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SUMMARY OF FFM PAPER Note: This copy of document was developed by for any further inquiries please visit our website.

Working Capital management cycle Inventory management and control Management of accounts payable Cash and cash flows Cash Budgeting and forecasting Cash forecasting techniques Cash management and the treasury function Overview of financial markets (1) Overview of financial markets (2) Managing surplus cash balances Money in the economy Short-term and medium-term financing Long-term finance Financing of small and medium-sized enterprises Relevant costs for decision-making Capital expenditure budgeting Capital investment appraisal Managing receivables Assessing creditworthiness and granting credit Monitoring and collecting debts

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Working Capital management cycle

- Working capital is the capital available for conducting the day-to-day operations of an organization. Net working capital of the business can be defined as its current assets less its current liabilities. Current assets

Current liabilities


Amounts owed to suppliers

Stocks of raw materials

Taxation payable

Work in progress and finished goods Marketable securities such as treasury bills

Dividend payment due

Amounts receivable from customers

Short-term loans, long-term debts maturing within one year

Working capital characteristics of different businesses 1- holding goods and materials 2- taking time to pay suppliers and creditors 3- allowing customers time to pay What is working capital management is Ensuring that sufficient liquid resources are maintained. Involves archiving a balance to minimize the risk of insolvency and maximize the return on assets. * Holding cash will effect on the profit because the opportunity to make return on the assets tied up as cash will have been missed. (Rather than investing the cash in marketable assets they are hold in. therefore, the interest on investment will be missed) Working capital cycle (cash operating cycle) is the period between the suppliers being paid and the cash being received from the customers.

Equation of working capital cycle in manufacturing businesses The average time that raw materials remain in stock Less the period of credit taken from the suppliers Plus the time taken to produce the goods Plus the time finished goods remain in the stock after production is completed Plus the time taken by the customers to pay for the goods


If the turnover periods for inventories and receivables lengthen, or the payment period to suppliers shortens, then the operating cycle will lengthen and the investment in working capital will increase. Working capital (liquidity) ratios Liquidity ratios may help to indicate whether a company is over-capitalized, with excessive working capital, or if a business is likely to fall. A business which is trying to do too much too quickly with too little long-term capital is overtrading. The standard test of liquidity is the current ratio.

The ratio in excess of 1 should be expected, otherwise there will be the prospect that the company might be unable to pay its debts on time.

Holding inventories and finished goods in stock for long time will cause to slow turnover on stock and therefore most of the stocks are not vary liquid assets. Quick ratio (acid test ratio) will be used to calculate the ratio.

The quick ratio should ideally be at least 1 for companies with a slow stock turnover; so at least they can cover their current liabilities. For companies with fast stock turnover the quick ratio can be less than 1 without suggesting cash flow difficulties.

The accounts receivable payment period A rough measure of the average length of time takes for the company’s customers to pay what they owe is the accounts receivable payment period

 Trade receivables are not the total figure of receivables in statement of financial position. - Trade receivable figure exclude prepayments and non-trade receivables. If receivables’ days are increasing year on year, this may show a poorly managed credit control function, and increasing in the risk of bad debts. Or otherwise, this might be for a good reason, for example a change in the customer base towards more export customers or changing from dealing mainly with wholesale customers to servicing mainly retail customers.

The accounts payable payment period Similar measures can be used for payables.

This indicates the average time taken, to pay for supplies received on credit. If the credit purchases information is not readily available, cost of sales can be used instead. 3|Page

The inventory turnover period This is another estimated figure calculating the inventory turnover, or inventory holding period days (average number of days that items of inventory are hold for, as with the average debts collection period). It is only an approximate figure; there may be distortions caused by seasonal variations of inventory levels. Formulas of calculation

Inventory turnover ratio is another measure of how vigorously a business is trading. A lengthening inventory turnover period indicates: - A slowdown in trading, or - A build-up inventory levels, (perhaps suggesting that the investment in inventories is becoming excessive)

Adding together the inventory days and the receivables’ days, this should give us an indication of how soon stocks is convertible into cash, as well as company’s liquidity. The ratios can be used in calculating the operating cycle


Raw materials inventory holding period


Payables’ payment period


Average production period


Inventory turnover period (finished goods)


Receivables’ payment period


Operating cycle


 Please refer to the example in FFM book page 10-11 to be clear with using these formulas.

Working capital requirements 1. The need for funds for investment in current assets. - Current assets may be financed by long-term funds or by current liabilities. Liquidity ratios are the best guide to the risk of cash flow problems and insolvency. 2. The volume of current assets required. - The company should keep sufficient inventories and efficient debt collection procedures and cash management.


Problems in working capital A) Over-capitalization and working capital. - If there are excessive inventories, receivables and cash, and very few payables, there will be an over-investment by the company in the current assets. Working capital will be excessive and company will be over-capitalized.  Over-capitalization will effect unfavorably on working capital ratio. 1- Sales/working capital The volume of the sales as a multiple of the working capital investment should indicate whether, in comparison with previous years or with similar companies, the total volume of working capital is too high. 2- Liquidity ratios A current ratio greatly in excess of 2:1 or a quick ratio much in excess of 1:1 may indicate over investment in working capital. 3- Turnover periods Excessive turnover periods for inventories and receivables or a short period of credit taken from suppliers, might indicate that the volume of inventories or receivables is unnecessarily high, or the volume of creditors too low. B) Overtrading - is excessive trading by a business with insufficient long-term capital at its disposal, raising the risk of liquidity problems. Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is short of money.

ď Ž Resonance of overtrading 1- A business seeks to increase its revenue too rapidly without an adequate capital base. 2- When a business repays a loan, it often replaces the old loan with a new one. However a business might repay a loan without replacing it, with the consequence that it has less long-term capital to finance its current level of operations. 3- A business might be profitable, but in a period of inflation, its retained profits might be insufficient to pay for the replacement non-current assets and inventories, which now cost more because of inflation. The business would then rely increasingly on credit, and find itself eventually unable to support its current volume of trading with a capital base that has fallen in real terms.

Predicting business failure A company with a current ratio well below 2:1 or a quick ratio well below 1:1 might be considered illiquid and in danger of failure. Liquidity ratios may help to indicate whether a company is over-capitalized, with excessive working capital, or if a business is likely to fail. A business which is trying to do too much too quickly with too little long-term capital is overtrading.



Inventory management and control

Inventory management is important as inventory is an expensive asset. Whilst it is important not to run out of inventory (as this may lead to customers going elsewhere), It is equally as important not to over invest in this asset. Some businesses have a substantial proportion of their total assets tied up in inventories. Financial aspects of inventory management consist of keeping the costs of procuring and holding inventory to a minimum. The inventories might be in form of raw materials, working in progress and/or finished goods. Managing inventories Some businesses attempt to control inventories on a scientific basis by balancing the costs of inventory shortages against those of inventory holding. This 'scientific' control may be analyzed into three parts. (a) The economic order quantity (EOQ) model can be used to decide the optimum order size for inventories which will minimize the ordering and holding costs. (b) If discount for bulk purchases are available, it may be cheaper to buy inventories in large order sizes so as to obtain the discount. (c) Uncertainty in the demand for the inventories and/or the supply lead time, which leads a company to decide to hold buffer inventories in order to reduce or eliminate the risk of running out of supplies. Inventory costs Inventory costs can be conveniently classified into four groups.  Holding cost, warehousing and handling costs, deterioration, obsolescence, insurance and pilferage costs.  procuring cost, depend on how the good are obtained but will consist of ordering costs for goods purchased externally, such as clerical costs, telephone charges and delivery costs.  Shortage costs, may be i. The loss of a sale and the contribution which could have been earned from the sale ii. The extra cost of having to buy an emergency supply of goods at high price iii. The cost of lost production and sale, where the running out of inventory brings an entire process to a halt  The cost of the goods, the supplier's price or the credit cost per unit of production, will also need to be considered when the supplier offers a discount on orders for purchases in bulk. EOQ formula D Co CH Q

Demand per year Cost of making one order The holding cost per unit of inventory for one year The reorder quantity

Uncertainties of demand and lead times: a re-order level system Reorder level = maximum usage x maximum lead time It is the measure of inventory at which a replenishment order should be placed. When the volume of the demand is uncertain, or the supply lead time is variable, there are problems in deciding what the reorder level should be. By holding safety inventory the risk of out-of-stock could be avoided. The average annual cost of safety inventory would be: = Quantity of safety inventory (in units) x inventory holding cost per unit per annum.


Maximum and minimum inventory level Maximum inventory level = reorder level + reorder quantity – (minimum usage x minimum lead time) Minimum inventory level or (safety inventory) = reorder level – (average usage x average lead time) Maximum inventory level

Minimum inventory level

It is the inventory level set for control purposes which actual inventory holding should never exceed.

It is the inventory level set for control purposes below which inventory holding should not fall without being highlighted.

Maximum level acts as a warning signal to management that inventories are reaching a potentially wasteful level

Minimum level acts as a warning to management that inventories are approaching a dangerously low level and that running out of supplies is possible

The effect of discounts If a bulk discounts (also called quantity discounts) are available the EOQ may need to be modified. To decide mathematically whether it would be worthwhile taking a discount and ordering larger quantities, it is necessary to minimize the total of:  Material costs  Ordering costs  Inventory holding costs The total cost will be minimized:  At the pre-discount EOQ level; the discount is not worthwhile, or  At the minimum order size necessary to earn the discount. Inventory control – Just-in-time (JIT) procurement Just-in-time procurement means obtaining goods from suppliers at the latest possible time, thus avoiding the need of carry any materials or component inventory. Deliveries will be small and frequent rather than bulk. Lean manufacturing implies a smooth and predictable production flow, with setup costs and time minimized. The aim is to match production with ultimate demand; therefore the work is carried out in response of customer wishes. The workforce should enjoy with flexibility, multi-skilling and able eliminating poor quality production, which will minimize production delay caused by shortage or absence of staff. Introducing JIT/lean manufacturing might bring the following potential benefits.      

Reduction in inventory holding costs Reduced manufacturing lead times Improved labour productivity Reduced scrap/rework/warranty costs Price reductions on purchased materials Reduction in the number of accounting transactions

Reduced inventory levels mean that a lower level of investment in working capital will be required. JIT will not be appropriate in all cases.



Management of accounts payable

Payables management is important not only from viewpoint of the smooth running of the business, but also because delaying payments to suppliers van give the business more finance for its operations. However there may be costs involved in using this source of finance. Managing payables Effective management of payables involves seeking satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers. Trade payables are those who are owed money for goods and services which they have supplied for the trading activities of the enterprise. The management of payables involves:  Attempting to obtain satisfactory credit from suppliers  Attempting to extend credit during periods of cash shortage  Maintaining good relations with regular and important suppliers  Payables as a source of short-term finance Taking credit from the suppliers is a normal feature of business. Trade credit is a source of short-term finance because it helps to keep working capital down. It is usually a cheap source of finance, since suppliers rarely charge interest. Trade credit from suppliers is particularly important to small and fast growing firms. The costs of maximum use of trade credit include:  The loss of suppliers’ goodwill  The loss of any available cash discounts for early payment of debts The cost of lost cash discounts is given by the formula: d t

Size of discount Payment period to obtain the early payment discount

Short-term finance can also be obtained: a) With a bank overdraft b) By raising finance from a bank or other organization. c) For larger companies, by issuing short-term debt, such as ‘commercial paper’ Other payables There is usually less scope for flexibility with other types of short-term payables. Management should ensure that finance is available when needed to pay what is due to payment on time, especially with tax because the fines for late payment can be very heavy. Because the payment dates are known in advance it is possible to plan ahead: this is what cash budgeting is all about.

Methods of paying suppliers The most commonly methods used for making payments are cheque and BACS- Bank Automated Clearing Services(especially for salaries and wages) 8|Page

1. Payments by cash Cash payments are used quite often by business for small payments out of petty cash, and for wages. Using cash to pay large amounts of money to suppliers ought to vary rare indeed. It will be difficult to keep control over cash if it is often used for making payments. Controlling over cash a) Cash needs to be kept secure: because it is easily stolen. b) Cash can get lost in the post (cash should not be sent in postal mails). c) Cash should not be paid unless there is receipt of payments. Otherwise there will be no evidence of cash payment; this is bad for record keeping. 2. Payments by cheque Cheques were once the most common method of payments by businesses but are less popular now due to greater use of direct debits and standing orders. Cheques are for payments out of a current account at a bank. Controlling over cheque a) An individual in the accounts department will be responsible for the safekeeping of the cheque books. b) Authorization of issuing cheques. Only certain specified individuals within the company will be permitted to sing a cheque on behalf of the company. The information of those individuals must be supplied to the bank on a bank mandate form or bank mandate letter. c) Cheques above a certain value, two authorized signatures are often required. 3. Bank giro credit It is credit transferring facility and it could be used for payment as well as receiving credit through bank account. This method of paying suppliers is rarely used by the businesses. It might also be used by small companies to pay monthly salaries. A business can pay a supplier by: a) Taking a cheque or cash to any bank b) Filling in abank giro credit transfer form, and c) Handing this together with the payment over the counter of the bank. 4. Payments by banker’s draft A supplier might sometime ask the customer to pay by banker’s draft. Unlike company cheques, a banker’s draft cannot be stopped or cancelled after it has been issued, and so the supplier payment is guaranteed.

5. Payments by standing order and direct debit  Standing orders Standing order payments might be used by the business to make regular payments of a fixed amount. It might be used for the following: a) Hire purchase (HP) payments to a hire purchase company (finance house), where an asset has been bought under an HP agreement b) Rental payments c) Paying insurance premiums It is up to the paying business to ask its bank to set up standing order arrangement. And the business must specify to its bank: 1. 2. 3. 4.

That it would like a standing order arrangement for regular payments form its account The fixed amount of each payment The frequency of each payment and the due date Banking details of the supplier 9|Page

 Direct debits Direct debits, like standing orders, are used for regular payments. They differ from standing orders mainly because: 1. The person who receives the payments who initiates each payment, and informs the paying bank of the amount of each payment, and 2. Payments can be for a variable amount each time, and at irregular intervals, as well as for fixed amount at regular intervals. Safeguards of direct debits a) All changes in amount and collection dates must be notified to the payers fourteen days in advance. b) The customer can cancel the direct debit by notifying the bank. c) The bank makes an immediate refund of any incorrect debit notified by customers, thus taking on the chore of getting a refund from the supplier. d) Only approved organizations can operate a direct debit scheme. 6. Payments by Telegraphic (TT) or Mail Transfer (MT) Electronic funds transfers are made quickly, and so it could be used if the supplier wants immediate payment. The banking details of the person to be paid (payee) should be obtained by the payer. a) b) c) d)

Bank name and branch Sort code Payee’s name and address Payee’s bank account number, and the name in which the account is held

It must the write to its own bank requesting the payment to be made. Type of payment


Telegraphic Transfer (TT) or cable payment order

Instructions for the payment are sent from the payer’s bank to the payee’s bank by cable (over the telecommunication system)

Mail transfer (MT) or mail payment order

Instructions are sent by postal mail

# the order must be authorized.

7. BACS Banker’s Automated Clearing Services (BACS) is a company owned by the major retail banks which operates the electrical transfer of funds between accounts within banking system. It might be used by the business to transfer and pay monthly salaries. The operation of funds transferring takes 3 working days.

8. CHAPS The Clearing House Automated Payments System (CHAPS) is a computerized system to enable same-day clearing, guaranteed if the instructions are received before 2pm. This method of payment will incur charges typically around $30 per transfer so it is not used every day.

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Cash and cash flows

A business which fails to make profits will go under in the long term. However, a business which runs out of cash, even for a couple of months, will fail, despite the fact that it is basically profitable.

Working capital is the net difference between current assets (mainly inventory, receivable and cash) and current liabilities (such as payables and bank overdraft)

The operating cycle (cash cycle) The operation cycle measures the period of time between cash outflows for materials and cash inflow from the customers. a) A firm buys raw materials, probably on credit b) It holds the raw materials for some time in stores before being issued to the production department and turned into an item of finished goods. c) The finished goods might be kept in warehouse for some time before they are eventually sold to customers. d) By this time, the firm will probably have paid for the raw materials purchased. e) If the customers buy the goods on credit, it will be some time before the cash from the sales is eventually received. Type of cash transaction There are many types of cash transactions and they differ in their purpose, form and frequency. a) Capital and revenue items i. Capital items generally relate to the long-term functioning of the business, such as rising money from the shareholders, or acquiring non-current assets ii. Revenue items generally relate to day-to-day operations. b) Exceptional and unexceptional items i. Exceptional items are unusual. For example the costs of closing down part of a business. ii. Unexceptional items include everything else. c) Regular and irregular items i. Regular items occur at predictable intervals (i.e. payment of wages, payment of dividends twice a year) ii. Irregular items do not occur at regular intervals. Cash outflows and inflows Cash outflows

Payments to

Cash inflows Suppliers for goods purchased Immediately from cash customers Employees for wages and bonuses From customers for sales made on credit Government for tax owing Long-term grants from government Cash Dividends to shareholders Equity share capital received Interest to debenture-holders, bondholders, banks Long-term loans Drawings by sole traders or partners Sales of non-current assets Acquire investment, investing surplus cash Liquidation of short-term investments

Types of payments and receipt Cash can be received and paid in a number of ways, for example: 1. Notes and coin

2. Cheques, bills of exchange and promissory notes

3. Automated payment system such as BACS 11 | P a g e

From the point of view of the accountant the main considerations are the security and certainty of payment. Accounts and treasury staff monitor these cash flows: a) Exceptional items, such as proceeds from share issues, should be planned for in advance. b) Accounts and treasury staff should monitor the activity in the cash so as to: i. Ensure that any unexpected receipts and properly accounted for ii. Ensure that any unexpected outflows and investigated c) Unexpected payments should be cleared with the bank and the accounts payable ledger. Unexpected receipts should be discussed with the bank and the accounts receivable ledger at first instance. Cash flows, unlike income statements and statements of financial position. Cash flow statement stands on the actual movement of cash in and out of the business. Income statements and statements of financial position both are stands on Accrual bases. Cash flow can be defined in many ways.  Net cash flow is the total change in a company’s cash balances over a period of time  Operational cash flow is the net cash flow arising over a period from trading operations.  Priority cash flows do not relate to trade, but are vital to keep the company afloat. # Net cash flow is the net charge in the cash position between the beginning and ending of the period.

Other type of cash flow a) Operational cash flows derive from normal trading operations. b) Priority cash flows are payments for non-trading cash payments that must be made to keep the company in afloat. Its include interest payments and tax payments. c) Discretionary cash flows are cash payments or receipts that do not have to be made. i. Discretionary outflows: capital expenditures, payments for acquisitions, the purchase of financial investments, payout of ordinary dividend and preference dividend. ii. Discretionary inflows: the sales on non-current assets. The sales of subsidiaries and sales of financial investments. d) Financial cash flows arise from variations in long-term capital. Financial inflows include cash from the issue of shares, or from new loans. Financial outflows include the repayment of a long-term loan.

Profits and cash flow Accounts showing trading profits are not the same as statements of cash flow.

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FFM - Foundation in Financal Management  

Summary of FFM paper

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