Working Capital Management - Booker Group Plc - Case Study Example

WORKING CAPITAL MANAGEMENT: OPERATING CASH CYCLE Student’s Name Institution Table of Contents Executive Summary...……………………………………………………………………………..3 A. Introduction……………………………………………………………………………….4 B. Data Analysis………..……………………………………………………………………5 C. Interpretation of Results/ Analysis………………………………………………………..6 D. Findings & Analysis…...………………………………………………………………….7 Conclusion……………………………………………………………………………………….10 Reference List……………………………………………………………………………………11 Appendices..……………………………………………………………………………………..13 Executive Summary The focus of the paper has been on examining the operating cash cycle of three companies; TOROTRAK- operates under the automobiles and parts sector; Distil Plc-operates under the beverages industry and Booker Group Plc-which operates under the food &drug retailers sector. Booker Group Plc’s operating cash cycle is favourable in comparison to the others, which is an indication that it enjoys a substantial period for which it can invest cash gathered as sales revenues before paying off its bills. This is attributed to the fact that it operates under a sector with a short shelf life hence do not extend credit terms to customers who are expected to pay for products on cash terms. It is also a result of efficient management policies in relation to purchasing and investment decisions. A. Introduction Working capital management is an aspect that remains relevant and paramount in any business operations especially because it has direct effects on their profitability, risk and value as a whole. The notion related to maintaining a high level of inventories help in reducing the overall cost of possible interruptions within the production process, reduction in supply costs and in most of other cases prevents businesses from the risks associated with price fluctuations (Ali & Ali, 2012). However, it can also result to imminent loss of business as a result of limited products. Certainly, it fosters trade credit platforms so that products are sold even in times of demand given that customers are incentivised. In essence, research indicates that businesses that opt to invest intensively in inventories and trade credit are exposed to significant reduction of profitability capacities (Marttonen, Viskari, & Kärri, 2014). Thus, it means that when management opts to invest greatly in current assets; it might results to lower risk as well as its profitability capacity. One of the most fundamental ways for which management can check on their efficiency in relation to capital management is through adoption of an operating cash cycle model. The objective of this paper is to examine the working capital management of three businesses operating in different sectors through computation and interpretation of their respective operating cash cycle. The three companies under analysis include; TOROTRAK- operates under the automobiles and parts sector; Distil Plc-operates under the beverages industry and Booker Group Plc-which operates under the food &drug retailers sector. The aim is to examine, which of these companies operates under a favourable operating cash cycle ratio and rationale behind the exemplary performance. B. Data Analysis Operating cash cycle is calculated as below; Operating Cash Cycle (OCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO) Days Inventory Outstanding (DIO) = 365 days / (Cost of goods sold/ Average inventory) 2015: Torotrak = 365/ (1,792/ (383+205)/2) = 365/ (1792/294) = 365/6.09 = 59 days Booker Group= 365/ (4,753/ (327.6+328.1)/2) = 365/ (4,753/327.85) = 365/14.5 = 25 days Distil Plc= 365/ (260/ (230+64)/2) = 365/ (260/147) = 365/ 1.8 = 202 days Days Sales Outstanding (DSO) = Accounts Receivables/ credit sales*365 Torotrak = 1,016/ 3,779*365 = 98 days Booker Group= 124.5/ 4,753 *365 = 9 days Distil Plc= 211/666*365 days = 115 days Days Payable Outstanding (DPO) = 365/ (cost of goods sold/ average accounts payable)*365 Torotrak= 365/ (1,792/ (5,373+5,433)/2) = 365/ (1792/5403) = 1100 days Booker Group =365/ (4,753/ (586.2+586.0)/2) = 365/ (4,753/586.1) = 45 days Distil Plc= 365/ (260/ (238+314)/2) = 365/ (260/276) = 365*276/260 = 387 days Therefore; OCC; Torotrak =59 days +98 days- 1100 days = -943 days Booker Group= 25 days+9 days- 45 days = -11 days Distil Plc = 202 days+115 days- 387 days = -70 days C. Interpretation of Results/ Analysis From the above computations, it can be noted that all of the three companies under analysis have a negative operating cash cycle. The negative values is an indication that all of these firms enjoy little or no time period that exists whenever it disburses cash to purchase inventories and collecting cash from all accounts receivables within a given period of time. In comparison to the other two companies Booker Group seems to have a lower DIO, which represents a fewer number of days it needs to convert all existing inventories into cash; days sales outstanding, which ascertains on its capacity to collect cash resource for all credit sales as well as; a smaller days payable outstanding that represents its immediate to meet all of its short term obligations specifically, accounts payable on time. In fact, its favourable ratio value as compared to the companies emanates from the fact that it operates under the food and drug retailers industry; a sector that is deemed to be fairly active given that food and drugs have a shorter shelf-life. It can be postulated that the firm’s immediate management has devised effective policies and strategies that are needed for conducting extensive short period sales. This might be through adoption of extensive marketing campaigns as well as pricing strategies that trigger enormous sales. Particularly, it is safe to indicate that since food and drugs sector enjoy a shorter shelf life hence the industry does not provide for possible credit sales as most of the sales are only conducted on a cash basis. D. Findings & Analysis Caballero, Garcia-Teruel & Solano-Martinez (2010,p.511) agrees that the process involving working capital management is significant and paramount to any business because of its immediate effects on a company’s profitability and risk as well as its overall value. A much longer operating cash cycle sets to increase on a company’s overall sales and its immediate profitability given the enormous level of investment made in relation to inventories and trade credit granted within any particular period. It is noted that firms will likely enjoy a significant level of discount in the event that they conduct early payments and also whenever they make efforts to significantly reduce the level of supplier financing. On the contrast, in the event that a company maintains a higher operating cash cycle then there will be an opportunity cost in case they choose to overlook other more productive investments that they can successfully maintain within that level of operations. Soenen (1993, p.55) identifies a list of different indicators that are used for determining the working capital management capacity of a firm especially while using an operating cash cycle model as well as possible expected relationships. The capacity to generate internal sources is one such aspect. It is argued that a company that produces asymmetric form of information postulates a rather high degree of cost for possible external sources of both finances and credit rationing given that it fosters a conflict of interest between the shareholders and the underlying creditors. The issue relating from this conflict of interest might eventually result to underinvestment decisions; which is likely backed by creditors’ priority in the case of possible bankruptcy (Ding, Guariglia, & Knight, 2013). Of particular interest, the existing shareholders have immense incentives to offer new debt funds into the company but this option has the attribute of increasing risk while lowering the value of the underlying debt (Enqvist, Graham, & Nikkinen, 2014). As a result of this, the company’s creditors will thus demand for a higher risk premium. The level of asymmetric information that exists between insiders within the company and the external potential stakeholder will lead to high cost for external sources of finances, which compels firms to allow top priority to resources that are produced on an internal manner over either debt or even equity funds; a clear and concise and assumption laid out by the pecking order theory (Chiou, Cheng, & Wu, 2006). Companies that enjoy an extensive capability to produce internal resources would, in most cases, possess significant level of current assets base due to lower cost of funds that are invested within the working capital. Consequently, leverage also affects working capital management. The cost of funds invested within the operating cash cycle is deemed to be significantly higher in companies with enormous leverage since these firms are expected to pay a rather high risk premium (Filbeck & Krueger, 2005). In essence, it has been demonstrated before that possible reduction in the level of working capital management is perceived whenever companies opt to improve on their existing leverage condition. Growth opportunities can also affect the degree and measure of an effective working capital management especially since it directly impacts on the trade credit granted and received by companies and, also investment made in relation to inventories. Michaelas, Chittenden, and Poutziouris (1999, p.115-118) successfully shows that firms enjoying a probable future sales growth and development has an imminent and positive influence on a given firm’s operating cash cycle, which might prompt companies to develop their underlying inventories in anticipation of future sales growth. It thus goes without saying that inventories levels always enjoy a positive relation with future expected sales revenues. On the contrary, Padachi (2006, p.47-53) note that companies with a higher level of growth options postulate a rather smaller operating cash cycle since they consumer more of trade credit as a paramount source of funds for possible growth since they do not have any other possible platforms for accessing affordable sources of finances. Size is yet another important aspect that affects the efficiency of working capital management. In fact, empirical evidence suggests that there is a positive relationship that exists between the underlying size of a company and its overall operating cash cycle (Wilner, 2000: Scherr & Hulburt, 2001). This is attributed to the fact that the cost of funds that have been adopted in order to invest in current asset base reduces in relation the size of the company; smaller companies with small market capitalisation portray a higher informational capacity and attract little or attention from market analysts. Conclusion To sum up the analysis above, it can be noted that working capital management is important because it affects the profitability, risk and the overall value of a company. Using a operating cash cycle technique on three different firms and each operating under different sections of the industry indicate that Booker Group Plc, which operates under the food and drugs retailer industry within the United Kingdom has a favourable ratio value, which indicates that it does not offer any of its products on credit terms. In fact, it means that the firm’s managerial decision on investing current assets is efficient and effective. The paper has also identified some of the most notable determinants of working capital management that include; size, leverage and the capacity to generate internal resources. An efficient operating cash cycle (OCC) value by Booker Group Plc, as opposed to its immediate counterparts, further ascertains to the fact that while it purchases most of its products on credit; it does not offer credit terms to its customers prompting it to withhold a significant portion of cash resource to invest elsewhere. 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Modelling the impact of working capital management on the profitability in industrial maintenance business. In Engineering Asset Management 2011 (pp. 349-364). Springer London. Michaelas, N., F. Chittenden, and P. Poutziouris, 1999, financial policy and capital structure choice in UK SMEs: evidence from company panel data, Small Business Economics 12, pp.113–130. Padachi, K., 2006, Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms, International Review of Business Research Papers 2, pp.45–58. Soenen, L., 1993, Cash conversion cycle and corporate profitability, Journal of Cash Management 13, pp.53–57. Scherr, F. C., and H. M. Hulburt, 2001, The debt maturity structure of small firms, Financial Management 30, pp.85–111 Wilner, B. S., 2000, The exploitation of relationships in financial distress: the case of trade credit, Journal of Finance 55, pp.153–178. Appendices Torotrak Financials Distil Plc Financials Booker Group Plc Financials Read More