PowerPoint to accompany

Chapter 13
Unit 7
Managing
Working Capital
 Learning Objectives
List the items making up working capital
Discuss the nature and importance of working capital
Illustrate the working capital cycle
Demonstrate the importance of inventory and the
techniques available to manage this asset efficiently
Discuss the provision of credit to customers and use
various management tools to monitor and control this
asset
Explain the reasons for holding cash, and the basis of
management and control
Summarise the key aspects of creditor management

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Nature and Purpose of Working
Capital
Working capital =
current assets less current liabilities
The main elements of current assets are:
Inventory
Accounts receivable (trade debtors)
Cash (in hand and at bank)
The main elements of current liabilities are:
Accounts payable (trade creditors)
Bank overdrafts
Represents a net investment in short-term assets

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Nature and Purpose of Working
Capital (continued)
Cash sales
Cash /
Finished bank
goods overdraft
Trade
receivables

Raw Trade
Work in materials
progress inventories creditors

Figure 13.1 - The working capital cycle of a manufacturing business

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Nature and Purpose of Working
Capital (continued)
Management of working capital is an essential part
of the short-term planning process
Costs:
holding too much/too little of each element
opportunity cost of using these elements elsewhere

Needs may change over time

externally driven or
changes to the internal environment

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Inventories
Inventories held mainly to meet the immediate
requirements of customers and production
Manufacturing businesses = tend to hold high
proportion of their assets as inventory:
Raw materials
Work-in-progress
Finished goods
Seasonal factors may vary inventory holdings over a
year
Retail businesses would try and minimise their
inventories because of costs
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia
 The Management of Inventories
(continued)
Forecasts of future demand:
Accurate forecasts are key
Can use statistical approaches or judgment of staff / managers
Financial ratios:
Inventory turnover period = Average inventory held x 365
Cost of sales
Recording and re-ordering systems:
Monitor efficiency
Decision authority = confined to a few senior staff
Lead-times and likely demand
Buffer levels

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)
Levels of control:
ABC system - a method of applying selective levels
of control to different categories of inventory
High levels of control and recording would apply to
high-value, low-volume A items
Lower levels of recording would apply to lesser-value,
higher-volume B items
Lowest levels of control and recording would apply to
low-value, high-volume Category C items

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)
Stock / inventory management models:
Economic order quantity (EOQ):
Recognises that total cost includes holding and
ordering costs
Calculates optimum size of the order, taking these
two costs into account
Decreasing inventory held
increase in order costs
EOQ seeks to identify the size of the order that will
minimise the total costs

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)

Figure 13.4 - Inventories holding and order costs

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)
The EOQ model:

2DC
EOQ
where: H
D is the annual demand for the item of stock
C is the cost of placing an order
H is the cot of holding one unit of stock for one year

Some limiting assumptions apply to the model:

Demand for product can be predicted accurately
Demand is even (no fluctuations)
No buffer inventory required
No discounts for bulk purchasing

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)
Materials requirements planning (MRP) systems:
Begins with forecasting sales demand
Technology schedules delivery of bought-in parts
to coincide with production requirements
By ordering those items of inventory necessary
for production, inventory holding costs may be
reduced
Recognises that ordering decisions cannot be
made independent of production decisions
Newer systems also take account of other
resources such as labour and machine capacity

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Inventories
(continued)
Just-in-time (JIT) stock / inventory management:
Aims to have materials delivered to production
just in time for their required use
Limits holding time and investment in raw
materials
Suppliers informed of production requirements in
advance
Some disadvantages:
May mean inventory is more expensive
Risk of non-supply

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Debtors
Credit sales incurs costs
Example: administration, bad debts and opportunity
costs
Business needs clear policy regarding:
Which customers should receive credit
How much credit should be offered
What length of credit it is prepared to offer
Whether discounts will be offered for prompt payment
What collection policies should be adopted
How the risk of non-payment can be reduced

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Debtors
(continued)
Length of credit period:
Varies but may be influenced by:
The typical credit terms operating in the industry
The degree of competition in the industry
The bargaining power of particular customers
The risk of non-payment
The capacity of the business to offer credit
The marketing strategy of the business

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Debtors
(continued)
Cash discounts (early settlement):
Weight cost against the benefits
Danger that customers will be slow to pay and still
take the discount offered
The benefit represents a reduction in the cost of
financing debtors and bad debts

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Debtors
(continued)
Collection policies:
Steps to ensure amounts owing are paid promptly may
include:
Develop customer relationships
Publicise credit terms
Issue invoices promptly
Monitor outstanding debts
Produce a schedule of aged debtors
Answer queries quickly
Deal with slow payers
Identify the monthly pattern of receipts from credit sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia
 The Management of Cash
Why hold cash?
Most businesses hold cash but amount held varies
considerably
3 reasons for holding cash:
Transactionary
Precautionary
Speculative
How much cash should be held?
No set formula - different businesses will have different
views
Amount held can be reduced if
funds can be raised quickly or
assets held that can be converted to cash such as shares
or bonds

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Cash
(continued)
Controlling the cash balance
Use of upper and lower control limits:
Assumes business can access cash as needed
The model proposes the use of two upper and two lower
limits
If an outer limit is exceeded, managers must decide if the
balance is likely to return over the next few days to within
the inner limits, if not, cash must be bought or sold to
restore the cash balance to within limits
Model relies heavily on management judgement to
determine where the control limits are set and what time
limits for breaches are acceptable

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Cash
(continued)

Figure 13.5 - Controlling the cash balance

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Cash
(continued)
Cash flow statements and management of cash:
Useful for a business to prepare cash flow
statements and / or cash budgets
Comparison of budgeted cash flows to cash flow
statements will identify variances for action
Expected cash surpluses and deficits can have a
course of action decided upon by management
prior to them occurring

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Cash
(continued)
Operating cash cycle:
Definition: The time period between the
outlay of cash to purchase supplies and the
ultimate receipt of cash from the sale of
goods
To effectively manage cash, must be aware
of the operating cash cycle
Management seeks to shorten the time and
reduce cash required in the cycle
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia
 The Management of Cash
(continued)
Operating cash cycle is calculated as
follows:
Average inventory holding period
+
Average settlement period for debtors
-
Average payment period for creditors

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Management of Cash
(continued)

Figure 13.7
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia
 The Management of Cash
(continued)
Cash transmission:
Benefit received immediately when payment made in cash
Cheques normally incur a delay
Opportunity cost of this delay can be significant
Alternatives to minimise delays can include:
Insist on payment in cash (not always practical)
Use direct debit facilities and card payments
Bank overdrafts:
Are simply a type of bank loan
Can be useful for managing cash flow requirements

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Trade Creditors
Trade credit = important source of finance for many
businesses
Tends to increase in line with the increase in sales
Widely regarded as free however, there can be
costs associated with taking credit:
Cost of goods may rise as credit needs to be paid for
May be given lower priority in terms of delivery dates
Administration costs associated with dealing with invoices
and confirming receipt of goods / service

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 The Management of Trade Creditors
(continued)
Controlling trade creditors:

Using the average settlement period method:

Average trade creditors
Average settlement period = x 365
Credit purchases
Alternative approaches:
- Ageing schedule
- Pattern of credit payments

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia