9.1 Working Capital Management

1. The Elements of Working Capital

(1) Definition

Working capital is the capital available for conducting the day-to-day operations of an organization, normally the excess of current assets over current liabilities.

Working Capital=Current asset - Current liability

(2) Objectives

The two main objectives of working capital management are to ensure that it has sufficient liquid resources to continue in business and to increase its profitability.

(3) Cash Operating Cycle

The cash operating cycle is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

Cash operating cycle = Inventory days + Receivable days–Payable days
      Inventory days=Inventory/cost of sales×365
      Receivable days=Receivales/credit sales×365

Payable days=payable/credit purchases×365

【Example 1】

Wines Co buys raw materials from suppliers that allow Wines 2.5 months' credit. The raw materials remain in inventory for one month, and it takes Wines two months to produce the goods. The goods are sold within a couple of days of production being completed and customers take on average 1.5 months to pay. Calculate Wines's cash operating cycle?

The cash operating cycle is calculated as following:

 The average time that raw materials remain in inventory               1.0
        The time taken to produce the goods                                               2.0
        The time taken by customers to pay for the goods　　　　　　  1.5 
        Less the time taken to pay suppliers                                            （2.5）

 Cash operating cycle                                                                        2.0

2. Management of Inventory

The economic order quantity（EOQ）is the optimal ordering quantity for an item of inventory which will minimise costs. Inventory costs are affected by purchase price, ordering cost and holding cost.

(1) Holding costs

The model assumes that it costs a certain amount to hold a unit of inventory for a year (referred to as Ch in the formula). Therefore, as the average level of inventory increases, so too will the total annual holding costs incurred.

If Q is the quantity ordered, the annual holding cost would be calculated as:

Holding cost= Holding cost per unit × Average inventory=  ×
  

Annual cost

                  Holding cost

 

 

Re-order quantity

 (2) Ordering costs

The model assumes that a fixed cost is incurred every time an order is placed. If D is the annual expected sales demand, the annual order cost is calculated as:

Ordering cost = Order cost per order × no. of orders per annum=Co ×

Annual cost

 

 

Ordering cost

                   Re-order quantity

Because you are trying to balance these two costs (one which increases as re-order quantity increases and one which falls), total holding costs will always be minimized at the point where the total holding costs equals the total ordering costs. This point will be the Economic Order Quantity.

 

Annual cost 

Total cost         Holding cost

 

               Ordering cost   Re-order quantity

 

The following assumptions are made：

l Demand and lead time are constant and known

l Purchase price is constant

l No buffer inventory held (not needed)

The calculation:
EOQ=
where
Co =cost per order,  D =annual demand,  Ch= cost of holding one unit for one year.

【Example 2】

Firm X faces regular demand of 150 units per month, it orders from its supplier at a purchase cost per unit of £25. Each order costs £32, and holding cost is 18% p.a. of the purchase price.

Required:

(a) Calculate the economic order quantity, and the average inventory level.

(b) Calculate total inventory related cost at this economic order quantity.

Answers:

(a) EOQ==160 units

average inventory=160/2=80 units

(b)Total cost= Purchase price + Ordering cost + Holding cost

       =150×12×25＋25×0.18×80+32×1800÷160 =45,720

3. Management of Account Receivable: Establishing a Credit Policy

l Assess creditworthiness

l Credit limits

l Invoice promptly and collect overdue debts

l Monitor the credit system