3.3 Working Capital

1. 3.3 Working Capital Chapter 20

2. Working Capital • The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. Working Capital=Current Assets – Current Liabilities

3. Working Capital • Without working capital, a business will not be able to pay its immediate (or short-term) debts. • Liquidity: The ability of a firm to be able to pay its short-term debts. • Liquidation: When a firm ceases trading and its assets are sold for cash.

4. How much working capital is needed? • Too much working capital • Capital tied up in stock purchases, debtor (accounts receivable), and idle cash ALL NOT GOOD because the cash could be used for other investments. • Too little working capital • Not enough cash to pay for wages, stock purchases, and the paying of debts ALL NOT GOOD because the business may need to liquidate to pay its debts even though it is profitable.

5. Working Capital Cycle • The period of time between spending cash on the production process and receiving cash payments from customers. • The longer the time between buying materials and receiving payment from customer the greater the working capital needs of the customer.

6. Working Capital Cycle SWEET Tooth, Inc. April May June -Buy candy bars -Sell to customer -Receive cash -Add crispys -Deliver -Wrap -Invoice -Store ready for sale $100 candy stock $1000 Sales $1000 cash receipts $25 crispys stock invoice customers $10 wrappers w/ 30 day terms $500 labor Cash outflow Cash inflow Cash inflow $635 $0 $1000 Profit:$365 Profit: $0

7. Working Capital Cycle Credit given to customers by business will lengthen the time before a sale is turned into cash—extending the cycle. Credit received by the business from suppliers will reduce the length of this cycle. Cash Materials and Stock Purchases Sell on Credit To give more credit to customers than received from vendors increases the need for working capital. To receive more credit from vendors than is given to customers reduces the need for working capital. Production

8. Cash Flow • The timing of payments to workers and suppliers and receipts from customers. • Businesses must plan this timing in order to meet its financial obligations, fund growth, and STAY in business.

9. Cash Flow • The sum of cash payments to a business (inflows) less the sum of cash payments made by it (outflows). • Insolvent: When a business cannot meet its short-term debts.

10. Why is cash flow important? • Business start-ups are offered less time to pay vendors (shorter credit periods) • Banks and lendors may not believe promises to pay because of lack of payment history and may demand payment at agreed upon times without extensions. • Finance is tight for start-ups so there is little flexibility.

11. Cash VS Profit • Profit: Revenue – Expenses or what is “left over” • Cash: The working capital of the business. • Goods are purchased for resale before the sale. • Cash is not always received at the time of sale. • Cash “timing” does not match profit “timing”

12. Forecasting Cash Inflows • Capital injection into the business by owner – easy to forecast • Bank loans – easy to forecast • Customer cash purchases – difficult to forecast; depends on sales • Debtor’s payments (Accounts Receivable) – difficult to forecast; depends on sales; depends on repayment by customer Debtor:Customers who have bought products on credit and will pay cash at an agreed upon date in the future.

13. Forecasting Cash Outflows • Lease/Rent payments – easy to forecast • Utilities – difficult to forecast; the vary due to external factors • Labor costs – forecast dependent on sales demand estimates • Variable costs – costs vary; usually consistent with sales demand

14. Structure of Cash-Flow Forecast • Section 1: Cash Inflow • Cash sales, payments for credit sales, capital injections • Section 2: Cash Outflow • Wages, materials, rent, and other costs • Section 3: Net monthly cash flow with opening and closing • Cash flow for period with start and ending cash balances. If a closing balance is negative, a bank overdraft will be needed (credit line access).

15. Vocabulary • Cash-Flow Forecast • Estimate of a firm’s future cash inflows and outflows. • Net Monthly Cash Flow • Estimated difference between monthly cash inflows and outflows. • Opening Cash Balance • Cash held by the business at the start of the month. • Closing Cash Balance • Cash held at the end of the month becomes the next month’s opening balance.

16. Example

17. Benefits of Cash Flow Forecasts • Negative periods of cash flow can be planned for handling with financing with bank or cash injections from owners. • Negative cash flows can be reduced by eliminating purchases or by reducing sales on credit. • Cash flow statements are required for new businesses by investors and bankers – with reasoning for the projections.

18. Causes of Cash Flow Problems • Poor Credit Control • Businesses must manage their collection from debt extended to customers (Accounts Receivable). • Allowing Customers too much Credit • In order to be competitive, extending generous payment terms to customers reduces short-term cash flows.

19. Causes of Cash Flow Problems • Expanding Too Rapidly • Expansion requires additional labor and materials which can cause cash shortages even though the company is profitable. • Unexpected Events • Unforeseen costs, equipment repairs, dip in sales, competitors lower prices can negatively impact cash flow.

20. How to Improve Cash Flow • Increase Cash Flow • Reduce Cash Outflows • CAREFULDo not harm Sales or Profits

21. How to Increase Cash Flow

22. How to Reduce Cash Flow