Management of inventories, accounts receivable, accounts payable and cash

Welcome to Working Capital Management!

Hello! Today, we are diving into one of the most practical parts of Financial Management (FM): Working Capital Management. Specifically, we are looking at how a business manages its "Current Assets" (Inventory, Receivables, Cash) and "Current Liabilities" (Payables).

Think of working capital as the lifeblood of a business. If a company has too little, it "bleeds out" (runs out of cash and fails). If it has too much, it’s like carrying around a heavy backpack—it’s safe, but it slows you down because that money could have been invested elsewhere to earn more profit. Our goal is to find the perfect balance.

Don't worry if this seems like a lot of moving parts. We will break it down into four simple sections. Let's get started!

1. Management of Inventories

Inventory (stock) is money sitting on a shelf. If you have too much, you waste money on storage and insurance. If you have too little, you run out of products to sell and lose customers.

The Economic Order Quantity (EOQ)

The EOQ is a clever formula that tells us the "magic number" of items to order each time to minimize the total cost of ordering and holding inventory.

The Formula:
\( EOQ = \sqrt{\frac{2 \times C_o \times D}{C_h}} \)

Where:
• \( D \) = Annual Demand (how many units you sell in a year)
• \( C_o \) = Cost per order (delivery fees, admin costs)
• \( C_h \) = Cost of holding one unit for one year (storage, insurance, interest)

Quick Tip: If the question gives you a percentage for holding cost, it’s usually that percentage of the purchase price of the item.

Bulk Discounts: Should we take them?

Sometimes a supplier says, "If you buy 5,000 units instead of 1,000, I'll give you a 5% discount." To decide, you must compare:
1. The Total Cost at EOQ (Holding + Ordering + Purchase Price)
2. The Total Cost at the Discount Level (Lower Purchase Price + Lower Ordering + Higher Holding)

Inventory Control Systems

• Re-order Level: The level of inventory at which you need to place a new order.
Formula: \( Maximum Usage \times Maximum Lead Time \)
• Just-in-Time (JIT): This is like ordering a pizza only when you are hungry. You keep zero inventory and rely on suppliers to deliver exactly when needed. It saves money but is risky if the supplier is late!

Key Takeaway: Inventory management is a trade-off. We want to minimize the total of ordering costs, holding costs, and the cost of the items themselves.

2. Management of Accounts Receivable (Debtors)

Accounts Receivable are customers who have bought your goods but haven't paid yet. In a perfect world, everyone would pay instantly. In reality, we have to manage them carefully to ensure we get our cash!

Setting a Credit Policy

A business must decide:
• Who to give credit to? (Check their credit score!)
• How much credit? (Set a credit limit)
• How long to give them? (e.g., 30 days)

Early Settlement Discounts

Sometimes you offer a customer a discount (e.g., 2%) if they pay within 10 days instead of 30. This gets cash in faster but costs you the discount amount.
Is it worth it? Use this formula to find the Annualized Cost of the discount:
\( Annual Cost = (1 + \frac{d}{100-d})^{\frac{365}{t}} - 1 \)

Where:
• \( d \) = The discount percentage
• \( t \) = The reduction in the payment period (e.g., if they usually pay in 60 days but now pay in 10, \( t = 50 \))

Factoring and Invoice Discounting

• Factoring: You "sell" your debt to a specialist company (a factor). They take over the collection process and give you the cash immediately (minus a fee). It's great for small businesses that don't have a credit department.
• Invoice Discounting: Similar to factoring, but you still collect the money, and your customers don't know you're using the service. It’s more private.

Quick Review: Managing receivables is about getting cash quickly without scaring away customers or losing too much money on discounts.

3. Management of Accounts Payable (Creditors)

Accounts Payable are your suppliers. This is "free" money! If you wait 60 days to pay a supplier, you are basically using their money for 60 days for free.

The Danger of Paying Too Late

While delaying payment helps your cash flow, be careful! If you pay too late:
• Suppliers might stop delivering to you.
• You lose Early Settlement Discounts.
• Your reputation suffers.

The Cost of Lost Discounts

If a supplier offers you a discount for paying early and you refuse it, that is effectively an interest cost to you. You use the same "Annualized Cost" formula from the Receivables section to see how expensive that "lost discount" is.

Key Takeaway: Accounts payable is a source of finance. Use it wisely, but don't abuse your suppliers, or they might walk away!

4. Cash Management

Cash is the most "liquid" asset, but it earns 0% interest if it's just sitting in a drawer. We hold cash for three reasons:
1. Transactions: To pay daily bills.
2. Precautionary: For emergencies (the "rainy day" fund).
3. Speculative: To take advantage of sudden opportunities (like a flash sale on raw materials).

The Baumol Model

The Baumol Model treats cash just like inventory. It assumes your cash flows are steady and predictable.
The Formula:
\( Q = \sqrt{\frac{2 \times F \times T}{i}} \)
Where:
• \( F \) = Fixed cost of selling investments to get cash (transaction cost)
• \( T \) = Total cash needed for the period
• \( i \) = Opportunity cost (interest rate you lose by holding cash)

The Miller-Orr Model

In the real world, cash flows are unpredictable. The Miller-Orr model sets a "safety zone" with an Upper Limit and a Lower Limit.
• If cash hits the Upper Limit, you buy investments to bring it back down to the Return Point.
• If cash hits the Lower Limit, you sell investments to bring it back up to the Return Point.

The Return Point Formula:
\( Return Point = Lower Limit + (\frac{3}{4} \times \text{spread}) \)
The Spread Formula:
\( Spread = 3 \times (\frac{\frac{3}{4} \times \text{Transaction Cost} \times \text{Variance of cash flows}}{\text{Interest Rate (Daily)}})^{1/3} \)

Don't panic! In the exam, the Variance and Interest Rate will be provided. Just focus on plugging the numbers into the formula carefully.

Common Mistake: Make sure the interest rate (\( i \)) in the Miller-Orr model is the Daily rate, not the annual rate!

Key Takeaway: Cash models help us decide when to move money between a bank account (which pays little interest) and short-term investments (which pay more).

Final Summary of Working Capital

Working capital management is all about Liquidity vs. Profitability.
• If you have High Liquidity (lots of cash and inventory), you are very safe, but your Profitability is low because that money isn't working for you.
• If you have Low Liquidity (very little cash), your Profitability might be high because every dollar is invested, but you are at high Risk of going bust.

You've got this! Focus on the trade-offs in each section, and practice the EOQ and Miller-Orr formulas until they feel like second nature. Good luck with your studies!