Real World Considerations and the Credit Related Funds System
Before concluding our study of working capital and moving on to Part Three and the role of strategic debtor investment, let us summarize our position so far.
In an ideal world, all firms would prefer to hold no inventory, sell everything for cash and not leave the balance lying idle. Conversely, they would prefer to purchase all stocks on credit. As a consequence, they would hold no current assets but finance their reinvestment activities by maximizing current liabilities, subject to no loss of goodwill.
In the real world, these options are obviously the exception rather than the rule, given the extent to which most firms buy and sell on credit and "manufacture" their products. 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. Likewise, a reduction in the period of credit granted to customers may cause the company's clientele to look elsewhere, thereby reducing future sales and profitability.
Nevertheless, whilst these "barriers to trade" may prohibit an ideal relationship between the two, companies should still strive to minimize current assets and maximize current liabilities. As a consequence, within the context of normative wealth maximization, we can still define the efficient objectives of working capital management as follows.
o The determination of optimum (minimum) inventory, debtor and cash investments.
o The acquisition of an optimum (maximum) level of creditor finance, subject to a firm's future profitability and debt-paying ability.
Assuming no loss of customer or supplier goodwill, the inflow of cash will then be maximized at minimum cost, satisfying the overall NPV criteria of financial management.
Exercise 5: Real World Solvency and Liquidity
Over the past decade, the Pixie Company has expanded its activities by the profitable reinvestment of retained earnings. But despite a significant increase in turnover and a history of Balance Sheet solvency; it is now beset by liquidity problems.
The CEO Mr. Francis has convened a Board meeting to establish what is wrong with its working capital position. The following "snapshot" data taken from the company accounts has been itemized as a basis for discussion.
($million) Last Year This Year
Raw materials 200 270
Work in progress 140 180
Finished goods 160 240
Debtors 320 480
Creditors 160 195
Sales 1,600 2,000
Purchases 960 1,300
Castoff goods sold 1,400 1,800
1. Reformulate the data, using ratio analysis and the derivation of the company's operating and financing cycles to interpret any possible "mismanagement" of working capital.
2. Having studied Chapter Five of either core text of the bookboon series (referenced at the end of this Chapter); critically evaluate alternative strategic options for how the company's future liquidity position might be improved.
3. Summarize your conclusions.
An Indicative Outline Solution
1. The Data Reformulation
Although we have no information concerning cash balances (presumably because of the company's reinvestment policy) the original data set itemizes the working capital components for what is a "manufacturing" company, which also buys and sells on credit (a creditor firm).
Based upon the normative, wealth maximizing objective of financial management (subject to future profitability, debt paying ability and neither a loss of supplier or customer goodwill) working capital efficiency requires the Pixie Company to:
o Minimize current assets, comprising raw materials, work in progress, finished goods and debtors, which define the firm's operating cycle.
o Maximize creditors (the financing cycle).
If we reformulate the data in terms of accounting ratios and derive the relationship between the operating and financing cycles, it becomes obvious why the firm is experiencing liquidity problems, even though it is extremely solvent.
Turnover Ratios (days) Last Year This year
RM 76 76
WIP 37 37
FG 42 49
Stocks 155 162
Drs J73 87
Operating Cycle 228 249
Financing Cycle (Crs) 61 55
Net Operating Cycle (Shortfall) 167 194
Current Assets/Current Liabilities 5:1 6:1
The company's management is schizophrenic. Despite (or perhaps because of) an aggressive policy of fixed asset reinvestment funded by maximum retention; the table reveals all the features of an extremely conservative working capital policy (with which you should be familiar from the Exercises contained in Chapter Three).
The Pixie Company's conversion of raw materials to the eventual receipt of cash from debtors (the operating cycle) not only exceeds the supplier credit period (the financing cycle) by a massive margin, but it has also widened year on year. So much so, that its "credit related fund system" defined by the net operating cycle has risen from 167 to 194 days. Thus, current assets far exceed current liabilities, with the working capital ratio rising one year to the next (5:1 to 6:1).
All of which is bad news for the company, unless it is extremely risk averse, (which is not supported by its approach to fixed asset formation).
2. The Strategic Options
Without the retention of "precautionary" cash balances from previous sales to finance current working capital (which presumably would compromise the company's long-term investment policy and may be impossible to unscramble) only two other strategic options are available to support the systematic funding of future production.
1. Increase the price of goods and services.
2. Seek external finance.
Unfortunately, both these remedies may also be worse than the original disease. The former might reduce demand. The latter will incur eventual capital repayments and periodic interest charges. A combination of the two could therefore reduce turnover and future cash profitability dramatically, with catastrophic consequences for liquidity.
Summary and Conclusions
Pricing policy and external finance should only fund working capital if corporate management already has optimum stock, debtor and creditor policies in place.
With regard to Pixie, the levels of inventory that comprise the "production process" are reasonably stable. However, the volatile "terms of trade" which define the balance of the company's net operating cycle provide cause for concern.
The fact that over the two years, debtors are taking 73 and 87 days to pay (compared with creditor turnover ratios of 61 and 55 days) suggests that whilst the period of credit offered by suppliers has tightened, the longer period of credit taken by customers is the root cause of the company's liquidity problem. When you consider that any turnover ratio is an average, many customers must be remitting payment well beyond 87 days
Before refinancing fixed asset investment from external sources (the capital market), re-negotiating its supplier credit terms, or toying with inventory control and cash budgeting requirements, Pixie's CEO is therefore advised to focus initially on the company's own customer terms of sale.
As we shall discover, when we return to this company in Part Three (Exercise 6.4):
For most firm's, it is their debtor policy and specifically the inter-relationship between its terms of sale and the eventual receipt of cash (the credit related funds system) which are the prime determinants of its overall investment-financing strategy and the efficient management of working capital.
Working Capital and Strategic Debtor Management, 2013.
Working Capital Management: Theory and Strategy, 2013.