Management Accounting Techniques

Lesson 10
Management Accounting Techniques

The 4 Main Topics of this Lesson

Starting the Working Completing the Working

Capital Cycle Capital Cycle

Improving Cash Flow Further Improvements

to Cash Flow

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The Working Capital Cycle

In the last lesson, we explained that the working
capital cycle describes the way cash moves through
the organisation and that managing it is fundamental
to controlling cash.

Organisations purchase goods, pay suppliers and hold

inventories. They make sales and collect cash from
credit customers so that they can purchase more raw
materials or goods to sell, and enable the cycle to
continue.

Managing the working capital cycle is key to

maintaining the liquidity of an organisation.

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Liquidity
Liquidity is the term we use when talking about how
quickly and easily an organisation’s assets can be turned
into cash. If we think about the cycle again, raw materials
are the least liquid of the current assets, as they need to
be made into finished items of inventory, which are then
sold to customers. We may receive cash at the point of
sale but it is more likely that we will have to wait for credit
customers to pay their invoices before any cash is received
into the organisation’s bank account, and becomes
available to make payments.

Cash is obviously the most liquid of our current assets and

there must always be sufficient cash in the system to pay
suppliers, wages and other expenses as they become due.
If there is insufficient liquidity in an organisation, in other words, if it runs out of cash, it will fail.

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The Length of the Cycle

As liquidity is vital to an organisation’s survival it needs to be monitored closely, using a cash
budget, and action taken to improve cash flow when necessary; calculating the number of days
it takes to complete the working capital cycle can help us do that.

The length of the cycle is calculated as inventory days plus receivables days less payables days,
so let’s start with inventory.

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Inventory Holding Period

Holding inventory costs money because we have to pay for things like warehousing costs, and
when cash is tied up in inventory, it cannot be used to make other payments, like rent or wages.
Therefore, it is important to understand how long inventory is stored for before it is sold. We can
calculate this by dividing the inventory figure by the cost of sales figure from the organisation’s
financial statements, then multiplying by 365 days.

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Inventory Holding Period (cont.)

Let’s look at an
organisation’s financial
statements that show
us two years of figures.
Having a double set of
figures enables us to
calculate ratios that are
comparable from one
financial year to the next.
We can see the cost
of sales figure on the
statement of profit or loss
and the closing inventory
figure on the statement of
financial position.

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Inventory Holding Period (cont.)

If we had opening and closing
inventory figures for both years,
it would be more accurate to
calculate the mean average of the
two figures and use that in our
calculation. Here, we will simply use
the closing inventory figure, which
is £16,200, for the first year, divide
it by the cost of sales and multiply
it by 365 days. This gives us a figure
of 59.13, which we’ll round to one
decimal point. In other words, it
takes us an average of 59.1 days to
sell each item of inventory.

Let’s see what it is for year two.

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Inventory Holding Period (cont.)

There is a slight increase in the actual inventory figure, and the inventory days have risen to 60.5
days. This means that more inventory is being held and it is taking longer to convert into sales.

The inventory holding period, or inventory days, is just one of the three ratios we need to
calculate in order to work out the length of the working capital cycle. Whilst it is useful in its own
right, as we now know we are taking longer to sell items than we did last year, it is important to
look at a range of ratios to understand the full picture and identify and explain any links we find.

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Inventory Holding Period (cont.)

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Payables Days/Receivables Days

Now we know how to calculate the inventory holding period, let’s see how we calculate the
trade payables payment period or payables days, and the trade receivables collection period,
the receivables days.

These are the number of days it takes to pay our suppliers and to receive funds from our
customers. They are important because if we are paying suppliers much more quickly than we
are receiving money from our customers, we are in danger of running out of cash.

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Payables Days/Receivables Days (cont.)

If we allow our customers a credit period of 30 days, we would expect the majority of invoices to
be paid at around 30 days and not at 60. We are effectively lending money to other businesses
by allowing them credit. If customers then take too long to pay, they are borrowing from us
without authorisation.

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Calculating the Payables Days

So let’s start by calculating the payables days for our business. This is the payables figure of
£13,000 divided by the cost of sales, and multiplied by 365 days.

We get 47.45, which we’ll round to 47.5 days.

A more accurate version of the formula would be payables divided by credit purchases, or even
total purchases. However these figures are not always available. This unit specifies cost of sales,
so we will use that.

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Calculating the Payables Days (cont.)

The second year’s
period is 35.5 days,
which means that we
are paying our suppliers,
on average, 12 days
earlier than we did a
year ago. This will make
our suppliers happy,
but we need to look
at how quickly we are
receiving funds from
our customers to be
sure that we are not
causing issues with cash
flow.

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Calculating the Receivables Days

The receivables collection period
is calculated as the receivables
figure divided by revenue
multiplied by 365.

Again, ideally we would use

credit sales. However this is
not always available, and the
standards for this unit use
revenue, so we will do the same.

For year one this will be £14,000

divided by the revenue figure
and multiplied by 365 to get
40.39, which rounds to 40.4
days.
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Calculating the Receivables Days (cont.)

As this figure is slightly less than the payables days for the year, there is a good relationship
between the two ratios. However, if our credit terms are 30 days, then we need to work with our
credit control team as customers should be settling their invoices approximately 10 days earlier
than they actually are.

Year two gives us a figure of 44.2 days, which is worse than the previous year and in contrast to
the reduction in the payables days.

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Calculating the Receivables Days (cont.)

If we continue to
pay suppliers more
quickly than we
receive funds from
customers, it is likely
that we will end
up with cash flow
problems.

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Calculating the Working Capital Cycle Days

What we need to do now is look at the overall
picture by calculating the working capital cycle
days, which is inventory days plus receivables
days minus payables days.

We calculated inventory days for each year

before and we use these, together with the
figures that we calculated earlier, to show that
the working capital cycle has changed from 52
days in the first year to 69.2 days in the second
year.

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Calculating the Working Capital Cycle Days (cont.)

The lengthening of the working capital cycle means that we have more money in it in year two,
than in year one. However, there is a problem with this. The extra cash is effectively tied up
in receivables and inventory, and is not being used elsewhere in the organisation. It could be
used to pay off long-term liabilities, reducing the interest that we are paying, or to invest in the
business in other ways, such as buying new assets or improving the building. What it means is
that the extra cash is not generating profit, it is simply keeping the company going, by funding
the additional 17.2 days in the cycle. In other words, because we are not selling goods quickly,
and not collecting funds from our customers promptly, the money is not working for us. It is
simply being used to ensure that we can pay our suppliers.

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Calculating the Working Capital Cycle Days (cont.)

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Improving Cash Flow

So far in this lesson we have calculated the length of the working capital cycle for the last two
financial years by adding the trade receivables collection period to the inventory holding period,
and deducting the trade payables payment period. We have seen that the working capital cycle
has lengthened as a result of:

• holding more inventory and taking longer to sell it

• reducing the time we take to pay suppliers
• and an increase in the time it takes customers to settle their invoices

Whilst this means that there is more cash in the working capital cycle, it is effectively tied up in
receivables and inventory. This means that it is not liquid and therefore not available to be used
elsewhere in the organisation.

In the last lesson, we prepared a cash budget to help us plan for the next six months, by
ensuring that we know exactly how much cash is flowing into, and out of, the business.

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Improving Cash Flow (cont.)

If you recall, as well as budgeting for day-to-day receipts and payments, we planned to invest in
a new machine to expand production capacity and increase sales. However, our analysis of the
working capital cycle shows that we are paying our suppliers more quickly than we are receiving
cash from customers. This, combined with our budgeted purchase of a non-current asset,
despite the majority of it being funded by a loan, shows up as a predicted negative cash balance
at the end of May.

Cash flow should then recover in June once sales income increases, due to the capital
investment in March, but we still have a shortfall in May.

So what can the business do in this situation?

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Improving Cash Flow (cont.)

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Dealing with a Negative Cash Balance

Well, we have already done the most important thing, which is to identify the issue five months
in advance. This gives us time to take action to address the problem.

Although the shortfall is a significant figure, our total budgeted cash outgoings for the month are
just over £70,000. This means we are really only worrying about two and a half percent more
than the budgeted figure.

It may be possible to speak to our bank and arrange an overdraft. This would act as a temporary
loan to cover the problem.

However, overdrafts are potentially expensive and there may be cheaper solutions that we can
use, especially as we are aware of problems within the working capital cycle.

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Delaying Payments to Suppliers

The most obvious one is to delay payments to our suppliers. Last year we paid them after 47
and a half days but this year that has reduced to 35 and a half days. This may have been because
we needed to improve our relationship with our suppliers. If we were regularly paying them
very late, our suppliers may have lost trust in us to be a good payer, and could have reduced
the amount of credit they made available. Whilst we wouldn’t want to return to that situation,
paying suppliers too quickly is not good for cash flow. We could try to negotiate a permanent
increase in our payment terms with our larger suppliers, from 30 days to 45 days, maybe timing
the negotiations to coincide with us placing a large order.

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Delaying Payments to Suppliers (cont.)

Let’s see what happens
to our cash budget if we
adjust it from paying 60% of
invoices in month one and
40% in month two, to 40%
in month one followed by
60% in month two.

The change in the payment

pattern, in effect, delays
payments to suppliers. So,
in January the payment
reduces slightly, which in
turn increases both the
net cash flow and closing
balance for the month.
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Delaying Payments to Suppliers (cont.)

Whilst the individual decreases in
payment amounts are relatively
small, the cumulative effect on the
net cash flow and balance each
month is significant.

We now only have a small negative

cash balance at the end of May,
which is likely to be within our
existing overdraft limit. However,
this is still far from ideal and we
will need to closely monitor our
cash position during this period
to ensure that we do not end up
with a more significant negative
balance.
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Collecting Funds From Customers More Quickly

Another solution would be to make a concerted effort to collect funds from customers more
quickly. We already know that, generally, customers are taking an additional 10.4 days of
unauthorised credit, on top of the standard 30 days agreed. If we could successfully chase
receivables and alter the pattern of receipts to 35% of credit sales in month one and 65% in
month two, this would solve the cash flow issue in May and result in a positive cash balance.
Whilst this is better than being overdrawn, it is still quite tight and leaves little room for error.
Some customers could agree to pay more quickly but then fail to deliver, maybe because of cash
flow problems of their own.

We could try incentivising customers to pay more quickly by offering them a prompt payment
discount. This would help improve cash flow but would come at a cost as our receipts would be
reduced by the discounts taken.

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Collecting Funds From Customers More Quickly

(cont.)

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Altering the Inventory Holding Period

We have seen how delaying payments to
suppliers and chasing customers to get them
to pay sooner, possibly by incentivising them
with prompt payment discounts, can improve
cash flow.

However, payables and receivables are only

two of the three elements in the working
capital cycle, and whilst the change in the
inventory holding period is not as significant
as for the other two ratios, we should still
consider ways to improve it.

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Altering the Inventory Holding Period (cont.)

The most obvious way would be to try and reduce the
amount of cash tied up in inventory by minimising the length
of time it is held in storage. Many organisations operate a
just in time inventory system, where goods are delivered
as needed. However, whilst this can be a way of improving
cash flow, it also increases the risk of running out of raw
materials, which could stop production, thus reducing
income and benefiting competitors.

Currently, the cash in our working capital cycle is effectively

tied up in receivables and inventory, meaning that it is
not liquid and unavailable to be used elsewhere in the
organisation. If the cycle was shortened, more cash would
be available to pay off long-term liabilities for example, or to
be re-invested in the business, maybe by buying new assets.

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Funding a New Machine

We can see that this is the case in
relation to the funding of our new
machine. In order to address the fact
that the business is insufficiently liquid
to resource its expansion plans, we have
budgeted to raise additional finance in
the form of a loan.

If our working capital cycle was the right

length to just facilitate the day-to-day
running of the organisation, surplus
cash would be released into our capital
reserves and we may not need to raise
additional finance.

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Changing the Payment Patterns

The actual purchase of the new machine
doesn’t have a significant effect on the
resources of the business because the
increase in the value of assets will be offset
by an increase in external debt, the loan,
with only £500 being funded from cash
reserves.

However, changing the payment patterns

for the debt could improve the cash flow
position. Currently the total amount is due
to be paid in March, so we could try to
negotiate a delay and spread the payment
across four months instead. This could
mean that we don’t end up with a negative
cash balance at the end of May.
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Drawings Payments
The final change we could make to
our cash budget to improve cash
flow is to even out the drawings
payments. Remember these are
the amounts that the owner
withdraws for their personal use.
Currently drawings range from £800
in February to £3,900 in May. A
total of £8,550 is taken out of the
business over the six month period.
If we evened out the payments,
so that £1,425 could be drawn
each month, it would significantly
stabilise the cash flow.

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Combining Strategies
In practice, a combination of more than
one of these strategies is likely to be used.
Indeed, if we made all four of the changes
we have discussed, then not only would
we avoid the negative cash balance in
May, but the cash flow would improve
significantly, giving us a positive cash
balance instead.

Managing cash, like all budgeting, is

based on a combination of forecasting
and planning, together with ongoing
monitoring. Using accounting software
undoubtedly makes the process quicker
and easier as budgets can be produced
and amended in a matter of a few clicks.
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Use of Technology
Alternatively, figures can be exported from software packages and
then adjusted on a spreadsheet. Either way, the use of technology to
automate cash flow budgeting is really helpful because of the planning,
monitoring, revising and re-monitoring process that is required, if the
cash budget is to be effective.

Once you have identified the strategies you are going to use, you may
need to present the cash budget to managers or a board of directors for
approval. The way you present the budget is key to success. As we have
seen, the cash budget, with its workings tables of lagged receipts and
payments, is not always the easiest document to understand and can be
overwhelming.

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Use of Technology (cont.)

When a spreadsheet is accompanied by visuals like graphs,
charts and maybe even photos, it becomes more accessible.
However, these are not necessarily the standard ones
produced by accounting or spreadsheet software, but rather
more creative graphic depictions of our figures.

The technique of visualisation is based on research that

shows we are much more likely to understand and remember
information when it is presented to us in a visual way. Providing
accurate information to management for the purposes of
planning, control and decision making is fundamental to all
the topics we have covered in this unit. So, ensuring that our
information is as understandable as possible, is key.

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Recap
In this lesson, you have learned about:

• Starting the Working Capital Cycle

• Completing the Working Capital Cycle
• Improving Cash Flow
• Further Improvements to Cash Flow

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