Cash is KING n How do companies boost

Cash is KING!!! n How do companies boost cash? n Some CEOs frequently see borrowing and raising equity as the only way to boost cash flow. n When faced with a cash crunch, these management teams pursue rampant cost cutting and restructuring that may later aggravate problems. 1

n recognized early that a good way to bolster shareholder value was to notch up working capital management. n The company's world-class supply-chain management system ensures that Debtors are collected quickly. n Inventory is sold faster n Thus, increases cash flow, n eliminating liquidity risk, n leaving Dell with more cash on the balance sheet to distribute to shareholders or fund growth plans. 2

Value of Company n 3

Working Capital Management © Correia, Flynn, Uliana & Wormald

LEARNING OBJECTIVES n After working through this chapter, you should be able to: u Explain the terms working capital, net working capital, working capital policy and working capital management. u Calculate the working capital cycle in days. u Describe the impact of inflation on working capital. u Outline the various working capital policies and their respective impact on risk and return. u Outline the various working capital financing policies and their respective impact on risk and return. u Calculate working capital funding requirements using the percentage of sales method. u Identify the factors that will influence expected sales. 5

Working Capital Definitions n Working capital n Net working capital n Working capital policy n Working capital management 6

What is Working Capital? n Working capital comprises of investment in the following current assets; u. Inventories u. Accounts receivable u. Operating cash 7

What is Net Working Capital? Net working capital is operating current assets less current liabilities. n Current liabilities comprise mainly of trade creditors (accounts payable) and other accruals. n Trade creditors are a source of interest free financing n Net working capital will often be financed with interest bearing short-term debt. n 8

Working Capital Management n Working capital policy = decisions on the optimal level of investment in and optimal level of finance of current assets n Working capital management = administration, within policy guidelines of : u. Current assets and u. Current liabilities. 9

Working Capital Policy n n n What is the optimal level of working capital required for a company to operate efficiently? Which problems arise if a company invests in too little inventory, does not offer credit to its customers or does not hold onto minimum levels of operating cash? Which problems arise if the company holds onto very high levels of inventory, is too lax about its credit terms to its customers or holds onto high levels of cash? 10

Working Capital Policy Trade-offs Debtors/Receivables: Increase in Sales vs. Bad Debts and amount outstanding. n Inventory: Increase in Sales vs. Investment & Holding costs. n Cash: Liquidity vs. opportunity cost. n Short-term credit: Risk vs. lower borrowing costs: n Cost of trade creditors. Cost of short term finance. 11

NB Inventory days = (Inventory balance / Purchases) x 365 n Inventory turnover = Purchases/ Inventory balance n Debtors Days/Collection period = (Accounts Receivable / Sales) x 365 n Creditors Days = (Accounts Payable / Purchases) x 365 n Working Capital Cycle = Inventory days + Debtors Days – Creditors days = Operating Cycle – Creditors days = Cash conversion cycle 12 n

Working Capital Cycle n What is the Working Capital Cycle? 13

Optimising Working Capital Cycle n Objective: Shorten the working capital cycle without impacting on operations. How? u Reduce the time raw materials spends in inventory u Reduce time to convert raw materials into production of finished goods u Reduce time to sell finished goods u Reduce time to collect cash from debtors u Lengthen the time taken to pay creditors n n n Any reduction in investment will increase the return on investment Reduction in the cycle results in increasing risk of losing sales Principle: while marginal cost of shortening cycle < marginal cost of external financing; then incur cost to shorten cycle 14

Changes in Sales & Working Capital Policy Changes in sales will cause changes in the level of working capital required. This will affect the level of short-term financing required. There are seasonality effects. Current assets needed for seasonal sales Current assets needed for expected sales 15

Working Capital Policies Involves two decisions: 1. The appropriate level of current asset investment 2. How to finance this investment in current assets n The greater the level of working capital the lower the level of risk of losing sales and experiencing disruption in production. n What is the effect of working capital levels 16 on the return on investment (ROI)? n

What is the Effect of Working Capital on Rates of Return? n Assume that a reduction in current assets will not result in a fall in sales or EBIT. Ignore the effects of current liabilities. Note how Return on Net Assets increases as the Working Capital Policy becomes more aggressive. What is the price of this increase? 17

Working Capital n What are the risks of an aggressive policy? u. Lower sales u. Lower liquidity and difficulty in paying accounts payable and other short-term liabilities. u. Poor credit ratings and increase in the cost of finance 18

Optimal Level of Working Capital n ROI vs investment in working capital. n ROI = Earnings/Assets ROI Decreased sales Increased total assets Level of working capital Optimal level 19

Optimal policy n Management should reduce current assets as long as u. Marginal benefit > expected loss u. Optimal point is when FMarginal benefit = expected loss 20

Working Capital Financing Policies n n Seasonal and cyclical fluctuations u Time of year u State of the economy – strong economy and higher sales levels will require higher levels of inventory and debtors Maturity matching: match the term of the financing with the term of the underlying investment u Plant and equipment is financed with long term debt or leases u Non-permanent current assets are financed with short-term finance 21

Working Capital Financing Policies: Moderate 22

Working Capital Financing Policies: Aggressive 23

Working Capital Financing Policies: Conservative 24

Forecasting Working Capital Requirements – Percentage of Sales n Percentage of Sales method expresses current assets as a percentage of sales. Once we determine future expected sales, we can determine the working capital requirements. 25

Forecasting Working Capital Requirements – Percentage of Sales n If sales are expected to grow to R 150 m, then this would result in an increase of R 12. 5 m in net working capital. Ex. Inventory at 20% of sales would increase by R 10 m. 26

Working Capital Financing n Increase in net working capital will be financed from; u. Retained earnings u. Short-term debt, such as a bank overdraft 27