Managing Working Capital. Managing Working Capital
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1 Managing Working Capital Working Capital is the name given to funds invested in the short-term assets of the business. While all assets should work to produce a return on investment, it is often easier to see this in short-term assets. Cash Raw Material Inventory Finished Good (Sold) A/C Receivable Cash 1 Managing Working Capital In a supermarket capital invested in working capital may transform itself into and out of cash more than 20 times a year. Working capital itself is defined as the excess of current assets over current liabilities. Managing working capital means deciding on a level of current assets and current liabilities. The level of working capital and the relationship between current assets and current liabilities provide measures of financial risk. (EG: The risk of becoming illiquid). 2 1
2 Managing Working Capital Working capital management and working capital policy seek to control the investment in each current asset so that an acceptable level of "cover" is provided. Need to manage each source of short term funds with a view to minimising both cost and risk. Why not finance current asset investments with long-term borrowings? A: Tends to be too expensive! 3 Managing Working Capital Consider the issues facing a firm trying to expand sales to increase profitability. Catch 22 situation! "Overtrading" - having too small a base of long term funds to finance an increase in operations. 4 2
3 Working Capital Policy Working capital policy requires that we simultaneously analyse the financing requirement to maintain a specific level of current assets and that level's impact on profitability and risk to the firm. The precise level of investment in working capital will depend somewhat on management's attitude toward risk. Managing investment in working capital is a dynamic task! i.e. One is managing a firms liquidity and investment decisions on a continuing basis. 5 Inventory Management Inventory is a significant investment for most firms. Tends to range from 5% to 20% of total assets for a company. (Although figures as high as 40% are not unusual). Ardmore figure? The objective for inventory management is to strike a balance between risk and return. Risk: Return: Delayed production due to stockout. Poor return on cash tied up in inventory. 6 3
4 Inventory Management Costs of holding inventory include storage, handling, insurance, breakage, wastage, obsolescence, and cost of money. 30% + Categories of inventory include raw materials, work in progress and finished goods. Inventory plays an important role in that it provides a link between production and sales. Companies rarely produce to order. Level of inventory maintained may often be a source of conflict between functional managers. 7 Inventory Management Objective of inventory management should be thus: Increase levels until additional costs equal the profits resulting from higher levels. Inventory Valuation Rule is "the lower of cost or net realisable value. Not as simple as it sounds. How do you measure "fair market value"? How do you measure cost? 8 4
5 Inventory Valuation FIFO Method First-in First-out. Assumes materials purchased first are used first. Inventory is thus valued at cost of recent purchases. Widely accepted for accounting and taxation purposes. In periods of inflation, inventory (closing) tends to have a high value and thus profit is high (relatively). 9 Inventory Valuation LIFO Last-in First-Out Assumes most recently acquired goods are used first. Closing inventory is thus valued at cost of oldest goods. COGS tends to be high and profit low as a result. Shows a more realistic profit figure in times of rising prices, but valuation may be out of date. Other methods used include average cost, standard cost and adjusted selling price. 10 5
6 Inventory Valuation It is important to be consistent in policy chosen between periods and to exercise prudence. The value of inventory on a balance sheet can vary significantly depending on the valuation method chosen. 11 Inventory Control As investment in inventory grows, proper management (control) of that inventory becomes more important. 80/20 Rule Rule of thumb stating that 80% of inventory value is accounted for by 20% of items in store. Concentrate on controlling the 20%. Becoming outdated due to more sophisticated techniques. 12 6
7 Inventory Control - EOQ Model Economic Order Quantity Model (EOQ) Used to determine the optimal order size for an inventory item given : - expected usage - carrying costs - ordering costs The model assumes that demand is know and uniform throughout the year. The EOQ is defined as the optimal inventory order size that minimises total cost (the sum of ordering costs and carrying costs). 13 Diagram : Economic Order Quantity Model Total Costs Cost Carrying Cost Order Costs EOQ Order Quantity (Units) 14 7
8 Inventory Control - EOQ Model The following formula calculates the economic order quantity (EOQ) : EOQ = 2DS Ic Where, EOQ = (Economic) Order Quantity. D = Usage in units of the product / period. S = Cost of Placing an Order. Ic = Carrying Cost per unit per period. 15 EOQ - Example A Manufacturing Company expects to use 8000 steel plates in the coming year. The estimated cost of placing an order (including follow up costs and written verification) is 20. Each plate costs 10 and it is estimated that annual carrying costs per plate runs at approximately 30%. Required: Calculate and interpret the EOQ. Class Exercise 16 8
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