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Working Capital Management

Chapter Four: Specific Strategies
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Inventories

Inventories are lists of stocks-raw materials, work in progress or finished goods-waiting to be consumed in production or to be sold.

The total balance of inventory is the sum of the value of each individual stock line. Stock records are needed:

                         to provide an account of activity within each stock line;

                         as evidence to support the balances used in financial reports.

A department also needs a system of internal controls to efficiently manage stocks and to ensure that stock records provide reliable information.

Departmental financial reports show only the total inventory balance. Analysts from outside the department can examine this balance by using ratio analysis or other techniques. However, this gives only a limited assessment of inventory management and is not adequate for internal management. Good financial management necessitates the careful analysis of individual inventory lines.

Inventory management is an important aspect of working capital management because inventories themselves do not earn any revenue. Holding either too little or too much inventory incurs costs.

Costs of carrying too much inventory are:

                         opportunity cost of foregone interest;

                         warehousing costs;

                         damage and pilferage;

                         obsolescence;

                         insurance.

Costs of carrying too little inventory are:

                         stockout costs:

-   lost sales;
-   delayed service.

                         ordering costs:

-   freight;
-   order administration;
-   loss of quantity discounts.

Carrying costs can be minimised by making frequent small orders but this increases ordering costs and the risk of stock-outs. Risk of stock-outs can be reduced by carrying "safety stocks" (at a cost) and re-ordering ahead of time.

The best ordering strategy requires balancing the various cost factors to ensure the department incurs minimum inventory costs. The optimum inventory position is known as the Economic Reorder Quantity (ERQ). There are a number of mathematical models (of varying complexity) for calculating ERQ. (Any standard accounting text will provide examples of these).

Analytical review of inventories can help to identify areas where inventory management can be improved. Slow moving items, continual stockouts, obsolescence, stock reconciliation problems and excess spoilage are signals that stock lines need closer analysis and control.

However, it is important to keep an overall perspective. It is not cost-effective to closely manage a large number of low value inventory lines, nor is it necessary. A usual feature of inventories is that a small number of high value lines account for a large proportion of inventory value. The "80/20" rule (PARETO) predicts that 80% of the total value of inventory is represented by only 20% of the number of inventory items. Those high value lines need reasonably close management. The remaining 80% of inventory lines can be managed using "broad-brush" strategies.

The overall management philosophy of an organisation can affect the way in which inventory is managed. For example, "Just In Time" (JIT) production management organises production so that finished goods are not produced until the customer needs them (minimising finished goods carrying costs), and raw materials are not accepted from suppliers until they are needed. (Large organi-sations have the power to insist that suppliers hold stocks of raw materials and thereby pass the carrying cost back to the supplier). Thus, JIT inventory strategies reduce bottlenecks and stock holding costs.

In summary:

                         There is a trade-off to be made between carrying costs, ordering costs, and stockout costs. This is represented in the Economic Reorder Quantity (ERQ) model.

                         Inventories should be managed on a line-by-line basis using the 80/20 rule.

                         Analytical review can help to focus attention on critical areas.

                         Inventory management is part of the overall management strategy.

Debtors

Debtors (Accounts Receivable) are customers who have not yet made payment for goods or services which the department has provided.

The objective of debtor management is to minimise the time-lapse between completion of sales and receipt of payment. The costs of having debtors are:

                         opportunity costs (cash is not available for other purposes);

                         bad debts.

Debtor management includes both pre-sale and debt collection strategies.

Pre-sale strategies include:

                         offering cash discounts for early payment and/or imposing penalties for late payment;

                         agreeing payment terms in advance;

                         requiring cash before delivery;

                         setting credit limits;

                         setting criteria for obtaining credit;

                         billing as early as possible;

                         requiring deposits and/or progress payments.

Post-sale strategies include:

                         Placing the responsibility for collecting the debt upon the center that made the sale;

                         Identifying long overdue balances and doubtful debts by regular analytical reviews;

                         Having an established procedure for late collections, such as

-   a reminder;
-   a letter;
-   cancellation of further credit;
-   telephone calls;
-   use of a collection agency;
-   legal action.

Creditors

Creditors (Accounts Payable) are suppliers whose invoices for goods or services have been processed but who have not yet been paid.

Organisations often regard the amount owing to creditors as a source of free credit. However, creditor administration systems are expensive and time-consuming to run. The over-riding concern in this area should be to minimise costs with simple procedures.

While it is unnecessary to pay accounts before they fall due, it is usually not worthwhile to delay all payments until the latest possible date., Regular weekly or fortnightly payment of all due accounts is the simplest technique for creditor management.

Electronic payments (direct credits) are cheaper than cheque payments, considering that transaction fees and overheads more than balance the advantage of delayed presentation. Some suppliers are reluctant to receive payments by this method, but in view of the substantial cost advantage (and the advantages to the suppliers themselves) departments may wish to encourage suppliers to accept this option. However, electronic payments are likely to be used in conjunction with, rather than as a replacement for, cheque payments.

Cash and Bank

Good cash management can have a major impact on overall working capital management.

The key elements of cash management are:

                         cash forecasting;

                         balance management;

                         administration;

                         internal control.

Cash Forecasting. Good cash management requires regular forecasts. In order for these to be materially accurate, they must be based on information provided by those managers responsible for the amounts and timing of expenditure. Capital expenditure and operating expenditure must be taken into account. It is also necessary to collect information about impending cash transactions from other financial systems, such as creditors and payroll.

Balance Management. Those responsible for balance management must make decisions about how much cash should at any time be on call in the Departmental Bank Account and how much should be on term deposit at the various terms available.

There are various types of mathematical model that can be used. One type is analogous to the ERQ inventory model. Linear programming models have been developed for cash management, subject to certain constraints. There are also more sophisticated techniques.

Administration. Cash receipts should be processed and banked as quickly as possible because:

                         They cannot earn interest or reduce overdraft until they are banked;

                         Information about the existence and amounts of cash receipts is usually not available until they are processed.

Where possible, cash floats (mainly petty cash and advances) should be avoided. If, on review, the only reason that can be put forward for their existence is that "we've always had them", they should be discontinued. There may be situations where they are useful, however. For example, it may be desirable for peripheral parts of departments to meet urgent local needs from cash floats rather than local bank accounts.

Internal Control. Cash and cash management is part of a department's overall internal control system. The main internal cash

control is invariably the bank reconciliation. This provides assurance that the cash balances recorded in the accounting systems are consistent with the actual bank balances. It requires regular clearing of reconciling items.

Other Components

Working capital, defined as the difference between current assets and current liabilities, may also include the following factors:

                         prepayments to creditors;

                         current portions of long-term liabilities;

                         revenue received before it has been earned;

                         provisions.

However, decisions on working capital management usually exclude these factors, so they have not been included in this booklet.

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