WORKING CAPITAL MANAGEMENT

Study unit 1: Analysing the firm’s cash flow

Statement of cash flows provides a summary of the firm’s operating, investment and financial cash
flows and reconciles in its cash and cash equivalent during the period.

Cash consists of cash on hand and demand deposits, while cash equivale3nts consists of short term
high liquid investments (or marketable securities) that are readily convertible to known amount of
cash. In general, entities view short term as three months or less from date of acquisition. Equity
investment (for example shares in listed companies) is usually not classified as cash equivalents as
they require a distinct transaction to be converted into cash.

Developing the statement of cash flow

Note that cash equivalents (marketable securities) are considered the same as cash because of their
high liquidity.
Both cash and cash equivalents are a reservoir of liquidity that is increased by cash inflows and
decreased by cash outflows.
Inflows and outflows of cash
Inflows equal sources of cash
Outflows equal uses for cash

INFLOWS (sources) OUTFLOWS (uses)

Sales of inventory for cash Purchases of inventory for cash
Receipt of rent income inn cash Payment of rent expenses for cash
Dividend received Dividends paid
Sales of machinery for cash Purchase of machinery for cash
Receipt of long term loan Re-payment of a long term loan
Issue of shares of the firm Buy-back of shares of the firm
Decrease in any asset Increase in any asset
Increase in any liability Decrease in any liability
Net profits after taxes Nett loss
Depreciation and other non-cash charges Dividends paid
Sale of shares Repurchase or retirement of shares
Firm’s Cash flows:

Three Cash flows:

1. Operating flows – cash flows directly related to sale and production of the firms products
and services. Those activities that relate to the principle revenue-generating activities of a
firm. The main transactions in this category are cash receipts from customers and cash paid
to suppliers for goods and services, but can also include:
a) Cash receipts from other income sources, such as rent income, royalties, fees and
commission;
b) Cash payments or refunds of income taxes
2. Investment flows – cash flows associated with purchase and sale of both fixed assets and
equity investments in other firms. For investing activities relating to the non-current assets
of the firm, a distinction must be made between those activities that will maintain the
operating capacity of the firm and those that will expand the operating capacity of the firm.
This distinction will assist us to evaluate the firm’s reinvestment policies and operating
capacity objectives. In general, if the new non-current asset replaces an existing item, the
operating efficiency and capacity of the firm will only be maintained. If, however, the new
non-current asset is added to the existing items without an old item being sold, then the
operating capacity will be increased leading to an expansion in the investments of the firm.
 3. Financing flows – cash flows that result from debt and equity finance transactions; includes
the incurrence and repayment of debt, cash inflow from the sale of stock, as well as cash
outflows to repurchase stock or pay cash dividends. Those activities that result in changes in
the equity or capital of a firm, as well as changes in its borrowings.
Incurring short term or long term debt equals cash inflow
Repaying debt equals cash outflow
Selling the firms shares equals cash inflow

Preparing the statement of cash flows:

The statement of cash flows for a given period is developed at the end of the reporting period after
preparing the statement of comprehensive income as well as the statement of financial position
with comparative information.

Source of Information:
Operating Activity source of information is Income including profits and expense including losses
from the statement of comprehensive income, including additional notes. Movement in working
capital changes (inventory, receivables and payables) from the statement of financial position

Investing Activity source of information is Movement in non-current assets and investment

information from the statement of financial position, including the notes thereof

Financial Activity source of information is Movement of the equity and borrowings from the
statement of financial position, including the notes thereof.

In preparing the statement of cash flows, all non-cash items and transactions must be identified and
excluded from every line item. Examples of non-cash items and transactions are depreciation, bad
debt, buying and selling of credit, profit or loses of sale of non-current assets, impairment losses on
assets and revaluation gain on assets.
Depreciation is the systematic allocation of the cost of an asset (Less residual value if any) over its
useful life. Firms are permitted, for tax and financial reporting purposes, to change systematically a
portion of the cost on non-current assets against revenue. It is the change that is called depreciation

Depreciable value of an asset is its cost plus outlays for installation; an adjustment is expected for
salvage value.
Land and buildings are not depreciable.
Depreciable life of an asset – The time period over which the asset is depreciated. Financial
managers prefer faster receipts of cash flows so they prefer a shorter depreciable life.
Depreciation methods

 Straight line
 Diminishing balance
 Sum of the years digits

Depreciation is written off proportionately for a part of the year if not acquired at the beginning
of the year.

Wear and Tear Allowance is determined by SARS (Depreciation rate in SA). They apply to both new
and used assets. Wear and Tear Allowance is used to determine depreciation of assets for tax
purposes.
Depreciation has no effect on the cash or bank balances of a firm. The change every year is merely
an accounting expense shown in the statement of comprehensive income. When preparing the
statement of cash flow, depreciation is an adjustment (Added back) to the net profit before tax to
show that it is a non-cash item that should be excluded from the statement of cash flows

So even if the firm has a loss adding back depreciation can result in a positive cash flow.
Because depreciation is treated as a separate cash inflow, only gross rather than net changes in non-
current assets appear on the statement of cash flows so as to avoid double counting of depreciation.
Changes in retained earnings are not included on the statement of cash flows and appear as net
profits or losses after taxes and dividends paid.

If the statement of cash flows is prepared using the direct method we immediately use cash flow
figures while the indirect method starts with the profit before tax of the firm and then adjusts that
figure to the end with a figure called cash from operations
Noe that all cash flows are treated as positive values, whereas all cash outflows are treated as
negative values. The items in each category – operating, investment and financing – are totalled, and
the three totals are added to get the net increase/decrease in cash and cash equivalent. The
statement of cash flows will then have to balance to the cash and cash equivalents at the end of the
period as per the statement of financial position.

Operating cash flow (OCF) - the cash flow a firm generates from its normal operations;.

Net Operating Profits after Taxes (represents the firms earnings before interest and tax) equals
earnings before interest and tax multiply bracket one minus corporate tax rate, T bracket.

NOPAT = EBIT x (1-T)

To convert Net Operating Profits after Taxes (NOPAT) to operational cash flow (OCF), we merely add
back depreciation:

Operating cash flow (OCF) equals Net Operating Profits after Taxes plus Depreciation

OCF = NOPAT + Depreciation

We can substitute the expression for Net Operating Profits after Taxes (NOPAT) into the Operating
cash flow (OCF) equation to get

Operating cash flow (OCF) equals earnings before interest and tax (EBIT) multiply bracket one minus
corporate tax rate, T bracket plus Depreciation

OCF = (EBIT x (1-T)) + Depreciation

Finance definition excludes interest cost as an operating cash flow

Free cash flow (FCF) - the amount of cash flow available to investors (creditors and owners) after
the firm has met all operating needs and paid for investments in net fixed assets and net current
assets.

Free cash flow (FCF) equals Operating Cash Flow (OCF) minus Net Non-Current Investment (NFAI)
minus Net Current Asset Investment (NCAI)
FCF = OCF - NNCI - NCAI
Net Non-Current Investment (NFAI) equals change in net non-current assets plus Depreciation
We can see if the depreciation during a year is less than the decrease in net non-current assets,
during that year the Net Non-Current Investment (NFAI) would be negative. Negative Net Non-
Current Investment (NFAI) represents a nett cash inflow attributable to the fact that the firm sold
more assets than it acquired during the year.

Negative NFAI represents a net cash inflow attributable to the sale of more assets than acquired.

Net Current Asset Investment (NCAI) equals change in current assets minus change in (trade and
other payables plus accruals)

“Net” refers to the difference between current assets and the sum of trade and other receivables
and accruals.
Short term borrowings are not included in the Net Current Asset Investment (NCAI) calculation as it
represents a negotiated creditor claim on the firm’s free cash flow.
Study unit 2: The financial planning process.
Two key aspects of financial planning process are cash planning and profit planning. Cash planning
involves preparation of the firm’s cash budget. Profit planning involves preparing of pro-forma
statements.
The financial planning process begins with long-term, or strategic, financial plans. These, in turn,
guides the formulisation of short-term, or operating, plans and budgets

Long term (strategic) financial plans lay out a company’s planned financial actions and the
anticipated impact of those actions over periods ranging from 2 – 10 years.
Generally high level of operating uncertainty and/or short production cycles tend to use shorter
planning horizons.
Long term is planning for outlays for non-current assets, research and development activities,
market and product development actions, capital structure and major sources of financing. Also
included would be termination of existing projects, production lines, or lines of business; repayment
or retirement of outstanding debt; and any planned acquisitions.

Short term (operating) financial plans specify short term financial actions and the anticipated
impact thereof.
1-2 year period is covered and the key inputs are; the sales forecast and the various operating and
financial data.
Key outputs are the cash budget and pro forma financial statements.

Short term financial planning begins with the sales forecast. From it, companies develop production
plans that take into account lead (preparation) times and include estimates of the required raw
materials. Using the production plan, a firm can estimate direct labour requirements, factory
overhead outlays and operating expenses. Once these estimates have been made, the firm can
prepare a pro forma statement of comprehensive income and cash budget. With these basic inputs,
the firm can finally develop a pro forma statement of financial position.
Cash planning: cash budgets
Cash budget (cash forecast) is a statement of the firm’s planned inflows and outflows of cash that is
used to estimate its short term cash requirements.
Sales forecast is the predication of the firm’s sales over a given period based on internal and
external data; used as the key input to the short term financial planning process.

External forecast – A sale forecast based on the relationships observed between the firms sales and
certain external economic indicators.

Internal forecast – A sale forecast is based on a build-up, or consensus, of sales forecasts through
the firm’s own sales channels.

Preparing the cash budget format is as follows

1. Cash receipts: are all of the cash inflows during the given period:
a. Forecast sales –merely information. It provides as an aid in calculating other sale
related items
b. Cash sales (0.2) – The cash sales shown for each month represent 20% of the total
sales forecast for that month.
c. Collection of accounts trade receivable – These entries represent the collection of
trade receivable (T/R) resulting from sales in earlier months.
i. Lagging 1 Month (0.5) – These figures represent sales made in the preceding
month (1 month earlier) that generated trade receivable collected in the
current month. Because 50% of the current month’s sales are collected one
month later.
ii. Lagging 2 Months (0.3) – These figures represent sales made two months
earlier than generated trade receivable collected in the current month.
Because 30% of the current month’s sales are collected one month later.
d. Other cash receipt – These are cash receipts expected from source other than sales.
Interest received, dividend received, proceedings from the sale of equipment, stock
and bond sale proceeds, as well as lease receipt may show up here
e. Total cash receipt – This figure represents the total of all cash receipts listed for each
month.

2. Cash disbursements: are all outlays of cash during the given financial period.
The firm’s purchases represent 70% of sales. Of this amount 10% is paid in cash, 70% is paid
in the month immediately following the month of purchase and the remaining 20% is paid
two months following the month of purchase.
a. Purchases(0.70 x sales) - The firms purchases represent 70% of sales
b. Cash purchases (0.10) – Cash purchases represent 10% of the month’s purchases.
c. Payments of trade and other payables(T/P) – These figures represent payment of
trade and other payables(T/P) resulting from purchases in earlier months.
i. Lagged 1 Month(0.70) - These figures represent purchases made in the
preceding month (1 month earlier) that are paid for in the current month.
Because 70% of the firm’s purchases are paid for one month later
ii. Lagged 1 Month(0.20) – These figures represent purchases made two
months earlier that are paid for in the current month. Because 20% of the
firms purchases are paid for two months later.
d. Rent or lease payments,
e. Wages and salaries – These amounts are obtained by adding the fixed salary cost
per month to 10% of the sale in each month, Amount over the fixed salary cost is
represented by wages.
 f. Tax Payments,
g. Non-current asset outlays,
h. Interest payments,
i. Cash dividend payments(loan) and
j. Repurchase or retirement of shares

Depreciation and other non-cash charges are NOT included in the cash budget, because they merely
represent a schedule write-off of an earlier cash outflow

Net cash flow is the mathematical difference between the firm’s cash receipts and its cash
disbursements in the given period. Net Cash flow is found by subtracting the cash disbursement
from cash receipt in each period. Then we add beginning cash to the firm’s net cash flow to
determine the ending cash for each period.
Ending cash: is the sum of the firms beginning cash and its net cash flow for the period
The final step is to subtract the minimum cash balance form the ending cash balance to determine
total financing requirements.
Finally, we subtract the desired minimum cash balance from the ending cash to find the required
total financing or the excess cash balance.
If the ending cash is less than the minimum cash balance, financing is required. Such financing is
typically viewed as short-term and is therefore represented by short-term borrowing.
If the ending cash is greater than the minimum cash balance, excess cash exists. Any access cash is
assumed to be invested in a liquid, short-term, interest-paying vehicle – that is, in marketable
securities.

Evaluating the cash budget can be used by management as well as creditors to communicate how
the money will be used and how loans will be repaid.
It indicates whether there is a cash shortage or surplus.
It is assumed that the firm will firstly liquidate its marketable securities before borrowing funds.
Coping with uncertainty in the cash budget one can prepare multiple budgets based on pessimistic,
most likely and optimistic forecasts. This is also called scenario analysis.
More complex method of simulation creates a probability distribution of outcomes which can be
used for decision making.

Profit planning: pro forma statements

Whereas cash planning focuses on forecasting cash flows, profit planning relies on accrual concepts
to project the firm’s profit and overall financial position. Shareholders, creditors, and the firm’s
management pay close attention to the pro forma statements which are projected income
statements and balance sheets.

The approaches for estimating the pro forma statements are all based on the belief that the financial
relationships reflected in the firm’s past financial statements will not change in the coming period.
The commonly used simplified approaches are presented in subsequent discussions.
Two inputs are required for preparing pro forma statements:
1. Financial statements for the preceding year and
2. the sales forecast for the coming year.
A variety of assumptions must also be made. Key point to note is that the pro forma statements
reflect the goals and objectives of the firm for the planning period.
Preparing the pro forma statement of comprehensive income
Percent of sales method is a simple method using the forecast sales and then expressing all items as
a percentage of projected sales.

Cost of sales/Revenue
Operating expenses/Revenue all expressed as a %
Interest expense/Revenue

This method assumes that all expenses are variable which they are not and as a result using the past
costs and expense ratios usually have the following effect:
Profits are understated when sales are increasing.
The best is to break the firm’s costs into fixed and variable components. (Regression analysis)

Preparing the pro forma statement of financial position

The simplified percentage approach can be used but the preferred method of the Judgemental
approach is used where the firm estimates the values of certain SFP accounts and uses external
financing as a balancing or “plug” figure.
A positive value indicates that external financing is required.
A negative value indicates that the firm will generate more financing in house than what their
requirements are.

The basic weakness of these simplified approaches lies in two assumptions:

 The firm’s past financial condition is an accurate indicator of its future.
 Certain variables (cash, trade receivables and inventories) can be forced to take on certain
“desired” values.
Study unit 3: Net working capital fundamentals.
An alternative definition of net working capital is that: it is a portion of the business’ assets financed
by long-term funds (when current assets exceed current liabilities) or the portion of the business’
fixed assets financed with current liabilities (when current assets are less than current liabilities).
Net working capital is associated with short-term financial decision making and typically involves
cash inflows and outflows whose timing falls within one year.
Therefore the manager has the task of ensuring that he or she manages the working capital
efficiently in order to sustain operations and produce a return for shareholders in the business.
Certain levels of working capital (current assets) are required for the firm to operate efficiently.
If levels are too low, then the firm will be exposed to additional risk.
Therefore an optimal working capital policy requires a level of investment in working capital where
the returns generated and the exposure to risk are finely balanced.

Short-term financial management: is the management of current assets and liabilities so as to

achieve a balance between profitability and risk that contributes to the firm’s value.

Net working capital:

Current assets or working capital represents that portion of investment that circulates from one
form to another in the ordinary course of business. Short term investments are considered part of
working capital.
Current liabilities represent the firm’s short term financing and usually include the following;
suppliers (trade and other payables), employees and government (accruals), banks (short term
loans/overdraft)
Net working capital is defined as the difference between current assets and current liabilities.
CA>CL= +NWC
CA<CL= -NWC
More predictable cash inflows means lower working capital requirement.

Trade-off between profitability and risk.

Profitability is the relationship between revenues and costs generated by using the firm’s assets –
both current and fixed - in productive activities.
So profitability can increase by increasing revenue or lowering costs.
Risk is the probability that a firm cannot pay its bills as they become due, the firm is then technically
insolvent.
Changes in current assets effects both profit and risk in the following way by analysing the ratio of
current assets to total assets.
If total assets remain constant and CA increase (i.e. the ratio increases) the effect is a decrease in
profits since CA are less profitable than non-current assets. Risk is also decreased since there is now
an increase in net working capital.
The closer an asset is to cash the less risky it is.

Changes in current liabilities also effects profit and risk in the following way by analysing the ratio of
current liabilities to total liabilities.
If total liabilities remain constant and CL increase (i.e. the ratio increases) the effect is an increase in
profits since CL are less expensive than non-current liabilities. Most CL is debts that bear no interest
payment (e.g. trade payables)

Current ratio = Current assets/ Current liabilities

Ratio of CA to CL determines the risk of the firm.
If the current ratio decreases the risk of insolvency decreases since an increase in CL decrease the
NWC and vice versa if the ratio CL to CA increases.

EFFECTS OF CHANGING RATIOS ON PROFIT AND RISK

Change in Effect on Effect on

Ratio ratio profit risk

Current assets/ Increase Decrease Decrease

Total assets
Decrease Increase Increase

Current Increase Increase Increase

liabilities/ Total
Assets
Decrease Decrease Decrease

Cash conversion cycle

A firm can lower the working capital requirement by speeding up the operating cycle.
Calculating the cash conversion cycle:
Operating cycle (OC)is the time from beginning of the production process to collection of cash from
the sale of finished goods.
Consists of two short term asset categories
 Inventory
 Trade receivables
OC is the sum of average age of inventory and average collection period
OC= AAI + ACP

Cash conversion cycle (CCC) is the operating cycle less average payment period of trade payables
CCC= OC - APP

BY SUBSTITUTION we can see that the CCC has 3 main components

 Average age inventory
 Average collection period
 Average payment period

CCC = AAI+ACP-APP
Funding requirements of the cash conversion cycle:
Permanent funding is a constant investment in operating assets resulting from constant sales over
time.
Seasonal funding is investment in operating assets that varies over time as a result of cyclical sales.

Short term funding is typically cheaper than long term but long term allows for the costs of those
funds to be fixed over time as well as the certainty of the availability of those funds in the future.
An aggressive funding strategy is where the firm funds its seasonal requirements with short term
debt and its permanent requirements with long term debt.
A conservative funding strategy is where both are funded by long term debt.
Strategies for managing the cash conversion cycle

The goal is to minimise the length of the CCC which in turn minimises the negotiated liabilities and
the costs associated with them. This can be achieved by using the following strategies
 Turn inventory over in shorter time without running out of stock.
 Collect trade receivables quicker without losing sales from high pressure collection
techniques.
 Manage mail, processing and clearing time to reduce them when collecting from customers
and to increase them when paying suppliers.
 Pay trade and other payables as slowly as possible with damaging the firm’s credit rating.
Study unit 4: Short term financing patterns.
Short-term financial planning is an important aspect of the firm’s operations because it provides the
road maps for guiding, coordinating and controlling the firm’s actions. It also facilitates the overall
long-term financing objectives of the business.
For all companies, these policies are primarily designed to efficiently support the working capital
(cash conversion) cycle of the business.
In the context of working capital management the manager’s goal is to focus on the short-term
(operations) of the business and to ensure that funds are available to sustain these operations.
The manager employs budgets which are then used as a benchmark to forecast future needs. This
ensures that the operations of the business run uninterrupted and that optimal levels of the
operational accounts are maintained.

Working capital policies

Lack of attention to the investment in working capital (which is receivables, inventory, and payables)
can result in a runaway need for cash, especially when sales are growing.
Two basic questions
 What is the appropriate level of current assets needed, both in total and in specific
accounts?
 How should these current assets be financed?

Relaxed current assets investment policy scenario where firm maintains relatively large amounts of
cash, inventory and a high level of receivables and the firms sales are stimulated by the use of credit
policy.
This policy is usually used in times of uncertainty. Firms maintain minimum account levels during
conditions of certainty since holding large levels would increase the need for financing without an
increase in profits. This strategy usually provides the lowest expected return on investment but has
the lowest risk.

Restricted current assets investment policy the firms hold on the above account is minimised.
This policy is usually followed in times of certainty. This strategy generally provides the highest
expected return on investment but has greater risk.

Moderate policy is in the middle of relaxed and restricted when it comes to both return on
investment as well as risk.

Policy and the Cash Conversion Cycle:

Relaxed policy creates high levels of inventories and receivables so longer inventory conversion and
receivables periods and thus longer CCC

Restricted policy tends to reduce inventory conversion and receivables periods thus a shorter CCC

Moderate is policy once again in between.

Seasonal or cyclical fluctuations

During seasonal or cyclical fluctuations growing demand rises above a particular threshold of current
assets that the business has to maintain during the normal cycle. This threshold is referred to as the
permanent current assets requirement.
The process by which these temporary and permanent current assets are financed is referred to as
the firm’s current asset financing policy and falls into three categories depending on the needs of
the business.
Maturity matching approach a firm attempts to finance a current asset account with a loan equal to
the maturity of that asset (matching).
Main disadvantage with this approach is that it is impossible to exactly match assets due to the
uncertainty associated with their lives.
Aggressive approach a firm finances temporary/seasonal assets with short-term, non-spontaneous
debt and finances its fixed assets and some of its permanent assets with long-term debt. This
approach is cheaper but riskier because short-term funds tend to fluctuate often and may not
always be available when required.
Conservative approach a firm finances its permanent assets requirements (both fixed assets and
permanent current assets) with long-term debt and also uses this long-term debt to meet some or
all its temporary/seasonal needs.
This approach is the safest of all approaches but is less profitable since the firm may carry
unnecessary liquidity.
Study unit 5: The Cash Conversion Cycle
Indicates how fast a company can convert cash on hand into even more cash on hand. Measured by
following the company cash as it is first converted into inventory and accounts payable (AP), through
sales and accounts receivable (AR), and then back into cash.
The shorter the cash conversion period is the better.
Companies use this cash conversion cycle in combination with other metrics (such as the return on
equity and the return on assets) as a benchmark for performance, and it is especially useful for
comparing close competitors because a company with the shortest CCC is often one with better
management.
A company’s cash conversion cycle stems out of its operating cycle, otherwise called the working
capital cycle.
The operating cycle (OC) is the time taken from the beginning of the production process to the
collection of cash from the sale of the finished product, and covers two major short-term current
asset categories: inventory and trade receivables.
The operating cycle is given by the expression:
Operating cycle = average age of inventory (AAI) + average collection period (ACP)

The operating cycle also includes the process of buying the raw materials which then reduces this
operating cycle to form the cash cycle or cash conversion cycle. This cash conversion cycle (CCC) is
then given by the expression:
CCC = operating cycle – average payment period (APP)

The CCC involves a series of activities and combines several activity ratios involving accounts
receivable, accounts payable and inventory turnover.
If the company sells what people want to buy, cash cycles through the business relatively quickly.
If management cannot figure out what sells in the market, the CCC slows down.
If too much inventory builds up, cash is tied up in goods that cannot be sold.
If the accounts receivable (AR) are handled poorly, it means that the company is having difficulty
collecting payments from customers.
A company can benefit by slowing down payment of accounts payable (AP) to its suppliers.

Therefore, the cash conversion cycle is managed essentially by

 producing finished goods in a relatively shorter time,
 efficiently managing the accounts receivable and
 By delaying payment to creditors without hampering the supplier-business relationship.

It is the fundamental task of the financial manager to ensure that these company accounts are
managed effectively at all times.

BY SUBSTITUTION we can see that the CCC has 3 main components

 Average age inventory Inventory/ Daily sales
Inventory turnover = cost of goods sold/ inventory
Average age of inventory = number of trading days/ inventory turnover
 Average collection period Trade receivable/ Average sales per day
 Average payment period Trade payables/Average purchases per day

CCC = AAI+ACP-APP
Study unit 6: Inventory management
Differing views on inventory level
Financial manager wants to keep it low so as not to tie up cash.
Marketing manager wants high levels to ensure all orders can be delivered.
Manufacturing manager wants high levels of raw material to avoid production delays and favours
large production runs.
Purchasing manager may buy larger quantities so as to get better prices.

Common techniques for inventory management

ABC system divides inventory into descending order of importance and level of monitoring on the
basis of the rand investment in each.
C group items are monitored with unsophisticated techniques such as two bin method where stock
is reordered when one of the bins is empty.

Economic Order Quantity (EOQ) can be used for A and B class stock. This method determines the
optimal order size, which is the size that minimizes the total of its order costs and carrying costs.
Order costs are the fixed clerical costs of placing and receiving an inventory order.
Carrying costs are the variable costs per unit of holding an item in inventory for a specific time. E.g.
storage cost, insurance, cost of deterioration and obsolescence, and the opportunity cost.

Order costs decrease as the order size increases while carrying costs increase as the order size
increases.

Formula development
S = usage in units per period
O = order cost per order
C = carrying cost per unit per period
Q = order quantity in units

Order cost = O * S/Q (cost per order * number of orders and number of orders is usage/order
quantity)
Carry cost = C * Q/2 (cost to carry a unit * average inventory and average inventory is order
quantity /2)
Total cost of inventory is the sum of the above two formula

Total cost = (O*S/Q) + (C*Q/2)

EOQ is the order quantity that minimises the total cost function, also called optimal order strategy.

So EOQ = √ (2*S*O)/C

Reorder point is the point at which inventory musty be reordered, expressed as days of lead time *
daily usage.
Safety stock is the level held to prevent stock out of critical items.
Inventory turnover is cost of goods sold / average inventory.
EOQ model determines the firm’s optimal order size and, indirectly through the assumption of
constant usage, the average inventory.
Thus the EOQ model determines the firm’s optimal inventory turnover rate, given the specific costs
of inventory.
Just in Time (JIT) minimises inventory by having it arrive exactly as it is needed for production. JIT
uses very little or no safety stock.
System requires high quality parts as well as extensive coordination between the various parties in
the supply chain.

Computerised systems
MRP material requirement plan is the most basic that applies EOQ concepts and computers to
compare production needs to available inventory balances and determines when orders should be
placed based on the products bill of material (BOM)
MRP2 is a sophisticated computer system that integrates data form numerous areas suxch as
finance, accounting, marketing, engineering and manufacturing to generate production plans, as
well as numerous financial and management reports.
MRP and MRP2 focus on internal operations there is now
ERP enterprise resource planning that electronically integrates external information about suppliers
and customers with the firm’s departmental data so that information on all available resources,
human and material, can be instantly obtained in a way that eliminates production delays and
controls costs.

International inventory management

Much more complicated and international inventory managers are less concerned about ordering
economically optimal quantity of inventory but rather to make sure sufficient quantities of inventory
are available when needed.
Study unit 7: Trade receivables management
Average collection period has two parts, first is the time from the sale until payment is mailed and
Secondly from the time from it is mailed until it is in the suppliers account.
First part is managing the credit available and the second part involves the collecting and processing
of payments.
Objective of managing trade receivables is to collect payment as quickly as possible without losing
sales as a result of high pressure collection techniques.
Three topics to accomplish this goal
 Credit selection and standards
 Credit terms
 Credit monitoring
Credit selection and standards:
Credit standards are the firm’s minimum requirements for extending credit to a customer

5C’s of credit provides a framework for extending credit, used for large amount credit requests
Character – credit record
Capacity – ability to repay
Capital – Applicant’s debt relative to equity
Collateral – amount of assets available to use as security
Conditions – current general and industry specific economic conditions

This does not provide an accept/reject decision, that still needs an analyst to make that decision.

Credit scoring high volume small amount credit and involves assigning a weighted score to key
financial and credit characteristics
Example:
Payment history 35%
Amounts owed 30%
Length of credit history 15%
New credit 10%
Type of credit used 10%

Different weights can be assigned

Changing credit standards

Relaxing credit standards and/or credit terms will increase the risk of the firm; it may however also
increase the return to the firm.
Average collection period and bad debts will both increase with more lenient credit standards or
credit terms.
The increase in revenue may produce revenues that exceed these costs.

Making the credit standard decision

To make the decision to relax credit standards the firm must compare the additional profit
contribution from sales to the added costs of the marginal investment in trade receivables and
marginal bad debts.
If additional profit > marginal costs then credit standards should be relaxed.

Average investment in Trade receivable = Total variable cost of annual sales/Turnover of trade receivables

Where
Turnover of trade receivables = 365/Average collection period
Managing international credit
Typically exposure to forex fluctuations; as well as long delays comes into play.
Credit insurance can help to reduce these risks.
Exports are usually priced in the currency of importers local market. Most commodities are however
priced in Rands.

Credit terms:
Credit terms are the terms of sale for the customers who have been extended credit by the firm.

Cash discounts as a percentage deduction are sometimes allowed to customers that pay within a
specified time period. Cash discounts can speed up the collection period as well as decrease the bad
debts. It can also increase sales as customers that pay early get a better price.
Industry types determine credit terms. Perishable products would have short credit terms while
seasonal businesses would tailor make their terms to suit their industry cycles.
A firms credit terms should match the industry norms it is competing in but the individual customer
terms should be a reflection of the customers risk profile.

Cash discount period is the number of days after the beginning of the credit period during which the
cash discount is available.
Increase in discount period will increase sales as well as profits.
Bad debt expense will decrease and thus increase profits.
Profit per unit will however decrease thus lowering profits.

Credit period is the number of days after the beginning of the credit period until full payment of the
account is due.
Increasing period should increase sales and thus increase profits.
Investment in trade receivables will also increase and thus lower profit.
There will be an increase in bad debts and this also lowers profits.

Credit monitoring:
Credit monitoring is the ongoing review of a firm’s trade receivables; to determine whether
customers are paying according to the stated terms.

Average collection period = Trade receivables / Average sales per day

An Ageing Schedule of trade receivables will indicate if slow collection is a norm or specific to certain
customers. Indicates the percentage of the total trade receivables balance that have been
outstanding for specified periods of time.

Management of receipts and disbursements:

The receipt, processing and collection time for the firm, both from its customers and to its suppliers,
is the focus of receipts and disbursements management.

Float refers to the funds that have been sent but are not yet available and it lengthens both the ACP
and APP. Goal should be to shorten average collection time but increase average payment time.
3 components:
Mail float – delay from date posted to date received
Processing float – time from receipt to deposit in account
Clearing float – time from deposit to time funds is available for use
Speeding up collections reduces customer collection float time and thus reduces average collection
period, which reduces the investment in the CCC.
Speeding up can be achieved by changing credit terms; increase cash discount and shorten the
required payment period.

Slowing down payments can be achieved by controlled disbursing which is the strategic use of
mailing points and bank accounts to lengthen mail float and clearing float respectively.

Cash concentration is the process used by a firm to bring lockbox and other deposits together into
one bank, often called the concentration bank.
3 advantages
It creates a larger pool from which to make short term investments, the costs of these investments is
then also lower.
It improves the tracking and internal control of the firm’s cash.
It allows the implementation of payment strategies that reduce idle cash.

Mechanisms to transfer lockbox depository transfer cheque (DTC) or automated clearing house
transfer (ACH)
Electronic funds transfer (EFT) is the third method to transfer funds.

Zero balance accounts are disbursement accounts that the end of day balance is zero, deposits are
made only to cover cheques that have been presented for payment on that day. This allows the firm
to keep all excess cash in interest bearing accounts.

Investing in short term investments

Short term investments can easily be converted to cash. They can be used to earn a return on
temporary idle funds. To be truly marketable it must have:
 A ready market so as to minimise time to convert
 Safety of principle so it experiences little or no loss in value over time
Most commonly used securities are divided into two groups:
 Government issues – low yields but low risk
 Non-government issues – higher yields but higher risks

CREDIT MANAGEMENT AND THE NATIONAL CREDIT ACT 34 OF 2005

National Credit Regulator (NCR) responsible for the regulation of the consumer credit industry, and a
National Consumer Tribunal tasked with dealing with matters relating to the act.
The NCA provides a consolidated set of rules for credit granting, reporting and monitoring. The Act
has been introduced to put a new framework in place for every type of credit transaction in South
Africa.
It aims to prevent reckless lending and over-indebtedness, regulates lending practices, and
establishes new and improved rights for credit consumers.

The following provisions of the Act, which any business extending credit must comply with, clearly
stipulate the rights of consumers.
 Protection from aggressive advertising
 Protection from over-indebtedness
 Pricing (interest rates and fees)

Applying for credit under the NCA

Pre-agreement and quotation: The credit provider must provide the consumer with a pre-
agreement, containing the main features of the proposed agreement and a quotation of the costs.
This pre-agreement is valid for five days and gives consumers an opportunity to shop around for the
best deal.
Credit assessment: The consumer will be required to provide detailed information to the credit
provider.
Consumer credit records and credit bureaux: The Act requires the credit provider upon entering or
amending or terminating a credit agreement to report the transaction to a credit bureau.
Records of application: Credit providers will be required to keep records of all applications for credit
and credit agreements for a prescribed time.
Payment of accounts: A consumer may pre-pay any amount owing at any time, and fully pay up the
account at any time without penalty, except in the case of mortgage bonds or agreements in excess
of R250 000 which are subject to a termination charge of not more than three months’ interest.
Over-indebtedness and reckless lending
The Act aims to promote responsible credit granting and use.
Actions to be taken by an over-indebted customer
The consumer should approach a debt-counselling service.

In order to ensure that the purpose of the NCA is followed and achieved, the following four vital role
players were established by the NCA:
1. The National Credit Regulator - administrative regulator
2. The National Consumer Tribunal - conduct hearings into complaints
3. Debt Counsellors
4. Consumer Courts
Study unit 8: Trade and bank credit
Spontaneous liabilities:
This is financing that arises in the normal course of business and has two sources; trade and other
payables and accruals. Normally no explicit cost attached to these sources of financing and both are
normally unsecured.

Trade and other payables management

The management by the firm of the time that elapses between its purchase of raw materials; and its
mailing of payment is the APP, the last component in the CCC.
Once again two components
 Time from purchase to the time of mailing payment
 Payment float time
Firm’s goal is to pay as slowly as possible without damaging its credit rating. Payment should be
made on the last day possible and not sooner.

Taking a cash discount that is offered has no cost associated with it. Taking cash discounts may
represent an important source of additional profitability.

Deciding not to take advantage of a cash discount has an implicit cost attached to it; the implied rate
of interest paid to delay payment of an account payable for the additional number of days.

Cost of giving up discount = (CD / 100%-CD) * (365/N) could be 360 so read the question
CD – cash discount in %
N - Number of days that payment is delayed by giving up the discount

This formula will give the annualised percentage of giving up the discount.
An approximation formula can also be used: Cost of giving up discount = CD * (365/N)
If bank borrowing costs are lower than the cost of giving up a cash discount then the cash discount
should be taken as it is a cheaper form of financing.

Effects of stretching trade and other payables is the strategy whereby a frim pays bills as late as
possible without damaging the firm’s credit rating. Stretching reduces the implicit costs of giving up
a cash discount. Stretching raises ethical issues.

Accruals are liabilities for services received for which payment has yet to be made. E.g. wages and
taxes, taxes can however not be manipulated but the accrual of wages can be manipulated to some
extent. This is done by delaying payment

Unsecured sources of short term loans:

Unsecured short term loans come from two sources; banks and sales of commercial paper. These
loans are negotiated and result from actions of the firm’s management.
Bank loans
Short term, self-liquidating loan is an unsecured short term loan in which the use to which the use to
which the borrowed money is put provides the mechanism through which the loan is repaid.
Normally used for seasonal financing needs.
Loan interest rates
Rate can be fixed or floating. Prime rate of interest is the lowest rate of interest charged by leading
banks on business loans to their most important borrowers.
Rates are normally adjusted depending on the risk profile.
Fixed rate loan the interest % remains constant
Floating- rate loan the interest rate varies depending on the prime rate.

Computing interest – once nominal annual rate is established, the method of computing interest is
determined. Interest can be paid when loan matures or in advance.

When interest is paid at maturity the effective annual rate is

Interest/Amount borrowed

If interest is paid in advance then it is called a discount loan and its effective annual rate is
Interest/ (Amount borrowed – Interest)

Paying interest in advance raises the effective annual rate above the stated annual rate.

3 basic ways that banks lend out short term

Single payment notes - short term, one time loan made to a borrower who needs funds for a specific
purpose for a short period.

Total interest cost ~ Loan amount * [interest rate * (loan days/365)]

Effective rate= Interest/Amount borrowed

Effective annual rate = [1 + (CD/100-CD)] days in year/N -1

Lines of credit or overdraft facility – a pre-approved line of credit to a firm and is the maximum
amount the firm can owe the bank at any one time. It is not a guaranteed loan but depends on
whether the bank has sufficient funds available.
Interest rate is normally a floating rate.
Operating-change restrictions are normally imposed by the bank which allows the bank to revoke
the line of credit if any major changes take place within the firm.
A compensating balance is sometimes required by the bank. This is a required cheque account
balance equal to a certain percentage of the loan amount.
This compensating balance will increase the effective interest rate since some of the loan amount
may not be used.

Annual clean up – is the requirement that for a certain number of days during the year borrowers
under a line of credit carry a zero balance, this ensures that short term loans do not become long
term loans.
Revolving credit agreements – line of credit granted to a firm regardless of the scarcity of money.
Since it is a guaranteed line of credit there is a commitment fee attached to it which is the fee
charged on the average unused portion of the credit line. (fee charged as the bank has to put this
unused amount one side in case the firm needs it and they can only charge interest on what is
actually owed).
The effective interest rate is calculated by adding the interest charged + commitment fee charged.

Commercial paper – is a form of financing consisting of short term, unsecured promissory notes
issued by firms with a high credit standing. Money market security with a fixed maturity date (3-9
months). Commercial paper is usually sold at a discount to its par value (face value).
Size of the discount and time to maturity determines the effective interest rate. The interest cost is
normally lower than the prime rate, so firms are able to raise funding cheaper than by going through
banks.
International loans

International transactions - Payments are normally made/received in foreign currency. There is a risk
of forex fluctuation exposure but these risks can be hedged through forward cover contracts.
Normally these are large transactions with long maturity dates.
Financing international trade – letter of credit is probably the most commonly used and is simply a
letter from the company’s bank addressed to the company’s foreign supplier, stating that the bank
guarantees payment of an invoiced amount if all the underlying agreements are met.
Transactions can also be financed in the foreign countries capital market so as to minimise exchange
rate risks.
Transactions between subsidiaries – parent companies can minimise foreign exchange fees and
transaction costs by “netting” amounts owed between subsidiaries.

Secured sources of short term loans

Secured short term financing has specific assets pledged as collateral. (Trade receivables, inventory)
There is a security agreement between the borrower and lender that specifies the collateral held
against a secured loan.
The presence of collateral has no impact on the risk of default but only ensures recovery in the event
of the borrower defaulting on the secured loan.
Definitions
Aging schedule: a credit monitoring technique that breaks down trade receivable into groups on the
basis of their time of origin. It shows the percentages of the total trade receivables balance that
have been outstanding for specified periods of time.
Average collection period (ACP): a useful means for evaluating credit and collection policies. It is
determined by dividing the average daily credit sales into the accounts receivable balance.
Average age of inventory (AAI): the cycle comprises two components - the period of time that
elapses between the building up of inventory and cash being collected from the sale of that
inventory.
Average payment period (APP): the time period that elapses between buying the products and
actual payment when companies buy inventory on credit from producers or suppliers. The APP is
determined by dividing the average daily credit purchases into the accounts payable balance.
Carrying cost: the cost of carrying inventory. Carrying costs of the company rise in direct proportion
to the size of the order.
Cash conversion cycle (CCC): the total number of days in the operating cycle of the company less the
average payment period. The maintenance of adequate levels of cash contributes to the
maximisation of the value of the company.
Cash concentration: the process used by the company to bring lockbox and other deposits together
into one bank, often called the concentration bank.
Cash discount: the amount by which a seller is willing to reduce the invoice price in order to be paid
immediately, rather than in the future. A cash discount of 2/10 net 30 means a 2 percent discount is
given on the invoice if the bill is paid within 10 days, otherwise the entire amount is due within 30
days.
Commercial paper: a form of financing consisting of short-term, unsecured promissory notes issued
by companies with high credit standing.
Compensating balance: the required checking account balance equal to a certain percentage of the
amount borrowed from the bank under a line of credit or revolving credit agreement.
Credit scoring: a credit selection method – commonly used with high-volume/small-rand credit
requests – that relies on a credit score of weights applied to an applicant's credit history.
Credit period: the length of time for which credit is extended. If the credit period is lengthened,
sales will generally increase as will accounts receivable. This will increase the financing needs and
possible bad debts. A shortening of the credit period has an opposite effect.
Economic ordering quantity (EOQ): the point where the total cost of ordering and carrying inventory
will be at its lowest or optimum level
Float: funds that have been sent by the payer but are not yet usable funds to the payee.
Finished goods: inventory (stock) held in order to provide an immediate service to the customer or
to provide for the immediate demand for a specific product.
Marketable security: short-term funds.
Near-cash assets: assets that can be converted into ready cash at short notice without the possibility
of losses attached to their conversion (liquidity of assets), for example a marketable security such as
a treasury bill.
Net working capital: the difference between current assets and current liabilities (also referred to as
net current assets). If the current assets exceed the current liabilities, the company is said to have a
positive net working capital.
Nominal rate interest: the actual rate of interest charged by the supplier of funds and paid by the
demander.
Non-recourse basis: the basis on which trade receivables are sold to a factor with the understanding
that the factor accepts all credit risks on the purchased accounts.
Ordering cost: the cost of inventory ordered. Ordering costs decline if orders are placed infrequently
and larger quantities of inventories are kept.
Operating (cash) flows: cash flows directly related to sale and production of the company's product
and services.
Operating cycle: this is the period of time that elapses between processing raw materials of
inventory and receiving cash for the finished product. The cycle comprises two components - the
average age of inventory (AAI), and the average collection period (ACP).
Revolving credit agreement: a line of credit guaranteed to a borrower by a commercial bank
regardless of the scarcity of money.
Short-term financial management: management of current and current liabilities.
Short-term financial plan: a plan that specifies short-term financial actions and the anticipated
impact of those actions.
Statement of cash flows: provides a summary of the company's operating, investment and financing
cash flows and reconciles them with changes in its cash and marketable securities during the period.
Turnover: sales of inventory for cash or on credit.
Working capital: the management of a company's current assets and current liabilities.