The Working Capital Cycle and Operating Efficiency

Introduction

The previous Chapter's Activities suggest that a conventional interpretation of working capital data contained published financial statements may not only mislead external users of accounts but also contrast sharply with the overall wealth maximising objective of financial management, namely:

To maximise the demand for a firm's products and services through optimum, profitable investments, financed at minimum cost.

To prove the case conclusively, we shall now confirm why the accounting concept of working capital (which defines an excess of current assets over current liabilities as an indication of financial strength) and its interpretation (often benchmarked by a 2:1 current asset ratio) is invariably suboptimal and way of target. As we shall discover:

The normative objective of efficient working capital management should be to minimise current assets and maximise current liabilities, subject to the constraint of maintaining a sound liquidity position, which also maximises opportunities for fixed asset investment.

The Working Capital Cycle

When evaluating overall corporate performance it is not sufficient to calculate the working capital and liquidity ratios from the Balance Sheet and corresponding sales to net working capital ratios and cash velocity using turnover data. As we observed from Figure 3.1 in Chapter Three, it is also necessary to analyses the turnover ratios for other working capital constituents (notably the relationship between inventory, debtors and creditors).

One simple framework is given by an equation which defines how many times net working capital is "turned over" within the period under observation, relative to the rate at which goods are sold, debtors pay and the firm repays its own creditors, typically calculated from the data contained in published annual reports.

As students of Financial Accounting you should also be familiar with reformulations of Equation (5) which express turnover in either days or months as follows:

You will see that each equation ignores cash turnover. Unlike stocks, debtors and creditors, it might not move in sympathy with sales. As we have observed elsewhere, cash has a variety of uses, which might not be related to any increase in sales. For example, loans may have been repaid one year to the next. Cash can also appear in the guise of new overdraft facilities that are not recorded in the velocity ratio (or even the Balance Sheet) even though they contribute to sales.

Note also that Equation (5) is simplistic because the debtor ratio is the only true turnover ratio, whereas the stock and creditor relationships are not. These don't compare like with like, because their denominators are expressed at cost but the numerators are at selling price. The stock and creditor ratios only exhibit their rate of variability with sales value. Nevertheless, these ratios are still useful indicators of the amount of working capital required to support sales and highlight a need for investigation if they deviate from standard or past trends.

A much more sophisticated analysis is provided by constructing a company's working capital cycle (or net operating cycle). This measures the average length of time between paying for raw materials that enter into inventory (the financing cycle) and the eventual receipt of cash from the sale of finished goods (the operating cycle, which also equals the production cycle for a trading company). You first encountered these cycles when we defined the objectives of working capital management in Chapter Two. The difference between the two, the net operating cycle is shown schematically in Figure 4.1.

As we shall discover, in this chapter and the next, the net operating cycle is an important concept in working capital management, which improves upon our previous working capital ratios.

- Stocks and creditors are now related to their appropriate costs and not revenues. As such they are proper turnover ratios. On a par with debtors, they produce an analysis in physical terms (days) rather than monetary values.

- The greater the time lag between the operating cycle and the financing cycle, the more funds the company presumably needs to support production.

- The relative significance of the net operating cycle's constituents can therefore suggest where managerial effort should be expended to reduce funds which are tied up in working capital.

- Conversely, the cycle reveals how profitability can be improved without putting undue strain on liquidity.

The Working Capital Cycles

Figure 4.1: The Working Capital Cycles

 
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