Effective Working Capital (Cash Flow) Management

• Effective Financial Management
• Management Strategies for Cash Flow Problems
• Effective Profitability Management

Strategies for managing working capital include:

·        Leasing represents an agreement between the owner of an item and the potential user of an item in return of payment of a periodic charge. The owner of the item is the lessor and the business using it is the lessee. Leasing is very much an instrument of the finance companies, which are the largest source of leasing arrangement, followed by the banks, with merchant banks and life assurance companies active in a minor way. Where a finance company agrees to enter into a lease with a client, it could just as well have lent the client the money. The main difference is that, in a lease, the finance company owns the equipment. The payments the lessee makes every month meet, among other things, the interest costs of the funds used by the finance company to purchase the leased asset.

There are two types of lease:

1. Financial leases, which are often indistinguishable from debt finance, provide the required item to the user, with the eventual purchase terms clearly written into the lease, it differs from time payment in its many guises by requiring no initial deposit, other than one periodic payment, usually monthly, and instead of an on-going lump sum there is usually a residual value. This figure is that at which the lessee may, but need not, offer to purchase the leased asset at the termination of the lease. No agreement to actually purchase may be written into the lease. If it is, or is even implied, the Australian Taxation Office (ATO) is likely to disallow the agreement as a lease, and deem it a purchase agreement, namely, that the lessee owns the equipment and has borrowed funds to acquire it. The residual value is the result of a complex calculation which includes:

§         The written down value of the item at the end of the lease.

§         The opportunity cost of the funds employed.

§         The interest earned from the lease payments.

§         The probable market value of the item at the end of the lease.

There are certain conditions to a financial lease, namely:

§         The pre-arranged agreement on the terms of the lease is usually firm, and may only be abrogated by the lessee at a substantial penalty. The term of the lease will usually cover the leased asset’s expected working life.

§         The lessee is responsible for maintenance, insurance, operating costs, and any legal government charged incurred by operating the item which is the subject of the lease, for example, paying registration and compulsory third party insurance on a motor vehicle. The leased item, and the lease agreement, both appear in the accounts of the lessee, in the non-current assets and deferred liabilities sections of the Balance Sheet.

§         The lease agreement will specify a series of monthly payments and a residual value. Both must be commercially acceptable to the Australian Taxation Office.

§         The transaction that brings the monthly lease payments to account is usually generated by a bank standing order. It may be paid by cheque.

§         From the financier’s standpoint, the item is purchased specifically for the lessee, at the lessee’s choice specification, and the first term of the lease amortises the cost of the item completely. Amortisation means paying of interest bearing liability by gradual reduction through a series of installments comprising of both principal and interest components, as opposed to paying it off by a single lump-sum payment.

Thus, the lesse has all the obligations of ownership, without actually owning the item. The main advantages are the taxation relief from the payments, and the conservation of initial capital.

2.      Operating leases, of which a sub-type is the rental lease. Operating leases differ from financial leases in not providing, as a right, an opportunity to purchase the item being leased when the lease agreement comes to an end. Here the emphasis is on rental, rather than what is effectively deferred purchase. The general conditions of these eases are:

§         The term of the lease generally has no relation to the leased asset’s working life.

§         The leased asset was probably not acquired specifically for the lessee by the lessor.

§         Usually no penalty attends early termination of the lease by the lessee.

§         No residual value is written into the lease, and the lessee has no vehicle by which he/she may offer to purchase the leased asset.

§         In the case of operating leases, the lessee may be responsible for paying all or any of the maintenance, insurance, operating costs, and any legal or government charges related to the operating of the equipment which is the subject of the lease, for example, paying registration on a motor vehicle.

§         In a rental lease it is usual for the periodic payments of the lease to cover all of these costs, except possible operating costs such as fuel and oil in the motor vehicle, although even these may be included, particularly in fleet management leases.

Neither of these leases appears in the Balance Sheet, being regarded as an ongoing current overhead expense of business. Thus, to the extent that they are used totally in the business, as opposed to the potential private use of a motor vehicle, the payments are totally tax deductible.

·        Factoring is the selling of accounts receivable or debtors’ ledgers to a third party for less than the book value. The factor advances the business the value of the invoices and takes over the collection of accounts from the customers. The balance, less the factoring fee, is paid to the business when the factor receives the customer’s remittance. In factoring, the debtors’ ledger itself is usually sold to a finance company, which will purchase it as a considerable discount from the face value of the balances, often 20 per cent of sixty days prior balances. For example, if the company has $1 million of debtor accounts to sell over sixty days, the factor will accept and then discount them to provide immediate working funds to the seller. The funds are expensive, compared to bank overdrafts, but are available immediately. The factor’s (finance company’s) calculations are:

$1 000 000

1 + 0.20   (60)      = $968 170
               (365)    

The factor therefore discounts the ledger by $31 830. This is the factor’s fee for taking the risk of collecting, or not collecting, the debtor balances. There are two types of factoring:

o       Non-resource factoring is one we see everyday. This is the bankcard, VisaCard and MasterCard system, in which the factors, in this case the banks, takes the total risk of the debts. The banks typically charge traders’ 2-5 per cent month of all current charges negotiated for the non-recourse debtors’ ledgers they accept and they make funds available on a daily basis. Despite some traders’ critical comments about the allegedly greedy banks, this service provides great security for the trader.

o       Recourse factoring in which the factor will return bad or doubtful debts to the original seller of the ledger. The factor’s discount reflects the amount of risk taken, and the higher the risk, the greater is the discount.

The term factoring is sometimes applied to loans offered by banks and finance companies, secured against the balances in the debtors’ ledger. This only becomes actual factoring if the borrower defaults, and the lender takes up his/her security.

·        Sale and leaseback refers to a transaction in which the seller retains the use of an asset, such as occupancy of a building, by simultaneously signing a lease (usually of long duration) with the purchaser of the asset at the time of sale. In this way the seller receives cash for the transaction, while the buyer is assured a lease, and thus a fixed return on his/her investment.

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Effective Financial Management

The Cash Flow Statement shows what was actually received and paid by the company in a particular year, not what was owed or recorded.

The Cash Flow Statement takes the Balance Sheet of the business entity, and proves it by detailing the sources of cash used to fund various accounts in the Balance Sheet.  For example, in current liabilities, a decrease in the trade creditors’ ledger from one period to another has to be funded, and this may be done by increasing the bank overdraft (or reducing the bank balance) or reducing trade debtors’ (given that sales have at least held even). The proof of the Statement lies in the equality of the two totals, that is:

Source of funds = application (use) of funds.

Sources include:

• Injection of new capital.

• Raising new loans.

• Profits earned (after adding back depreciation).

• Reduction in stock.

• Increases in creditors.

• Proceeds of sales of fixed assets, for example plant and equipment.

Applications include:

• Pay-out of business loans.

• Payments of dividends.

• Taxation paid.

• Increases in stock and debtors.

• Reduction of creditors.

• Purchase of fixed assets.

• Losses incurred by the business.

A typical cash flow statement is divided into three parts:

1.      Cash flows from operating activities. These are mainly receipts from customers, payments to suppliers, wages, dividend and interest payments, and receipts and taxes. Generally, operating activities is negative. However, an established company should maintain regular positive cash flows, unless it is in the process of major expansion.

2.      Cash flows from investing activities. These are such things as research and development expenditure, exploration and evaluation costs, payments for plant and equipment, loans to associated companies, new investments and the proceeds from the sale of property and investments.

3.      Cash flows from financing activities. These are largely cash flows related to borrowing or from the issue of new shares.

An overall positive cash flow could result from borrowing, while a negative cash flow could mean that the company is paying off loans. Thus, it is important to consider what is behind the figures.

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Management Strategies for Cash Flow Problems

·        Shortening the operating cycle. Increasing the inventory turnover or reducing the days debtors, while maintaining the same level of sales, will release cash. This requires more aggressive collection of trade debtors and tighter control of inventories. It may even pay to offer discounts for early payments.

·        Increase net profit margin. This can be achieved by increasing price, reducing costs of sales, or reducing operating expenses.

·        Reduce sales volume. This reduces the investment required in the components that make up the operating cycle. It is often preferable to show growth than to have a cash crisis. It is possible to increase profit margin and cash flow while reducing sales volume by selectively increasing prices.

·        Increase trade payables. To slow down cash disbursements, the business may rely more heavily on available credit. Credit terms may be extended. Otherwise, it may be possible to acquire goods on consignment, which means that the business does not pay until the goods are sold.

·        Borrow money. This can be used to solve both short-term and long-term cash flow problems.

Short-term borrowing is used to finance temporary increases in working capital, such as a seasonal build-up of stock financed by an overdraft. It should be self-liquidating, so that when the operating cycle returns to normal it produces the cash flow necessary to repay the loan. Long-term borrowing can be used for permanent increases in working capital or for the acquisition of fixed assets. It is repaid over a longer period to give assets enough time to generate the cash flow necessary for repayment.

·        Look for equity capital. This can be done by either the owner putting more of his/her own money into the business, or taking in new owners in the form of partners or shareholders. It is long-term capital and should be used for long-term purposes.

·        Maintain a minimum cash reserve. While cash is an idle asset, it is sometimes prudent to have minimum cash reserve. The size of a cash reserve will depend upon the extent of owner can count on collections from debtors, the flexibility of business’s disbursements and the availability of external finance.

Cash flow shows cash in and cash out. It does not show non-cash items. There are two key risks not covered by cash flows statements, namely:

·        Liabilities, which are amounts owing and yet to be paid.

·        Assets losing value which, if acquired by paying cash for them, appear in the Cash Flows Statement when paid for. Over-valuation of assets is often difficult to detect.

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Effective Profitability Management

Profitability is concerned with managing the flow of sales revenue into, and operating expenses out of, the business. Profitability management is concerned with maintaining or increasing a business’s earnings through attention to:

• Cost control.
• Pricing policy.
• Sales volume.
• Stock management.
• Capital expenditure.

Gross profit is obtained by subtracting costs from revenue. The greater the ‘gap’, the greater the profit.

There are two types of controls that improve profit levels:

1.      Cost controls, such as:

• Fixed and variable costs. Fixed, or overhead costs, are those whose amount is not influenced by the plant’s production level. They exist even if the plant is idle, for example, council rates and fire insurance. Variable costs are those that vary with the level of production, such as wages and salaries, raw materials and electricity. Total costs for a business for various levels output are the summation of total fixed costs and the total variable costs for those outputs. From knowing the business’s costs, the break-even point can be ascertained. Break-even occurs where S = FC + VC, where S is the break-even level of sales in dollars, FC is fixed costs, and VC is variable costs in dollars. If, for example, variable costs divided by sales, expressed as percentage, resulted in a figure of 75 per cent, this means that 75 cents of every dollar of sales, is required to cover the variable cost. The remainder, 25 cents of every dollar of sales, is available to make a contribution towards paying the fixed costs and eventually to make a profit. This 25 cents is called the contribution margin, and it represents the percentage of each dollar of sales available to pay for the fixed costs and to make a profit. The margin of safety is the difference between the break-even point and the current level of sales. It indicates the extent to which sales may decline before the firm begins to operate at a loss.
   
• Cost centres. Particularly in large diversified companies, separate departments may be designated cost centres for accounting and cash flow monitoring by a central finance department. They enable managers to quickly and easily see when one department’s costs are growing too fast.
   
• Expense minimisation. There is a saying: “The business that watches its cost, does not get lost”. This means that while it is necessary to sell goods to generate inward cash and gross profits, it is even more necessary to guard against waste of the asset that the business has worked so hard to gain, namely, cash. Thus, most businesses aim to minimise expenses.

2.      Revenue controls, which include:

• Sales analysis. A sales analysis would be conducted to compare sales objectives with actual results. However, a study of total sales is not enough to give an accurate picture of performance. A consideration of the sales mix, or a sales volume analysis of different market segments, is required to show what happened where, and to assist in explaining revenue collection. More detailed analysis would be provided by considering:

o       Sales by product lines.

o       Marketing segments.

o       Territories.

o       Customer groups.

o       Individual sales representatives.

• Pricing policy. Pricing can be a critical decision. Factors such as cost, customer reaction, competitor pricing policies, marketing strategies, types of products or services being offered, impact of Government legislation, and the price elasticity of demand can all affect a business’s pricing policy. Price elasticity of demand refers to the degree of responsiveness of demand for a good, as a result of a price change. In the case of basic necessities as price change has little effect on the demand. Necessities have a relatively inelastic demand and a price rise will result in increased sales revenue and rising profits. On the other hand, if the demand for product is relatively elastic, the business that increases its price will be faced with falling sales revenue and profits. The  pricing of products may follow one of several methods:

o       Full cost pricing (which reflects the business’s costs).

o       Flexible mark-up pricing.

o       Gross margin pricing (which takes operating costs and marketing factors into account).

o       Pricing to achieve a certain rate of return on investment.

o       Pricing that follows current market prices.

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