The cash operating cycle estimates the time taken from the receipt of raw materials to actually receiving the cash from selling the finished good. It also measures the extent to which the investment in current assets is funded by free credit and how much is funded by long-term capital employed (working capital)
Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
Zero Cash Operating Cycle may not be achievable in practice Even if it is achievable, this may lead to liquidity problems
Even if it is possible to find credit term from suppliers to match the time taken from the receipt of raw materials to the actual receipt of cash. Example Average Raw Materials holding period Average production period Average finished goods holding period Average days to collect from debtors = Average time taken to pay off suppliers This situation can easily lead the company to liquidity problems
Short-Term funding is cheaper since for example bank overdraft interest is charged on overdrawn amount only and limit is reviewed every year and can be reviewed upwards or downwards according to business needs Invoice Discounting – advantage is that the business can benefit from the credit worthiness of its customers (if this is better than that of business)
Although Equity from a financial accounting perspective appears to be cheap, it is in fact the most expensive source of funding A business is not legally obliged to pay dividends but if the company does not pay dividends it has to deliver capital gains. Capital Gains are delivered if the return on investment is greater than the required return of shareholders.
Deterioration in profit margins: Cash Discounts given by suppliers will be foregone Bank charges (returned cheques and encroachments) and interest burden will increase Cash Discounts given to debtors to raise cash Trade Discounts given to increase stock turnover with the objective of increasing cash flows from operations The best suppliers in the market will be reluctant to do business with you as you are no longer seen as a ‘good’ customer
Accessibility to financial markets most often depends on the size of the business. Small and Medium sized companies normally resort to overdraft facilities. Large companies can access other types of short-term funding such as Commercial Paper which gives them more flexibility in managing their working capital needs. In addition, it is easier for large companies to raise medium and long-term funding Business practices might also affect working capital management, for example bank overdrafts are not common in Italy, where they rely more on Invoice Discounting. In analyzing the level of working capital whether it is over-capitalized or not, ratio analysis may prove to be useful. Trends Peer Group Analysis
Food Retail Industry – Characteristics High Inventory Turnover Low Operating Margins (to mitigate this they diversify into non-food goods and also services). They can afford a higher gearing Stability of Revenue (although earnings from non-food sales are more volatile) Property Portfolio
Working Capital needs may increase due to food inflation Earnings fairly stable but prone exchange rate risk as company has a major presence in emerging countries.
For instance even among industries companies may have different production processes or different inventory management policies. On the other hand although debtors policies are formulated internally, these would be constrained by market practices The size of the company matters as well, since it can negotiate better terms with suppliers and also accessibility to capital markets.
Inventory management deals with minimizing these costs. These costs are negatively correlated and the objective is to strike a balance between these costs Examples: To minimize shortage costs, companies need to hold buffer stock and therefore incur holding costs Procurement costs and holding costs are negatively correlated – trade off between more frequent order (maximize procurement costs and minimize holding costs) or less frequent orders (minimize procurement and maximize holding costs) A model that helps us striking an optimal balance is the Economic Order Quantity
Reliable suppliers are essential as they have to deliver raw materials or components in time and of the right quality. Some companies might be willing to pay a premium over the normal purchase prices Since stock levels would be at a minimum, company cannot afford wastages due to bad workmanship Since the output of one process is the input of another, semi-finished goods must be of good quality otherwise the whole production process will stop Minimizing lead times is essential, otherwise in order that production continues a company would need to keep inventories If the company manages to achieve these, apart from the benefit of reduced inventories costs, efficiency in the organization would increase
Credit Analysis System It is important that before selling on credit to a particular customer, the company assesses his credit worthiness. In addition to looking at the accounts to analyze the financial health of the company and possibly evaluating the track record of management, one can use bank references, trade references and the services of credit rating agencies. Credit Control System After the analysis, the company will determine the credit limit and period to be offered. This would need to be reviewed from time to time. Company should also monitor that customers are respective the credit terms given. Debt Collection System Prepare an aged listing of debtors Issue regular statements and reminders Have clear procedures for taking legal action Analyze whether to use cash discounts to encourage early payment
The main benefit of invoice discounting is that you can borrow on the financial strength of your customers. In addition sales growth can be financed through sales Nonetheless the factor would not want to incur any bad debts and so can be quite aggressive. Apart from savings of administration costs, management can concentrate more on business rather than on collection of debtors.
Credit Terms are usually given either through market practice or by supplier. Large corporations may have negotiating power for example large food retailers such as Tosco, Wal-Mart they can negotiate favourable terms. Good Relations are important and so company must ensure that trade payables are settled within the allowable period. Reliability – delivery in expected time and of the right quantity and quality – link with Just-in-Time Early Settlement Discounts should be evaluated in terms of the impact on cash operating cycle. Early settlement will be funded from short-term or long-term funding Price although important, should not be the main decisive factor
Cash is not just vault cash and balances with bank but also unutilized amounts on overdraft facilities Holding cash is like holding inventory and there is a cost, more specifically an opportunity cost.
Permanent Surpluses Temptation to invest in long-term finance assets such as equities or bonds. Nonetheless these should be avoided. If there are no feasible long-term investments return cash to shareholders (share buy-backs or one-time dividends) as they can invest in equities or bonds themselves.
Money procurement costs can be lending processing fees, cost of transferring money or brokerage costs in selling short-term investments
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