prepaid 11250

Bank 13930

Total current assets 170880

Less Current Liabilities -creditors 32450 138430

Net assets 515000

Notes on calculations

Note 1

opening share capital and reserves 500000

Add retained profits 15000

Total 515000

Note 2

Opening Fixed assets 361570

Add Purchases 75000

Total 436570

Less Depreciation 60000

Balance as at 31st December 1992 376500

Note 3

Finished goods at 31st December 1992

150/500 of next quarters production = next quarters but one sales

150/500 * (125000 +10% of 125000) = 41240

Note 4

Raw materials at 31st December 1992

330/150* (75000+10%*75000) = 54450

Note 5

Creditors for raw materials = 27500

Creditors for variable

overhead 4950

Creditors as at 31st December 1992 32450