Managing Receivables And Inventories For Effective Working Capital Essay.

Discuss the management of Receivables (Debtors) and Inventories (Stocks) as part of the working capital management requirements of companies In addition, select two non-financial companies listed on the London Stock Market and analyse the published financial statements for the last five years.

Working capital management

The assignment discusses about the management of working capital. It shows about the relationship between current liabilities and current assets. It depicts the stakeholders, that whether the company is able to pay off its current liabilities from current assets. It provides a brief introduction on inventory management and receivable management. Inventory management helps the management in maintaining the required level of inventory so that current and latent demands of the customer can be fulfilled. While the receivable management ensures the company that all the receivables are good, and the payment would be made at the right time. The assignment discusses about the importance of requirement of inventory management and receivable management. The assignment has taken two companies which are listed on London stock exchange those are: acacia mining plc and abbey plc for better understanding of receivables and inventory (London stock exchange, 2016).

The management of working capital defines the relationship between short term liabilities and short term assets of the company. The main aim of the company behind managing working capital is to make sure the stakeholders that the short term assets are sufficient to pay off the short term liabilities and operating expenses. The working capital management involves management of inventories, account payable, account receivable, cash. Effective management of working capital can be done by making cash flow statement from operating activities, or doing ratio analysis such as collection ratio, working capital ratio and inventory turnover ratio. Effective working capital management ensures the company about profitability, earning and smooth functioning of operations (Abiodum & Samuel, 2014).  

According to Ross, Jaffe, Jordan, and Westerfield in 2008, account receivables are the amount which has not been collected from the customer for the goods and services which has been offered to them. It is considered as one of the key transactions in financial statements. It is an account which depicts about the payment that needs to be paid by the customers of the company. The proof of account receivable is invoice, in which the amount that need to be paid by the customer and time as when it should be paid by the customer. This is also known as credit and payment terms. Management of account receivables or debtors would lead to maintain and process the debtor records efficiently, maintaining security and accuracy in account receivable (Siddaiah, 2010).

For effective working capital management by managing receivables, the company must prefer credit scoring model. This is used to know about whether the company should extend the period of credit or not. It is preferred that, company should analyze the credit behavior of the customer or debtor, for this his previous records need to be analyzed. The company should calculate average collection period for receivables to get an overview of time in which payment is made by its debtors.

Management of receivables

According to Fabozzi and Peterson in 2003, when a company allows the facility to customer to pay the money in return of goods and services on a later date, is known as trade credit. This facility is also known as credit management. The main objective behind receivables management is to increase the sales, which would also lead to increase in profits. Though credit sales increases in the profits but at the same time, it also lead to increase in the management of receivables. If the receivables are not managed properly, then it can lead to bad debts. Hence for effective management of receivables, management need to form some credit policies, collection policies, plan to identify the measures of deviations in payment (Salek, (2005). The management needs to balance between risk, liquidity and profitability.  Account receivables can be calculated as:

Credit sales

Average debtors + average bills receivables

The more account receivable would be, the more time would be to receive the payment from debtors. Hence the company need to make policies in such a way that the average account receivable comes out to be minimum. Here in the above formula average debtors and bills receivables are calculated as: (opening debtors and bills receivables+ closing debtors and bills receivables)/2.

The management also needs to find out the average collection period of receivables or debtors. This can be calculated out as:

365 days

Account receivables

Inventory includes work in progress (WIP), raw material and finished goods. Management of inventory needs to be done by the management, in order to avoid the situation of overstock and out of stock. If management holds a large amount of inventory it would lays a heavy burden on the business cash availability. Besides this if inventory is not managed in an effective manner, it can lead to insufficient stock, delay in customer payment, reduction in sales. Inventory management can be established by the management by doing asset tracking, order management, product identification, number of times order need to be made.  The main objective of inventory management is to make a balance between ordering and carrying cost. Effective inventory management would lead to: form a balance between overstock and going out of stock, tracking inventory between different locations, warehousing the inventory and tracking the products which are at the stage of finishing but not sold yet (Bose, 2006).

In capital management, inventory management plays a considerable role. Inventory management helps the organization in maintain the required level of inventory. Here required level of inventory is that quantity which is sufficient to meet the current and latent demands of market. Inventory is managed for three motives: transactionery motive, precautionary motive, speculative motive. Transactionery motive is when inventory is maintained to meet the cycle of production and sales. Precautionary motive is when, the company maintains a reserved stock so to avoid the situation of stock out and losses arising out of this. Whereas, speculative motive is when, the company maintains its stock so to enjoy the pricing advantages due to inventory (Sagner, 2010). Inventory can be managed by following techniques like economic order quantity, just in time and planning of MRP (manufacturing or materials resource planning). Economic order quantity (EOQ) tells the level of quantity at which the cost of holding inventory and carrying cost would be at minimum. It also tells about the number of orders that needs to be made by the company. Just in time (JIT) approach was introduced by Japanese concept. According to this approach holding of inventory should be avoided. By this, there is a minimal amount of inventory cost that will make the prices attractive for the customer. This approach assumes that there is no time in ordering the goods and taking delivery of the goods. However this approach is not realistic because, it takes time in ordering the good and getting the delivery of goods. MRP (Manufacturing or material resource planning) establishes the coordination between planning of production and managing the inventory (Wild, 2007).  

Requirement of managing receivables in working capital management

For effective management of inventory management, the management of the organization needs to calculate the inventory turnover ratio and the number of days of inventory. Inventory ratio can be calculated as:

Cost of goods sold or net sales

Average inventory

Inventory ratio tells about the relationship of cost of goods sold and average inventory. By this an enterprise get to know the level of sales that comprises of inventory. It measures the time of inventory sold during the period. Here in the above formula average inventory is calculated as: (opening inventory+ closing inventory)/2.

Inventory conversion period can be calculated as:

Days in a year

Inventory turnover ratio

The interpretations of this ratio is that, the more the ratio would be, the more time would be taken by the company to generate cash from its inventory. Higher the ratio of inventory conversion period, more the liquidity risk for the company (Muller, 2011).

It has been assumed that the sales mentioned in the table of both the company are credit sales. The days in a year are assumed as 365 days. The debtor amount is including debtors and bills receivables. These assumptions are taken for effective calculations and lack of information provided in the company financial statements.

The above analysis is done on two companies which are Acacia mining plc and Abbey plc. Acacia mining plc is also known as African Barrick gold plc. It is a mining business of gold, which is operated in Tanzania. The company is headquartered in London, United Kingdom. The company was founded in 2000. Abbey development limited is a house building company which develops homes for the United Kingdom customers. The company is headquartered in United Kingdom. The company was founded in 1939 (ACACIA, 2017).

By analyzing both the company’s financial statements, it can be said that Acacia mining plc has better inventory turnover ratio as comparison to Abbey national building plc. This is so, because Acacia mining plc has more sales as in comparison to Abbey national building plc (Bloomberg, 2017). In case of inventory conversion period, Acacia has lesser period as in comparison to Abbey plc (Annual report & accounts, 2011). This means, that Acacia plc is more able to generate cash from its inventory as compare to Abbey national building plc. The more inventory conversion period is, the more time would be taken to convert cash from inventory (Acacia, 2013). In case of debtor conversion period Acacia plc has lesser ratio as in comparison to Abbey building financial plc. This means Acacia is more able to generate cash from its debtors than in comparison to Abbey national building plc (Acacia, 2014). Inventory and receivables lays a considerable share in working capital. Hence these need to be manage effectively so to manage the liquidity in the business (Abbey, 2015). This can be understood as, if a company has more conversion ratio, the more time would be taken by it to generate cash from it (Abbey, 2010). The more time would lead to more risk for the company (Abbey, 2011). Here risk in working capital management can be understood as if the inventory conversion period is more, there is increase in risk of getting material returned or obsolete (Abbey, 2012). While in case of increased debtor conversion period, there is an increase in risk of nonpayment by debtors, or insolvency of debtor, or any other related uncertainty (Abbey, 2013). To manage this effectively company required to make some effective policies related to working capital management.  Hence to run the regular business operations company might require holding more amounts of cash and cash equivalents. While to better manage the inventory conversion, the management should from procedures in such a manner that it answers when to make orders for inventory, what should be the quality, price, and discount?  

Management of inventories

By analyzing to the analysis over inventory conversion period and debtor conversion period, it is said, that though company has good command over inventory turnover ratio and debtor turnover ratio, but it takes a long time to recover it from customers. While by comparing both the company data, it is recommended that Acacia mining plc has good debtor conversion period, but has high inventory conversion period. This creates a burden on working capital. While in case of Abbey plc, it has comparatively higher debtor conversion ratio as well as inventory turnover ratio. Hence company should make effective credit policies and inventory management strategy to maintain the liquidity in business (Abbey, 2014).

Conclusion

By studying the assignment, it can be said that working capital management has three dimensions: the first dimension is that, it affects profitability, liquidity and risk of the company. The second dimension is composition, level of current assets and level of current liabilities. For effective capital management, the management needs to calculate operating cycle period by calculating inventory turnover ratio, inventory conversion ratio, average receivables ratio, debtor conversion ratio. However these are not fixed, as there are other measures too which affect the inventory and receivables management such as size of the company, nature of competition, and many more. Hence working capital management does not only depends upon level of inventory, debtor, rather there are many other factors affecting working capital management. Hence in case of these two companies, it is said that Acacia plc has better working capital management, and it is better able to generate cash from its inventory and debtors. At last it can be concluded that Abbey building national plc would be requiring holding more cash and cash equivalents to manage the regular operations of the company.

References

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