BAFS Study Notes: Working Capital Management
Hello everyone! Welcome to your study notes for Working Capital Management. Don't worry if this topic sounds a bit complicated, we're going to break it down together. Think of this as learning the secrets to keeping a business healthy and running smoothly every single day. By the end of this, you'll understand how businesses manage their daily cash, inventory, and bills to succeed!
1. What is Working Capital and Why is it So Important?
Imagine you're running a small bubble tea shop. You need money for daily expenses like buying milk, tea leaves, and pearls, paying your staff, and covering the electricity bill. The money you use for these short-term, daily operations is related to working capital.
Working Capital is the money a business has available to meet its current, day-to-day obligations. It's a measure of a company's short-term financial health and efficiency.
The formula is simple:
$$ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} $$Let's quickly review the key terms:
Current Assets: Things the business owns that will be used or converted into cash within one year. Examples: Cash, inventory (like the pearls and tea leaves), and accounts receivable (money customers owe you).
Current Liabilities: Debts the business must pay within one year. Examples: Accounts payable (money you owe your milk supplier) and short-term loans.
Why is it important?
Properly managing working capital is crucial for survival.
Too little working capital: The business might not be able to pay its bills on time (e.g., can't pay the milk supplier). This is a liquidity crisis!
Too much working capital: The business might have too much cash sitting idle or too much money tied up in inventory that isn't selling. This cash could be invested elsewhere to earn a better return.
The Operating Cycle and Cash Conversion Cycle
To understand working capital better, we need to know how cash flows through a business. This is where the Operating and Cash Conversion Cycles come in. It's simpler than it sounds!
1. The Operating Cycle (OC)
This is the time it takes for a business to turn its inventory into cash. Let's stick with our bubble tea shop example:
Day 1: You buy pearls and tea from a supplier. → Day 10: You sell a bubble tea to a regular customer on credit. → Day 25: The customer pays you back.
The Operating Cycle is the time from buying the ingredients to collecting the cash from the sale (25 days in this case).
2. The Cash Conversion Cycle (CCC)
This is the number of days a company's cash is "stuck" in the business operations. It's the Operating Cycle, but we also consider when we have to pay our own suppliers!
Let's add one more detail to our example: Your pearl supplier gives you 15 days to pay them.
Your cash is paid out to the supplier on Day 15.
You get the cash back from your customer on Day 25.
So, your cash was gone for 10 days (from Day 15 to Day 25). This is your Cash Conversion Cycle!
The formula is:
$$ \text{Cash Conversion Cycle} = \text{Operating Cycle} - \text{Accounts Payable Period} $$The goal for most businesses is to have a short CCC. This means they get their cash back quickly, which they can then use to buy more inventory and grow the business.
Did you know? Some companies, like Amazon, have a negative Cash Conversion Cycle! This means they collect cash from customers (e.g., when you pay with your credit card online) before they even have to pay their suppliers. It's like getting a free loan from their suppliers to run their business!
Key Takeaway
Working capital management is about managing the short-term assets and liabilities to ensure a business runs smoothly. The goal is to keep the Cash Conversion Cycle as short as possible to maintain healthy cash flow.
2. Managing Cash
Cash is the lifeblood of a business. Without it, a business can't survive, even if it's profitable on paper. Managing cash means making sure you have enough to pay your bills, but not so much that it's sitting around doing nothing.
Basic Principles of Cash Management
It's a simple game of timing:
Speed up cash inflows: Collect money owed by customers (accounts receivable) as quickly as possible.
Slow down cash outflows: Pay your own bills (accounts payable) as late as possible without harming your relationship with suppliers or missing out on valuable discounts.
Invest surplus cash: If you have extra cash, put it in a short-term investment to earn some interest. Don't let it be lazy!
The Relevance of a Cash Budget
(Syllabus Note: You don't need to know how to PREPARE a cash budget, just why it's important!)
A cash budget is a forecast of a company's cash inflows and outflows over a specific period (e.g., a month or a quarter). Think of it like making a personal budget to make sure you have enough money for your MTR fares and lunches for the month.
A cash budget is relevant because it helps a manager to:
Identify potential cash shortages: If the budget shows you'll be short on cash next month, you have time to arrange a short-term loan.
Identify potential cash surpluses: If the budget shows you'll have extra cash, you can plan to invest it.
Plan and make better decisions: It provides a clear financial picture for planning major purchases or expansions.
Key Takeaway
Good cash management involves speeding up collections, slowing down payments, and using a cash budget to plan for the future and avoid surprises.
3. Managing Accounts Receivable
Accounts Receivable is the money owed to a business by its customers who bought goods or services on credit.
Offering credit is a great way to attract more customers, but it comes with a risk: what if they don't pay you back? Managing accounts receivable is about setting the right rules to minimise this risk. This is done through a credit policy.
Elements of a Credit Policy
A credit policy has three main parts. It's a balancing act: being too strict might scare away customers, but being too lenient might lead to huge losses from unpaid bills (bad debts).
1. Credit Terms
These are the conditions of the credit sale. A common example is ‘2/10, n/30’. Let's decode this!
'2/10' means the customer can take a 2% discount if they pay within 10 days.
'n/30' means the net (full) amount is due in 30 days if they don't take the discount.
Offering a discount encourages customers to pay faster, which is great for your cash flow!
2. Credit Standard (The 5Cs)
This is how a business decides WHO to give credit to. They assess a customer's creditworthiness using the "5Cs".
Memory Aid! Think: "Can Charlie Cuddle Cute Cats?"
Capital: The customer's financial strength. How much money or assets do they have?
Character: The customer's reputation and willingness to pay their debts. Are they known to be reliable?
Capacity: The customer's ability to generate cash to pay the bill. Is their business profitable?
Collateral: Assets the customer can pledge to secure the credit. (e.g., a property or equipment).
Conditions: The current economic climate. Is the economy strong or in a recession? This can affect a customer's ability to pay.
3. Collection Policy
This outlines the steps the business will take if a customer pays late. It usually starts gentle and gets more serious:
Step 1: Send a polite reminder letter or email.
Step 2: Make a follow-up phone call.
Step 3: Stop offering further credit.
Step 4: Take legal action (as a last resort).
Key Takeaway
Managing accounts receivable means having a clear credit policy (credit terms, standards, and collection procedures) to ensure that customers who buy on credit will actually pay.
4. Managing Accounts Payable
Accounts Payable is the money a business owes to its suppliers for goods or services bought on credit. It's the flip side of accounts receivable.
Think of this as a source of free, short-term financing! Your supplier is essentially giving you an interest-free loan until the payment is due.
The Balancing Act of Paying Your Bills
The main decision here is WHEN to pay your suppliers. It's a trade-off:
Benefits of Delaying Payment:
You hold onto your cash for longer, which improves your own cash flow.
This cash can be used for other purposes in the short term.
Costs of Delaying Payment:
Losing early payment discounts: If a supplier offers terms like '2/10, n/30', paying late means you miss out on that 2% discount. This can add up to a lot of money over a year!
Damaging supplier relationships: Consistently paying late can annoy your suppliers. They might become less willing to help you with urgent orders or offer you good terms in the future.
Harming your credit rating: A poor payment history can make it harder to get credit from other suppliers or banks.
Key Takeaway
Managing accounts payable involves strategically timing payments to suppliers to maximise your cash availability without missing valuable discounts or damaging important business relationships.
5. Managing Inventory
Inventory refers to the raw materials, work-in-progress, and finished goods that a business holds. For our bubble tea shop, it's the pearls, tea, milk, cups, and straws.
Managing inventory is like stocking your fridge at home. If you buy too little, you run out of food. If you buy too much, food might spoil and you've wasted money.
Objectives of Inventory Management
The main goal is to minimise the total costs associated with inventory. There are two main types of costs to balance:
Holding Costs (or Carrying Costs): The costs of storing inventory. Examples: Warehouse rent, insurance, security, and the cost of spoilage or obsolescence (e.g., pearls going bad).
Ordering Costs: The costs associated with placing an order. Examples: Clerical costs to prepare the order, delivery fees.
Notice the trade-off? If you place large orders less frequently, your ordering costs are low, but your holding costs are high. If you place small orders more frequently, your holding costs are low, but your ordering costs are high!
Inventory Control Techniques
So how do you find the perfect balance? We use simple models to help!
1. Economic Order Quantity (EOQ)
The EOQ is the ideal order quantity a company should purchase to minimise its total inventory costs (the sum of ordering costs and holding costs).
Here's the formula you need to know:
$$ EOQ = \sqrt{\frac{2 \times D \times O}{H}} $$Where:
D = Annual Demand (total units needed for the year)
O = Ordering Cost per order
H = Holding Cost per unit per year
Let's try an example:
A shoe shop sells 1,000 pairs of a popular sneaker each year (D). The cost to place one order from the supplier is $50 (O). The cost to hold one pair of sneakers in the storeroom for a year is $10 (H). What is the EOQ?
$$ EOQ = \sqrt{\frac{2 \times 1000 \times 50}{10}} $$ $$ EOQ = \sqrt{\frac{100,000}{10}} $$ $$ EOQ = \sqrt{10,000} $$ $$ EOQ = 100 \text{ units} $$
So, the most cost-effective strategy is for the shop to order 100 pairs of sneakers at a time.
2. Re-order Level Methods
The EOQ tells you how much to order, but the re-order level tells you when to order.
The Re-order Level is the inventory level that triggers a new order to be placed.
You need to order before you run out! The calculation depends on two things:
Usage: How many units you sell per day.
Lead Time: How many days it takes for your order to arrive after you place it.
The formula is:
$$ \text{Re-order Level} = \text{Average daily usage} \times \text{Lead time in days} $$Example:
The shoe shop sells, on average, 3 pairs of sneakers per day. The lead time from the supplier is 5 days.
$$ \text{Re-order Level} = 3 \text{ pairs/day} \times 5 \text{ days} = 15 \text{ pairs} $$
This means the manager should place a new order for 100 pairs (the EOQ) as soon as the stock level drops to 15 pairs. This ensures the new stock arrives just as the last pair is sold, preventing a stockout.
Key Takeaway
Inventory management aims to have enough stock to meet demand while minimising holding and ordering costs. Techniques like EOQ (how much to order) and Re-order Level (when to order) help businesses achieve this balance.