ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 3: Working capital management
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3.3 Sales revenue: net working capital ratio
The sales revenue: net working capital ratio is another ratio that might be used to
assess whether the investment in working capital is too large or insufficient. This is
because it might be assumed that the amount of working capital should be
proportional to the value of annual sales, because there should be a certain amount
of working capital to ‘support’ a given quantity of sales.
‘Net working capital’ is simply total current assets less total current liabilities.
Example
Last year a company had sales revenue of $20 million. Its average current assets
were $2.8 million and its average current liabilities were $1.1 million.
Last year its sales: net working capital ratio was 12.5 times. The current average
sales: net working capital ratio for other companies in the same industry is 12.4
times.
Current year
Net working capital = $1.7 million
Sales: net working capital ratio = $20 million/$1.7 million = 11.8 times
Analysis
The company’s sales: net working capital ratio has fallen since the previous year. It
is now below the industry average.
A lower ratio means that working capital is now larger relative to sales revenue.
This might be an indication that the investment in working capita is getting too
large.
If the ratio had remained at 12.5, the same as last year, working capital would be
$1.6 million (= $20 million/12.5). This suggests that working capital might now
be about $100,000 more than necessary.
If the ratio had been 12.4, the industry average, working capital would be about
$1.61 million (= $20 million/12.4). This suggests that working capital might now
be about $90,000 more than necessary.
This analysis is not necessarily conclusive, but it might be sufficient to justify a
closer investigation into working capital investment, the reasons for the change in
the ratio and whether measures might be taken to improve the management of
working capital (and in doing so increase the ratio back towards the industry
average).
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Overtrading
The meaning of overtrading
Symptoms of overtrading
Consequences of overtrading and possible remedial action
4 Overtrading
4.1 The meaning of overtrading
Overtrading means carrying on an excessive volume of trading in relation to the
amount of long-term capital invested in the business. A company that is overtrading
has inadequate capital for the volume of sales revenue it is earning.
Although it is possible for any business entity to overtrade, it is probably most
common in small companies that are now expanding rapidly, with a very high rate
of sales growth.
4.2 Symptoms of overtrading
A company that is overtrading will usually show most of the following symptoms.
A high rate of annual sales growth.
Low profitability. The company might be reducing its gross profit margin in
order to grow sales quickly. As it grows, the company might also incur much
higher expenses, such as higher administration costs, which reduce the net profit
margin.
Because profitability is low, retained profits are also low. Retained profits are an
important source of new equity, but the company is not increasing its equity
investment quickly enough because there are insufficient profits.
The growth in sales revenue will also mean a large increase in inventory and
trade receivables. Working capital management might become less efficient,
because systems that operated well when the company was small (such as
inventory control and collection of receivables) no longer operate efficiently
when the company is larger. Turnover times for inventory and collections might
increase.
The company might also need to acquire some new non-current assets to
support the growth in sales volume.
The growth in assets has to be financed by equity and liabilities. Because profits
are low, equity capital increases only by a small amount. The growth in assets is
therefore financed by liabilities, and in particular by current liabilities.
The increase in current liabilities takes the form of:
− a much longer time to pay suppliers, so that the average payments period
increases substantially and trade payables in the statement of financial
position (balance sheet) are much higher
− a very big increase in its bank overdraft.
Chapter 3: Working capital management
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Example
Vesuvius is a rapidly-growing company. Its summarised financial statements for the
current financial year (just ended) and the previous year are as follows.
Summarised income statements
Current year
Previous year
$000
$000
Revenue 4,000
3,000
Cost of sales 2,400
1,500
–
–––––––
–
–––––––
Gross profit 1,600
1,500
Operating expenses 1,550
1,250
–
–––––––
–
–––––––
Net profit 50
250
–
–––––––
–
–––––––
Summarised statements of financial position
Current year
Previous year
$000
$000
$000
$000
Non-current assets
2,000
1,800
Current assets
Inventory 600
300
Trade receivables 650
330
Cash nil
20
1,250
650
Total assets
3,250
2,450
Equity and liabilities
Share capital
1,800
1,800
Retained earnings
500
450
Current liabilities
2,300
2,250
Trade payables 450
200
Bank overdraft 500
nil
950
200
3,250
2,450
This is a company that displays all the symptoms of overtrading.
Sales in the current year are 33.3% higher than in the previous year. This is a
very high rate of sales growth.
Profits are low. The gross profit margin has fallen to 40% in the current year
compared with 50% in the previous year. The company might be reducing its
sales prices in order to sell more goods.
Net profit fell from $250,000 in the previous year to just $50,000 in the current
year. All this profit has been retained, but the growth in equity and reserves is
small in relation to the growth in the size of the business.
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There has been a big increase in inventory, by 100%. The average turnover
period for inventory increased to 91 days in the current year [(600/2,400) × 365]
from 73 days in the previous year [(300/1,500) × 365].
The average time to collect trade receivables has also increased substantially, by
$320,000 or 97%. The average collection period was 59 days in the current year
[(650/4,000) × 365] but only 40 days in the previous year [(330/3,000) × 365].
There has been some increase in non-current assets, which has been largely
financed by current liabilities – probably bank overdraft.
There as been a very large increase of $250,000 or 125% in trade payables, as well
as a movement from a cash surplus of $20,000 to a bank overdraft of $500,000.
The increase in trade payables is due not only to the growth in sales volume and
cost of sales, but also to an increase in the average payment period to 68 days in
the current year [(450/2,400) × 365] from 49 days in the previous year
[(200/1,500) × 365].
4.3 Consequences of overtrading and possible remedial action
The consequences of overtrading are eventual insolvency, unless remedial measures
are taken. Insolvency will occur if sales continue to grow and overtrading continues
because a company cannot finance its growth in business indefinitely with growth
in current liabilities.
In the previous example, the company’s bank will eventually refuse to allow any
more overdraft, and might even withdraw the existing overdraft facility if it believes
that the company cannot repay what it already owes. The company’s suppliers will
also eventually refuse to allow longer credit.
Overtrading therefore eventually leads to inadequate liquidity due to insufficient
long-term capital funding.
Remedial action
The action to restore the financial position when a company is overtrading is either
to increase capital or reduce the volume of business that the company is conducting.
The aim should be to achieve a better ratio of long-term capital to sales, and a
suitable level of working capital investment.
One way of increasing long-term capital is to increase profits. A company that is
overtrading should look for ways of improving both the gross profit and net profit
margins, by cutting costs or increasing sales prices. Higher profits will enable the
company to improve its operating cash flows and also to increase its equity capital
by retaining more profit.
However, a problem with trying to resolve a problem of overtrading by improving
profits is that the company might not have time to build up cash flows and profits
soon enough. The bank might withdraw its overdraft facility without notice, making
the company insolvent.
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Paper F9
Financial management
CHAPTER
4
Management of working
capital: inventory control
Contents
1 Materialpurchasequantities:Economicorder
quantity
2 Reorderlevelandbufferstock
3 Just‐in‐Time(JIT)andotherinventory
managementmethods
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Material purchase quantities: Economic Order Quantity
Minimising materials costs
Holding costs and ordering costs
Economic order quantity (EOQ)
EOQ: changes in the variables in the formula
1 Material purchase quantities: Economic Order
Quantity
Many companies, particularly manufacturing and retailing companies, might hold
large amounts of inventory. They usually hold inventory so that they can meet
customer demand as soon as it arises. If there is no inventory when the customer
asks for it (if there is a ‘stock-out’ or ‘inventory-out’) the customer might buy the
product from a competitor instead. However holding inventory also creates costs.
1.1 Minimising materials costs
Companies that purchase and consume large quantities of materials should try to
minimise the total costs. For any item of materials, these consist of:
the cost of materials purchased (purchase costs)
the costs of making purchase orders to buy the material (ordering costs)
the costs of holding inventory.
In most cases, the most significant cost is the purchase cost of the materials.
However, ordering costs and holding costs might also be substantial.
1.2 Holding costs
Holding costs for inventory include costs such as:
the interest cost of the investment in inventory
the costs of losses through holding inventory, due to obsolescence, deterioration
in the condition of the inventory and theft of inventory items
the costs of insurance of inventory.
The investment in inventory has a cost. Capital is tied up in inventory and the
capital investment has a cost. Inventory has to be paid for, and when an
organisation holds a quantity of inventory it must therefore obtain finance to pay
for it. For example suppose that a company holds between 0 units and 10,000 units
of an item of material that costs $10 per unit to purchase. The cost of the materials
held in store therefore varies between $0 and $100,000. On average the cost of the
inventory in store is likely to be about $50,000. This inventory must be financed, and
it is usual to assume (for simplicity) that it is financed by borrowing that has an
interest cost. In this example, if the interest cost of holding inventory is 5% per year,
the cost per year of holding the inventory would be $2,500 (= $50,000 × 5%).
Chapter 4: Management of working capital: inventory control
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There are also running expenses incurred in holding inventory, such as the
warehousing costs (warehouse rental, wages or salaries of warehouse staff).
A distinction can be made between variable inventory holding costs (cost of capital,
cost of losses through deterioration and loss) and fixed inventory costs (wages and
salaries, warehouse rental). Changing inventory levels will affect variable inventory
holding costs but not fixed costs.
1.3 Order costs
Order costs are the costs of making orders to purchase a quantity of a material item
from a supplier. They include costs such as:
the cost of delivery of the purchased items, if these are paid for by the buyer
the costs associated with placing an order, such as the costs of telephone calls
costs associated with checking the inventory after delivery from the supplier.
1.4 Economic order quantity (EOQ)
The Economic Order Quantity model (EOQ) is a mathematical model that can be
used to calculate the quantity of inventory to order from a supplier each time that
an order is made.
The aim of the model is to identify the order quantity for any item of inventory that
will minimise total annual inventory costs.
Assumptions in the basic EOQ model
Several assumptions in the basic EOQ model, as follows:
There are no bulk purchase discounts for making orders in large sizes. All units
purchased for each item of material cost the same unit price.
Annual demand for the inventory item is constant throughout the year.
The order lead time (the time between placing an order and receiving delivery
from the supplier) is predictable, so that the delivery of a new order is always
timed to coincide with running out of inventory.
As a result, there are never any stock-outs.
Also as a result, the minimum inventory level at any time is 0, and the maximum
inventory level is the size of the order quantity.
The EOQ model formula
If the price of materials is the same, no matter what the size of the purchase order,
the purchase order quantity that minimises total costs is the quantity at which
ordering costs plus the costs of holding inventory are minimised.
This order quantity or purchase quantity that minimises the total annual cost of
ordering the item plus holding it in store is called the economic order quantity or
EOQ.
EOQ minimises Ordering costs + Holding costs
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Ordering costs each year =
⎟
⎠
⎞
⎜
⎝
⎛
×
Q
DC
o
Inventory holding costs each year =
Q
2
⎛
⎝
⎜
⎞
⎠
⎟
×CH
where:
Q = the quantity of materials purchased in each order (EOQ)
D = the annual demand for the materials
C
o
= the cost of making an order for materials
C
H
= the cost of holding one unit of material in store for one year
Notes:
There will be an immediate supply of new materials (Q units) as soon as existing
as quantities in store run down to 0. The minimum quantity held in store is
therefore 0 units and this always occurs just before a new purchase order
quantity is received. The maximum quantity is Q units. The average amount of
inventory held is therefore Q/2 and total holding costs each year are (Q/2) × C
H
.
The number of orders each year is D/Q. Total ordering costs each year are
therefore (D/Q) × C
O
.
The economic order quantity (EOQ) is the order size that will minimise the total of
these costs during a period (normally one year), given the assumptions stated
above.
The formula for the EOQ is as follows:
Economic order quantity (EOQ) =
2CoD
C
H
This formula is given to you in the examination (on the formulae sheet), although
you should be able to learn it.
Example
A company uses 120,000 units of Material X each year, which costs $3 for each unit.
The cost of placing an order is $605 for each order. The annual cost of holding
inventory each year is 10% of the purchase cost.
What is the order quantity for Material X that will minimise annual costs?
Chapter 4: Management of working capital: inventory control
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Answer
H
o
C
D2C
EOQ =
Where:
C
O
= 605
D = 120,000
C
H
= 10% × 3 = 0.3
=
⎟
⎠
⎞
⎜
⎝
⎛
××
0.3
605120,0002
= 0484,000,00 = 22,000 units
The economic order quantity is 22,000 units, which means that the average number
of orders placed with suppliers will be 5.45 orders each year (= 120,000/22,000).
EOQ: Annual holding costs = Annual ordering costs
It might be useful to know that the EOQ is also an order quantity where the total
annual costs of ordering and the total annual holding costs are exactly the same. In
the example above:
EOQ = 22,000 units
Annual ordering costs = (C
O
× D)/Q = $605 × 120,000/22,000 = $3,300
Annual holding costs = (Q/2) × C
H
= (22,000/2) × $0.30 = $3,300.
Ordering costs and holding costs each year are both $3,300.
Total annual ordering costs and annual holding costs are always the same whenever
the purchase quantity for materials is the EOQ and the assumptions on which the
EOQ is based (described earlier) apply.
1.5 Optimum order quantity with price discounts for large orders
The optimum purchase quantity for materials is the order size that minimises the
total costs of:
Annual purchase costs = (D × price per unit)
Ordering costs each year =
Co
×
D
(
)
Q
Inventory holding costs each year =
Q
2
⎛
⎝
⎜
⎞
⎠
⎟
×CH
When the EOQ formula is used to calculate the purchase quantity, it is assumed that
the purchase cost per unit of material is a constant amount, regardless of the order
quantity.
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In some cases, however, a supplier might offer a discount on the purchase price for
orders above a certain quantity. When this situation arises, the order quantity that
minimises total costs will be either:
the economic order quantity, or
the minimum order quantity necessary to obtain the price discount.
To identify the order quantity that minimises costs, you need to calculate the total
costs each year of purchases, ordering costs and holding costs, for both order
quantities (the EOQ and the minimum order quantity to obtain the discount).
If a supplier offers a discount for order quantities above a certain amount and an
larger discount orders above an even larger quantity, you need to compare total
costs for the EOQ and for each minimum quantity at which a different purchase
discount applies.
Example
A company uses 120,000 units of Material X each year, which costs $3 for each unit
before discount. The costs of making an order are $605 for each order. The annual
cost of holding inventory is 10% of the purchase cost. The supplier will offer a price
discount of $0.10 per unit for orders of 25,000 up to 40,000 units, and a discount of
$0.20 per unit for orders of 40,000 units or more.
What is the order quantity that will minimise total costs?
Answer
The economic order quantity, ignoring discounts, is 22,000 units (see earlier
example). The order quantity that will minimise costs is therefore one of the
following:
22,000 units, the economic order quantity
25,000 units, the smallest quantity required above the EOQ to get a discount of
$0.10 per unit
40,000 units, the smallest quantity required above the EOQ to get a discount of
$0.20 per unit.
Orderquantity
22,000units 25,000units 40,000units
$ $ $
Annualpurchasecosts(120,000units)(W1) 360,000 348,000 336,000
Annualorderingcosts
Q
)DCo(
×
(W2)
3,300 2,904 1,815
Holdingcosts
HC
2
Q
×
⎟
⎠
⎞
⎜
⎝
⎛
(W3)
3,300 3,625 5,600
–
–––––––
–
––––––– ––––––––
Totalcosts 366,600 354,529 343,415
–
–––––––
–
––––––– ––––––––