Question Two

Introduction
Working Capital
Tennent (2009) looks at working capital as money tied up inventories and
receivables less payables. Barry and Jamie (2008) saw working capital as the current
assets and current liabilities of the business. In addition to providing a means of
making management accountable, cash flows are the raw data required by financial
managers when making decisions on the working capital management. To others,
working capital is referred to as the difference between an organizations current
assets and its current liabilities (McCaney and Atrill, 2005). According to McCaney
and Atrill working capital is used interchangeably with net working capital. In
addition, working capital also refers the amount of resources the business has in a
form that is readily convertible into cash (Wood and Sangster, 2007). For the
purpose of this study, working capital refers to all current assets and liability of a
business entity.
According to Mehta (1974),

working capital management is to create a set of

decision rules and logically interrelated control indices which aid the managers
in evaluating policies and taking effective action. In 1977, Van Horne looked at
working capital management as the administration of current assets in the name of

cash, marketable securities, receivables, and inventories. Also Osisioma (1997),

described working capital management as the regulation, adjustment and control of
the balance of current assets and current liabilities of a firm such that maturing
obligations are met and the fixed assets are properly serviced. In addition, working
capital management is an accounting strategy in which a company seeks to maximize
its cash flow so as to pay for its current liabilities and operating expenses. Working
capital management, if done properly, can help a company improve its earnings and
maintain a healthy financial state. According to Chadwick (2001) working capital
management is concerned with the control and management of stocks, debtors, short
term investment, cash and creditors. Furthermore, working capital management
involves the administration within policy guidelines of current assets and current
liabilities. (Brigham et al; 1997).
Working Capital Cycle
According to McCosker (2003), the working capital cycle (the time taken to convert cash received
net of creditors) starts when stocks are purchased on credit from suppliers and are sold for cash
and credit.

Source: http://www.planware.org/workingcapital.htm#1

The working capital cycle commences when the company receives an order from its
customer or decide to make stock. Inventories are acquired, which may be converted
through the stages of work in progress into finished goods. These stocks are held as
current assets until the customer buys them. However, at that point no money has
changed hands and the asset inventory is merely replaced by an asset of trade debtors
if sales have been done on credit. The inventory is either sold on cash or on credit
which will further be converted into cash in due course. It is not until the cash is
actually received that the working capital cycle is complete (Bender and Ward,
2009).

Working capital cycle clearly identifies how sales are converted into receivables and
then cash. The same cash is being used to meet operating expenses, to purchase
inventory and to pay the accounts payable. Every business needs some amount of

working capital. It is needed for the following purposes: for the purchase of raw
materials, components and spares, for the payment of wages and salaries, for
incurring day to day expenses and overhead cost such as fuel, power and office
expenses and for the provision of credit facilities to customers.

EXAMPLE with ERANG Enterprise

Background of ERANG enterprise

ERANG enterprise is located in Buea, it produces ever fresh (air fresher) and ever
fresh (liquid soap). It buys its raw materials from Douala And Yaounde. It operates
on an initial capital of 1.350.000FCFA, with more of the capital engaged in working
capital as current assets. The production process of the Everfresh product does not
involve the use of machines; it involves a lot of mixing the chemicals in water. The
main customers of ERANG enterprise are some higher health institutions, private
hospitals and small retail stores. The product has just been in the market for just 3yea
and is struggling to expand its market shares.
Working Capital Management of ERANG enterprise
ERANG has total current assets of 1.800.000FCFA and a current liability of
687.500FCFA as of the 31/06/2015. Thus giving it a net working capital of
1.112.500frs and a current ratio of

1.800.000
687500

= 2.6: 1

The current asset structure of ERANG Ltm as of 31/06/2015 is as follows:

Trade receivables=500.500FCFA

Inventory =805.000FCFA
Cash =494.500FCFA
From the above figures the following calculations can be made;
1.800.000

Current ratio =

687500

=2.6:1

Which means the enterprise is able to lay it hands on 2.6FCFA for every 1FCFA it
owes. From the above ratio, it is easy for the company to meet up with its current
obligations. Quick Ratio =
=

995000
687500

= 1.4:1

Thus even without inventory, the enterprise can still meet up with its current
obligation.
Payable days=
=

687500
1,275,000

365

365=179days, it takes approximately 179days for the entity

to pay her creditors.

Receivable days=
=

500500
2300500

365

365 =79days

The above payable days and receivable days computed above are too high but the
high payable day is advantageous to the organization.
Cash Operating Cycle of ERANG Enterprise

Cash flows in a circle into, around and out of a business. It is the businesss
life blood and every managers primary task is to help keep it flowing and to use the
cash flow to generate profit. This implies that the manager must endeavor to see that
they have a generate cash surplus without which the business will eventually run out
of cash and expire. The main sources of finance to this enterprise are: payables and
cash sales as shown on working capital circle below.

Payable
s
Cash

Raw materials
Eg acid, oil

Receivable
s

Sales

Inventor
y eg ever
fresh

The management of this enterprise looks at each component of working capital (ie
inventory, receivables and payables) in two dimensions, the time and monetary value
of the component. The components are managed as follows.
Inventory Management
The inventory of A&B Enterprise being ever fresh air fresher and Ever-fresh liquid
soap poses a bit of work to the management in terms of what volume to supply. But

so far, the following strategies have been put in place in order to manage this
inventory effectively.
A security or safety stock of 100pieces of each type is kept.
Whenever the inventory level is closer to the safety stock level or equals to it an
order for raw materials is placed which takes a day or two for the raw materials to
arrive Buea and for the production of the products, it takes two days to produce
100litres of each type, (that is 200litres) and thus giving the total lead time of
averagely four days for an order of 200litres to be replenished which is our re-order
quantity. 20%of these products are made available to some retailers, 60% supplied
to the main costumers who mostly collect on credit most of the time and pay after
two months and some extending up to 3 to 4 months. The enterprise allows a
3months period for debts to be settled unfailingly which is merely due to the reaction
of some of the customers behaviors.
Moreover, there is increase advertisement of the products using cheap media such
as the retailers, student and their main customers in order to boost sales every day.
On every credit sale made, the must be 50% cash settlement to enhance the running
of the business.
Receivables management
To every organization or business cash flow can be significantly enhanced if the
debts are collected faster. The maximum period of three months is allowed for
receivables and any debtor who fails to abide to the terms is served a notification
later and if it is proven that the debtor is not willing to pay, legal procedures are
applied.

Payables Management
Payables being the main external source of finance to this enterprise have a
maximum period of one month for settlement given by the suppliers. But the
enterprise settles these debts at the end of every month.
Cash Management
Lose of blood in the human system will leads to ineffective functioning of the system
as well as lose of cash in business will lead to ineffective functioning of the business.
It is worth nothing that all cash sales of this enterprise are saved in the bank as well
as cash settlement of receivables. There is a minimum cash level of 200000FCFA
plus an imprest of 100.000FCFA.
The Cash Conversion Cycle (CCC)

By applying the cash conversion cycle, managers can keep track of how effective
their working capital is managed in their operating cycle. The cash conversion cycle
starts from the time the company purchases resources and proceeds until when cash
is received from products sold. By calculating the average time it takes for capital to
travel between the starting and finishing points of the cash conversion cycle, one can
estimate the approximate time it takes to release capital that is tied up in the shortterm assets. If cash is tied up in different activities for too long, the company has a
non-effective cash flow in the cycle and this cost money
In general, most companies benefit from having a short cash conversion cycle since
that will generate more value in the long run. The benefits that a reduced or even

zeroed net working capital can provide are better liquidity, due to an effective
operating cycle and increased earnings due to the faster routines and therefore less
tied up capital. More and more companies are taking into account the significance
of a well managed working capital and the benefits that it brings. This awareness has
increased the trend for a net working capital close to zero (Maness & Zietlow, 2005).
The cash conversion cycle is illustrated below.
Figure 5: The Cash Conversion Cycle (CCC)

Inventory

Accounts

Accounts

Payable

Receivable

Cash

Source: Commercial Loan Advice http://www.loanuniverse.com/cashcycle.gif

B. Weaknesses realized
The following weaknesses have being realized in the ERANG enterprise
- There is no cash budget
- The duration for receivables is too long.
- The economic order quantity of 200litres of the product does not take into
carry cost before establishment.

- The payable days or period the enterprise practice is too short.

- The credit policy is not a good one.
C. Recommendations
- If cash budgets are need, it will give the enterprise a guide on how to manage
cash effectively or the components of working capital.
- based on the receivable days of this enterprise being 79days, it should reduced
the minimum receivable period to about 80days or even less, reason being that
slow payments has a crippling effect on the business especially small businesses
like this A&B enterprise. The manager should remember that if you do not
manage your business, your debtors will manage it for you, which may eventually
lead to incidence of bad debts.
- The credits policy should be restructured with say, not more than 40% credit
be made on the total sales.
- The reorder quantity as well as safety stock should take into consideration
carrying cost and the demand trend. Since main customers buy by placing orders,
the enterprise should produce with respects to orders placed.