Financial management in construction working capital management 2017/18

5 WORKING CAPITAL MANAGEMENT

5.1 Working Capital Policy

One of the most important areas in the day-to-day management of the firm deals with the management of
Working Capital, which is defined as all the short term assets used in daily operations. As discussed in the
previous chapters, the key difference between long-term financial management and short term financial
management (also referred as working capital management) is in terms of the timing of cash. While long term
financial decisions like buying capital equipment, building structures or issuing debentures involve cash flows over
an extended period of time, short term financial decisions typically involve cash flows within a year or within the
operating cycle of the firm.

There are two concepts of working capital: gross working capital and net working capital. Gross working capital is
the total of all current assets. Net working capital is the difference between current assets and current
liabilities. The constituents of current assets and current liabilities are shown hereunder.

Current Assets: Liquidating assets in the accountable period

 Inventories that comprise
 Raw materials and components
 Work in progress
 Finished goods
 Trade debtors ( Accounts receivable)
 Cash and marketable securities
Current Liabilities: Cash or services delivered in advance but repayment not yet effected.
 Sundry creditors ( Accounts payable)
 Trade advances
 Short term borrowings
 Accruals, deferred tax etc,

Working capital management is the functional area of finance that covers all the current accounts of the firm. It
is concerned with the adequacy of current assets as well as the level of risk posed by current liabilities. Arranging
short term financing, negotiating favorable credit terms, controlling the movement of cash, administering
accounts receivable and monitoring the investment in inventories consume a great deal of time of financial
managers. It is a discipline that seeks proper policies for managing current assets and liabilities and practical
techniques for maximizing the benefits from managing working capital.

5.1.1 Characteristics of Current Assets

In the management of working capital, two characteristics of current assets must be borne in mind:
 Short life span,
 Swift transformation into other asset forms.
Current assets have a short life span. Cash balances may be held idle for a week or two, accounts receivables may
have a life span of 30 to 60 days, and inventories may be held for 30 to 100 days. The life span of current assets
depend upon the time required in the activities of procurement, production, sales and collection and the degree of
synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used for acquiring raw materials; raw
materials are transformed into finished goods ( these transformation may involve several stages of work in
process); finished goods generally sold on credit basis are converted to accounts receivable; and finally accounts
receivable, on realization, generate cash. Fig 5.1 shows the cycle of transformation of current assets.

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Finished Goods

Accounts
Receivable Work in Progress

Wages, Salaries,
Overheads

Raw Materials

Cash Suppliers

Fig 5.1 Current Asset Cycle

5.1.2 Operating Cycle and Cash Cycle

Investments in working capital are influenced by four key events in the production and sales cycle of the firm:
 Purchase of raw materials,
 Payment for raw materials,
 Sale of finished goods
 Collection of cash sales.
Fig 5.2 depicts these events on the cash flow line.
The firm begins with the purchase of raw materials which are paid for after a delay
which represents the accounts payable period. The firm converts the raw materials
into finished goods and then sells the same. The time lag between the purchase of
raw materials and the sale of finished goods is the inventory period. Customers pay
the bills some time after the sales. The period that elapse between the date of sales
and the date of collection of receivables is the accounts payable period. The time
that elapse between the purchase of raw materials and the collection of cash for
sales is referred to as the operating cycle, whereas the time length between the
payment for raw material purchases and the collection of cash for sales is referred
to as the cash cycle. The operating cycle is the sum of the inventory period and the
accounts receivable period, whereas the cash cycle is equal to the operating cycle
less the accounts payable period.

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Order Cash
Received
Stock
arrives

Inventory Period Accounts Receivable

Accounts Payable

Credit Cash paid for

Invoice Materials

Operating Cycle

Cash Cycle

Fig 5.2 Operating and Cash Cycle

From the financial statement of the firm, one can estimate the inventory period, the accounts receivable period
and the accounts payable period.

Acc. Receivable Period (days) = Accounts Receivable ($)/ (Annual Sales ($)/ 365 days)
Acc. Payable Period (days) = Acc. Payable ($) / (Annual Cost of Goods sold ($)/ 365 days)
Inventory Period (days) = Inventory ($)/ (Annual Cost of Goods sold ($)/365 days)

For the example below, estimate the operating and cash cycle of the firm given the following data taken from the
financial statement.
 Annual Sale: Birr 500 million
 Total cost of goods sold: Birr 360 million
 Inventories: Birr 60 million
 Accounts Receivables: Birr 80 million
 Accounts Payable: Birr 50 million

Solution:
Accounts Receivable = (80/ 500) X 365 = 58 days
Accounts payable = (50/ 420) X 365 = 43 days
Inventory Period = (60/ 420) X 365 = 52 days.
Operating Cycle = inventory period + A/R period
= 52 + 58 = 110 days
Cash Cycle = operation cycle – A/P period

=110- 43 = 67 days.

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5.1.3 Factors Affecting Working Capital Requirements

The working capital needs of a firm are influenced by numerous factors. The important ones are:

i) Sales Volume: A firm maintains current assets because they are needed to support the operational
activities that culminate in sales. Over time, a firm will keep a fairly steady rate of current assets to annual sales.
A firm realizing a steady level of sales operates with a fairly constant level of cash, receivables, and inventory, if
properly managed. Firms experiencing growth in sales require additional working capital. If sales are declining, a
reduction in working capital can be expected.

ii) Nature of Business: The working capital requirement of a firm is closely related to the nature of its
business. A service firm with a short operating cycle and which sells predominantly on cash basis has modest
working capital requirement. On the other hand, a firm which has a long operating cycle and which sells largely on
credit has a very substantial working capital requirement.

iii) Production Policy: A firm marked by pronounced seasonal fluctuation in its sales may pursue a production
policy which may reduce the sharp variations in working capital requirements. For example, a manufacturer of
ceiling fans may maintain a steady production throughout the year rather than intensify the production activity
during the peak business season. Such a production policy may dampen the fluctuations in working capital.

iv) Market Conditions: The degree of competition prevailing in the market place has an important bearing on
working capital needs. When competition is keen, a larger inventory of finished goods is required to promptly
serve customers who may not be inclined to wait because other manufacturers are ready to meet their needs.
Further, generous credit terms may have to be offered to attract customers in a highly competitive market. Thus
working capital needs tend to be high because of greater investment in finished goods inventory and accounts
receivable.

v) Conditions of Supply: The inventory of raw materials spares and stores depend on the conditions of
supply. If the supply is prompt and adequate, the firm can manage with small inventory. If, however the supply is
unpredictable and scant with the firm, to ensure continuity of production, the firm would have to acquire stocks as
and when they are available and carry large inventory on average.

5.1.4 Cash Requirement for Working Capital

As a finance manager, one will be interested in figuring out how much cash to be arranged to meet the working
capital need of the firm. To do this, two step procedures shall be followed:
Step 1: Estimation of the cash cost of various current assets require by the firm:
This follows to estimate the following:
 Cash cost of debtors (receivables) by removing the profit element (ROCE),
 Raw materials in stock
 Finished goods in stock
 Cash balance
Step 2: Deduct the current liabilities from the cash cost of current assets:
A portion of the cash cost of current assets is supported by trade credit and accruals of wages and expenses,
which may be referred to as spontaneous current liabilities. The balance left after such deduction has to be
arranged from other sources.
Example: Given the following annual figures of a firm:
 Annual sales ( Two months credit is given) : Birr 240 million
 ROCE: 20%
 Material cost (Suppliers give three months credit): Birr 72 million
 Wages ( wages are paid with one month arrears): Birr 48 million
 Manufacturing Expense (Plant expense) paid in one month arrears: Birr 48 million
 Administrative expenses (Paid as incurred) : Birr 32 million
 The firm keeps two months’ stock of raw materials and one month’s stock of finished goods.
 The firm wants to maintain a cash balance of Birr 5 million.

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 Neglect work in progress

Estimate the working capital requirement of the project.
Solution:
Given cost of sale = Birr 200 million
ROCE = Birr 40 million
Step1: Current Assets:
 Receivables = (200/12) x 2 = Birr 33.33 million
 Raw material in stock = (72/12) x 2 = Birr 12 million
 Finished goods = (168/12) x 1 =Birr 14 million
 Cash Balance = Birr 5 million
Total Current Assets = Birr 64.33 million

Step 2: Current Liabilities

 Sundry creditors = (72/12) x 3 = Birr 18 million
 Wages = ( 48/12) x 1 = Birr 4 million
 Plant expense = (48/12) x 1 = Birr 4 million
Total current liabilities = Birr 26 million

Working Capital requirement = Birr 64.33 million – Birr 26 million = Birr 38.33 million
Birr 38.33 million should be arranged from other financial sources.
5.2 Cash & Liquid Management

In a financial sense, the term cash refers to all money items and sources that are immediately available to help
pay a firm’s bill. Cash, the most liquid asset, is of vital importance to the daily operations of business firms. On the
balance sheet, cash assets include deposits in financial institutions and cash equivalents in money market funds or
marketable securities. All highly liquid short-term securities are treated as cash.

Three securities are widely used as short-term investments and alternative forms of cash. Each security offers
different characteristics that make it suitable for different firms.
i) Treasury Bills: A treasury bill is an unconditional promise by Government’s Treasury Agent to pay to the
holder of the bill a specified amount at maturity. Treasury bills are issued for short periods of time, normally 3, 6
or 12 months. Two characteristics of treasury bills should be noted:
 Non interest bearing: Treasury bills are sold at a discount on a bid basis, mainly to security dealers and
large commercial banks, who resell them to individuals and firms.
 Most secure and liquid marketable security: Treasury bills are most secured and liquid kind of
marketable security because government guarantees their redemption.
ii) Commercial Paper: Commercial paper represents short term unsecured promissory notes issued by firms
that are generally considered to be financially strong. Commercial paper usually has a maturity period of 90 days
or 180 days. They are purchased by individuals or other firms with excess cash that have a desire to earn a higher
yield than available from treasury bills. In turn for the higher yield, the firm accepts slightly greater risk and less
liquidity.
iii) Certificates of Deposit: A certificate of deposit represents a negotiable receipt of funds deposited in a
bank for a fixed period. The bank agrees to pay the bearer the amount of the deposit plus a stipulated amount of
interest at maturity. Certificate of deposits are a popular form of short term investment for companies since
they are fairly liquid, generally risk free and offer a higher rate of interest than treasury bills.

5.2.1 How large a cash balance is needed?

The size of a firm’s cash balance depends basically upon the three major reasons for liquidity. This includes:
i) Transaction needs: A firm needs cash to carry out the day-to-day functions of the business. Just as
the firm’s level of operations affects working capital requirements, it affects the need for cash. If
the volume of sales increases, cash will be received from customers and will be expended for

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materials and wages in large amounts. Adequate cash to cover these and other transactions allow the
firm to pay its bills on time.
ii) Contingency needs: If the firm could perfectly forecast its needs for cash, it would not have to be
concerned with unexpected occurrences or emergencies that require cash. Because this is not
possible, the firm must be prepared for contingencies.
iii) Opportunity needs: These involve the chance to profit from having cash available. For example, a
supplier may have several cancellations of orders and may wish to move a large unwanted inventory of
raw materials from his warehouse. If the supplier offers a large discount for cash purchasing of the
materials, the firm will have the opportunity to realize a substantial savings on its purchase and,
hence, profits from the sale of the finished goods.

5.2.2 Forecasting Cash Flow

Once the financial manager has identified the firm’s policies on cash flow management, he must face the problem
of predicting the amounts and timing of future inflows and outlays of cash. This is a difficult process for most
firms because cash flows are affected by many factors. The failure to prepare for the proper level of cash poses
three risks to the company:
i) Default: The failure to pay interest or principal payments on a firm’s borrowings or failure to perform as
per contract is a default, a situation that may result in legal actions by the firm’s creditors.
ii) Overdue Bills: The failure to pay short-term obligations, such as payables, is less serious than default but
may result in a lowering of the firm’s credit rating in the business community. This may be accompanied by higher
interest rates when the firm applies for loans or may cause creditors to refuse to ship supplies on credit.
iii) Lost Savings on Purchases: Inadequate cash may cause the firm to lose opportunities to make special cash
purchases or to take generous trade discounts on purchases of goods.
In attempting to minimize these risks, the firm pursues the twin goals of cash forecasting, namely:
 Liquidity: By predicting cash surpluses or cash shortages, the firm achieves liquidity- sufficient money in
the bank to pay debts as they come due.
 Profitability: Accurate cash forecasting achieves profits by allowing the firm to take profitable discounts
on purchases, invest surplus funds, or reduce the costs of maintaining idle cash balances.
Example: On Cash flow forecast & Working Capital

Given the following information for a construction project:

 A contract budget has been prepared and the monthly evaluation forecasts are as indicated hereunder:
Month 1 2 3 4 5 6

Monthly Value (Birr) 8,000 10,000 12,000 14,000 10,000 6,000

 Profit included in the estimate is 12 %

 Payments are to be made monthly within 28 days
 Retention money for every monthly payment – 3 % where 1.5% will be released during the completion
period and the remaining at the expiry of defects liability period.
 Defects liability period – 6 months
 No advance payment
 5 % of the total project cost is used as mobilization cost.
i) Prepare the gross and net cash requirements for the project.

ii) Assuming even contract budget throughout the contract period, estimate the working capital.

 Material on site to be considered in the payment as delivered to the site: 50% of production cost

 Wages and plants : every month amounting to 40% of production cost

 Overhead cost 10%

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Solution:
i) Cash flow forecast:

1) Cumulative contract value forecast from the monthly value forecast.

Months 1 2 3 4 5 6
Cumulative
Forecast (Birr) 8,000 18,000 30,000 44,000 54,000 60,000

2) Cumulative self-cost of contract & expenditure:

Cumulative self-cost = Cumulative contract value – profit release- mobilization cost

Months 1 2 3 4 5 6
Cumulative self-cost
(Birr) 6,640 14,940 24,900 36,520 44,820 49,800

Cumm. Expenditure = Cumulative self-cost + mobilization

Months 1 2 3 4 5 6
Cumm.Expenditure
(Birr) 9,640 17,940 27,900 39,520 47,820 52,800

3) Cumulative Income
Monthly Income Forecast: It can be determined from cumulative contract value forecast subject to deductions as
retention money, advance payment and any previous payments.
Income month( i+1) = Cumm. Contract Value month( i) – retention – previous payments
Income month (2) = 8,000 – 0.03( 8,000) -0 = Birr 7,760
Income month (3) = 18,000 – 0.03 ( 18,000) – 7,760 = Birr 9,700
Income month (4) = 30,000 – 0.03( 30,000) – (7,760+9,700) = Birr 11,640
Income month (5) = 44,000 – 0.03( 44,000) – ( 7,760 +9,700+11,640) = Birr 13,580
Income month (6) = 54,000 – 0.03 (54,000) – (7,760+9,700+11,640+13,580) = Birr 9,700
Income month (7) = 60,000- 0.015(60,000) – (7,760+9,700+11,640+13,580+9,700) = Birr 6,720
Income month (12) = 0.0015 (60,000) = Birr 900

Cumulative Income:
Months 1 2 3 4 5 6 7 12
Monthly Income (Birr) 0 7,760 9,700 11,640 13,580 9,700 6,720 900
Cumm. Income (Birr) 0 7,760 17,460 29,100 42,680 52,380 59,100 60,000
4) Gross and Net Cash Requirements
Net cash required (monthly) = Cumm. Income after receipt of each monthly payment - Cumm. Expenditure
Gross cash required (monthly) = Cumm. Income prior to receiving monthly payment - Cumm. Expenditure

Months 1 2 3 4 5 6 7 12
Net Cash Req’d (Birr) -9,640 -10,180 -10,440 -10,420 -5,140 -420 6,300 7,200
Gross cash Req’d (Birr) -9,640 -17,940 -20,140 -22,060 -18,720 -10,120 -420 6,300

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Value (Birr)

60000
Expenditure

Value Forecast
Income/ Revenue

30000

0
1 2 3 4 5 6 7 Time, months
Fig 5.3a Cash Flow Forecast

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Cash (Birr)

+ 30000

Self-Financing Date

Surplus

1 2 3 4 5 6 7 Time,month
0 Time, Months

Short
Fall
Gross Cash Requ’t
Net Cash Requ’t

-30000 Max. Capital Required

Fig 5.3b Gross and Net Cash Requirements.

ii) Working Capital Requirement:
Given cost of sale = Birr 52,800
ROCE = Birr 7,200
Step 1: Current Assets
 Receivables: (52,800/6) x 1 = Birr 8,800
 Raw material on stock= ((0.5 x 52,800)/6) x 1 = Birr 4,400
Total current assets = Birr 13,200

Step 2: Current Liabilities

 Wages and plant cost = (( 0.4 x 52,800)/ 6) x 1 = Birr 3,520
 Raw material (( 0.5 x 52,800)/6) x 1 = Birr 4,400
Total Current liabilities = Birr 7,920

Working capital Requirement = Birr 5,280 monthly.

iii) Working Capital assuming 20% advance payment.

5.3 Credit Management

While business firms would like to sell on cash, the pressure of competition and the force of custom persuade
them to sell on credit terms. Firms grant credit to facilitate sales. It is valuable to customers as it augments
their resources. It is particularly appealing to those customers who cannot borrow from other sources or find it
very expensive or inconvenient to do so. The credit period extended by business firms usually ranges from 15 to
60 days. When goods are sold on credit, finished goods get converted into accounts receivable (trade debtors) in
the books of the seller. In the books of the buyer, the obligation arising from credit purchase is represented as
accounts payable (trade creditors).

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A firm’s investment in accounts receivable depends on how much it sells on credit and how long it takes to collect
receivables. For example, if a firm sells Birr 1 million worth of goods on credit a day and its average collection
period is 40 days, its accounts receivable will be Birr 40 million.

5.3.1 Terms of Payment

Terms of payment vary widely in practice. At one end, if the seller has financial sinews it may extend liberal credit
to the buyer till it converts goods bought into cash. At the other end, the buyer may pay cash in advance to the
seller and finance the entire trade cycle. Most commonly, however, some in between arrangements is chosen
wherein the trade cycle is financed partly by the seller, partly by the buyer, and partly by some financial
intermediary. The major terms of payment are discussed below:

Order Delivery Sale

Cash Terms Credit Terms

Converted to cash
Cash in Cash on
Advance Delivery

Fig 5.4 Terms of Payment

i) Cash Terms: When goods are sold on cash terms, the payment is received either before the goods are
shipped (cash in advance) or when the goods are delivered (cash on delivery). Cash in advance is generally insisted
upon when goods are made to order. In such a case, the seller would like to finance production and eliminate
marketing risks. Cash on delivery is often demanded by the seller if it is in a strong bargaining position and/or the
customer is perceived to be risky.
ii) Credit Terms:
 Open Account: Credit sales are generally on open account. This means that the seller first ships the
goods and then sends the invoice. The credit terms (credit period, cash discount for prompt payment, the
period discount, and so on) are stated in the invoice which is acknowledged by the buyer.
 Bill of exchange: A more secure arrangement that represents an unconditional order by the seller asking
the buyer to pay on demand or at a certain future date, the amount specified on it. It is typically
accompanied by shipping documents that are delivered to the buyer when he pays or accepts it. The bill of
exchange performs three useful functions:
 It serves as a written evidence of a definite obligation
 It helps in reducing the cost of financing to some extent,
 It represents a negotiable instrument.
 Consignment: When goods are sent on consignment, they are merely shipped but not sold to the
Consignee. The consignee acts as the agent of the seller. The title of the goods is retained by the seller
till they are sold by the consignee to the third party.
 Letter of Credit (L/C): Commonly used in international trade. A letter of credit is issued by a bank on
behalf of its customer to the seller. As per this document, the bank agrees to honor drafts drawn on it
for the supplies made to the customer if the seller fulfills the conditions laid down in the L/C. The L/C
serves several useful functions:
 Virtually eliminates credit risk,
 Reduces uncertainty as the seller knows the conditions that should be fulfilled to receive
payment,

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 Offers safety to the buyer who wants to ensure that payment is made only in conformity with
the conditions of the L/C.

5.3.2 Costs of Maintaining Receivables:

As with all assets and operations, the willingness to allow credit sales involve certain costs. These include:
i) Financing the Receivables: Carrying accounts receivables ties up a portion of the firm’s financial
resources seeking for addition in working capital. These resources must be financed from other sources such as
past profits retained in the business, contributed capital from owners and debt from creditors.
ii) Administrative and Collection Expenses: To keep records on credit sales and payment and the efforts
made to aware and push debtors to settle their payments incurs additional cost to the firm. In addition, most
firms conduct investigations of potential credit customers to determine their creditworthiness. These and other
expenses, such as telephone charges and postage constitute the administrative and collection costs of maintaining
receivables.
iii) Bad Debt Loss: After making serious efforts to collect on overdue accounts, the firm may be forced to
give up. If a customer declares bankruptcy, no payment may be forthcoming. If the customer leaves the city or
state, it may be too costly to trace him and demand payment. In these cases, the firm is forced to accept a bad
debt loss on the account.

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