Chapter 22

The management of working capital and sources of finance

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Introduction

Sources of finance are vital to a business. They allow it to survive and grow. Sources of finance may be raised internally and externally. The efficient use of working capital is an important internal, short-term source of funds, while retained profits can be an important internal, long-term source. External funds may also be short-term or long-term. Bank loans and debt factoring are examples of external short-term finance. External long-term sources allow businesses to carry out their long-term strategic aims. Share capital and loan capital are examples of long-term finance. Every business aims to optimise its use of funds. This involves minimising short-term borrowings and financing long-term infrastructure investments as cheaply as possible.

Nature of Sources of Finance

Sources of finance may be generated internally or raised externally. These sources of finance may be short-term or long-term. If short-term, they will typically be associated with operational activities involving the financing of working capital (such as inventory, trade receivables or cash). If long-term, they will typically be associated with funding longer-term infrastructure assets, such as the purchase of land and buildings.

Normally, it is considered a mistake to borrow short and use long (e.g., use bank overdrafts for long-term purposes). For instance, if a bank overdraft was used to finance a new building, then the company would be in trouble if the bank suddenly withdrew the overdraft facility. As Figure 22.1 shows, internal sources of finance may be generated over the short term through the efficient management of working capital, or over the long term by reinvesting retained profits.

External sources of capital may be raised in the short term by cash overdrafts, bank loans, invoice discounting, debt factoring or sale and leaseback. Over the longer term the three most important external sources of finance are leasing, share capital and long-term borrowing. Although ‘short-term’ is defined as less than two years, this is, in fact, very arbitrary. For example, some leases may be for less than two years while bank overdrafts and bank loans will sometimes be for more than two years. However, this division provides a useful and convenient simplification.

Short-Term Financing

Short-term financing is often called the management of working capital (current assets less current liabilities). One of the main aims is to reduce the amount of short-term finance that companies need to borrow for their day-to-day operations. The more money that is tied up in current assets, the more capital is needed to finance those current assets. Essentially, as well as using its working capital as efficiently as possible, a company may use short-term borrowings to finance its inventory, trade receivables or cash needs.

Figure 22.2 provides an overview of a company's short-term sources of finance. This includes internal management techniques for the efficient management of working capital (for example, debtor collection model and economic order quantity) and the main external sources of funds.

Internal Financing

Companies will try to minimise their levels of working capital so as to avoid short-term borrowings. In this section, we look at the main elements of efficient working capital management and three important techniques used to control working capital levels. In Chapter 5, we looked at the working capital cycle.

(a) Cash

As we saw in Chapter 8, cash is the lifeblood of a business. Companies need cash to survive. As Soundbite 22.1 shows, good cash control is crucial especially in hard economic times.

Businesses will try to keep enough cash to manage their day-to-day business operations (e.g., purchase inventory and pay trade payables), but not to maintain excessive amounts of cash. Businesses prepare cash budgets (see Chapter 17), which enable them to forecast the levels of cash that they will need to finance their operations. They may also use the liquidity and quick ratio to assess their level of cash (see Chapter 9). If despite careful cash management the business's short-term cash requirements are insufficient then the business will have to borrow. Companies can, as Real-World View 22.1 shows, introduce a range of effective cash control processes such as very tight credit control, reviewing unnecessary investments and using forecasts.

(b) Trade Receivables

Trade receivables management is a key activity within a firm. It is often called credit control. Trade receivables result from the sale of goods on credit. There is, therefore, the need to monitor carefully the receipts from trade receivables to see that they are in full and on time.

There will often be a separate department of a business concerned with credit control. The credit control department will, for example, establish credit limits for new customers, monitor the age of debts and chase up bad debts. In particular, they may draw up a trade receivables age schedule. This will profile the age of the debts and allow old debts to be quickly identified.

Trade Receivables Collection Model

A useful technique designed to maintain the most efficient level of trade receivables for a company is the trade receivables collection model. A trade receivables collection model balances the extra revenue generated by increased revenue with the increased costs associated with extra revenue (i.e., credit control costs, bad debts and the delay in receiving money). The model assumes that the more credit granted the greater the revenue. However, this extra revenue is offset by increased bad debts as the business sells to less trustworthy customers. Whether the delay in receipts means that the business receives less interest or pays out more interest depends on whether or not the bank account is overdrawn. Usually, the cost of capital (i.e., effectively, the company's borrowing rate: see later in this chapter) is used to calculate the financial costs of the delayed receipts. Figure 22.3 illustrates the trade receivables collection model.

(c) Inventory

For many businesses, especially for manufacturing businesses, inventory is often an extremely important asset. Inventory is needed to create a buffer against excess demand, to protect against rising prices or against a potential shortage of raw materials and to balance revenue and production.

Inventory control is concerned not primarily with valuing inventory (see Chapter 16), but with protecting the inventory physically and ensuring that the optimal level is held. Inventory may be stolen or may deteriorate. For many businesses such as supermarkets the battle against theft and deterioration is never-ending. A week-old lettuce in a supermarket is not a pleasant asset!! For supermarkets, inventory can also be a competitive advantage (see Real-World View 22.2). Woolworth, a UK company, went on to build a nationwide chain of shops and proved very successful for over a century until its demise in the credit crunch in 2010.

Three common techniques associated with efficient inventory control are materials requirement planning and/or the economic order quantity model and just-in-time inventory management.

(i) Materials Requirement Planning (MRP) and Economic Order Quantity (EOQ). Material requirements planning (see Definition 22.1) is a sophisticated approach designed to coordinate the production process, particularly the purchase of raw materials. It was devised in the 1960s as a computerised program designed to coordinate the acquisition of materials. This program has subsequently been updated to include other areas of corporate activity such as finance, logistics, engineering and marketing (MRPII) (see Definition 22.1). MRP can be used in conjunction with EOQ which is a way of determining the optimal size of inventory that is required by a company.

The EOQ model seeks to determine the optimal order quantity needed to minimise the costs of ordering and holding inventory. These costs are the costs of placing the order and the carrying costs. Carrying costs are those costs incurred in keeping an item in inventory, such as insurance, obsolescence, interest on borrowed money or clerical/security costs. The costs of ordering inventory are mainly the clerical costs. The EOQ can be determined either graphically or algebraically. Figure 22.4 on the next page demonstrates both methods. A key assumption underpinning the EOQ model is that the inventory is used in production at a steady rate. A much simpler but effective method of stock control is called the ‘two bins system’. In essence, once one bin is used up then an order is placed to replenish this bin, while the other bin is used up.

(ii) Just-in-Time. Just-in-time was developed in Japan, where it has proved an effective method of inventory control. As Definition 22.2 shows, there are various types of just-in-time (i.e., production and purchasing).

Just-in-time seeks to minimise inventory holding costs by the careful timing of deliveries and efficient organisation of production schedules. At its best, just-in-time works by delivering inventory just before it is used. The amount of inventory is thus kept to a minimum and inventory holding costs are also minimised. In order to do this, there is a need for a very streamlined and efficient production and delivery service. The concept behind just-in-time has been borrowed by many UK and US firms. Taken to its logical extreme, just-in-time means that no inventory of raw materials is needed at all. One potential problem with just-in-time is that if inventory levels are kept at a minimum there is no inventory buffer to deal with unexpected emergencies. For example, in the fuel blockade of Autumn 2000 in the UK, many supermarkets ran out of food because they had kept low levels of inventory in their stores.

External Financing

(a) Cash

If a company is not generating enough cash from trading it may need to borrow. The most common method of borrowing is via a bank overdraft or a bank loan. Bank overdrafts are very flexible. Most major banks will set up an overdraft facility for a business as long as they are sure the business is viable. A bank overdraft is a good way to tackle the fluctuating cash flows experienced by many businesses.

An alternative to a bank overdraft is a bank loan. The exact terms of individual bank loans will vary. However, essentially a loan is for a set period of years and this may well be more than two years. The rate of interest on a loan will normally be lower than on a bank overdraft. Loans may be secured on business assets, for example specific assets, such as inventory or motor vehicles.

(b) Trade Receivables

Since trade receivables are an asset, it is possible to raise money against them. This is done by debt factoring or invoice discounting.

(i) Debt factoring. Debt factoring is, in effect, the subcontracting of trade receivables. Many department stores, for example, find it convenient to subcontract their credit sales to debt factoring companies. The advantage to the business is twofold. First, it does not have to employ staff to chase up the trade receivables. Second, it receives an advance of money from the factoring organisation. There are, however, potential problems with factoring. The debt factoring company is not a charity and will charge a fee, for example 4% of revenue, for its services. In addition, the debt factoring company will charge interest on any cash advances to the company. Finally, the company will lose the management of its customer database to an external party. As Soundbite 22.2 shows, debt factoring has traditionally been viewed with some suspicion.

(ii) Invoice discounting. Invoice discounting, in effect, is a loan secured on trade receivables. The financial institution will grant an advance (for example, 75%) on outstanding sales invoices (i.e., trade receivables). Invoice discounting can be a one-off, or a continuing, arrangement. An important advantage of invoice discounting over debt factoring is that the credit control function is not contracted out. The company, therefore, keeps control over its records of trade receivables. Figure 22.5 compares debt factoring with invoice discounting.

The aim of trade receivables management is simply to collect money from trade receivables as soon as possible.

For an optimal cash balance, with no considerations of fairness, a business will benefit if it can accelerate its receipts and delay its payments. Receipts from customers and payments to suppliers are measured using the trade receivables/trade payables collection period ratio (see Chapter 9).

(c) Inventory

As with trade receivables, it is sometimes possible to borrow against inventory. However, the time period is longer. Inventory needs to be sold, then the trade receivables need to pay. Inventory is not, therefore, such an attractive basis for lending for the financial institutions. However, in certain circumstances, financial institutions may be prepared to buy the inventory now and then sell it back to the company at a later date.

Long-Term Financing

There are potentially four main sources of long-term finance: retained profits; leasing; share capital and loan capital (see Figures 22.6 and 22.7).

For long-term finance, there is a need to raise money as cheaply and effectively as possible. Long-term finance is usually used to fund long-term infrastructure projects and can often be daunting, given the huge sums involved.

Internal Sources

Retained Profits

Retained profits (or revenue reserves) represent an alternative to external financing. In effect, the business is financing itself from its past successes. Instead of distributing its profits as dividends, the company invests them for the future. Shareholders thus lose out today, but hope to gain tomorrow. As the company grows using its retained profits, it will in the future make more profits, distribute more dividends and then have a higher share price. In theory, that is!

In many businesses, retained profits represent the main source of long-term finance. It is important to realise that retained profits, themselves, are not directly equivalent to cash. They represent, in effect, retained assets which may, but importantly may not, be cash. However, indirectly they represent the cash dividends that the company could have paid out to shareholders. Retained profits are particularly useful in times when interest rates are high.

External Sources

(a) Leasing

In principle, the leasing of a company's assets is no different to an individual hiring a car or a television for personal usage. The property, initially at least, remains the property of the lessor. The lessee pays for the lease over a period of time. Depending on the nature of the property, the asset may eventually become the property of the lessee or remain, forever, the property of the lessor.

The main advantage of leasing is that the company leasing the asset does not immediately need to find the capital investment. The company can use the asset without buying it. This is particularly useful where the leased asset will directly generate revenue which is then used to pay the leasing company. Many of the tax benefits of leasing assets have now been curtailed. However, leasing remains an attractive way of financing assets such as cars, buses, trains or planes. Normally, leasing is tied to specific assets.

In the end, the company leasing the assets will pay more for them than buying them outright. The additional payments are how the leasing companies make their money. Leases are usually used for medium or long-term asset financing. Hire purchase or credit sales, which share many of the general principles of leases, are sometimes used for medium to short-term financing.

Strictly, leasing is a source of assets rather than a source of finance. It does not result in an inflow of money. However, it is treated as a source of finance because if the asset had been bought outright, not leased, the business would have needed to fund the original purchase. Long-term leasing can be considered equivalent to debt. The asset is purchased by the lessor, but used and paid for by the lessee, including an interest payment. Long-term leases must be disclosed on the statement of financial position. There is a recent trend where businesses that own property portfolios sell them for cash. They then lease back the original properties. For example, in 1999 Marks and Spencer was in talks to sell and lease back its prime sites such as at Oxford Circus (Morrison, Sunday Telegraph, 21 March 1999).

(b) Share Capital

Apart from reserves, there are two main types of corporate long-term capital: share capital and loan capital. Share capital is divided into ordinary shares and preference shares. Both sets of shareholders are paid dividends. However, while ordinary shareholders are owners, preference shareholders are not (Chapter 9 provides a fuller discussion of these issues).

When a company wishes to raise substantial sums of new money, the normal choice is either raising share capital or loan capital. Freeserve, the Internet service provider, for example, chose a stock market flotation raising an anticipated £1.9 billion from shares.

There are three main methods by which a company may raise share capital: rights issue, public issue and placing. The main features of these alternatives are listed in Figure 22.8.

A rights issue is therefore an issue to existing shareholders. In June 2001, for example, British Telecom asked its existing shareholders for £5.9 billion extra cash. Rights issues are a continual fact of corporate life. They are regularly reported in the financial press. For example in 2011, Lamprell, a UK company, sought to acquire Maritime Industrial Services for £208 million, £139 million being from a rights issue. The Investors Chronicle recommended that investors should take up this rights issue.

By contrast, public issues and placings involve new shareholders. The public issue is distinguished from the placing chiefly by the fact that the shares are ‘open’ to public purchase rather than being privately allocated. In all three types of share issue, the company receives the amount that the shareholders pay for the shares. This money can then be used to finance expansion or on any other corporate activity. Stock market issues can make entrepreneurs potentially very rich. Real-World View 22.3 looks at the placing by Arbuthnot Banking Group of a quarter of its shares in the Alternative Investment Market of the UK Stock Exchange. This flotation is aimed at raising money to strengthen its retail subsidiary, the Secure Trust's loan book and also for possible future acquisitions.

(c) Loan Capital

Loan capital is long-term borrowing. The holders of the loans are paid loan interest. Long-term loans are often known as debentures. Loan capital can chiefly be distinguished from ordinary share capital by five features. First, loan interest is a deduction from profits not, like dividends, a distribution of profits. Second, loan capital, unlike ordinary share capital, is commonly repaid. Third, unlike ordinary shareholders, the holders of loan capital do not own the company. Fourth, interest on loans may be allowable for tax purposes. And, finally, most loans will be secured either on the general assets of the company or on specific assets, such as land and buildings. In other words, if the company fails, the loan holders have first call on the company's assets. For example, in Real-World View 22.4, the debenture holders of Enterprise Inns are in the position whereby they are holding over 500 pubs as security. They will be able to sell the assets of the company to recover their loans.

Sometimes convertible loans are issued which may be converted into ordinary shares at a specified future date.

Loans and debt have always attracted humorists, as Real-World Views 22.5 and 22.6 show.

As we saw in Chapter 9, the relationship between ordinary share capital and a company's fixed interest funds (long-term loans and preference shares) is known as gearing. Gearing is particularly important when assessing the viability of a company's capital structure.

Cost of Capital

From the details of a company's different sources of finance, it is possible to determine its cost of capital (see Definition 22.3). In essence, the cost of capital is simply the cost at which a business raises funds. Companies aim to arrive at an optimal cost of capital. Cost of capital is often used as a discount rate in investment appraisal decisions. The two main sources of funds are debt (from long-term loans) and equity (from share capital). Normally, debt finance will be cheaper than equity. Each source of finance will have an associated cost of capital. However, it is important to calculate the business's overall cost of capital (known as the weighted average cost of capital or WACC).

WACC is the cost of capital normally used as the discount rate in capital investment appraisal (see Chapter 21). However, it should be borne in mind that individual projects will often be financed using different sources of finance which will not necessarily be the company's WACC. WACC is perhaps best seen as the company's targeted sustainable cost of capital.

The same principles can be adopted for personal finance and for business. The proportion of the debt is multiplied by the effective cost of capital for each source. The cost of capital for debt finance is normally taken after taking into account the effect of interest. We take the examples of Deborah Ebt, a student, in Figure 22.9 and Costco plc in Figure 22.10.

As Soundbite 22.3 below shows, cost of capital is an important business concept.

Figure 22.9 thus shows that overall the weighted average cost of capital is 13% for D. Ebt. The most expensive source of finance was the credit card and the cheapest was the personal loan.

Figure 22.10 thus indicates that overall the weighted average cost of capital is 7.3%. The equity capital constitutes most of this (i.e. 5.3%).

The cost of capital is a potentially complex and difficult subject. However, the basic idea is simple: the company is trying to find the optimal mix of debt and equity which will enable it to fund its business at the lowest possible cost. Investors show great interest in a company's cost of capital (see Real-World View 22.7).

Conclusion

Sources of finance are essential to a business if it is going to grow and survive. We can distinguish between short-term and long-term sources of finance. Short-term financing concerns the management of working capital: cash, trade receivables and inventory. This may involve the more efficient use of working capital using various techniques such as the trade receivables collection model and the economic order quantity model. Alternatively, it may involve raising loans from the bank by an overdraft, or loans secured on trade receivables by debt factoring, or by the sale and leaseback of inventory. Long-term sources of capital are used to fund the long-term activities of a business. The four main sources are an internal source (retained profits) and three external sources (leasing, share capital and loan capital). Retained profits are not borrowings but, in effect, represent undistributed profits ploughed back into the business. Leasing involves a company using an asset, but not owning it. Shareholders own the company and are paid dividends. Loan capital providers do not own the company and are paid loan interest. A key function of managing long-term finance is to minimise a company's cost of capital which is the effective rate at which a company can raise funds.

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