CORPORATE FINANCE

WORKING CAPITAL MANAGEMENT

Working capital refers to all short-term or current assets used for daily operations by a firm. Working capital could be viewed in terms of gross or net. The concept of gross working capital is synonymous with total current assets or circulating capital. The concept of circulating capital is used in the sense that cash is initially converted into inventories (raw materials, work in progress, finished products). Inventories, when disposed of (sold), are converted into accounts receivable through credit sales and accounts receivable are converted into cash. this could be presented as in figure 8.1 below:

Circulating Nature of Current Assets

The concept of net working is synonymous with net current assets i.e current assets minus current liabilities. The net working capital represents a more appropriate measurement of a firm’s liquidity. It measures the level of adequacy of ‘near’ cash items which could be used to meet a firm’s short-term obligations. Thus, working capital management is concerned with the ways and means of making current assets adequate to meet the needs of the firm. It refers to all measures that could be adopted to minimize financial risk which could manifest as a result of efforts made to meet current liabilities.

INVENTORY VALUATION

The most important factor in determining the value of a stock is its basic of valuation. There are two main methods which are widely known in accounting. These methods of valuation are the F.I.F.O and L.I.F.O. The first method, first in-first-out, is based on the principle that goods purchased first or produced first should be the first to be sold. The implication is that financial results are determined by comparing current receipts with past cost (historical costs). The result will be that stocks represent latest purchases and productions valued by the use of current prices. It is not advisable to adopt this method in a situation where prices continue to increase. This is because the financial results would be made up of two parts one would consist of variations in prices of stocks which will be valued at current price level. Thus, F.I.F.O enables computed earnings to be inflated by selling old stocks at inflated prices.

A simplified example will clarify the difference between stocks valued on the basis of FIFO and LIFO. A trading company purchases 200 bags of feeds at N8.00 per bag on the 8^th of November, and another 150 bags at N10.00 per bag on the 15^th of December. The company is able to sell 230 bags before 31^st December. The position would be as follows:

FIFO LIFO

8^th November – 200 bags at N8.00 each N1,600 N1,600

15^th December – 150 at N10.00 each 1,500 1,500

Sales: 230 bags at N12.00 each 2,760 2,760

Cost of goods sold (i) FIFO 1,900 2,140

(ii) LIFO

Gross Profit = 860 620

Value of Stock = N1,200 960

INVENTORY MANAGEMENT

Inventories are made up of raw materials which are necessary inputs in the production process, work in progress which are semi-finished product or products in the process of production and finished products which are meant for sales. Inadequacy of raw materials inventory would cause inadequacy of work in progress as well as inadequacy of finished products of other firms without having to produce themselves. In any of the three types of inventory, holding costs, ordering costs etc. have to be critically considered. These are the costs that need to be minimized.

It is important to assert that investment in inventory is highly recommendable because of the following reasons.

1. Meeting of increase in the demand for a firm’s products due to deliberate sales strategies that induce more sales.

2. Avoiding running short of inventories when the need arises

3. Establishing a good reputation of meeting demand on time.

It should be emphasized that over investment or under investment in inventory is ill-advised. Thus, a firm should determine the level of inventory to order and keep in order to minimize cost and minimize benefits. Therefore, economic order quantity is what is required in stock control.

Economic order quantity involves the following:

1. Consideration of:

i. The advantages of ordering or producing the goods in large quantities

ii. Handling charges

iii. Transportation costs

2. The disadvantages of

i. Increasing cost of holding stocks

ii. Deterioration in product quality

iii. Obsolescence

Economic order quantity is that which minimizes the associated costs of inventory management. The local cost of stockholding is made up of:

a. Capital cost as well warehouse cost

b. Handling charges

c. Insurance charges

d. Alternative earnings of funds tied up to the stock

e. Possible deterioration in the quality of the stock and the replacement cost.

Economic order quantity could be determined if the following are known

D = annual demand for the product

Q = size of the batch

T = time intervals for recording = D/Q

AS = average stock = Q/2

C = cost of delivery per batch of the product

P = unit cost of the product

X = annual stockholding cost; this is expressed as a percentage

of the stock value.

Annual stock holding cost per unit of the product = XP

Total annual stock holding = XPQ/2

Number of delivery per annum = D/Q

Annual delivery cost = CD/Q[

Total variable cost = XPQ/2 + CD/Q (stock trading cost plus

delivery cost)

what is required is to determine the batch size which will minimize the total variable cost. This could be obtained by differentiating the total variable cost with respect to Q and equating it to zero.

I.e D/Q - XP/2 - CD/Q² = 0

Thus, XP/2 = CD/Q² and Q =

Example 1

XYZ Co. Ltd has a constant demand for about 60 crates of star beer per month. The cost per create of beer is N340.00 from the nearest depot of the company. However, the ordering and delivery cost per each order is N20.00. it is assumed that the stock holding cost is about 15 percent per annum of stock value. Assume also that the demand rate is constant, the lead time – time between ordering and receiving – is zero and no zero stock is permitted, determine the frequency of stock replenishment.

Solution

i. Annual demand for beer = 60 x 12 = 720 crates

ii. Delivery charge = N20.00

iii. Stock holding cost = 20%

iv. Cost price per crate of beer = N340.00

Q = =