Management of Working Capital

Session Summary (1) learning objectives working capital and working capital requirement the operating cycle Flatco plc balance sheet as at 31 December 2005 Flatco plc profit and loss account for the year ended 31 December 2005 working capital policy stocks management just in time (JIT), materials requirement planning (MRP), and optimised production technology (OPT)

Session Summary (2) debtors and credit management example of an aged debtors report creditors management example of an aged creditors report operating cycle performance balance sheet items that impact on short-term and long-term cash flow cash management

Learning Objectives (1) explain what is meant by working capital and the operating cycle describe the management and control of the working capital requirement outline some of the working capital policies that may be adopted by companies implement the systems and techniques that may be used for the management and control of stocks, and optimisation of stock levels

Learning Objectives (2) outline a system of credit management and the control of debtors consider the management of creditors as an additional source of finance use the operating cycle to evaluate a company’s working capital requirement performance consider the actions and techniques to achieve short-term and long-term cash flow improvement

Working Capital and Working Capital Requirement working capital requirement, WCR = stocks + debtors – creditors – accruals + prepayments the difference between working capital (WC) and working capital requirement (WCR) is cash less short-term financial debt (bank overdraft) WC = WCR - short-term debt + cash

The Operating Cycle (1) the operating cycle relates to working capital (WC), the net of current assets less current liabilities the 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 the customer

The Operating Cycle (2)

Flatco plc Balance Sheet as at 31 December 2005

Flatco plc Profit and Loss Account for the Year Ended 31 December 2005

Working Capital Policy (1) the working capital requirement is normally financed by bank overdraft because of its flexibility in accommodating the fluctuating nature of net current assets the general lower cost of short-term financing the working capital policy adopted depends on individual company objectives and there is inevitably a conflict between the goals of profitability and liquidity

Working Capital Policy (2) aggressive policies may involve holding low levels of cash and stocks, with the risk of potential cash shortages and stock-outs conservative policies may be more flexible with higher levels of cash and stock, giving lower risk at the expense of reduced profitability

Stocks Management (1) Effective management and control of stocks requires its appropriate location and storage establishment of robust stock purchase procedures and reorder systems accurate and timely systems for the recording, control and physical checks of stocks

Stocks Management (2) Stock levels may be monitored using the following ratios: stock days = or stock stock value_________ average daily cost of sales in period turnover stock weeks = total stock units_____ average weekly units cost of sales Internal stock utilisation efficiency may be measured using finished goods despatches raw materials work in progress average weekly average weekly raw average weekly material usage production

Just in Time (JIT) JIT is a management philosophy that incorporates a ‘pull’ system of producing or purchasing components and products in response to customer demand in a JIT system products are pulled through the system from customer demand back down through the supply chain to the level of materials and components the consumer buys, and the processes manufacture the products to meet this demand - the consumer therefore determines the schedule

Materials Requirement Planning (MRP) Materials requirement planning MRP (or MRPI) is a system that converts a production schedule into a listing of the materials and components, required to meet that schedule a system that ensures that adequate stock levels are maintained and items are available when needed

Manufacturing Resource Planning (MRPII) Manufacturing resource planning (MRPII) is an expansion of material requirements planning (MRPI) to give a broader approach than MRPI to the planning and scheduling of resources, embracing areas such as finance logistics engineering marketing

Optimised Production Technology (OPT) (1) OPT is a philosophy, combined with a computerised system of shopfloor scheduling and capacity planning OPT differs from a traditional approach of balancing capacity as near to 100% as possible and then maintaining flow

Optimised Production Technology (OPT) (2) OPT aims to balance flow rather than capacity, and like JIT, it aims at improvement of the production process and focuses on factors such as manufacture to order quality lead times batch sizes setup times

Debtors and Credit Management (1) Effective management and control of debtors requires the establishment of appropriate policies covering the choice of customers the way in which sales are made the sales invoicing system the means of settlement the implementation of a credit management and overdue accounts collection system

Debtors and Credit Management (2) Debtor levels may be monitored using the following ratio debtor days = accounts receivable x 365 sales

Example of an Aged Debtors Report

Creditors Management (1) although not free, trade creditors provide the company with an additional source of finance effective management and control of creditors requires the establishment of appropriate policies covering the choice of suppliers the way in which purchases are made the purchase invoicing system the means of settlement

Creditors Management (2) Creditor levels may be monitored using the following ratio creditor days = accounts payable x 365 cost of sales (or purchases)

Example of an Aged Creditors Report

Operating Cycle Performance regular measurement of the operating cycle, which determines the short-term financing requirements of the business, enables the company to monitor its working capital performance against targets and identify areas for improvement operating cycle (days) = stock days + debtor days creditor days Or alternatively as a percentage operating cycle % = working capital requirement (stocks + debtors - creditors) sales

Balance Sheet Items that Impact on Short-term and Long-term Cash Flow

Cash Management (1) The short-term cash position of an organisation may be improved by reducing current liabilities, and/or increasing current liabilities stock levels debtors cash at bank creditors overdrafts taxation VAT PAYE/NI dividends payable

Cash Management (2) The long-term cash position of an organisation may be improved by increasing equity, and increasing long-term liabilities, and reducing the net outflow on fixed assets: shareholders’ capital loans leasing and hire purchase purchases of fixed assets sales of fixed assets