Managing Receivables, Inventories, And Working Capital Is Crucial For Financial Stability.

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. Any analysis must compare the proportion of Receivables (Debtors) and Inventories (Stocks) for each company; and comparisons between the two selected companies, using financial ratios. (See the marking scheme below).

Detailed calculations of specific and relevant financial values and ratios must be included, together with appropriate graphs/charts.

Your assessment must contain an Introduction, Conclusion and Recommendation detailing the results of your analysis.

Working Capital Cycle

Working capital can be defined as the measurement aspect related to the efficiency and liquidity of any business. It can also be stated as the capital, used for operate the daily business activities. In general, the excess amount of current assets over the current liabilities of any business firm is regarded as the working capital.

The managerial activities, which efficiently maintain the working capital for general business operations and meeting the short-term financial obligations, are considered as the working capital management. The working capital management follows the goal to continue the capability for covering the current liabilities and other expected operational costs. The managerial activity mainly manages the inventories, trade receivables and cash for ensuring the smooth business operations (Corelli 2016).

The working capital management helps to maintain the liquidity position of the business at satisfactory level. Amongst all the current assets, cash and cash equivalent items are the most liquid assets. Hence, working capital management must ensure that the cash flows of the business should not be interrupted. However, as per the working capital flow, the cash asset is generated through conversion of other current assets. Therefore, working capital management involves other important current assets also, which are directly related to the cash conversion cycle. Amongst the various current assets, inventory and accounts receivable are given maximum importance for this purpose.

The report is prepared to describe the importance of accounts receivable and inventory from the perspective of working capital management. It states the relationship between the two assets and the operational objectives and the necessity of managing these assets efficiently for achieving the desired business goals. Tesco and Sainsburys, the two popular retail companies of United Kingdom, have been selected for providing practical demonstration of the concept.

The working capital cycle is the circular business process, which describes how the businesses use to rotate its cash fund in various business activities. It also exhibits the process, through which the business converts its various current assets into cash funds. Different forms of business convert its working capital in different formats. The working capital cycle of the manufacturing business is stated below:

The diagram states that cash funds are utilized to purchase raw material inventories, which are in turn converted into finished goods inventory through production process. The finished goods are sold in credits, which creates accounts receivable and the business recollects the cash fund, invested initially, by collecting the credit amounts from debtors. Thus, the working capital cycle complete. In this cycle, the inventory and accounts receivable are inter mediate assets between the initial cash outflow and final cash inflow (Baños-Caballero et al. 2014).

It has been observed that the business firms, which maintain shorter working capital cycle, can earn higher profit. Therefore, every business organization intends to shorten the working capital rotation period and the best possible method to shorten the period is to reduce the conversion time of inventory to accounts receivable and accounts receivable to cash (Enqvist et al. 2014).

In general, inventory is the business assets, which are acquired by the business firms for converting into saleable finished products or to resale directly. There are three types of inventories, stored by the businesses:

• Raw Material: Raw materials are the goods, which is used in manufacturing finished products with the support of other production factors, such as, labor, capital etc. The manufacturing firms convert the raw materials into completely new product, whereas, in trading firms, the raw material is not altered fully except the packaging and branding.
• Work-in-Progress: Work-in-progress or, in other words, work-in-process, is the stocks goods, which are partly completed. Work-in-progress is the sum of costs, incurred for raw materials, labors and other overheads, at various level of production.
• Finished Goods: When the raw materials or the work-in-progress stocks are converted into saleable end-product completely, but is not sold yet, then such saleable stocks are referred as finished goods (Bhattacharya 2014).

Importance of Inventory

Most of manufacturing firms incur highest amount of expenses production processes and the trading firms use to spend maximum amount of its operating expenses for purchasing raw materials. It implies that the firms invest significant amount of cash funds into raw material purchase and production process. The working capital, in form of invested cash funds, is recovered with returns only when the finished products, produced by converting the raw materials through various production processes, are sold into the market. Therefore, it is very necessary to manage the inventory flow at various operational levels efficiently. Otherwise, the working capital cannot be circulated properly and provide the desired returns timely (Kieschnick et al. 2013).

The business firms should implement the following techniques for maintaining proper control over inventories:

• Accounting Records:- It is very essential to record the inflows and outflows of inventories accurately in the books of accounts. Such up-to-date accounting records can help the management to get information about the inventory status at any time and take inventory related decisions in a better way.
• Physical Counting:Apart from accounting records, the firms should conduct physical counting of inventories at regular intervals. It not only reduces the chances of any disparity between the record books and the actual inventory level, but also helps in eliminating the risk of theft or other losses, caused by the negligence of warehouse staffs, such as, breakage, wastage etc.
• Maintaining proper Inventory Level:As discussed above, the firms should always maintain a optimum level of inventory. The optimum level of inventories can be determined through various processes, such as, Economic Order Quantity. It helps in reducing the working capital investment in inventory and the inventory holding costs, but does not hamper the production due to shortage of raw materials.
• Maintaining the Quality: Quality level of the purchased inventories should be up to the mark. Inventories with poor quality not only affect the quality of the finished goods, but it also increases the amount of abnormal losses, such as, shrinkage, wastage, leakage etc.

Accounts receivable is the amount of money, due from the customers for selling of products or providing services. It is generated from the selling and marketing activities. The finished inventories are converted into accounts receivables through selling processes. It is the final stage of working capital cycle before realizing the invested cash funds. However, in many cases, the amount of accounts receivables may convert into bills receivable before the recovering of cash funds (Naser et al. 2013).

Accounts receivable is created due to credit sales. Hence, the firms, which mostly sell its products or services in cash, use to have lower amount of accounts receivable. However, most of large firms use to trade in credits. Hence, in such firms, accounts receivable accounts cover a significant proportion of the total current assets (Agha 2014).

• The business firms cannot invest in the next working capital cycle properly until it recover the invested cash fund from the earlier cycle. Therefore, if any firm would delay in collecting cash from debtors, then it would not be able to process the next operating cycle for shortage of funds.
• Thus, longer interval between two working capital cycles would lead the firms in lesser numbers of cycles in a particular period. It would result in lower amount of profit.
• If the accounts receivables are not managed efficiently, then it might cause bad debts, where, the firms fail to realize cash from the credit sales. For such bad debts, the firms suffer from loss of invested working capital (Michalski 2014).

The following accounts receivable management techniques can help the business firms to rotate the working capital efficiently:

• Customer Data Analysis: The customer data should be analyzed properly before providing them any credit facility. The credit facilities should be limited or restricted for the customers with bad payment reputation. Thus, it can reduce the possibility of late payment or bad debts.
• Maintaining A/R Ageing Report: The firms must maintain accounts receivable ageing report, which determines the amount of unpaid invoices and the expected time of cash collection for each invoice. It also shows which customers have crossed the credit limit. Thus, the collection department can easily track and give continuous remniders the customers, who have failed to pay the dues within the credit periods.
• Discount for Early Payments: The firms may offer cash discounts to the customers for early payments. It may encourage the customers to pay the dues before the due dates.
• Proper Follow-Up by Collection Team: The collection team should start to follow-up with the customers some days prior to the payment date on regular basis. It helps to create pressure on the customer for paying the dues on time.
• Encouraging Collection Team: To increase the efficiency of the collection department, the management may provide additional incentives or other reward systems to the collection team for early collections. It can motivate the collection staffs to collect the dues before the credit periods.

As discussed above, Tesco and Sainsburys are selected for demonstrating the impacts of proper control over inventory and accounts receivables. Tesco Pls. is the UK based grocery  and general merchandise retailer, which has been ranked third amongst the largest retailer of the world in terms of profit. Sainsburys is another well known retailer of United Kingdom, which operates the second largest chain of supermarkets in all over UK. As per the nature of operations, both the companies can be classified under trading businesses.

The efficiency of the management in controlling the accounts receivables and inventories can be evaluated through various efficiency ratios. The most effective ratios for this purpose are calculated in the following tables on the basis of the information, provided in the financial statements of both the companies over five years:

The inventory turnover ratio explains the period, taken by the business firms to convert the inventories into finished goods. As discussed above, the business firms, which maintains lower inventory period, can circulate its working capital faster and earn higher profits (Höglund et al. 2016). The inventory turnover ratios of Tesco and Saisnburys over the five years period are shown in the following graph:

The graph denotes that Sainsburys has maintained lower inventory turnover ratio steadily over the period. On the other hand, the turnover ratios of Tesco were very higher in the first three years. However, it has lower down the ratios in the last two years.

Inventory Management System

Accounts receivable turnover ratio indicates the average time, taken by the firms, to collect cash from its debtors. Thus, the firms can realize how efficiently its cash management teams have been converting its accounts receivables into cash inflows (Bhimani et al. 2013). The following graph is presented to show the accounts receivable turnover ratios of both the companies:

The accounts receivable turnover ratios of Sainsburys have been very low over the periods. On the other hand, Tesco has lower the ratios significantly in the last two years comparing to the higher ratios in the first three years.

Along with the efficiency ratios, it is important to measure the liquidity position and financial strength of the business firm. Hence, various liquidity ratios and gearing ratios of both the companies are computed below:

The acid-test ratio explains the capability of any firm to cover its current liabilities through its highly liquid assets. The graph, given below, exhibits the outcomes of the acid-test ratio, computed above:

The graph denotes that Sainsburys can cover almost 50% of its current liabilities through its highly liquid assets and has maintained the capacity over the period. However, the liquidity position of Tesco had significantly increased in the first three years, but has fallen down drastically in the last two years. It indicates that the company used to hold more highly liquid assets comparing to its current liabilities initially, but, it has reduced the liquid assets in the recent years.

Working capital ratio denotes that proportion of working capital, invested in the business. The following graph compares the working capital ratios of the two companies for the last five years:

The working capital ratio of Sainsburys has remained almost fixed over the period at the level of 0.60. Tesco had increased its working capital in the first three years, but the proportion has reduced in the recent two years.

The gearing ratio is computed to derive the financial strength of the business for covering its all liabilities through its equity capital. The graph, presented below, compares the financial strength of the two companies:

The gearing ratios of Sainsburys has remained above 1 in all the five years and in the recent years, it has increased the ratios above 1.50. It explains that the company has maintained the ability to cover all its liabilities through its equity capital and in the last few years, it has increased its financial strength further. In the first three years, the gearing ratios of Tesco were very poor, but in the last two years, the ratios have increased at the level above 4. It implies that in the initial period, the company did not have the adequate financial strength to cover its liabilities. However, in the last two years, it has improved the strength significantly and has been able to cover the liabilities comfortably.

The net profit margins of Tesco and Sainsburys over the last five years are shown in the following graph:

From the graph, it may be stated that the Tesco has suffered from fall in net profit margins in the first four years. However, in the last year, it has been able to increase it slightly. On the other hand, Sainsburys have maintained s steady net profit margin over the period, except 2015.

Importance of Accounts Receivable

Conclusion

The above discussions and the financial performances of Tesco and Sainsburys implies that it is very necessary to manage the inventory and accounts receivables efficiently. Otherwise, it would affect the profit generating capability negatively.

The ratio analysis exhibits that Tesco had failed to convert its inventory and accounts receivable timely in the initial periods and could not rotate its working capital efficiently to generate higher profits. The higher acid-test ratio and working capital ratio in the first three years implies that though it had invested higher amount of working capital in the operation, most of the amount had been blocked in the form of inventories and accounts receivables. Hence, due to shortage in the internal funds, it had taken higher amount of debts for continuing the operations, which caused in poor gearing ratio. The financial reports of the company also exhibit the same fact. It had slowed down the profit generating process and the profit margins had lower down consecutively in the first four years. However, by improving the turnover ratios in the recent two years, Tesco has managed to increase the net profit margin in the last year. Moreover, due to proper circulation of working capital and increase in profit margins, it has been able to increase its equity capital and strength to cover all its liabilities efficiently (Mathuva 2015).

On the other hand, Sainsburys has maintained the turnover ratios low and steady over the five consecutive years. Therefore, it has not faced any issue to circulate its working capital at normal rate. The stable acid-test ratio and working capital ratios also implies the same fact. As the result, it has been able to maintain its net profit margins more or less same over the period, except 2015. As the result, the gearing ratios of the company have been under control in all over the period (DRURY 2013).

Therefore, it is clear that, inventory and accounts receivable management is very important for producing returns from the invested working capital. Though the business firms cannot avoid these two current assets and have to incorporate it in the working capital cycle, it should convert these assets as fast as possible. For faster conversion, the business firms can implement various strategies and techniques, appropriate for the firm, and increase the efficiency in managing the inventory and accounts receivable.

References

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