January 2012 – Michael Rauch

Working capital (WC) can be represented as follows:

Working Capital = Current Assets – Current Liabilities

It can be said that WC measures a company’s efficiency as well as their short-term financial health (Investopedia, n.d.).

A company should always have a positive WC value. If there are less assets than there are liabilities then this means that the company is unable to repay all of their liabilities, this should be considered a “red flag” when assessing the financials of a business (Investopedia, n.d.). It should also be compared with previous WC amounts to assess a decline in profits/sales and should also be cause for concern (Investopedia, n.d.).

Management of Stock-in-trade:

It is important to consider the costs behind holding and not holding your inventories (stock-in-trade). Holding stock incurs costs such as storage space, insurance, loss of interest on the cash used to purchase stock as well as the potential losses in the case that stock becomes obsolete (Atrill & McLaney, 2011). On the contrary, not holding stock on hand poses risks of losing sales, reordering costs, production being slowed down, and potential time critical opportunities for large quantities of stock being missed (Atrill & McLaney, 2011).

Companies should therefore manage their inventories wisely. When managing inventories a company should identify the most efficient amount of stock to be ordered by using assessment models and methods to find out the best frequency and quantity to order stock, it is important to keep accurate inventory logs so that historical data can be used in this (Atrill & McLaney, 2011), taking into consideration future forecasts of required stock.

“Just in Time” (JIT) inventory management can also be considered (Atrill & McLaney, 2011). JIT is used by most online stores today and, as the name implies, stock is ordered or re-ordered only when it is needed (often after the purchase has been made in the scenario of online stores).

Management of Trade Debtors:

This can also be referred to as “trade receivables”. Careful consideration should be made when deciding which customers should receive credit. Atrill & McLaney (2011) outline the 5 C’s of credit, as explained by Investopedia (2011):

1) Character – The reputation of the borrower (eg: via credit check)

2) Capacity – Compare the borrowers income to their recurring debts to work out their capacity to repay more debt

3) Capital – Consider the amount of capital (deposit) the borrower is going to put down on the purchase, the higher the deposit the less chance of default.

4) Collateral – Does the borrower have collateral (eg: property) that can be used to recover bad debt.

5) Conditions – Interest rates and the term of repayment should also be considered.

The costs behind giving credit are also a factor. These are costs such as losing interest from having cash on hand in investments, as well as the lost purchasing power due to the lack of cash on hand, administration costs for maintaining customer accounts and the additional costs involved in vetting potential trade debtors must also be considered; perhaps the biggest concern would be the risk of bad debts (Atrill & McLaney, 2011). If potential clients are refused credit then the potential of a poor reputation, or losing clients is also there.

All of these above issues should be carefully evaluated and policies on all possible risks and situations as well as contingency plans should be drawn up to maintain trade debtors.

Cash

When managing cash it is important to evaluate the benefits behind keeping cash on hand as well as the best amount of cash to keep on hand. If cash is on hand, the company is losing out on interest that could be gained from the cash being in investments, also, purchasing power due to bank statements reflecting a lower balance (Atrill & McLaney, 2011).

The potential losses from not having enough cash on hand can be that of losing “supplier goodwill” (Atrill & McLaney, 2011) if there are not enough funds to keep up to date on payments. As well as missed opportunities for purchasing in cash and receiving cash discounts. Another major issue to consider is the cost of borrowing money needed (interest charged) if there is not enough cash on hand.

As with trade debtors, it is important to plan, using historic records to base your plans on. Make contingency plans and policies and find the lowest source of funding if needed (overdrafts etc.).

Trade Creditors

Also referred to as “trade payables”, is the amount of credit the company itself has (for purchasing inventories etc.) Costs to consider when managing trade credits are that of purchases on credit generally being of a higher cost than purchasing in cash (due to interest, or just simply a higher price); additional administration costs are also required to manage trade creditors for the company (Atrill & McLaney, 2011).

Trade credit can also favour the company as some suppliers may allow for borrowing without charging any interest, some suppliers may also require the company to have credit (or at least, be “credit worthy”) to be able to get discounts or be able to make large orders (helps build goodwill) (Atrill & McLaney, 2011).

As with the previous areas it is important to develop policies and plans around trade creditors. If the company is able to get interest free credit then they should take advantage of this to increase cash flow in the business (Atrill & McLaney, 2011).

Conclusion

Accounting ratios should be used where ever possible to help evaluate and assess the best possible option in managing working capital. The working capital ratio can be used to calculate the efficiency of a company when it comes to managing stock in trade, trade debtors and creditors (MoneyTerms.co.uk, n.d.) – the calculation is as follows:

Working Capital Ratio = (stock-in-trade + trade debtors – trade creditors) / sales

MoneyTerms.co.uk (n.d.) give an example that if the ratio is 0.20 then that means that the company requires 20p (cents) of working capital for every 1GBP of annual sales, which can be put as : “If annual sales increase by £100,000 of then the company will have to invest £20,000 in working capital to be able to meet this.”.

References

Atrill, P. & McLaney, E. (2011) Accounting and Finance for Non-Specialists. 7th Edition. Prentice Hall.

Investopedia (n.d.) 5 Cs of Credit [Online]. Available from: http://www.investopedia.com/terms/f/five-c-credit.asp (Accessed: 30 April 2011).

Investopedia (n.d.) Working Capital [Online]. Available from: http://www.investopedia.com/terms/w/workingcapital.asp (Accessed: 30 April 2011).

MoneyTerms.co.uk (n.d.) Working capital [Online]. Available from: http://moneyterms.co.uk/working_capital/ (Accessed: 30 April 2011).

Methods for investment appraisal

Atrill & McLaney (2011, p.358) describe the four main methods of investment appraisal to be:

1) Accounting Rate of Return (ARR)

2) Payback Period (PP)

3) Net Present Value (NPV)

4) Internal Rate of Return (IRR)

It is noted that companies do have variations on the above but these are the main methods used. Details of the four methods are as follows:

1) Accounting Rate of Return
Atrill & McLaney (2011, p.359) explain the ARR method to use the two main pieces of information.

Annual average operating profit
Average investment

The equation to calculate the ARR is as follows:
ARR = Annual average operating profit / Average investment (to achieve profit) x 100%

The company should decide a minimum target ARR and base their decisions upon projects achieving an ARR of that minimum percentage or higher. If there are numerous projects that meet the required minimum, the one with the highest ARR should be selected (Atrill & McLaney, 2011, p.360).

The main risk with using ARR is that it does not take into consideration the time factor for return on investment (Atrill & McLaney, 2011, p.362). If three projects have an equal investment and projected return a fixed period of time, they will all have the same ARR; but if one of those projects covers its investment costs within 1 year and the other only after 4 years, project 1 should be the clear winner.

The second major flaw in the ARR method is that ARR is based on Accounting profits rather than cash profits. As explained in an example by Atrill & McLaney (2011, p.362); if an asset has a residual value at the end of life of the project, giving it away rather than selling it allows for a higher ARR (Average Investment = Cost of Asset + Residual Value).

2) Payback Period

This calculates the amount of time that is required for a project to repay the initial investment amount out of its resulting cash inflow (Atrill & McLaney, 2011, p.364).

Companies should base their decisions when using PP on a predefined maximum time limit for projects to repay their investments, the project with the shortest projected time to repay initial investment should be chosen (Atrill & McLaney, 2011).

The flaw with this method is that it doesn’t consider the amount of cash flow in the period it takes to repay the investment. As per Atrill & McLaney’s example (2011, p.366) if project A B and C repay an investment in the exact same amount of time (3.5 years), but project C repays almost all of the investment in the first year while project B and A in the late 2^nd and 3^rd respectively, project C should be the clear winner. Also, it does not consider the cash flows after the initial investment has been reach, it concentrates on high initial returns which lends itself to a more negative idea that the project is going to fail so the money must be recouped as soon as possible. If project A gives twice as much return as project C after the third year then that should be strongly considered as a better option.

3) Net Present Value

The NPV method allows us to make a decision based on all of the costs and benefits as well as the exact timings in which they occur (Atrill & McLaney, 2011, p.368).

To put it simply, NPV compares the value of the invested currency today and compares it with the value of that invested currency in the future, also taking into consideration inflation and returns (Investopedia, 2011).

Value Based Management (n.d.) describes the steps to calculating NPV as follows:

1) Calculate expected free cash flows per year as a result of the investment

2) “Subtract/discount for the cost of capital (an interest rate to adjust for time and risk)”
This intermediate result is called the Present Value

3) Subtract initial investment amounts

This end result is the Net Present Value

Companies should consider projects with a positive NPV, negative NPV’s should be rejected and the project with the highest positive NPV should be chosen when faced with multiple projects.

The problem with NPV as explained by Value Based Management (n.d.) is that it does not account for flexibility or changes / uncertainty after the decision has been made to proceed with the project.

4) Internal Rate of Return

This method is closely tied with NPV. IRR uses the method of discounting future cash flows from an investment but it produces the discount rate at which an NPV value of zero is achieved (Atrill & McLaney, 2011, p.379). It is noted that IRR is difficult to calculate as it involves trial and error to get the value down to 0.

IRR can be thought of as “the rate of growth a project is expected to generate” (Investopedia, n.d.).

Investopedia (n.d.) explains that generally a project with a higher percentage IRR is more desirable than one with a lower percentage IRR. The project that yields the highest percentage IRR is the project that should be considered first.

The flaw with IRR is that it does not take into consideration the scale of development (Atrill & McLaney, 2011, p.383), basically an increase in investment can increase returns yet give us the same percentage. Another issue is that it does not cater for fluctuations in cash flows. With a fluctuating cash flow, multiple IRR’s or none at all may be the result (Atrill & McLaney, 2011).

Atrill & McLaney (2011, p.383) mention that NPV overcomes the flaws of IRR and out of the 4 options outlined above I would also tend to lean towards NPV as being the best method of assessing a risky investment because it gives us closer to real world values of our returns on a project. I believe it is very important to consider that even if we are getting a positive return when projecting, what would that amount really equate to in the time frame that it is being returned, with inflation and rising labour costs it wouldn’t be wise to exclude them from your assessments.

That being said, as Atrill & McLaney (2011, p.388) point out, companies use combinations of the above 4 methods to evaluate investments and I would consider using NPV and IRR and PP when considering an investment.

References

Atrill, P. & McLaney, E. (2011) Accounting and Finance for Non-Specialists. 7th Edition. Prentice Hall.

Investopedia (n.d.) Internal Rate of Return – IRR [Online]. Available from: http://www.investopedia.com/terms/i/irr.asp (Accessed:

Investopedia (n.d.) Net Present Value – NPV [Online]. Available from: http://www.investopedia.com/terms/n/npv.asp (Accessed: 30 April 2011).

Value Based Management (n.d.) Net Present Value Method [Online]. Available from: http://www.valuebasedmanagement.net/methods_npv.html (Accessed: 30 April 2011).