The Working Capital Cycle and Operating Efficiency
Like the Activities in both texts of my bookboon working capital series, some Exercises have focused on accounting transactions and their interpretation using external financial reports. Others have required a more literary, theoretical approach from an internal managerial perspective. To vary the pace and style of analysis, this Chapter combines the two with an expanded Case Study based on a true story. It complements the Review Activity contained in Chapter Three of the companion books and is structured to reinforce our developing critique of the subject.
The Case Study: An Introduction
From the outset, we have observed that for a given level of sales using financially efficient time value of money criteria:
o Accounts receivable (from debtors) should be collected as soon as possible.
o Conversely, accounts payable (to suppliers) should be delayed as long as possible.
Of course, this approach to working capital management may be an oversimplification because of its goodwill implications. The former ignores the fact that a reduction in the period of credit granted to customers may cause the company's clientele to look elsewhere, thereby reducing future sales. Likewise, an increase in the creditor payment period offered to suppliers may cause them to cease trading with the company altogether, thereby interrupting the whole production process.
On the other hand, as we shall now discover, subject to two constraints, these policies conveniently "benchmark" the normative wealth maximization objective of efficient working capital management mentioned earlier:
To minimize current assets and maximize current liabilities based on a company's "terms of trade" without compromising its future profitability and debt paying ability.
When I was at university, an extremely intelligent friend of mine bored with his studies decided to leave our course part way through the second year (despite every lecturers' attempts to convince him otherwise). The next time we met, he had just set himself up in business.
The financial details were as follows:
o On January 1st he signed an open-ended monthly agreement to purchase imperfect shoes from a local manufacturer for £10,000 on three months credit.
o He then occupied part of his sister's market stall in the city centre (who sold second-hand designer clothes) for two days a week, free of charge.
o At the end of each month he hoped to sell everything at a 50% mark-up (well below High Street prices) cash up front.
Using the information available, prepare forecast beginning and end of month Balance Sheets to April 1st to evaluate the financial wisdom of my friend's decision to leave his degree course and go into business At this stage in our analysis there is no need to use ratio analysis.
An Indicative Outline Solution
The forecast sequence of beginning and end of month Balance Sheets to April 1st presented in Table 4.1 reveals that the business is extremely profitable, solvent and liquid. So much so, that as I have also illustrated, it would be awash with cash by the following January. But as we now know from the previous Chapter's Exercises, the burgeoning working capital structure is far too conservative and grossly inefficient, from both an investment and financing perspective.
Using creditors, rather than your own money (or borrowing) to fund a business start-up is financially desirable. But once the venture is up and running, idle cash is unprofitable cash. If my friend's business objective was to make as much money (cash profit) as possible (what we formally term wealth maximization) then as mentioned earlier:
Any profit-maximizing enterprise should strive to minimize current assets and maximize current liabilities compatible with its future profitability and debt paying ability.
Two options therefore confronted my friend, which are not necessarily mutually exclusive.
o Withdraw the maximum proportion of periodic cash balances and enjoy the proceeds.
o Reinvest the maximum proportion of periodic cash balances and diversify the business.
Table 4.1: Forecast Statements of Monthly Financial Position