Index of contents
Objective of the assignment
Working Capital Management
Recommended approaches for Laura Ashley
Calculation of the ratios
Figures used for calculation
Working Capital ratios
Objective of the assignment
This assignment aims to identify whether the effect of working capital is variable for different types of retail businesses. Therefore, working capital management, the term itself and its elements is illustrated first, followed by the examination of the concrete examples of the UK retailing industry to show differences in distinct retail types. Finally, to demonstrate the understanding of this topic, an effective approach for managing working capital for a carpet retailer will be formulated.
Especially at the moment, companies do not face the best time concerning the economic conditions. In times of credit crunch, rising commodity prices, growing competition by the companies from the new integrated EU countries and tightened regulations for banks concerning loan approvals such as Basel II, institutional as well as private investors and banks tie up their budgets. As a consequence, firms should not base their whole finance strategy on external resources but moreover seek for internal enhancement. To raise their efficiency, they should not only check the income sheet for improvements but also include positions of the balance sheet in the analysis. Generally, the required money to run business processes is already available but just backed up in companies’ assets. For this reason, the firm has to examine their short-term and long-term finance strategies more detailed. In the case of short-term finance, the use of working capital management is one instrument to improve a company’s productivity.
Working Capital Management
Referring to a definition of PriceWaterhouseCoopers, the “fundamental principles of Working Capital Management are very clear: reduce the capital employed and improve efficiency in the areas of receivables, inventories and payables.” (2009). It also aims to maximise or at least enhance the wealth of shareholders (McLaney, 2006, p.348). He explains that ”this will be achieved by optimising positive cash flows through striking an appropriate balance between costs and revenues […] and risk” (2006, p.348). But to explain it in very simplistic words: It “involves management of the current assets and the current liabilities of a firm.” (Besley and Brigham, 2005, p.549). But working capital management deals also with the appropriate balance of liquidity as a crucial source to run the business (J.P. Morgan, 2009). Besley and Brigham support this issue, as liquidity problems could “often multiply into more serious problems.” (2005, p.549). To sum up, working capital management has several objectives to fulfil:
- Minimise the amount of hidden capital
- Enhance efficiency of current assets and current liabilities
- Improve shareholders value
- Balancing liquidity
Therefore, managing working capital is essential and need special awareness in run a successful company.
Many authors like Stutely choose the simple definition of working capital which is: “Current assets less current liabilities” (2003, p.276). A bit more clarification is brought by Higson who mentions inventory, payables, receivables, cash and short-term investments as working capital (1995, p. 383). The following table shows Arnold’s view of working capital:
illustration not visible in this excerpt
Adapted from Arnold, 2005, p. 625
The need of working capital becomes even more understandable by referencing the operation cycle. A company needs to use “some of its funds to finance its stocks, through the manufacturing process, from raw materials to finished goods, and also the time lag between delivery of the finished goods or services and the payments by customers of accounts receivable.” (Davies and Boczko, 2005, p.557).
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The working capital cycle (Arnold, 2005, p. 644)
To get a deeper insight in the meaning of the four elements of working capital, each of them will be explained more detailed relating to three retail businesses in the UK. The ratios presented in the table attached in appendix 4 will demonstrate differences or tendencies between the businesses and they will be interpreted in the context to achieve a better understanding whether working capital depends on the type of retail business. But as the use of ratios is not the only method to enhance working capital management, other approaches will be illustrated as well. Appropriate techniques relating to working capital figures of Laura Ashley will be described at the end.
Stock managers always have to struggle with finding the right proportion of too much or too less inventory. Overproduction, waiting caused by no working progress, inappropriate processing, low orders and even more problems will lead to high stock. Emerging from this, there arise various kinds of costs like acquisition costs which cover the costs of inventory itself over one distinct period, then order costs to place orders and finally carrying costs which bear storage costs, insurance, taxes, spoilage, obsolescence and opportunity cost of funds tied up in the inventory (Berk and DeMarzo, 2007 p.841). This could definitely be the case for Laura Ashley with a stockholding period of approximately 115 days. But holding not the appropriate amount of stock also brings some risks like seasonality or stock out which could generate a loss of consumer goodwill and loss of flexibility. Retailers such as Tesco or HMV have periods of 21 and 44 days because they do not sell high valuable items like Laura Ashley. Tesco’s inventory holding period is even shorter than HMV’s as they also offer a broad range of perishable products which cannot stored for long time.
There are several methods possible to improve a company’s stock management apart from the use of ratios. Structuring stock by grouping similar items together, stock recording and physical checks supported by inventory control systems are some instruments to achieve a better holding period. But also economic models like the ABC analysis for products, the use of the Economic Order Quantity (EOQ), just-in-time production, materials required planning (MRP) or the philosophy of optimised production technology (OPT) offer opportunities to improve inventory management (Davies and Boczko, 2005 p. 569).
Businesses have to decide whether they want to offer credit possibilities to their customers or not. Both sides uphold benefits and disadvantages. On the one side, granting credit means cheap and convenient payment for customers. On the other side, it constrains a firm’s liquidity as it will take longer until the money is collected. In the retail sector, customers do not always need credit as the debtor collection periods of Tesco with only 11 days and of HMV with only 12 days demonstrate. This relatively short time can be explained by the use of immediate payment by cash or by debit or credit cards in this type of business because of quite affordable goods they sell. Other businesses may require the offer of credit opportunities because of dealing with more precious goods such as Laura Ashley which cannot be paid at once. But even 42 days does not appear too long for a furniture company considering the costs for furnishing. If competitors grant credit, companies may come under pressure if they do not follow this strategy which could effect loss of consumer goodwill. However, offering credit also results in loss of interest, risk of bad defaulting debts and costs of administration and record keeping.
To find the right balance for debtor management, a policy should be set up which includes guidelines for granting credits. This could involve checking creditworthiness by reviewing references of trade with other suppliers or setting credit limits. Moreover the cash collection methods could be refined, contracts with customers need to be set or debts can be sold to factoring companies.
“Trade credit is an important source of ‘free’ finance, which should be taken seriously.” (McLaney, 2006, p.376). It enhances the cash flow as a firm can buy products on credit from another firm (Besley and Brigham, 2005, p.621). Comparing the credit payment period of three chosen retailer, significant differences emerge from the ratios: Tesco has the shortest period with 61 days, followed by HMV with 87 days and far behind at last comes Laura Ashley with a length of 202 days before they pay their creditors. As Tesco and HMV probably purchase their products from just a few wholesalers they maybe collect the liabilities for one month for example and pay within two or three months time. Long periods for more valuable do not sound surprising but the duration of Laura Ashley is extremely long. On reason could be a lack of liquidity to pay their creditors. Surely, they arranged payment agreement with their suppliers because they have to buy items in advance to offer customers a wide range to choose from. But this is definitely an area Laura Ashley needs to be alarmed of.
Therefore a well structured framework for the credit management is crucial. By initiating deals with new suppliers, the quality of their service and products should be evaluated. The managers need to be able to control the outflow of cash by date, amount and recipient. An efficient recording system could support to identify incorrect invoices or deliveries. Furthermore, detailed reports of all unpaid invoices are essential to keep track.
Generally, the aim should be to exploit trade credit as far as reasonable because it presents a free interest loan which is often cheaper than short-term borrowing from banks and is sometimes more convenient for suppliers than payments in cash. But extending the payment period too long, the loss of supplier goodwill and the increasing costs for administration and accounting can be the consequences.
- Quote paper
- Geraldine Grosch (Author), 2009, Managing Working Capital; it depends upon the type of retail business?, Munich, GRIN Verlag, https://www.grin.com/document/124227