.

A Guide to theManagement of DepartmentalWorking CapitalTable of Contents

CHAPTER ONE: INTRODUCTION

About this Booklet

Financial Management Reform

Legislative Requirements for Working CapitalManagement

IO

CHAPTER TWO: WORKING CAPITAL MANAGEMENT

11

Defining Working Capital

11

The Importance of Good Working Capital Management

I2

Approaches to Working Capital Management

12

CHAPTER THREE: FINANCIAL RATIO ANALYSIS

14

Introduction

14

Working Capital Ratio

14

Liquid Interval Measure

15
Stock Turnover

15

Debtor Ratio

15

Creditor Ratio

16

CHAPTER FOUR: SPECIFIC STRATEGIES

18

Inventories

18

Debtors

20

Creditors

21

Cash and Bank

21

Other Components

23

CHAPTER FIVE: SUMMARY

24

FURTHER INFORMATION

25

7Chapter One: Introduction

About this booklet

Managing working capital is a matter of balance. A departmentmust have sufficient cash on hand to
meet its immediate needswhile ensuring that idle cash is invested to the organisation’s bestpossible
advantage. To avoid tipping the scale, it is necessary tohave clear and accurate reports on each of
the components ofworking capital and an awareness of the potential impact ofoutside
influences.This booklet provides some guidelines to the good managementof working capital. This
chapter takes a brief look at the financialmanagement reform programme and the legislative
requirementsfor working capital management.Later chapters offer an overview of working capital
management,explore ratio analysis and describe specific strategies for manag-ing the various
components of working capital. The booklet

focuses on practical management techniques, providing an indi-cation of what may be required for
good management in each area.If, after reading this booklet, you would like more information onany
of the topics discussed, the

Further Information

section atthe end of the booklet lists available resources.

Financial Management Reform

In 1988 the Government adopted the financial managementreform programme, a wide-ranging

reform package designed toimprove the efficiency and accountability of the public sector,thereby
improving the efficiency of the economy as a whole.Major components of the reforms are:

A change in focus from inputs to outputs and outcomes.

In the past, budgets were designed around the purchase of agreed inputs. Departments are now
allocated resources to produce Government’s choice of outputs, which in turn willcontribute to the
achievement of Government outcomes.

8A change in types of appropriation to acknowledge the factthat the Government plays several roles
in its relationships with departments. The new system of resource allocation recognises three
different departmental/Government relationships the Government may be a purchaser of goods and
services provided by a department; the Government may be the owner of a department; a
department may act as an agent for the Government. A clearer accountability structure between
Chief Executivesand their Ministers and between the Government and Parlia-ment. This system is
designed to increase scrutiny so thatefficiency in the public sector can be monitored and
improvedwhere necessary.Greater delegation of authority to Chief Executives. ChiefExecutives have
been delegated the authority to select theappropriate mix of resources for their departments.A
change in the balance date. The balance date for the budg-eting cycle has been changed from 31
March to30 June

to allow for the assessment of the major tax inflows before the budget is announced. A change from
cash accounting to accrual accounting meth-ods. Accrual accounting recognises the full costs of
resourcesconsumed and matches these with the revenue for goods and services produced in a
particular period. Previously, depart-ments used cash accounting, which

recognised
 only the cashinflows and cash outflows in a given period. This meant plansand budgets were
incomplete.Two major pieces of legislation have aided the implementation ofthe financial
management reform (FMR) programme. They are theState Sector Act 1988 and the Public Finance
Act 1989.

The State Sector Act 1988 had two essential purposes. Itestablished a framework for the relationship
between ChiefExecutives and their Ministers. It also created a new industrialrelations and
employment regime, giving Chief Executives thepower to hire and fire staff and to fix salaries.

The Public Finance Act 1989 repealed the Public Finance Act1977 (with the exception of Part II and
certain other provisionsrelating to the Audit Office), and gave statutory effect to a setof financial
systems that have been implemented to operatewithin the framework of the State Sector Act. The
Act requiresthat no expenditure of public money be made without Parliamentary approval and lays
down the information to be provided to Parliament in the Estimates to gain that approval. The Act
also provides a new basis for the appropriation and management ofpublic resources and it
strengthens the-reporting requirementsfor the Crown, departments and, eventually, Crown
agencies.

Legislative Requirements for Working CapitalManagement

The Public Finance Act 1989 does not address detailed manage-ment issues. There are therefore no
provisions which relatespecifically to working capital management.However, Section 33 of the Act
makes departmental Chief Ex-ecutives responsible for the financial management and
financialperformance of their departments. Good working capital man-agement is a component of
good financial management and willenhance financial performance.Part II of the Act deals with
banking and investment activities ofthe Crown and departments. It is therefore indirectly relevant
tothe subject matter of this booklet.Section 49 limits the obtaining of credit to 90 days.

If- Chapter Two: Working Capital Management

Defining Working Capital

The term working capital refers to the amount of capital which isreadily available to an organisation.
That is, working capital is thedifference between resources in cash or readily convertible intocash
(Current Assets) and organisational commitments for whichcash will soon be required (Current
Liabilities).Current Assets are resources which are in cash or will soon beconverted into cash in “the
ordinary course of business”‘.Current Liabilities are commitments which will soon require
cashsettlement in “the ordinary course of business”.

Thus:

WORKING CAPITAL = CURRENT ASSETS-CURRENT

LIABILITIES

In a department’s Statement of Financial Position, these compo-nents of working capital are

reported under the following headings:

Current Assets
Liquid Assets (cash and bank deposits)

Inventory

Debtors and ReceivablesCurrent Liabilities

Bank Overdraft

Creditors and Payables

Other Short Term Liabilities

The term “the ordinary course of business” is not particularly precise. It usually meansa time horizon
of one year, in line with annual reporting.

11 The Importance of Good Working Capital Management Working capital constitutes part of the
Crown’s investment in adepartment. Associated with this is an opportunity cost to theCrown.
(Money invested in one area may “cost” opportunities forinvestment in other areas.) If a
department is operating with moreworking capital than is necessary, this over-investment repre-
sents an unnecessary cost to the Crown.From a department’s point of view, excess working capital
meansoperating inefficiencies. In addition, unnecessary working capitalincreases the amount of the
capital charge which departments arerequired to meet from 1 July 1991.

Approaches to Working Capital Management

The objective of working capital management is to maintain theoptimum balance of each of the
working capital components. Thisincludes making sure that funds are held as cash in bank
depositsfor as long as and in the largest amounts possible, therebymaximising the interest earned.
However, such cash may moreappropriately be “invested” in other assets or in reducing
otherliabilities.Working capital management takes place on two levels:

Ratio analysis can be used to monitor overall trends in workingcapital and to identify areas requiring
closer management (seeChapter Three).

The individual components of working capital can be effectivelymanaged by using various techniques
and strategies (seeChapter Four).When considering these techniques and strategies,
departmentsneed to

recognise

that each department has a unique mix ofworking capital components. The emphasis that needs to
beplaced on each component varies according to department. Forexample, some departments have
significant inventory levels;others have little if any inventory.Furthermore, working capital
management is not an end in itself.

It
is an integral part of the department’s overall management. The

12needs of efficient working capital management must be consid-ered in relation to other aspects of
the department’s financial andnon-financial performance.Chapter Three: Financial RatioAnalysis

Introduction

Financial ratio analysis calculates and compares various ratios ofamounts and balances taken from
the financial statements.The main purposes of working

captital

ratio analysis are:

to indicate working capital management performance; and

to assist in identifying areas requiring closer management.Three key points need to be taken into
account when analysingfinancial ratios:

The results are based on highly summarised information. Con-sequently, situations which require
control might not be appar-ent, or situations which do not warrant significant effort mightbe
unnecessarily highlighted;

Different departments face very different situations. Compari-sons between them, or with global
“ideal” ratio values, can bemisleading;

Ratio analysis is somewhat one-sided; favourable results meanlittle, whereas unfavourable results
are usually significant.However, financial ratio analysis is valuable because it raisesquestions and
indicates directions for more detailed investigation.The following ratios

ale

of interest to those managing working

capital:

working capital ratio;liquid interval measure;stock turnover;debtors ratio;creditors ratio.

Working Capital Ratio

Current Assets

divided by
Current Liabiiities

The working capital ratio (or current ratio) attempts to measure thelevel of liquidity, that is, the level
of safety provided by the excessof current assets over current liabilities.

14The “quick ratio” a derivative, excludes inventories from thecurrent assets, considering only those
assets most swiftly

realis-

able. There are also other possible refinements.There is no particular benchmark value or range that
can berecommended as suitable for all government departments. How-ever, if a department tracks
its own working capital ratio over a

period of time, the trends-the way in which the liquidity ischanging-will become apparent.

Liquid Interval Measure

Liquid Assets divided by Average Operating ExpensesThis is another measure of liquidity. It looks at
the number of daysthat liquid assets (for example, inventory) could service dailyoperating expenses
(including salaries).

Stock Turnover

Cost of Sales divided by Average Stock LevelThis ratio applies only to finished goods. It indicates the
speed withwhich inventory is sold-or, to look at it from the other angle, howlong inventory items
remain on the shelves. It can be used for theinventory balance as a whole, for classes of inventory,
or forindividual inventory items.The figure produced by the stock turnover ratio is not important
initself, but the trend over time is a good indicator of the validity ofchanges in inventory policies.In
general, a higher turnover ratio indicates that a lower level ofinvestment is required to serve the
department.Most departments do not hold significant inventories of finishedgoods, so this ratio will
have only limited relevance.

Debtor Ratio

There is a close relationship between debtors and credit sales tothird parties (that is, sales other
than to the Crown). If salesincrease, debtors will increase, and conversely, if sales decreasedebtors
will decrease.

15The best way to explain this relationship is to express it as thenumber of days that credit sales are
carried on the books:Credit Sales per Period x Days per periodAverage DebtorsWhere trading terms
are 30 days net cash, and customers buyfrom day-to-day during the 30 day period and pay 30 days
after astatement is rendered, a collection period of 45 days (the averagebetween 30 and 60 days)
would be satisfactory.If the average collection period extends beyond 60 days, debtorsare holding
cash that should have flowed into the department. Thismeans that the department is unable to
satisfy pressing liabilitiesor to invest that cash.The debtor ratio does not solve the collection
problem, but it actsas an indicator that an adverse trend is developing. Remedialaction can then be
instigated.

Creditor Ratio

This ratio is much the same as the debtor ratio. It expresses the.relationship between credit
purchases and the liability to creditors.It can be stated as the number of days that credit purchases
arecarried on the books.Credit Purchases per Period x Days per periodAverage CreditorsNote that
non-credit purchases (such as salaries) and non-cashexpenses (such as depreciation) need to be
excluded from “creditpurchases” and any provisions need to be excluded from “credi-tors

‘I.

There is no need to pay creditors before payment is due. Thedepartment’s objective should be to
make effective use of thissource of free credit, while maintaining a good relationship
withcreditors.As with debtors, if a department has been granted credit terms of30 days net cash,
credit purchases should not be carried on thebooks for more than an average of 45 days. If payment
is withheldfor 60 days or more it is likely that creditors will become impatient 16 and impose stricter
and less convenient trading terms-for exam-ple, “cash on delivery”.The Public Finance Act 1989
(section 49) places a legal constrainton the amount of credit allowed to a department. It restricts to
amaximum of 90 days the purchase of goods and services throughthe use of a credit card or
suppliers’ credit.Chapter Four: Specific Strategies Inventories are lists of stocks-raw materials, work
in progress orfinished goods-waiting to be consumed in production or to besold.

The total balance of inventory is the sum of the value of eachindividual stock line. Stock records are
needed:to provide an account of activity within each stock line;

as evidence to support the balances used in financial reports.Adepartment also needs a system of
internal controls to efficientlymanage stocks and to ensure that stock records provide
reliableinformation.Departmental financial reports show only the total inventorybalance. Analysts
from outside the department can examine thisbalance by using ratio analysis or other techniques.
However, thisgives only a limited assessment of inventory management and isnot adequate for
internal management. Good financial manage-ment necessitates the careful analysis of individual.
Inventory lines.

Inventory management is an important aspect of working capitalmanagement because inventories

themselves do not earn anyrevenue. Holding either too little or too much inventory
incurscosts.Costs of carrying too much inventory are: opportunity cost of foregone interest;
warehousing costs;

damage and pilferage;

obsolescence;

insurance.Costs of carrying too little inventory are:

stockout

costs:-lost sales;-delayed service.

ordering costs:-freight;-order administration;-loss of quantity discounts.Carrying costs can be
minimised by making frequent small ordersbut this increases ordering costs and the risk of stock-
outs. Riskof stock-outs can be reduced by carrying “safety stocks” (at a cost)and re-ordering ahead of
time.The best ordering strategy requires balancing the various costfactors to ensure the department
incurs minimum inventorycosts. The optimum inventory position is known as the EconomicReorder
Quantity

(ERQ).

There are a number of mathematicalmodels (of varying complexity) for calculating ERQ. (Any
standardaccounting text will provide examples of these).Analytical review of inventories can help to
identify areas whereinventory management can be improved. Slow moving items,continual
stockouts, obsolescence, stock reconciliation problemsand excess spoilage are signals that stock
lines need closeranalysis and control.However, it is important to keep an overall perspective. It is
notcost-effective to closely manage a large number of low valueinventory lines, nor is it necessary. A
usual feature of inventoriesis that a small number of high value lines account for a largeproportion
of inventory value. The

“80/20”

rule (PARETO) predictsthat 80% of the total value of inventory is represented by only 20%of the
number of inventory items. Those high value lines needreasonably close management. The
remaining 80% of inventorylines can be managed using “broad-brush” strategies.The overall
management philosophy of an organisation can affectthe way in which inventory is managed. For
example, “Just InTime”

(JIT)

production management organises production so thatfinished goods are not produced until the
customer needs them(minimising finished goods carrying costs), and raw materials arenot accepted
from suppliers until they are needed. (Large

organi-

sations

have the power to insist that suppliers hold stocks of rawmaterials and thereby pass the carrying
cost back to the supplier).Thus, JIT inventory strategies reduce bottlenecks and stockholding costs.

19In summary:

There is a trade-off to be made between carrying costs, orderingcosts, and

stockout

costs. This is represented in the EconomicReorder Quantity

(ERQ)

model.
Inventories should be managed on a line-by-line basis using the

80/20

rule.

Analytical review can help to focus attention on critical areas.

Inventory management is part of the overall managementstrategy.

Debtors

Debtors (Accounts Receivable) are customers who have not yetmade payment for goods or services
which the department hasprovided.The objective of debtor management is to minimise the time-
lapsebetween completion of sales and receipt of payment. The costs ofhaving debtors are:

opportunity costs (cash is not available for other purposes);

bad debts.Debtor management includes both pre-sale and debt collectionstrategies.Pre-sale

strategies include:

offering cash discounts for early payment and/or imposingpenalties for late payment;

agreeing payment terms in advance;

requiring cash before delivery;

setting credit limits;

setting criteria for obtaining credit;

billing as early as possible;

requiring deposits and/or progress payments.Post-sale strategies include:

Placing the responsibility for collecting the debt upon the centrethat made the sale;

Identifying long overdue balances and doubtful debts by regularanalytical reviews;

Having an established procedure for late collections, such as-a reminder;-a letter;-cancellation of
further credit;-telephone calls;-use of a collection agency;-legal action.

Creditors

Creditors (Accounts Payable) are

supplie&
whose invoices forgoods or services have been processed but who have not yet been

paid.

Organisations often regard the amount owing to creditors as asource of free credit. However,
creditor administration systemsare expensive and time-consuming to run. The over-riding concernin
this area should be to minimise costs with simple procedures.While it is unnecessary to pay accounts
before they fall due, it isusually not worthwhile to delay all payments until the latestpossible date.,
Regular weekly or fortnightly payment of all dueaccounts is the simplest technique for creditor
management.Electronic payments (direct credits) are cheaper than chequepayments, considering
that transaction fees and overheads morethan balance the advantage of delayed presentation. Some
suppli-ers are reluctant to receive payments by this method, but in viewof the substantial cost
advantage (and the advantages to thesuppliers themselves) departments may wish to encourage
sup-pliers to accept this option. However, electronic payments arelikely to be used in conjunction
with, rather than as a replacementfor, cheque payments.

Cash and Bank

Good cash management can have a major impact on overallworking capital management.

21