Genesis Management Services Pty Ltd gmservices.com.au
genesis
SERVICES
EXPERIENCE
UNIT 6. MANAGING SHORT TERM FINANCES
We have said before that the three key dimensions of financial management are profitability, liquidity and security. Our short term finances have to be managed effectively to preserve liquidity. Liquidity refers to having a reasonable float of cash and short term ready access to cash.
WORKING CAPITAL
What is Working Capital?
In Schedule 8 of Travel 'n' Tour you will notice separate sub-totals for current assets and current liabilities. These figures have been copied to Schedule 9 "Balance Sheet Analysis". eg.
1981
Current Assets 98
Current Liabilities 61
Difference 37
We call this difference "Working Capital". It is the amount of liquid capital that we have to work with to meet our short term commitments. Notice that in 1981 the current assets were 1.61 times (or 161% of) current liabilities.
98 = 1.61
61
or
98 x 100 = 161%
61 1
Working Capital is always calculated by subtracting Current Liabilities from Current Assets and it should be a surplus. For 1981 we can say that for every $1 of Current Liabilities we have $1.61 of Current Assets.
The 61 cents represents a comfort zone or cushion to meet the demands of our current liabilities and operating expenses as they occur. Without this comfort zone every time a demand is made for payment we would have to raise funds from current assets. We would always be robbing Peter to pay Paul and as a result a great deal of management energy would be wasted scratching around for funds rather than getting on with the job of making a profit.
Now working capital is not just cash. It represents cash plus other current assets (which we expect will become cash in the short term) minus the short term commitments we have (current liabilities and operating expenses) which we expect will be paid for in cash in the short term.
So we are not just looking at our bank balance when we are talking about working capital. We are looking at what we can normally expect will flow into our bank account in the short term provided we don't invest in long term assets or have to rely on raising money from other sources (eg. long term liabilities and capital).
Normally we like to see current assets twice the level of our current liabilities although for a travel agency a lower figure in the vicinity of 1.5 would be acceptable. This gives us a comfortable float to meet our short term cash requirements for overheads, particularly in the event that income falls dramatically and we start to make losses.
As you saw in the AFTA Financial Viability Tests we also like to compare the amount of working capital we have with our monthly overheads to see how many weeks/months we could survive if there were no income. You should try this calculation for yourself.
Normal Sources of Working Capital
How can we improve working capital? In other words, how can we raise current assets, lower current liabilities or both?
We can raise current assets by increasing cash at bank with new funds through one or more of the following alternative approaches:
reducing fixed assets (selling)
increasing long term liabilities (borrowing)
increasing capital (new capital, profit or both)
The only option we have for reducing current liabilities is by convincing the outsiders concerned to swap their short term benefits for long term, eg. convincing the banker who holds a short term bank overdraft (where we are responsible to repay the overdraft within 12 months) to convert it to a long term one (not due for repayment until after 12 months).
Another possibility for reducing current liabilities is where shareholders have made loans to the business and these are classified as current liabilities. When working capital is tight there is often pressure by bankers and other parties for these loans to be converted into capital. The object here is to improve the working capital picture. Another effect is that shareholders would no longer rank equally with creditors and unsecured lenders (eg. unsecured bank overdraft). In the event of liquidation the shareholders would then have to wait in line after the current liabilities and long term liabilities have been repaid. Their priority, or order of preference, in that event would be downgraded.
We can calculate very easily the amount required to restore working capital to a healthy level, eg. assume in our Travel 'n' Tour example that a ratio of 2 is preferable to 1.61 then our current assets would have to be $122, an increase of $24 over the existing level of $98. This increase would have to be arranged through one of the methods outlined above. Alternatively we could try to reduce the $61 of current liabilities independently or at the same time to achieve the desired result. When we are budgeting it is important to budget to achieve a desired working capital ratio.
Normal Uses of Working Capital
How can we use working capital?
We have to imagine working capital as a reservoir which is filled by a pipe at one end with the sources listed above and with an outlet at the bottom for uses. We have to picture a constantly changing flow whilst maintaining the level in the reservoir at a desired level.
It follows then that the working capital in the reservoir will fall if we reduce current assets, increase current liabilities, or both. We mightn't want to but we may be forced to if trading conditions deteriorate.
Operating losses will eat into this reservoir of working capital by worsening our situation with the bank and forcing us to speed our collection on debtors, liquidate stock and postpone payments to creditors to raise the necessary cash for survival.
Notice however that reducing stock might improve our bank balance but leave our working capital unchanged because our total current assets are unchanged.
This reservoir illustration could also be used for our bank balance with cash receipts as the inlet pipe and cash payments the outlet. Providing the inflow matches the outflow the level will remain unchanged. Working capital as a reservoir is similar but we include not just cash but also the excess of short term claims to cash (current assets) over short term commitments to cash (current liabilities).
We have to accept that anything that reduces current assets will reduce our working capital reservoir. The following situations will cause a reduction in current assets through cash flowing out of the bank:
increasing fixed assets (buying)
decreasing long term liabilities (paying back principal)
decreasing capital (returning capital, losses, or both).
Current liabilities could be increased by increasing bank overdraft as a current liability through a reclassification of that overdraft from long term to short or by reclassifying other long term loans to short term. Such a reclassification may be forced on us. Normally however it is a natural occurrence as time goes by when long term loans become due for repayment within the next 12 months.
Working Capital & Survival
When a travel agency starts off in business the financial situation is usually tight. It's a struggle for survival and to generate enough income to offset expenses (make a profit) whilst at the same time guarding against over-reaching by investing too much too soon in long term resources which siphon off too much badly needed short term liquidity.
If the agency doesn't survive the short term there won't be a long term and so the temptation to get too big too quick must be resisted often at a cost to personal prestige and ego. However the stayers who survive the birthing process will then have the opportunity to stabilise their business as they go through a consolidation phase.
After this consolidation they will gather financial strength and go on to become successful and able to work within a longer term planning horizon for continued long term success.
The wayside is littered, however, with the players who failed the survival test which is very much liquidity oriented. Some players who passed the survival test in boom times fail when there is a recession and so we must ensure that we have adequate working capital to meet all the expected contingencies in the next 12 months whether there is a boom or a recession.
Many of the dramatic corporate collapses in 1990 were companies that had adequate working capital during the boom but failed dismally on that score when times got tough. A business may fail in a liquidity squeeze even if its business is profitable. Cash flow is as important as profitability in the survival stage, perhaps more so, although, obviously, it is important at all stages in the life of the agency.
The Need for Strong Internal Control
Internal control is a management concept which involves more than just internal control over working capital. In general terms internal control over working capital is a system which is built into job descriptions embracing special rules and routines to safeguard assets, ensure truthful reporting and encourage operational effectiveness and efficiency.
Travel agency managers must have strong internal control over all the variables affecting the level and flow of working capital. In this context we are concerned with safeguarding precious liquidity, ensuring that all incoming and outgoing obligations are accurately recorded and reported and that the business is being managed to a plan to prevent being sidetracked into impulsive non- core decisions.
There are three critical areas for maintaining strong internal control over working capital:
cash control
debtors control
creditors control
Cash Control
The main procedural essentials are that:
A weekly cash flow report is essential prepared from the cash payments and cash receipts books. This should show the main categories for the week and the total compared with previous figures (eg. last month or same month last year). It is often helpful to show these figures on a chart which shows three graph lines...actual, budget, previous.
Debtors Control
Providing credit is a fact of life, so are bad debts. We must have an early warning system to avoid bad debts. Bad debtors usually display a pattern of being slow payers before they crash. It is essential therefore to prepare an aged listing of debtors which allocates the total debt due over separate columns for current, 30 days, 60 days, 90 days, 120 days and over. For a travel agency it would be better to use weeks. Percentage calculations for each time category should then be made and compared with budgeted expectations, eg.
Total Current 30 Days 60 Days 90 Days
S. Smith 1000 1000
J. Jones 1000 1000
T. Thompson 2000 1000 1000
D. Davies 4000 4000
8000 2000 1000 4000 1000
Actual 100% 25% 12.5% 50% 12.5%
Budget 100% 75% 25% - -
Creditors Control
Once you have verified suppliers' invoices and they have been approved they are then paid and recorded. The main area to be controlled is payments for travel and accommodation. An aged listing for creditors is also essential.
CASE STUDY
To help you get a better appreciation of managing working capital we would like to continue working with our case study "Austral Travel Agency". The financial statements for this agency were set out at the beginning of this unit. Here is an illustrative analysis.
Current Ratio
Current Assets 39,400 = 1.62:1
Current Liabilities 24,300
This ratio was calculated at balance date and therefore represents the situation at that point in time. We have to remember that this ratio can change in the short term. If we accept that 1.5 is a satisfactory industry standard then we could conclude that there is a satisfactory coverage of short term funds with no liquidity problems apparent. If our standard or target were 2:1 then current assets, for example, would need to be raised to $48,600 and the means for financing this would have to be found (see Unit 7).
Liquid Ratio
This is sometimes called a "quick asset" or "acid test" ratio. We deduct stock from our current assets and bank overdraft from our current liabilities.
Current Assets minus Stock = 39,400 = 1.7
Current Liabilities minus Overdraft 23,100
The liquid ratio is designed to measure the firm's ability to meet its short term financial obligations solely from its cash and debtors (and any other short term securities like shares that can be sold on the stock exchange, etc.).
Since stock is not normally involved in travel agencies we are not concerned with it. If it is a factor then you should remember that stock is not a very liquid form of current asset in that it takes longer to convert into cash in the event of a need for a quick sale and so it is not usually a reliable source of cash in a crisis.
Likewise an unsecured bank overdraft, whilst theoretically being subject to payment on call, is not normally expected to be repaid in the very short term.
Since our current liabilities have fallen compared with the current ratio we obviously expect a higher liquid ratio than the current ratio. In many other business situations the amount of stock is sizeable and therefore greater than the overdraft figure and usually the liquid ratio is lower than the current ratio.
Assuming an industry standard of, say, 1.2 there appears to be no immediate liquidity problem and the main factor affecting our cash prospects will be debtors which we discuss below.
Debtors Turnover
This ratio is sometimes called the "average collection period" and refers to the time it takes an average day's credit sales to be collected. It is calculated as follows:
Average daily credit sales = credit sales
365
In our example we will have to assume all the sales were made on credit although in real life we would need to deduct cash sales from total sales.
2,480,000 = $6,790 average daily credit sales
365
Debtors turnover (collection period) =
Debtors = 39,400 = 5.8 days
Average daily credit sales 6790
Thus it takes on average 5.8 days to collect a credit sale. The business is financing its debtors and until the sum is collected it will have to pay creditors and operating expenses associated with the sale. A good credit management system should be aimed to minimise the collection period and the level of bad debts and speed the rate at which credit sales turn over into cash.
This turnover process is sometimes called a "cash cycle" and usually we are looking for the fastest cash cycle possible.
Stock Turnover
We don't have any stock in this case study but just in case you have to deal with it the method is as follows:
stock turnover = cost of goods sold
average stocks
This ratio measures the speed with which a business can sell its average stock. Average stock is calculated by averaging the opening and closing stock for the accounting period.
If for example the calculation were 12 times per annum then we would say that on average it only takes one month to dispose of our average stock.
Stock is the slowest current asset to be realised in cash and remains a critical area for working capital control. Stock has a bad habit of deteriorating or becoming obsolete. It is good management practice to liquidate slow moving lines so that the funds released can be put to more profitable use on product lines with higher turnovers.
Remember that ROI is a function not only of earning power (as indicated by the Profit & Loss Statement) but also of asset turnover (of which Stock and Debtors are a part).
Copyright © Bill Wright 1994