Issues for small business

What might be the consequences for its working capital management of the weak 'market power' of a small business?

(The answer is at the end of the chapter)

Key chapter points

• The amount tied up in working capital is equal to the value of raw materials, work-in-progress, finished goods inventories and accounts receivable less accounts payable. The size of this net figure has a direct effect on the liquidity of an organisation.

• The two main objectives of working capital management are to ensure the business has sufficient liquid resources to continue in business and to increase its profitability.

• The cash operating cycle is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer.

• The cash operating cycle in a manufacturing business equals:

• The average time that raw materials remain in inventory Less the period of credit taken from suppliers

Plus the time taken to produce (and store) the goods Plus the time taken by customers to pay for the goods

• Ideally, a business should aim to minimise the length of its cash operating cycle. This can be achieved by managing the various components of working capital.

• Inventory days can be reduced by minimising the holding of raw materials and finished goods and ensuring production processes are efficient so as to reduce work-in-progress.

• In managing accounts receivable, early settlement discounts may be employed to shorten average credit periods. Some companies use factoring and invoice discounting to help short-term liquidity or to reduce administration costs. Insurance, particularly of overseas debts, can also help reduce the risk of bad debts.

• Effective management of trade accounts payable involves seeking satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers.

• Cash shortages can be eased by postponing capital expenditure, selling assets, taking longer to pay accounts payable and pressing accounts receivable for earlier payment.

• Temporary surpluses of cash can be invested in a variety of financial instruments. Longer-term surpluses should be returned to shareholders if there is a lack of investment opportunities.

• Businesses can take an aggressive, moderate or conservative approach to working capital

management. A company needs to be aware of the distinction between fluctuating and permanent assets.

• Working capital can be funded by a mixture of short and long-term funding. A moderate strategy is to match the length of the finance with the life of the asset, so short-term finance is used for current assets and long term finance for non-current assets.

Quick revision questions

1 What is the working capital requirement of a company with the following average figures over a year?

$

Trade accounts receivable 1 500

Cash and bank balances 500

Trade accounts payable 1 800

Inventory 3 750

2 The key trade-off at the heart of working capital management is between:

A current assets and current liabilities B accounts receivable and payable C liquidity and profitability D business stability and solvency 3 The cash operating cycle is:

A The time Less B The time Plus C The time Plus D The time Fill in the blanks.

4 The following information relates to a company:

Debt collection period 10 weeks

Raw material inventory holding period 2 weeks

Supplier's credit period 7 weeks

Production period 3 weeks

Finished goods inventory period 5 weeks What is the cash operating cycle of the business?

A 8 weeks

B 10 weeks

C 13 weeks

D 27 weeks

5 Consider the following two statements concerning invoice discounting:

An invoice discounter will take on:

I the administration of receivables of the client business

II responsibility for any bad debts relating to discounted invoices

Which one of the following combinations (true/false) relating to the above statements is correct?

Statement

I II

A true true

B true false

C false true

D false false

6 Which one of the following would be appropriate if a cash budget identified a short-term cash deficit?

A replace non-current assets B issue shares

C implement better credit control procedures D pay suppliers early

Answers to quick revision questions

1 Working capital requirement = current assets less current liabilities

= 3 750 + 1 500 + 500 – 1 800

= $3 950

2 C Adequate liquidity is needed to ensure the survival of the business in the long term, since even a profitable company may fail without adequate cash flow to meet its liabilities. However an excessively conservative approach to working capital management which results in high cash holdings will harm profits because the opportunity to make a return on the assets tied up as cash will have been missed. Thus most working capital decisions involve a trade-off between liquidity and profitability.

3 A The time raw materials remain in inventory B The time period of credit taken from suppliers C The time taken to produce (and store) goods D The time taken by customers to pay for goods 4 C 10 + 2 – 7 + 3 + 5 = 13 weeks

5 D Both statements are false. They would be true for debt factoring but not invoice discounting.

6 C A and D would create a bigger cash deficit. B would be more appropriate as a source of long-term finance. Implementing better credit control procedures should result in the earlier collection of receivables and reduced incidence of bad debts and would therefore be the most appropriate option to correct a short-term cash deficit.

Answers to chapter questions

1 D Rapid increase in sales

2 (a) Inadequate control of inventories, receivables and payables.

(b) Inadequate cash management.

(c) Making losses.

(d) Seasonal trading patterns and the build-up to a busy trading season.

(e) Growing the business and investing more in working capital and non-current assets.

(f) Large one-off expenditure items.

3 Administrative costs of debt collection, procedures for controlling credit to individual customers (e.g. assessing creditworthiness), procedures for debt collection, credit policy and its effect on total receivables and profits, early settlement discount policy.

Credit insurance is a form of insurance in which the insurance provider undertakes to reimburse the policy holder in the event of non-payment of a debt by a customer. When a factoring organisation provides credit insurance, it will insist on collecting the debt itself.

4 Suppliers unwilling to grant sufficient credit.

Customers taking longer to pay than agreed.

Banks unwilling to grant a sufficient overdraft facility, or to lend without a personal guarantee from the business owner.

Topic list

1 What is the cost of capital?

2 The cost of equity capital

3 The cost of preference share capital 4 The cost of debt capital

5 The weighted average cost of capital (WACC) 6 The cost of leasing

7 The NPV of new projects and shareholder wealth

Learning objectives Reference

Capital budgeting: ROCE, payback, IRR, NPV LO1

Calculate the weighted average cost of capital and apply it in capital

budgeting LO1.8

Cost of funds LO4

Calculate and interpret the cost of various sources of finance LO4.4 Calculate and interpret the cost of capital associated with leases; and debt

and equity LO4.7

Valuation of corporate securities LO9

Calculate and interpret effective interest rates; and apply the concepts of financial mathematics to loans and debt and equity securities

LO9.1 Calculate and interpret share price in both perfect and imperfect markets LO9.2

Chapter 6