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HSC Business Studies 2007

HSC Business Studies 2007. Topic 2-5 Working Capital (liquidity) Management. Short-term liquidity is essential to the success of a business. It means a business can take advantage of profit opportunities that arise and meet its short-term financial obligations. For example, it can:

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HSC Business Studies 2007

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  1. HSC Business Studies 2007 Topic 2-5 Working Capital (liquidity) Management

  2. Short-term liquidity is essential to the success of a business. It means a business can take advantage of profit opportunities that arise and meet its short-term financial obligations. For example, it can: • Pay creditors on time to claim discounts • Pay tax • Meet payments on loans and overdrafts • Avoid interest payments on overdue accounts • Maintain a good credit rating • Take advantage of bargains and avail of cash discounts in purchasing inventory • Pay wages on time • More precise and effective cash flow management.

  3. Poor short-term liquidity can necessitate the sale of non-current assets to raise cash which in the long-run may reduce profitability and return on equity. Net Working Capital (NWC) refers to the funds available for the short-term financial commitments of a business. NWC = Current Assets – Current Liabilities Throughout the operating cycle of a business, current assets and current liabilities are constantly changing. Hence working capital needs to be managed.

  4. Working Capital Management involves determining the best combination of current assets and current liabilities to achieve the objectives of the business. A business must achieve the right trade off between using funds to create profits and holding sufficient funds to cover payments. The better the working capital management of a business, the more efficient and profitable it will be.

  5. The working capital ratio shows the extent to which current assets can cover current liabilities. That is, it shows whether or not the business is managing cash flow so as to be able to pay its immediate debts. A high working capital ratio of say 4:1 or 400%, may indicate that the business has invested too much in current assets thus limiting its profit making potential. A low current ratio of say 1.1:1 or 110%, may mean that the business is taking greater risk with its liquidity than it should. A working capital ratio of 2:1 is generally acceptable, but it ultimately depends on the nature of the industry, trends, and the ease with which current assets such as inventory and receivables can be converted into cash.It will also depend on the business’ relationship with creditors and banks which are sources of cash.

  6. Control of Current Assets Management of current assets is essential to maintaining sound liquidity. Excess inventories and lack of control over accounts receivable lead to an increased level of unused assets, increased costs and liquidity problems. Management must select the optimal amount of each type of current asset to be held, as well as the cheapest and most reliable way of funding them.

  7. Cash Cash ensures the business can pay its debts and repay loans in the short-run and that a business can survive over the longer term. Planning for the time of cash receipts, cash payments and asset purchases avoids the situation of cash shortages or holding of excess cash. Despite good cash flow budgets, unforeseen cash shortages can occur, borrowing will need to occur and necessary contingency plans should be in place. Businesses try to keep their cash balances to a minimum and hold marketable securities as reserves of liquidity. This guards against sudden disruptions to cash flow. A bank overdraft may also be used.

  8. Receivables Efficient collection of receivables is an essential component of good working capital management. The quicker the debtors pay, the better will be the business’ cash position. Procedures for good debtor (receivables) management are: • Check the credit rating of customers applying for credit • Sent out statements to debtors monthly and at the same time each month so that debtors know when to expect accounts • Follow up on accounts that are not paid by the due date • Stipulate a reasonable period (e.g. 30 days) for payment of accounts • Have policy for collection of bad debts such as use of a debt collection agency. The disadvantage of using too tight a credit control policy is that potentially good customers can be lost to other firms.

  9. Inventories Inventories make up a significant amount of current assets and their levels must be continuously monitored to ensure that excess or insufficient levels of stock does not occur. Too much inventory or too slow moving inventory will lead to cash shortages. Insufficient inventory of popular and quick selling items may lead to a loss of customers. If inventory remains unsold it is a cost to the business. Holding too much stock carries increased storage costs and the greater likelihood of deterioration and damage. Slow moving inventory may be offered in sales or on special. Inventory turnover must be sufficient to ensure that suppliers and receivables are paid on time. A good inventory control system is essential – electronic systems and occasional physical stocktakes. JIT stock ordering techniques help achieve more effective inventory management.

  10. Control of Current Liabilities

  11. Minimising costs associated with current liabilities is an important part of working capital management. This involves being able to convert current assets into cash to ensure that the business’s creditors (payables), bank loans or overdrafts, expenses due etc are paid on time. Payables Holding back accounts payable until their final due date can be a cheap means to improve a firms liquidity position as some suppliers provide periods of interest-free credit. Some creditors also provide discounts for early payment or payment on time. Alternative financing arrangements should be investigated with suppliers such as floor plan and consignment finance.

  12. Loans Funds may be required to cover the sale and purchase of property, unforeseen circumstances, and import and export commitments. Short-term loans and bridging finance are important sources of short-term funding for business. Establishment costs and interest rates charged by various loan providers must be compared. Short-term loans can be a very expensive form of finance.

  13. Overdrafts

  14. Bank overdrafts are a convenient and relatively cheap form of short-term borrowing for a business. They enable a business to overcome temporary cash shortages. Banks may demand immediate repayment of an overdraft, something that is rare. However, regular payments have to be made on overdrafts and banks may charge account-keeping fees, establishment fees and varying rates of interest. Interest payable on a bank overdraft is usually lower than interest on a short-term loan.

  15. Strategies for Managing Working Capital • Leasing • Factoring • Sale and lease-back

  16. Leasing ‘frees-up’ cash that can be used elsewhere in the business, thus improving the level of working capital. Leasing allows 100% financing. Leasing allows firms to increase the number of assets they use. Regular and fixed payments can be planned to meet the business’s cash flow.

  17. Factoring is growing in popularity as a strategy to improve working capital. It involves selling of accounts receivable at a discounted price to a specialised factoring company. By doing so, a business has immediate access to cash and saves on the costs of debt collection.

  18. Sale and lease-back Involves the selling by a business of one of its assets to a leasing company (lessor) and leasing the asset back through fixed payments for a specified number of years. Sale and lease-back increases a business’s liquidity because the cash that is obtained from the sale is then used as working capital.

  19. Effective Financial Planning Cash Flow Management Most businesses’ goal relate to profits and business decisions will reflect this. Adequate cash flow is essential to a businesses short-term survival. Cash flow in must be matched with cash flow out.

  20. Key elements of cash flow management are: 1. Regular statements of cash flow. Cash flow statements are used by creditors, lenders, suppliers, banks, potential shareholders. A fluctuating cash flow may indicate instability in a business Statements of cash flow can can show: • Whether a business an generate favourable cash flow • Pay financial commitments as they fall due • Have sufficient funds for future expansion or change • Obtain finance from external sources when needed • Pay drawings to owners or dividends to shareholders

  21. Operating Activities are the cash inflows and outflows relating to the main activity of a business. Revenue from cash and credit sales make up the main cash inflow. Outflows include payments to: • Suppliers • Employees • Other operating expenses (insurance, rent, advertising etc) Investing Activities are the inflows and outflows of cash relating to the purchase and sale of non-current assets and investments. Financing Activities are generally the cash inflows and outflows relating to the borrowing activities of the business. However, such inflows and outflows can also relate to equity. A statement of cash flow is usually prepared from the revenue statement and balance sheet. These three statements show how effectively finance is being used in the business.

  22. Cash Flow Management Strategies • Use of bank overdraft for temporary cash flow shortages. • Time inflows may not correspond with time of outflows. Provisions must be made for accessing cash during periods of deficit cash flow. • Distribute payments throughout the month or year so that cash shortfalls and surpluses will not occur. • Efficient debtor control system so as to ensure that funds are not tied up in overdue accounts. Interest charges on overdue accounts or discounts for early payment. • Stretching (delaying) payment of creditors. This has ethical implications.

  23. Other Methods of Acquiring Productive Assets Hire Purchase is another way of acquiring assets – you use now and pay later. The financier owns the the asset until it is fully Paid on an principal plus interest basis. Interest is tax deductible. Loans: If you take out a loan to acquire an asset, the interest is tax deductible as is depreciation.

  24. Profitability Management

  25. Profitability Management Management must control both the business’s costs and its revenues. Cost Control For all organisations costs must be: • Identified • Analysed • Controlled Business costs can be divided into fixed costs and variable costs.

  26. Changes in the scale of operations needs to be monitored in relation to the associated changes in costs. Comparisons of actual costs with budgets, with with previous costs and industry standards can ensure the minimisation of costs and thus the maximisation of profits. Some costs can be directly attributable to a particular department or process – these are known as internal cost centres. Cost centres have direct and indirect costs. Direct costs are related directly to a particular line of production such as depreciation on machinery producing steel frames. Indirect would be when the depreciation is spread over the production of various products. Management must seek to minimise costs associated with each centre, if it does not, profit levels will be smaller.

  27. Revenue Controls Revenue is income earned from the main activity of a business, for most businesss this is from sales. To maximise profits, a business must have clear ideas about: • Sales objectives • Sales-mix • Target market Sales objectives must be such that costs are covered, both fixed and variable, so as to ensure at least break-even. The sales-mix must be under constant review so as to ensure that poor performing products are either deleted or marketed in new ways. Research should be conducted so as to ascertain the likely impact of a change in sales-mix on existing and potential customers.

  28. Pricing Policy affects revenue and therefore affects working capital. Overpricing could fail to attract buyers, underpricing could bring higher sales but still lead to cash flow problems. Factors that influence pricing include: • Costs associated with producing goods and services • Prices charged by the competition • Short and lon-term goals • The image or quality the business wants to project for its product • Government policies.

  29. Ethical and Legal Aspects of Financial Management Recent years have seen growing emphasis on exposing unethical practises in financial management. In financial management, ethical considerations are important in the valuing of assets, since such valuations influence the level of working capital and hence the shrt-run financial stability of the business. There are serious ethical issues surrounding the use of debt funds. The estimation of revenues and expenditures, like all other valuations, should seek to present a true and fair view of the business’ financial position and future prospects. Investment in lon-term expenditure impacts on future operating activities and needs to be evaluated accordingly.

  30. Law relating to corporations include the responsibilities of directors and the requirement for disclosure by corporations. These responsibilities include: • To act in good faith • Exercise power for proper purposes in the interests of the business/corporation • Exercise discretion reasonably and responsibly • Avoid conflicts of interest The ASX corporate governance council overseas the activities of companies listed on the exchange to see if they comply with the relevant law.

  31. Audited Accounts An audit is an independent check of the accuracy of financial records and accounting procedures. Audits help protect the resources of an organisation and improves efficiency. There are three types of audit which are: • Internal audits (Conducted internally by employees to check accuracy of accounts and financial statements) • Management audits (Review of strategic plan to gauge if changes should be made) • External audits (Required under Corporatins Act 2001. Auditor checks to see that accounts give true and fair view of the business finances and that accounts comply with Australian Accounting Standards or International Financial Reporting Standards)

  32. Australian Securities and Investments Commission ASIC is an independent statutory commission accountable to the Commonwealth parliament. It enforces and admisters the Corporations Act and protects consumers in the areas of investment, life and general insurance. The aim of ASIC is to reduce fraud and unfair practices in financial products and markets.

  33. Corporate Raiders and Asset Stripping Business entities that use outdated asset values can become targets for takeovers and for asset stripping. Asset stripping describes the practice of organisations that identify, takeover and sell off for a profit the readily saleable assets of a company. Business entities that do this are known as corporate raiders. The term ‘corporate raiders’ also applies to individuals and companies trying to acquire a controlling interest in another business entity.

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