In this blog, we will look at the short-term elements of the balance sheet, the net current asset or working capital which is normally supported with short-term financing.
Working Capital Requirements (WCR) technique may be used to improve inventories, trade receivables, trade payables. It may be used to monitor the company's effectiveness in management of its working capital requirements. We need to focus on an effective management of cash and how both long-term and short-term cashflow may be improved.
Working capital requirements (WCR)
The balance sheet will normally be presented showing all the assets in one part and liabilities in another part.
Assets = equity and liabilities
or,
Non-current assets + inventories + trade receivables + prepayments + cash = equity + financial debt + trade payables + accruals
so,
Equity + financial debt - cash = non-current assets + inventories + trade receivables - trade payables - accruals + prepayments
therefore,
Equity = non-current assets + inventories + trade receivables - trade payables - accruals + prepayments - financial debt + cash
Financial debt comprises two parts:
* long-term debt ( loans repayable after one year),
* short-term debt (overdraft and loans repayable within one year).
So from the equation we can summarise that:
equity + long term debt = non-current assets + working capital
WC (Working Capital) = inventories + trade receivables - trade payables - accruals + prepayments - short term financial debt + cash
This operating circle can be clearly illustrated in the figure below.
Source: Davies T, 2011, "Business accounting and finance", Pearsons Education
This circle includes:
* acquisition of raw materials and packaging - these are stored, invoiced by suppliers and reported on the accounts payable and paid;
* use of materials and packaging in manufacturing process to create partly or fully finished goods, work in progress that is stored in the company warehouse;
* despatch of finished goods and delivery to customers that is account receivables;
* use of cash resources to pay overdraft;
* use the cash to pay trade payables for production overheads and other expenses;
* use the cash to pay for raw materials;
A company with low operating circle in days will have better cash position with longer operating circle.
We can identify which components are contributing to the operating circle:
* plant and machinery,
* trade payables,
* investment in subsidiaries,
* cash,
* work in progress,
* patents,
* accounts receivables,
* fixtures and fittings.
Non-current assets are not renewed within the operating circle: machinery and plant, investments in subsidiaries, patents, fixtures and fittings. Therefore only the remaining items relate to the operating circle: accounts payable, work in progress, cash, accounts receivable.
We know that the total financial resources of the company are equity plus long-term and short-term financial debt minus cash. We can then calculate the total investment.
Total investment = non-current assets + inventories + trade receivables - trade payables - accruals + prepayments
Therefore the total investment is into: non-current assets and/or investment in operations.
The investment is operations is the Working Capital requirement (WCR).
The company has to use and raise its financial resources to invest in the operating circle. In most manufacturing companies the WCR is positive.
WCR = inventories + trade receivables - trade payables - accruals + prepayments
so,
WC = WCR - short-term debt + cash
or,
WC = equity + long-term debt - non-current assets
Trade receivables are all the invoices for goods and services that have been delivered to customer but haven't yet been paid for. They are likely to be the largest asset of most businesses balance sheet. This is the outstanding money due to the business to be paid soon.
Prepayments are the amount paid for by a business in advance for goods and services being delivered later on.
An accrual expense is a mean of recording expense that was incurred in one accounting period but not paid until further accounting period.
As a general rule, except in certain commercial circumstances the WC should always be positive in a long run and the aim is for WCR to be as small as possible or even negative. If net cash is negative then the short-term is higher then the cash balance so WCR is financed with short-term debt. If the quality of WCR is poor then the bank is unlikely to finance WCR with short term debt. The management needs to control each of the elements of the WCR: inventories, trade receivables, trade payables.
Working capital policy
A company should adopt a policy that finances the long-term investment in non-current asset with long-term funding such as loans, bonds, equity and retained earnings. Financing in short-term capital requirements (WCR) bring number of options to the company. The external finance of WCR is generally provided by bank overdraft because of its flexibility in accommodating fluctuating nature of current assets. But short term debt interest rates are normally higher then long-term loans.
Companies should still maintain the overdraft balance to a minimum level. The policy approaches may be either aggressive or conservative.
Aggressive attitude companies operate with low level of inventories and cash to increase profitability. These can cause issues such as short-stock, poor customer relationships due to tight credit terms, inability to pay suppliers because of cash shortages.
If a company adopts a conservative working capital it will aim to operate in the higher level of inventories and cash in order to increase liquidity. Liquidity refers to efficacy in which asset or security can be converted into ready cash without affecting its market price. The most liquid asset is the cash itself. The more liquid an asset is, the more easy is to turn it back into cash.
This policy provides greater flexibility, but higher levels of inventory and cash will result in lower profitability. This is because of the high cost of holding inventories, cash is received from customers later and company may use overdraft, as well as the opportunity cost of holding cash as returns otherwise could of been raised from investment in profitable projects. But conservative approach presents lower level of risk because the customer demand is easier to meet with increased inventory, more favourable credit terms to the customer and the ability to meet current commitments to pay suppliers to avoid interruptions in the supply chain.
Working capital is the 'lubricant' of the investment in company operations, enabling investment in non-current assets. Maintaining an optimal level of WCR increase level of efficacy and effectiveness, increasing profitability and reduction in external financing requirements.
Inventories management
One of the main areas of waste is inefficient handling of inventories. Companies need to improve this aspect of working capital.
Overproduction - is the most serious area of waste that leads to excessing storage times, results in production deterioration, causes excessive work in progress, encourage to push overstocked goods through the system for example through bonuses. Kanban provides opportunity to overcome this production issue.
Waiting - exists where there is no moving or work taking place and it affects materials, products and people. This time should be used for training, maintenance and kaizen but not overproduction.
Transportation - this waste is incurred from unnecessary transportation and double handling that may result in damage and deterioration. Increased distance means slower communication and corrective action delay.
Inappropriate processing - this waste often results from complex solutions such as use of large inflexible machines instead of small and flexible ones which encourage overproduction. Poor layouts encourage excessive transportation and poor communication.
Unnecessary inventories - this waste leads to increased lead-times and higher storage costs. It also prevents rapid identification of problems and discourages communication. Hidden problems may be resolved with decreased inventories.
Unnecessary motion - this waste refers to ergonomics for quality and productivity.
Product defects - this waste is direct money costs that provides an opportunity for improved performance. Kaizen can help here. The immediate effect of overproduction relates to increased operating circle and increase the need for further funding. High inventories have negative effects on the profits with the increased waste. There are serious impacts on business not to clean its inventories.
Inventory levels should be optimised and forecasting of inventories shall be part of the management process. Robust inventory purchasing procedure should be established, there should be appropriate storage for inventories, systems should be timely and accurate for recording, control and physical checks. The management should monitor the inventory turnover performance.
For cashflow purposes there needs to be established an efficient level order process and purchasing procedures with highly trained staff. Authorisations for purchases are to be established.
A variety of options also exist for the appropriate location of stock. Related items may be grouped together, by pack number, frequency of picking or by size and weight.
All inventory transactions should be recorded along with their physical movement. Damage or obsolete inventory shall be removed for some scrap value. Slow moving inventories should be reviewed.
One of the efficacy ratios for inventories is the inventory turnover measured in days:
Inventory days = Inventory value / Average daily cost of sales in period
or,
Finished goods / average weekly dispatches
and
Raw materials / Average weekly raw materials use
and
Work in progress / average weekly production.
The appropriate level of control may be determined through assessment of costs against potential benefits. We can use the "Parento analysis" to categorise items to A,B or C category. It multiplies the usage of each inventory by its value and calculating cumulative result. Inventories can also be categorised to:
Vital (V) - not having it would be a disaster;
Important (I) - out of inventory would give a significant operational problem;
Nice to Have (N) - out of inventory would present insignificant problem.
Economic Order Quantity method may be used may be defined as the most economic replenishment of order which minimises the inventory costs.
P - the £ cost per purchase order;
Q- order quantity in each order in units;
N- annual unit usage;
S- annual £ cost of holding such unit;
then,
The annual cost of purchasing = P X NQ or PN/Q
and
The Economic order quantity formula is as below:
Source: Davies T, 2011, "Business accounting and finance", Pearsons Education
This formula allows for inventory optimisation, but inventory volumes may depend on the storage space, facilities, purchasing department resources and logistical efficacy. In periods of changing prices, interest rates may also present some other limitations for use of the EOQ.
Just in Time (JIT), Materials Requirement Planning (MRP) and Optimised Production Technology (OPT)
Just in Time
People incorrectly refer JIT as zero inventory system. But its aim is the reduction of product life cycle and the increased level of quality. It incorporates a 'pull' system in purchasing components in response to customer demand. Products are pulled from customer demand back to supply chain so the consumer determines the schedule.
JIT is the opposite of the 'buffer system' where products are produced to schedule based on the 'best guess' of the demand, last years sale or intuition.
The key principle around the JIY is waste limitation and includes the implementation of TQC - right first time, Kanban ( i.e cards for demands to the next process), operators are encouraged to stop operation when quality issue arise avoiding poor quality and demanding immediate solution. Businesses try to improve the production layouts, encourage employee involvement through self-quality, multi-skilling of employees to allow for flexibility. Suppliers are being also developed to higher quality through supply chain terms and conditions and checks.
Material Requirement Planning (MRP) and its development to Manufacturing Resource Planning (MRP) as well as Optimised Production Technology (OPT) are seen as the alternatives to JIT or used to complement the JIT system.
Materials Requirement Planning (MRP)
This is a set of techniques which uses the Bill of Material, inventory data and master production schedule to calculate future requirements for materials. It takes recommendations to release the materials to the production system. It is the 'push' approach where customer demand is forecasted. It relies on accurate BOM and scheduling algorithms, EOQ analysis as well as allowance for waste.
Optimised Production Technology (OPT)
It is a philosophy combined with computer system of the shop-floor scheduling and capacity planning. It aims to balance flow rather then capacity. Just like the JIT technique it aims to improvement of the production process and manufacture to order, quality, lead times, batch sizes and set-up times.
The aim of OPT is to make money and reducing the operating circle. Factory schedule is the root of OPT and elimination of waste.
Trade receivables and credit management
All companies who sell on credit need to exercise some level of credit control. This is the area where resources may be profitably devoted. Cash flows will be affected by the choice of customer, the way in which sales are made, invoicing system, speedy correction of errors, the means of settlement, monitoring customer settlement performance and overdue accounts collection system.
Sales need to assess customer risks with slow payments or no payments. Authorisations must be made to cover credit periods or sales discounts. Credit checks should always be made. The procedure for opening new account must be a formal process to show to customer that organisation takes it seriously. Before new account is opened we need to take into account references from the company bank and two from high profile suppliers. A credit limit should be set that represents a minimum risk. A copy of the latest annual accounts should be requested. It will indicate the legal status of the company, its owners and financial strength. This is especially important with large contracts.
If we have established a relationship with credit-worthy customer we may further minimise the risks through 'sale of goods with reservation of title'. This means that the goods remain in the ownership of the selling company until paid in full. Credit insurance cover or passing of invoices to factoring company for settlement to provide some type of insurance cover against non-payments.
Payment collection methods should be agreed with customer at the outset. Bank transfers and electronic payments are often used. Extreme care needs to e taken with letter of credit and these must be completed providing full details and the conditions must be fully complied with. A letter of credit is a contractual commitment by the foreign's buyer bank to pay once the exporter ships the goods and present documentation as proof. Letter of credit is designed to protect both importers and exporters.
Electronic collections increase in popularity. Absolute control is required over the receivables and payables and all businesses will benefit from strict adherence from administration routines by all the staff involved. Cash taking must be strictly controlled in terms of logs and issues.
The Sales invoicing system must ensure that accurate invoices are submitted to customers for all goods and services. Incorrect pricing, VAT calculations, invoice totalling and customer names and addresses may result in delays.
Sales invoices may be followed up by outstanding balance and the credit period offered to customers should be as short as possible.
Trade receivables collection days is another ratio for calculating trade receivables performance.
Collection days = (Trade receivables X 365) / Revenue
Collection days indicate the average time taken to receive payments from credit customers. Currently UK export for countries abroad is not subject to VAT.
One of the main tasks would be to identify the person within the customer organisation for processing of payments through customer organisation. Payments are generally authorised by finance director, managing director or accountant. Good relationships with that person should be cultivated.
There are many benefits of issuing of monthly statements as it resolve queries. A routine should be set for when payments are being overdue. A credit controller would generally chase overdue accounts by telephone which would be the most effective method.
The accounts receivable information should be accurate and obtained in timely manner. The credit controller should have a list of all outstanding invoices. One method to receive settlement is to stop supply of goods and services. Letters may also be sent asking for settlement. Solicitor should be contacted as the last resort.
Trade payables management
The balance sheet category of trade and other payables that are payable within one year are: Taxes, National Insurance, VAT etc. and accounts payable to suppliers i.e invoices. These trade payables may sometimes be considered as 'free' source of finance. If the company has not paid the supplier, they may use that cash. However, it is not a good method of borrowing money.
Many companies intentionally delay payments to suppliers in order to improve cash flows, but this should only be regarded as temporary. It is a very short-term thinking and not a good strategy. Instead, policies should be established to the choice of suppliers, the way in which purchases are made, the purchase invoicing system, speedy correction of errors, means of settlement and monitoring of supplier performance.
New suppliers should be evaluated even more rigorously with regards to product quality, sustainability of supply, reliability of distribution and financial stability.
Payments to suppliers should be made in line with terms of trading. Automatic payments may be set.
Trade payable ratios may be use to measure performance. Payable days measure the supplier payment performance.
Payable days = (Trade payables X 365) / Cost of sales (or purchases)
It indicates the average time taken, in calendar days, to pay for supplies received on credit. The payments should be controlled to ensure no interruption to manufacturing process and effort is to be made to maintain good relationships with suppliers. The manager responsible for authorising payments should have accurate and timely information.
Operating cycle performance
As mentioned above, the operating cycle is the time between the point the cash is being expanded on the production of the product and collection of the cash from customer.
Operating cycle (days) = inventories days + collection days - payable days
Operating cycle % = WCR/Revenue
Good management of WCR is therefore important. Overtrading is a condition of business which enters into commitments in excess of its available short-term resources. Often caused by lengthy production circle and operating circle. Reduction of business activity or improvement of working capital may be implemented to deal with it. Sometimes these may be critical for the survival of the company.
Cash improvements techniques
We know that profit and cashflow do not mean the same thing. Cashflow does not equal profit. Day-to-day expenses are usually expressed in cash, non-current assets may be acquired with immediate withdraw of cash, but the cost of those is reflected in the profit. Sales of products and services are reflected in revenue. Purchases of materials are taken into inventories.
Therefore, cashflow is important for business performance and profit. The short-term cash position may be improved by reducing current assets and increasing current liabilities. The long-term cash position can be improved by: increasing equity, increasing non-current liabilities or reducing net-outflow of non-current assets.
Short-term cashflow improvements
Inventories levels - inventories levels should be optimised to reduce waste. It requires planning, control and honesty. Many companies ignore inventory errors, over-ordering or over stocking . Some people do not want to admin their mistakes. It is essential to put in place an efficient sales order system, material procurement system as well as the inventory control system. Staff needs to be trained and highly skilled.
Inventory turnover should be regularly reviewed so that obsolete inventory is removed. Hanging to unsalable inventory is waste as it uses valuable space and time.
Account receivables arise from the sale of products and services. Methods of sales, sales invoicing system and payment terms, collection systems need to be controlled.
Account payable may be paid more slowly to gain short-term cash advantage but only regarded as temporary. More systematic process developed is more ethical and professional that may provide greater and sustainable benefits. Controls should be in place to determine which suppliers must be dealt with, acceptable ranges pf products, purchase volumes, price negotiations, discounts, credit terms, invoicing, payment methods and payment terms.
Supplier invoices must match the purchase order. Buyers should be skilled to purchase high quality products for the best price and the frequency required at the best possible terms. Sufficient recording system should be in place so that any errors are suitably reported in timely manner.
If bank overdraft facility is required, then the lowest possible rate of interest should be negotiated. Bank charges should be checked in detail if they are correct. Bank statements should be thoroughly checked.
Penalties and interest changes for late tax payments should be avoided.
If a business is registered for VAT it is required to charge VAT at appropriate rate on all goods and services that are vatable. Accurate records shall be maintained in regards to VAT.
Employee taxes - PAYE and National Insurance contributions must be looked after and paid to HRMC. Interests and penalties are put for non-compliance.
Dividends are to be looked after and paid as needed. The timing of dividend payments is important and could be paid on the most convenient dates.
Long-terms cashflow improvements
Equity - can improve long-term cashflow. Provision of additional equity strengthen the balance sheet and the profit position. It does not bear a commitment to pay interest. When owners provide additional equity, the funding is from their own capital.
Loans - long-term loans have certain advantages, particularly for acquisition of non-current assets, even that they carry a commitment. The period of the loan might be matched with the life of an asset and agree reasonable payment schedule for cashflows. Borrowing has its cost and has to be repaid. Ability to repay must be assessed before making loan decisions. The payback should be in the re-use of equipment, renovation of equipment or renegotiation of the terms of trading.
Long-term loans are secured by lenders on the company's existing non-current assets, or those long-term or short-term assets. Some acquisitions of property has been disastrous for companies and renting may be a better solution as it gives the required flexibility.
Leasing - may be a solution for non-current assets. Short-term or long-term leases exist. Interests and depreciation is charged against the profit.
Purchases of non-current assets - may be represented by immediate outflow of cash. Majority of funding can come from shares, loans or leasing. The use of overdraft is not a good idea. Non-current assets have long-life.
Sales of non-current assets - is an obvious mean of raising funds.
Cash management
Cash improvement solutions should be regularly reviewed. Cashflow statements should be prepared on a monthly basis even 6 months in advance. The cashflow plan should also be updated monthly or weekly.
Cash shortages is a common reason for business failures. Opportunities may arise due to acquisition of new businesses, investment in research and development, investment in new products and even lending.
All investments should recognise the discounted cashflow techniques. A realistic capital cost should be used to determine the return on investment.
If surplus funds are available for short-term investment, the most tax-efficient investment should be sought.
Companies should maintain good relationships with their bankers, including plans and new initiatives. The accounting staff should check accuracy of bank statements.
Bibliography
Davies T, 2011, "Business accounting and finance", Pearsons Education
Hayes Adam, 2023, "Understanding liquidity and how to measure it", accessed from https://www.investopedia.com/terms/l/liquidity.asp#:~:text=Tara%20Anand%20%2F%20Investopedia-,What%20Is%20Liquidity%3F,turn%20it%20back%20into%20cash., accessed on 22/04/2023
International Trade Association, "Methods of Payment: Letter of Credit", accessed from https://www.trade.gov/letter-credit#:~:text=A%20Letter%20of%20Credit%20is,protect%20both%20exporters%20and%20importers. accessed on 22/04/2023
Office of Finance and Treasury, " Year-End Accruals", Princeton University, accessed from https://www.investopedia.com/terms/l/liquidity.asp#:~:text=Tara%20Anand%20%2F%20Investopedia-,What%20Is%20Liquidity%3F,turn%20it%20back%20into%20cash. accessed on 22/04/2023
SumUp, "Prepayments - What are prepayments", accessed from https://www.sumup.com/en-gb/invoices/dictionary/prepayments/ accessed on 22/04/2023
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