ACCA F9 Financial Management - 2010 - Study text

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Chapter 2: The financial management environment

Certificates of Deposit (CDs)

There is also a money market for Certificates of Deposit (CDs). A CD is a financial

instrument issued by a bank, acknowledging that the bank is holding a short-term

bank deposit on which interest is being earned. At the end of the deposit period, the

holder of the CD is entitled to take the deposit with interest. A company placing a

deposit with a bank for a fixed short term, say six months, can ask the bank to

provide it with a CD; if the company subsequently needs the cash before the end of

the deposit period, it can sell the CD in the secondary market. The advantage of a

CD for the bank is that it can hold onto the deposit for the full period to maturity,

even if the original depositor needs cash earlier.

Repo market

The repo market is a market for the sale and repurchase of short-term financial

instruments, in particular Treasury bills, government bonds with a very short time

remaining to maturity and some bank bills. A repo transaction is the simultaneous

agreement to sell a quantity of financial instruments and to buy them back again at

a later date, say 14 days later, at a higher price. The difference between the sale and

the repurchase price represents, in effect, interest on a cash loan secured by the

financial instruments in the transaction. This is the money market used by central

banks to manage the interest rate.

3.3 The trade-off between risk and return

When investors put money into financial investments, they expect to receive a

return on their investment. In most cases, they also expect to accept some

investment risk. Investment risk is the risk that returns will not be as high as

expected.

For example:

 an investment might fall in value, as well as rise in value; for example, shares

can go up or down in price

 the investment will lose all its value, for example if a company goes into

liquidation, there is a risk that shareholders will lose their entire investment

 borrowers will not repay what they owe in full or on time. For example, if a

company goes into liquidation, its bondholders will not be repaid in full,

although there might be some receipts from the sell-off of the collapsed

company’s assets.

 Investors in bonds rely on the creditworthiness of the bond issuer. Some bond

issuers are more creditworthy than others, and so the investment is less risky.

In the case of equities, investors buy shares hoping for some dividends out of the

profits each year, and for some increase over time in the share price. Equity returns

are therefore a combination of dividends and capital gain. However, unprofitable

companies might pay no dividends, and share prices might fall. Equity investors

can therefore face a substantial risk of negative returns.

As a general rule, investors will demand a higher return for putting their money

into higher-risk investments. Each investor has his own preference for risk and

returns, and will build an investment portfolio that appears to provide a suitable

balance or ‘trade-off’ between risk and return.

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A guide to the risk in capital instruments is as follows:

Highest

risk

Equities  Risk of lower dividends and a falling share price.

 If the company goes into liquidation, equity

shareholders are the last in line for payment from

the sale of the company’s assets.

 Shareholders are not entitled to any dividend unless

there are distributed profits available after paying

all interest obligations and any dividend payment

obligations to preference shareholders.

High

risk

Junk bonds

 Bonds issued by companies that are considered a

high credit risk. Junk bonds have a ‘sub-investment

grade’ credit rating. A high interest yield is required

to compensate investors for the high risk of default.

Corporate

bonds with an

investment

grade rating

 Bonds issued by companies with a higher credit

rating are ‘investment grade rating’. Top-rated

bonds are ‘triple-A rated’ (credit rating AAA).

 The better the credit rating, the lower the credit risk

and the lower the yield paid to bondholders.

Low

risk

Government

bonds

 Bonds issued by a government in their own

currency, such as gilts issued by the UK government

or Treasuries issued by the US government, are

considered risk-free. Investors consider the risk of

default by the issuer to be zero.

 The interest yield on domestic government bonds of

a government in a stable economy is therefore

considered ‘risk free’. In financial management, we

refer to this interest yield as the ‘risk-free rate of

return’.

The same principle applies to interest rates on bank loans. Banks will charge a

higher rate of interest on loans where they consider the credit risk to be higher.

Therefore:

 the interest rate on secured loans will be lower than the rate for unsecured loans

to the same borrower

 the interest rate on a subordinated loan will be higher than the rate on a senior

loan to the same borrower. (A subordinated loan ranks below a senior loan in

the right to payment of interest, and the right to repayment out of selling the

borrower’s assets in the event of the borrower’s default and liquidation).

Financial managers should be interested in risk and return in financial investments,

and the risks and returns from the financial markets (for example, the equity

markets) as a whole. However, financial managers do not concern themselves with

the investment decisions of investors, and how individual investors make the trade-

off between risk and return in their personal investment portfolio.

Separating the risk and return characteristics of market investments from the

individual investment decisions of investors (and their individual preferences for

risk and return) is known as the Separation Theorem.

Paper F9

Financial management

CHAPTER

Working capital management

Contents

1 Financingworkingcapital

2 Cashoperatingcycle

3 Otherworkingcapitalratios

4 Overtrading

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Financing working capital

 The nature and elements of working capital

 The objectives of working capital management

 Investment in working capital

 Determining the level of working capital investment

 Financing working capital: short-term or long-term finance

1 Financing working capital

1.1 The nature and elements of working capital

Working capital is the capital (finance) that an entity needs to support its everyday

operations. To operate a business, an entity must invest in inventories and it must

sell its goods or services on credit. Holding inventories and selling on credit costs

money.

Some of the finance required for operations is provided by taking credit from

suppliers. This means that the suppliers to an entity are helping to support the

business operations of that entity. Some short-term operating finance might also be

obtained by having a bank overdraft.

Cash and short-term investments are also elements of working capital. Some cash

might be held for operational use, to pay liabilities. Surplus cash in excess of

operational requirements might be invested short-term to earn some interest.

Working capital can therefore be defined as the net current assets (or net current

operating assets) of a business.

The total investment in working capital is calculated as:

$ $

Current assets:

Inventory

Trade receivables

Short-term investments

Cash

Minus current liabilities:

Bank overdraft (X)

Trade payables (X)

Other current liabilities (X)

(X)

Investment in working capital

Working capital is financed by long-term capital.

Chapter 3: Working capital management

1.2 The objectives of working capital management

The management of working capital is an aspect of financial management, and is

concerned with:

 ensuring that the investment in working capital is not excessive

 ensuring that enough working capital is available to support operating activities.

Note on surplus cash and short-term investments. For entities with surplus cash,

there is also the management problem of how to use the surplus. If the surplus is

only temporary, it might be invested in short-term financial assets. The aim should

be to select investments that provide a suitable return without undue risk, and that

can be converted back into cash without difficulty when the money is eventually

required. The management of surplus cash is discussed in more detail in a later

chapter.

Avoiding excessive working capital

An aim of working capital management should be to avoid excessive investment in

working capital. As stated earlier, working capital is financed by long-term capital

(equity or debt) which has a cost.

It can be argued that it is essential to hold inventory and to offer credit to customers,

so investment in current assets is unavoidable. However, the investment in

inventory and trade receivables does not provide any additional financial return. So

investment in working capital has a cost without providing any direct financial

return.

Avoiding liquidity problems

On the other hand, a shortage of working capital might result in liquidity problems

due to having insufficient operational cash flows to pay liabilities when payment is

due. Operational cash flows come into a business from the sale of inventories and

payment by customers: inventory and trade receivables are therefore a source of

future cash income. These must be sufficient for the payment of liabilities.

A company that has insufficient working capital might find that it has to make

payments to suppliers (or other short-term liabilities) but does not have enough

cash or bank overdraft facility to do so, because its current assets are insufficient to

generate the cash inflows that are needed and when payment falls due. Liquidity

problems, when serious, can result in insolvency.

The conflict of objectives with working capital management

A conflict of objectives therefore exists with working capital management. Over-

investment should be avoided, because it reduces profits or returns to shareholders.

Under-investment should be avoided because it creates a liquidity risk. These issues

are explained in more detail below.

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1.3 Investment in working capital

The total amount that an entity invests in working capital should be managed

carefully.

 The investment should not be too high, with excessive inventories and trade

receivables. If the investment is too high, the entity is incurring a cost (the

interest cost of the investment) without obtaining any benefits.

 The investment should not be too low. In particular the entity should not rely,

for its financing of operations, on large amounts of trade credit from suppliers or

a large bank overdraft. If working capital is too low, there could be a risk of

having insufficient cash and liquidity.

The amount to invest in working capital depends on the trade-off between:

 the benefits of having sufficient finance to support trading operations without

excessive liquidity risk, and

 the costs of financing the working capital.

Benefits of investing in working capital

There are significant benefits of investing in working capital:

 Holding inventory allows the entity to supply its customers on demand.

 Entities are expected by many customers to sell to them on credit. Unless

customers are given credit (which means having to invest trade receivables) they

will buy instead from competitors who will offer credit.

 It is also useful for an entity to have some cash in the bank to meet demands for

immediate payment.

Disadvantages of excessive investment in working capital

However, money tied up in inventories, trade receivables and a current bank

account earns nothing. Investing in working capital therefore involves a cost. The

cost of investing in working capital is the reduction in profit that results from the

money being invested in inventories, receivables or cash in the bank account, rather

than being invested in wealth-producing assets and long-term projects.

The cost of investing in working capital can be stated simply as:

Average investment in working capital × Annual cost of finance (%)

= Annual cost of working capital investment.

1.4 Determining the level of working capital investment

The target level of working capital investment in an organisation is a policy decision

which is dependent on several factors including;

 the length of the working capital cycle

 management attitude to risk

Chapter 3: Working capital management

The length of the working capital cycle

Different industries will have different working capital requirements. The working

capital cycle measures the time taken from the payment made to suppliers of raw

materials to the payments received from customers. In a manufacturing company

this will include the time that:

 raw materials are held in inventory before they are used in production

 the product takes in the production process

 finished goods are held in inventory before being purchased by a customer.

The working capital cycle will also be affected by the terms of trade. This is the

amount of credit given to customers compared to the credit taken from suppliers. In

a manufacturing company it may be normal practise to give customers lengthy

periods of credit.

The level of working capital in manufacturing industry is therefore likely to be

higher than in retailing where goods are bought in for re-sale and may not be held

in inventory for a very long period and where most sales are for cash rather than on

credit terms.

Management attitude to risk

High levels of working capital are expensive but low levels of working capital are

high risk.

 An aggressive working capital policy will seek to keep working capital to a

minimum. Low finished goods inventory will run the risk that customers will

not be supplied and will instead buy from customers. Low raw material

inventory may lead to stock-outs (or ‘inventory-outs’) and therefore high costs of

idle time or expensive replacement suppliers having to be found. Tight credit

control may alienate customers and taking long periods of credit from suppliers

may run the risk of them refusing to supply on credit at all. However low levels

of working capital will be cheap to finance and if managed effectively could

increase profitability.

 A conservative working capital policy aims to keep adequate working capital for

the organisation’s needs. Inventories are held at a level to ensure customers will

be supplied and stock-outs will not occur. Generous terms are given to

customers which may attract more customers. Suppliers are paid on time.

Risk-seeking managers may prefer to follow a more aggressive working capital

policy and risk-averse managers a more conservative working capital policy.

1.5 Financing working capital: short-term or long-term finance?

Working capital may be permanent or fluctuating.

 Permanent working capital refers to the minimum level of working capital

which is required all of the time. It includes minimum levels of inventories,

trade receivables and trade payables.

 Fluctuating working capital refers to working capital which is required at

certain times in the trade cycle. For example it may be economic for companies

to purchase raw materials in bulk. The finance required to fund the purchase of

the order will be a temporary requirement because eventually the raw material

Paper F9: Financial management

will be made into a product and sold to customers. The levels of fluctuating

working capital may be higher if companies have seasonal demand. For example

manufacturers of ski-ing equipment might build up inventories of products

before the winter season.

Long-term finance, such as equity and debt, is expensive but low risk. Short-term

finance is less expensive but there is a higher risk of it being withdrawn. The type

of financing used within the business may depend on management attitude to risk.

 Aggressive funding policies use long-term finance to fund non-current assets

and short-term finance to fund all working capital requirements

 Matching funding policies use long-term finance to fund non-current assets and

permanent working capital. Fluctuating working capital is funded using short-

term finance.

 Conservative funding policies use long-term finance to fund non-current assets,

permanent working capital and a proportion of fluctuating working capital.

Minimal short-term finance is used.

Entity 1 Entity 2

Assets

Equity and

liabilities

Assets

Equity and

liabilities

Non-current

assets

Long-term

finance

Non-current

assets

Long-term

finance

Current

assets

Current

liabilities

Current

assets

Current

liabilities

Entity 1: An aggressive funding policy. Most of the current assets are financed by

current liabilities (short-term finance). Short-term finance is generally cheaper than

long-term finance, because trade payables do not have any obvious cost. (However,

bank overdraft costs can be high). Therefore, an entity can save money, in theory, by

financing its current assets mainly from current liabilities.

Entity 2: A conservative funding policy. The entity is financing most of its current

assets with long-term finance. Potentially, this will reduce profitability due to the

higher cost of financing. However, the liquidity risk to Entity 2 should be much less

than for Entity 1.

The benefits of using short-term finance (trade payables and a bank overdraft)

rather than long-term finance are as follows:

 Lower cost. Trade credit is the cheapest form of short-term finance – it costs

nothing. The supplier has provided goods or services but the entity has not yet

had to pay.

 Much more flexible. A bank overdraft is variable in size, and is only used when

needed.

Chapter 3: Working capital management

However, although there are the benefits of low cost and flexibility with short-term

finance, there are also risks in relying too much on short-term finance.

 Short-term finance runs out more quickly and has to be renewed. Suppliers must

be asked for trade credit every time goods or services are bought from them.

 A bank overdraft facility is risky, because the bank has the right to demand

immediate repayment of an overdraft at any time. When an entity needs a

higher bank overdraft, this can often be the time that the bank decides to

withdraw the overdraft facility.

Paper F9: Financial management

Cash operating cycle

 The nature of the cash operating cycle

 Elements in the cash operating cycle

 Calculating the inventory turnover period

 Calculating the average collection period

 Calculating the average payables period

 Analysing the cash operating cycle

 Changes in the cash flow cycle and implications for operating cash flow

2 Cash operating cycle

2.1 The nature of the cash operating cycle

An important way of assessing the adequacy of working capital and the efficiency of

working capital management is to calculate the length of the cash operating cycle,

also called the working capital cycle. This cycle is the average length of time from:

 paying suppliers for goods and services received, to

 receiving cash from customers for sales of finished goods or services.

The cash operating cycle is linked to the business operating cycle. A business

operating cycle is the average length of time between obtaining goods and services

from suppliers to selling the finished goods to suppliers.

A cash operating cycle differs significantly for different types of business. For

example, a company in a service industry such as a holiday tour operator does not

have much inventory, and it might collect payments for holidays from customers in

advance. The time between paying suppliers and receiving cash from customers

might be very short.

In contrast a manufacturing company might have to hold large inventories of raw

materials and components, work in progress and finished goods, and most of its

sales will be on credit so that it has substantial trade receivables too. The time

between paying for raw materials and eventually receiving payment for finished

goods could be lengthy.

Retail companies have differing cash operating cycles. Major supermarkets have a

very short cash operating cycle, because they often sell goods to customers before

they have even paid their suppliers for them. This is because supermarkets enjoy

very fast turnover of most items and their sales are for cash. In contrast a furniture

retailer might hold inventory for a much longer time before selling it, and some

customers might arrange to pay for their purchases in instalments.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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