Fundamentals of business accounting and finance Lecture 2
Tankertanker Design AGENDA Tankertanker Design 1 Fundamental of business accounting and finance 2 Working capital Tankertanker Design
Tankertanker Design Skills and abilities • Explain how the definition of "working capital" differs between financial analysts and accountants. • Understand the two fundamental decision issues in working capital management. • Discuss how to determine the optimal level of current assets. • Describe the relationship between profitability, liquidity, and risk in the management of working capital. • Explain how to classify working capital according to its “components” and according to “time” (i. e. , either permanent or temporary). Tankertanker Design 08. 02. 2018 Tankertanker Design
Fundamental of business accounting and finance
Tankertanker Design To understand business finance, two things must be clear: Tankertanker Design • How money moves in any business • How information evolves from the questions raised by those concerned with business investment - investors and managers. Tankertanker Design
Tankertanker Design FUNDAMENTAL OF BUSINESS ACCOUNTING AND FINANCE HOW MONEY MOVES IN BUSINESS INCOME STATEMENT BALANCE SHEET CASH FLOW Fundamental of business accounting and finance Tankertanker Design
Working capital
Tankertanker Design Working capital • Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities. • These items are also referred to as circulating capital Tankertanker Design
Tankertanker Design Working Capital Concepts Net Working Capital Current Assets - Current Liabilities. Gross Working Capital The firm’s investment in current assets. Working Capital Management The administration of the firm’s current assets and the financing needed to support current assets. Tankertanker Design
Tankertanker Design Concept of working capital Tankertanker Design There are two possible interpretations of working capital concept: 1. Balance sheet concept 2. Operating cycle concept Tankertanker Design
Tankertanker Design Balance sheet concept There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities b. Gross or total current assets. 08. 02. 2018 Tankertanker Design
Tankertanker Design Balance sheet concept • Excess of current assets over current liabilities are called the net working capital or net current assets. Tankertanker Design • Working capital is really what a part of long term finance is locked in and used for supporting current activities. Tankertanker Design
Tankertanker Design Current assets Inventories Trade and other receivables Current tax assets Other financial assets Cash and short term assets Current liabilities Short term borrowings Trade and other payables Current tax liabilities Other financial liabilities Short term provisions Balance Sheet Short Term Items 1, 910 1, 713 13 43 733 4, 412 1, 903 1, 625 78 917 4, 523 355 1, 690 121 119 82 1, 367 555 1, 735 44 13 130 2, 477 Turnover 9, 577 Cost of goods sold 8, 943 13 Tankertanker Design
Tankertanker Design Operating cycle concept Tankertanker Design A company’s operating cycle typically consists of three primary activities: – Purchasing resources, – Producing the product and – Distributing (selling) the product. These activities create funds flows that are both unsynchronized and uncertain. Tankertanker Design
Tankertanker Design Operating cycle of a typical company Tankertanker Design Receive Cash Sell Product On credit Purchase resources Pay for Resources purchases Inventory conversion period Receivable Conversion period Cash conversion cycle Payable Deferral period Operating cycle Tankertanker Design
Tankertanker Design Purchase Resources Operating Cycle Pay Sell on Credit Receive Cash Inventory Conversion 78 days Payables Period 69 days Receivables Conversion 65 days Cash Conversion Cycle 74 days Operating Cycle 143 16 Tankertanker Design
Tankertanker Design Working capital investment Tankertanker Design • The size and nature of investment in current assets is a function of different factors such as type of products manufactured, the length of operating cycle, the sales level, inventory policies, unexpected demand unanticipated delays in obtaining new inventories, credit policies and current assets. Tankertanker Design
Tankertanker Design These investments are: a) Raw material stock Materials not yet sold b) Work in progress stock Made up of materials, labour overheads which have gone c) Finished goods stock Into the partly finished or finished goods unsold d) Debtors The amount owed for the materials, labour and overheads which have gone into the inventory and debtors e) Less creditors Amounts the company owes to suppliers for goods and services purchased on credit Tankertanker Design
Tankertanker Design Working Capital Issues Optimal Amount (Level) of Current Assets Policy A Policy B ASSET LEVEL ($) Assumptions • 50, 000 maximum units of production • Continuous production • Three different policies for current asset levels are possible Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Impact on Liquidity Optimal Amount (Level) of Current Assets Greater current asset levels generate more liquidity; all other factors held constant. Policy A Policy B ASSET LEVEL ($) Liquidity Analysis Policy Liquidity A High B Average C Low Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Impact on Expected Profitability Tankertanker Design Optimal Amount (Level) of Current Assets Return on Investment = Let Current Assets = (Cash + Rec. + Inv. ) Return on Investment = Net Profit Current + Fixed Assets Policy A Policy B ASSET LEVEL ($) Net Profit Total Assets Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Impact on Expected Profitability Optimal Amount (Level) of Current Assets As current asset levels decline, total assets will decline and the ROI will rise. Policy A Policy B ASSET LEVEL ($) Profitability Analysis Policy Profitability A Low B Average C High Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Impact on Risk Optimal Amount (Level) of Current Assets Policy A Policy B ASSET LEVEL ($) • Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! • Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! • Lower inventory levels increase stockouts and lost sales. More risk! Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Impact on Risk Tankertanker Design Optimal Amount (Level) of Current Assets Risk increases as the level of current assets are reduced. Policy A Policy B ASSET LEVEL ($) Risk Analysis Policy Risk A Low B Average C High Policy C Current Assets 0 25, 000 OUTPUT (units) 50, 000 Tankertanker Design
Tankertanker Design Summary of the Optimal Amount of Current Assets SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy A B C Liquidity Profitability Risk High Low Average Low High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!) Tankertanker Design
Tankertanker Design Classifications of Working Capital u Components u Cash, marketable securities, receivables, and inventory • Time – Permanent – Temporary Tankertanker Design
Tankertanker Design Permanent Working Capital Tankertanker Design DOLLAR AMOUNT The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME Tankertanker Design
Tankertanker Design Temporary Working Capital Tankertanker Design The amount of current assets that varies with seasonal requirements. DOLLAR AMOUNT Temporary current assets Permanent current assets TIME Tankertanker Design
Tankertanker Design TYPES OF WORKING CAPITAL Tankertanker Design WORKING CAPITAL BASIS OF CONCEPT Gross Working Capital Net Working Capital BASIS OF TIME Permanent / Fixed WC Temporary / Variable WC Seasonal WC Regular WC Special WC Reserve WC Tankertanker Design
Tankertanker Design FACTORS DETERMINING WORKING CAPITAL Tankertanker Design 1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle contd… Tankertanker Design
Tankertanker Design Working Capital Determinants (Contd…) Tankertanker Design 13. Credit control 14. Inflation or Price level changes 15. Profit planning and control 16. Repayment ability 17. Cash reserves 18. Operation efficiency 19. Change in Technology 20. Firm’s finance and dividend policy 21. Attitude towards Risk Tankertanker Design
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