Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 13 Treasury Management and working capital policy 345
cost of carrying this million additional working capital? The main carrying cost
is the return that could be earned by investing the additional million in finan-
cial assets outside the business. If these could generate 10 per cent p.a., the addi-
tional earnings would be million (less any interest earned on short-term cash
and securities). Other carrying costs include the additional storage and handling
costs for stock.
Aggressive or restrictive working capital policies are more susceptible to incurring
shortage costs. These costs are usually of two types:
1 Ordering costs – costs incurred in placing orders for stock, cash, etc. (in the case of
stocks this may also include the production setup costs). Operating a restrictive pol-
icy means ordering stock more regularly and in smaller amounts than for more
relaxed policies.
2 Costs of running out of stock or cash – the most obvious costs here are the loss of
business and even the possible liquidation of the firm. Less tangible costs are the
loss of customer goodwill, the disruption to the production schedule, and the time
and cost of negotiating alternative sources of finance.
The trade-off between carrying costs and shortage costs is shown in Figures 13.6
and 13.7. In Figure 13.6, carrying costs are seen to increase steadily as current assets
grow. Conversely, shortage costs fall with the level of investment in current assets. The
cost of holding current assets is the combined cost of the two, the minimum point being
the optimal amount of current assets held. For simplicity, we have shown current assets in
total. Later, we consider each element, such as cash or stock, separately.
Different businesses will be more sensitive to certain types of cost. An aggressive
policy is more appropriate when carrying costs are high relative to shortage costs, as
£2.5
£25
£25
Total cost of
holding current
assets
Carrying costs
Shortage costs
Optimal level
£
0
Figure 13.6
Optimal level of work-
ing capital for a
‘relaxed’ strategy
Total cost of holding
current assets
Carrying costs
Shortage costs
Optimal level of
working capital
Investment in working capital (£)
£
0
Figure 13.7
Optimal level of work-
ing capital for an
‘aggressive’ strategy
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346 Part IV Short-term financing and policies
Here, we address the problems arising from operating a business with an inappropri-
ate capital structure, a phenomenon known as overtrading.
Overtrading arises from at least three serious managerial mistakes:
1 Initial under-capitalisation. Many businesses experience overtrading problems from
the very start because they never invested sufficient equity at the time of formation
to finance the anticipated level of trading. Experience suggests that the early years
of trading are often difficult years, and shareholders will probably want some
incentive in the form of dividends.
2 Over-expansion. When a business expands to such a degree that its capital base is
insufficient to support the new level of activity, the business is overtrading or, to
put it another way, under-capitalised. In many cases, the business looks healthy,
in that the level of activity is growing and the business is profitable. But unless
sufficient cash is generated to finance the anticipated increase in working capital
and fixed investment, the business may encounter serious overtrading problems.
3 Poor utilisation of working capital resources. Even when a business has been adequately
capitalised and is not over-expanding its activity, overtrading can still occur in sev-
eral ways:
(a) Failure to achieve planned profit and cash flow levels may mean that debt capac-
ity, originally intended for working capital needs, is used to replace lost earnings.
(b) Cost overruns on fixed capital projects and other unanticipated capital invest-
ment can swallow up finance intended for working capital needs.
(c) Similarly, strategic decisions, such as a major acquisition, can have adverse effects
on working capital finance unless the capital basis is adequately enlarged.
(d) Higher dividends mean reduced profit retentions, often the major source of
finance for working capital.
■ Overtrading problems: Growfast Publishers Ltd
Growfast Publishers Ltd distributes books worldwide. Its most recent accounts reveal:
Sales 280
Cost of sales (all variable) (240)
Profit 40
Stock is two months’ cost of sales. Trade creditors pay within one month, while
debtors take three months to pay.
Growfast Publishers has recently gained exclusive rights to publish Corporate
Finance and Investment in Mongolia and is confident that this will lead to a doubling in
total sales. Because all costs are variable, the profit will also double, giving a healthy
profit.£80,000
£000
overtrading
Operating a business with an
inappropriate capital base, usu-
ally trying to grow too fast with
insufficient long-term capital
13.11 OVERTRADING PROBLEMS
in Figure 13.7. For example, a major car manufacturer like Ford will not want to hold
excessive quantities of raw material stocks, but will buy in materials and parts just
before they are to be used in car production, reflecting the Just-in-Time philosophy.
Often there will be penalty clauses for non-delivery of such materials to the manufac-
turer by agreed dates. A flexible policy tends to be more suited to low carrying costs
relative to shortage costs.
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Chapter 13 Treasury Management and working capital policy 347
Cash flow for the year, however, is less impressive:
Trading profit 80
Increase in stocks (240/6) (40)
Increase in debtors (280/4) (70)
Increase in creditors (240/12) 20
Net cash flow from operating activities (10)
Taxation on trading profit (30%) (24)
Consequence (34)
The consequence of a doubling in sales and profits is actually a reduction in cash by
If the increased working capital is thought to be permanent, it should be fund-
ed by longer-term finance.
■ Consequences of, and remedies for, overtrading
The consequences of overtrading can be extremely serious and possibly fatal. As the
pace of activity increases, working capital needs will also increase. Without the neces-
sary capital structure and cash flow, serious liquidity problems will arise. Business life
then becomes a matter of crisis management: finding the cash to meet the wage bill, the
creditors’ claims and the tax charges. Such myopic behaviour takes attention away
from the business of creating wealth and will, ultimately, lead to a decline in competi-
tiveness and profitability.
What can management do to remedy the cash flow problems caused by overtrading?
1 The most drastic step is to reduce the level of business activity. Profitable orders may
be rejected due to insufficient capital to finance additional working capital needs. If
the alternative is to accept the order and, in so doing, jeopardise the business by
exceeding the overdraft limit, a slower rate of growth is the preferred course of
action.
2 The most obvious remedy is to increase the capital base. Figure 13.2 showed that an
aggressive strategy for financing working capital operates on a lower long-term
capital base, thus making overtrading more likely. Movement towards a match-
ing approach is perhaps called for, where permanent increases in current assets
are matched by the injection of permanent capital, preferably in the form of equi-
ty or long-term loans, perhaps with a moratorium on repayments in the early
years.
3 Finally, steps should be taken to maintain tight control over working capital.
Constant review of the working capital policy and its cash flow implications
can allow the firm to minimise the extra capital resources required to fund
expansion.
£34,000.
£000
Self-assessment activity 13.8
Define overtrading. How does it arise and what are its consequences?
(Answer in Appendix A at the back of the book)
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348 Part IV Short-term financing and policies
Further reading and website
Treasury management is a highly practical topic and The Treasurer is a useful guide. Collier et al.
(1988) cover the subject of treasury management, while Smith (1988) is a helpful book of read-
ings and Gentry (1988) a good article on short-term financial management. A pioneer paper on
predicting corporate failure is Altman (1968). Risk management and the benefits of hedging are
discussed in Mastering Finance (1997). A useful website is the Association of Corporate Treasurers:
www.corporate-treasurers.co.uk.
SUMMARY
Treasury management is central to corporate finance in practice. Even in smaller busi-
nesses, where no formalised treasury function exists, the main treasury activities of
managing corporate funding, risk, banking relationships, liquidity and working capi-
tal will still be conducted. This chapter has introduced the reader to those treasury
activities, but most of them receive extensive treatment in subsequent chapters.
Key points
■ Treasury management is the efficient management of liquidity and financial risk in
the business.
■ Each company should establish whether it requires a separate treasury function
and whether it should be a cost or profit centre.
■ Clear treasury policies are required for funding, banking relationships, risk man-
agement and working capital management.
■ In general, long-term finance should be used to fund both fixed assets and perma-
nent current assets, fluctuating current assets being funded by short-term borrowing.
■ Hedging can take various forms, but derivative instruments, such as futures, for-
ward contracts, options and swaps, are the most common.
■ Working capital policy trades off expected profitability and risk. An ‘aggressive’
working capital policy, which seeks to employ the minimum level of net current
assets (including cash and marketable securities), will probably achieve a higher
return on investment, but may jeopardise the financial health of the business.
■ The cash operating cycle (the length of time between cash payment and cash
receipt for goods) should be regularly reviewed and controlled.
■ The consequences of overtrading (or under-capitalisation) can be extremely
serious, if not fatal, for the firm.
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Questions with
coloured numbers have solutions in Appendix B on page 705.
1 Atlas Ltd is a newly formed digital media company with a number of locations in the UK, France and
Germany. The board of directors is currently discussing whether the finance function should be centralised or
decentralised. What advice would you offer?
2 What are the risks that a manufacturing company might encounter as a result of interest rate movements?
Describe two financial instruments the company could use to reduce such risks.
3 ABC plc is a UK-based service company with a number of wholly owned subsidiaries and interests in associ-
ated companies throughout the world. In response to the rapid growth in the company, the Managing Director
has ordered a review of the company’s organisation structure, particularly the finance function. The Managing
Director holds the opinion that a separate treasury department should be established. At present, treasury func-
tions are the responsibility of the chief accountant.
Required
(a) Describe the main responsibilities of a treasury department in a company such as ABC plc and explain
the benefits that might accrue from the establishment of a separate treasury function.
(b) Describe the advantages and disadvantages which might arise if the company established a separate
treasury department as a profit centre rather than a cost centre.
(CIMA, November 1995)
4 (a) (i) Discuss the theories, or arguments, which suggest that financial analysis can be used to forecast the
probability of a given firm’s failure; and
(ii) explain why such an analysis, even if properly applied, may not always predict failure.
(b) Discuss the following statement: ‘It is always a sound rule to liquidate a company if its liquidation value
is above its value as a going concern.’
5
(a) Explain, with the use of a numerical example, the meaning of the term ‘cash operating cycle’ and its sig-
nificance in relation to working capital management.
(b) Delcars plc own a total of ten franchises, in a variety of United Kingdom locations, for the sale and serv-
icing of new and used cars. Six of the franchises sell only second hand vehicles, with the remaining four
operating a car service centre in addition to retailing both new and used vehicles. Delcars operate differ-
ent systems for banking of sales receipts, depending on the type of sale. All monies from new car sales
must be banked by the garage on the day of the sale; receipts from second hand car sales are banked once
a week on Mondays, and receipts from car servicing work are banked twice a week on Wednesdays and
Fridays. No banking facilities are available at the weekend, i.e. Saturdays and Sundays. The sales mix of
the three elements (as a percentage of Delcars’ total revenue) is as follows: 60 per cent new vehicles;
25 per cent second hand vehicles; 15 per cent servicing. Total sales for all three business areas amounted
to million in 1999. Delcars pays interest at a rate of 8.5 per cent per annum on an average overdraft of
and the company’s finance director has suggested that the company could significantly reduce
the interest charge if all sales receipts were banked on the day of sale. All the garages are open every day
except Sunday. Assume that the daily sales value (for all three areas of business) is spread evenly across
the week.
Calculate the value of the annual interest which could be saved if all ten franchises adopted the finance
director’s suggestion of daily banking.
(c) Using the example of a car dealership such as Delcars, as given in (b) above, outline the advantages and
disadvantages of centralisation of the treasury function.
(ACCA)
£65,000,
£25
Chapter 13 Treasury Management and working capital policy 349
QUESTIONS
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6 Hercules Wholesalers Ltd has been particularly concerned with its liquidity position in recent months. The
most recent Profit and Loss Account and Balance Sheet of the company are as follows:
Profit and Loss Account for the year ended 31 May 199X
££
Sales 452,000
Less: Cost of sales
Opening stock 125,000
Add purchases 341,000
466,000
Less: Closing stock (143,000) 323,000
Gross profit 129,000
Expenses (132,000)
Net loss for the period (3,000)
Balance Sheet as at 31 May 199X
££ £
Fixed assets
Freehold premises at valuation 280,000
Fixtures and fittings at cost less depreciation 25,000
Motor vehicles at cost less depreciation 52,000
357,000
Current assets
Stock 143,000
Debtors 163,000
306,000
Less creditors due within one year
Trade creditors (145,000)
Bank overdraft (140,000) (285,000)
21,000
378,000
Less creditors due after more than one year
Loans (120,000)
258,000
Capital and reserves
Ordinary share capital 100,000
Retained profit 158,000
258,000
The debtors and creditors were maintained at a constant level throughout the year.
Required
(a) Explain why Hercules Wholesalers Ltd is concerned with its liquidity position.
(b) Explain the term ‘operating cash cycle’ and state why this concept is important in the financial man-
agement of a business.
(c) Calculate the operating cash cycle for Hercules Wholesalers Ltd based on the information above.
(Assume a 360-day year.)
(d) State what steps may be taken to improve the operating cash cycle of the company.
(Certified Diploma)
7 Micrex Computers Ltd was established in 1989 to sell a range of computer software to small businesses.
Since its incorporation, the business has grown rapidly and demand for its products continues to rise. The
most recent financial accounts for the company are set out below:
350 Part IV Short-term financing and policies
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Balance Sheet as at 31 May 199X
££ £
Fixed assets
Freehold land and buildings at cost 55,000
Less: Accumulated depreciation (4,000) 51,000
Equipment and fittings at cost 20,000
Less: Accumulated depreciation (5,000) 15,000
Motor vehicles at cost 24,000
Less: Accumulated depreciation (6,000) 18,000
84,000
Current assets
Stocks 26,000
Trade debtors 59,000
85,000
Less creditors: amounts falling due within one year
Trade creditors (88,000)
Proposed dividend (1,000)
Taxation (6,000)
Bank overdraft (10,000) (105,000) (20,000)
64,000
Less creditors: amounts falling due beyond one year
14% bank loan (secured on freehold property) (20,000)
44,000
Capital and reserves
Ordinary shares 25,000
Retained profit 19,000
44,000
Profit and Loss Account for the year ended 31 May 199X
££
Sales
660,000
Less: Cost of sales
Opening stock 22,000
Purchases 426,000
448,000
Less: Closing stock (26,000) 422,000
Gross profit 238,000
Less: Selling and distribution expenses (176,000)
Administration expenses (38,000)
Finance expenses (7,000) (221,000)
Net profit before taxation 17,000
Corporation tax (6,000)
Net profit after taxation 11,000
Proposed dividend (1,000)
Retained profit for the year 10,000
The company is family-owned and controlled and, since incorporation, has operated without qualified
finance staff. However, the managing director recently became concerned with the financial position of the
company and therefore decided to appoint a qualified finance director to help manage the financial affairs
of the business. Soon after joining the company, the finance director called a meeting of his fellow directors
and at this meeting, stated that, in his opinion, the company was overtrading.
£1
Chapter 13 Treasury Management and working capital policy 351
Continued
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Required
(a) What do you understand by the term ‘overtrading’ and what are the possible consequences of this type
of activity?
(b) What are the main causes of overtrading and how might the management of a business overcome the
problem of overtrading?
(c) Use financial ratios for Micrex Computers Ltd that you believe would be useful in detecting whether the
company was overtrading. Explain the significance of each ratio you calculate.
(Certified Diploma)
352 Part IV Short-term financing and policies
Look at the annual reports of two companies in the same industry. What do they say about the treasury function
and treasury or risk management policies? How do the two companies differ and what might be the implications
of such differences in treasury management?
Practical assignment
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Short-term asset management
14
Learning objectives
Having read this chapter, you should have a good appreciation of the importance of short-term
asset management in corporate finance and of the basic control methods involved. Specific atten-
tion will be paid to the following:
■ Managing trade credit.
■ Inventory management.
■ Cash management.
SOS from ASOS: from hero to zero
For retailers, the most important current asset is
stock. Failure to have on hand the right amount of
stock at the right time results in lost opportunities to
make profits. For a clothing retailer, this is especially
important if the product quickly goes out of fashion,
as these opportunities may never reappear.
ASOS (formerly As Seen On Screen), the online fash-
ion retailer that specialises in selling celebrity-style
clothes to 20-something shoppers, was the top per-
former on the London Stock Exchange during 2004,
when its shares rose from 5p to 78p. However, in March
2005, it was forced to issue a profits warning. As a result
of problems with distribution of merchandise, winter
stock that should have been sold over Christmas had
become backed up, necessitating sharp price cuts to
shift excess produce. ASOS’s Chief Executive said that:
This discounting had led to a significant increase in
sales, well beyond budgeted levels. As a consequence,
we are bearing the costs associated with very high
sales volumes, but without the gross margin to sup-
port them.
In fact, average gross margin fell from 50% to about
30%. He added that ASOS would have done even bet-
ter than its 70% sales leap over Christmas, had it not
been working out of four dispersed warehouses, when
it needed a centralised strategic site. The difficulties in
coordinating distribution resulted in delays in items
appearing on the ASOS website, causing the backlog of
stock. Happily, he was able to report the appointment
of a new general manager to oversee distribution, and
that ASOS had found a 70,000 sq. ft. warehouse
expected to come into use in three months. This
mixed message probably helped to moderate the
market’s reaction to the profit warning, limiting the
share price fall to 11%.
Source: Based on article by Lisa Urquhart, Financial Times, 4 March 2005.
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354 Part IV Short-term financing and policies
14.1 INTRODUCTION
It is a common mistake to assume that financial management concerns only long-term
financial decisions, such as capital investment, capital structure and dividend policy
decisions. In reality, much of financial management addresses issues of shorter dura-
tion, such as short-term financing and working capital management. In this chapter, we
examine how short-term assets, such as debtors, inventory and cash, can be managed
to maximise shareholder wealth.
14.2 MANAGING TRADE CREDIT
Trade credit can be both a source and a use of finance because it can be received (via
trade creditors or payables) and offered (via trade debtors or receivables). We will con-
centrate on the extension of trade credit and its management, although many of the
issues raised apply also to the receipt of trade credit (discussed further in Chapter 15
because it is a form of finance).
Debtors represent the currently unpaid element of credit sales. While the extension
of credit is accepted practice in most industries, credit is essentially an unproductive
asset (unless it generates additional business) which both ties up scarce financial
resources and is exposed to the risk of default, particularly when the credit period
taken by customers is lengthy. Effective management of debtors is therefore an essen-
tial element of sound financial management practice.
■ Why offer trade credit?
Approximately one-third of the assets of UK businesses is in the form of trade debt –
money to be paid at some future time for goods or services already received. The ben-
efits to the customer are obvious, but why should the seller incur financing and other
costs in extending credit to selected customers?
1 Investment and marketing. Trade credit should be viewed as an investment forming
part of the sales package, the payoff being profitable repeat business. Most compa-
nies would lose a significant proportion of their customer base to their competitors
were they to demand cash on delivery. As with all investment, there are risks
involved. Credit risk exists when the company offering credit is exposed to the pos-
sibility that the debt will not be paid on time or at all.
The decision to grant credit involves a trade-off between the credit risk and the
reward from the profit margin. A common mistake is to assume that a credit sale is
a ‘one-off’, ignoring potential repeat business. If a firm loses business from refusing
a customer credit, what is the effect? It is more than simply the lost profit
margin of, say, 40 per cent on the sale. The business from many new customers will
grow in time and offer significant repeat business. Assuming they would have
entered into a long-term relationship and ordered p.a., growing at 3 per cent
a year, the present value of the lost business (given a 13 per cent interest rate) could
be as much as
2 Industry and competitive pressures. It is difficult for firms to offer credit terms that are
less generous than their competitors’ offerings.
3 Finance. Certain types of firm have better access to capital markets and can raise
finance more cheaply than others. This competitive advantage can be reflected in offer-
ing generous credit to customers who experience greater difficulties in raising finance.
PV
£10,000 11.032
0.13 0.03
0.4 £41,200
£40,000:
£10,000
£1,000
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