IV.2. Planning for working capital requirements

Determining the working capital requirements is part of the operational planning of a business. It is concerned with the effect of target operations on the enterprise's liquidity.

It is not possible to generalize about what level of working capital a business requires. This depends on the type of business, its size, sales policy, the trade norms, seasonality, interest rates and other factors. What the minimum cash balance should be, how much trade credit should be given and can be taken, whether stocks should be high or low: these are questions for each individual business. The important thing is that it does ask these questions, and then manages its affairs with regard to the answers.

(i) Setting targets

At a meeting of its management committee Fibre Mat Society decides that its target sales for 1986 7 will be 150,000. This would represent only a modest increase, but market conditions seem difficult at present. Nobody is showing much interest in the range, and customers are taking longer than usual to settle their dues. In the circumstances, everyone would be happy if sales could just push ahead a little bit, so that the Society's good record of employment in the needy local community could be maintained. It was estimated that 14,000 sales per month would be achieved in October, November and December and 12,000 per month for the rest of the financial year.

Some further decisions are made at the meeting. In response to recent difficulties in obtaining raw material supplies, the maximum credit period taken will henceforth be 60 days, as it will remain for other suppliers. Artisans will be paid immediately, as they always used to be before money got tight. No new fixed assets will be purchased. It was assumed that stock and debtors would remain as at present in cash terms; a small decrease relative to sales. Overhead costs should not increase in the coming year because of improved efficiencies.

Having set its targets the Society invites its accountant to look at the financial implications, and report back.

(ii) Working capital budget

The means to express a plan in financial terms is a budget. Realizing that the Society's worsening liquidity situation can only be aggravated by its decision to make payments more quickly, the accountant first establishes a working capital budget. The objective is to find out whether sufficient funds will be—or can be —made available to carry out operations at the target level.

A working capital budget is not concerned with profitability projections. If Fibre Mat Society manufactures a mat in August at a cost of 40 and sells it for 46 in September on three months' credit it has made a profit of 6. However, it will receive the revenue only in December, although it bore the cost in August. A working capital budget looks at the effect of having to wait before that revenue is received.

It would normally be drawn up in the form of a monthly cash flow projection. In order to ascertain the outflows and inflows in each month, the proposed expenditure and income is calculated in terms of when the cash will be paid out or received.

Expenditure: Production costs:

· if stock held remains constant, production at the level of cost of sales will be required. The Society's mark-up on direct costs is assumed to be 25%, so that new stock must be produced to the value of 120,000. Seasonal sales fluctuations imply that production costs will be 11,200 October to December, and 9,600 January to September. According to the 19X5-6 profit and loss account, 60% of these costs are labour, and 40% materials and other direct costs. The monthly labour cost will be 6,720 October to December and 5,760 January to September. The monthly raw materials cost will be 4,480 October to December and 3,840 January to September.

· Material costs will be paid two months after taking delivery, but artisans will be paid the same month as production.

· At the start of the year. the artisans are owed 6,600 and raw material suppliers 13,200. The artisans must be paid in October; repayment of the debt to the suppliers will be spread equally between the first two months.

Other expenses:

· Indirect costs will be incurred at the rate of 1,350 per month, payable two months later.

· At the start of the year 2,7()() credit is outstanding and must be settled in the first two months, 1,35() per month.

Income:

· Sales will be 14,000 per month October to December and 12,000 per month January to September. Because debtors are taking 117 days to pay, the cash will be received only in the fourth month after sales.

· 12,500 must be deducted from sales revenue because the cash has already been received as advance payments for some small export orders. Assuming the goods to be produced and supplied in October the effect will be to reduce February's cash inflow.

· At the start of the year debtors total 45,000. As the balance sheet does not show the age of the debt, it will be assumed that this will come in at the end of each month as follows: 16,000 in October, 8,000 in November, 9,000 in December and 12,000 in January.

In this way, the operating targets of the business are translated into cash movement terms. Cash flows relating to the previous financial year's transactions must be included. Those relating to the current year's transactions, but which would not be paid or received until the following year, would not be included.

Depreciation is not included in a cash flow projection, because it is not a cash expense. Bank interest is not included here because the objective is to point up the financing requirement, on which the amount of bank interest would depend. It is a fairly simple exercise to add the bank interest calculation in at the end when the overall picture emerges.

(iii) Cash flow tabulation

The cash projections are now tabulated month by month, adding in the opening cash balance, which is calculated as cash on hand minus overdraft (Figure 11).

It can be seen that, at target operational level, the Society's total financing requirement would increase to over 55,000, although it would not require this amount throughout the year.

Even if the bank were willing to meet this requirement, the additional interest charge would be considerable. Assuming a rate of 18%, and an overdraft level rounded to 47,000 for eight months and 57,000 for four months, in order to allow for interest payments as well, the interest expense for the year would be 9,05O, an increase of 3,500 on 1985-6. Yet gross profit would increase by only 2,000, with a 2()% profit margin on an additional 10,000 sales. Hence, despite an increase in sales at the normal profit margin, profitability would actually decrease.

It is unlikely that the bank would in fact extend its overdraft facility in the light of present trends, even were it to have a policy of trying to help small employment generating units. It would probably look for evidence that the Society was addressing its mounting liquidity problem by seeking to generate cash internally.