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Summary FIN2603_Study Unit 08
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- University Of South Africa (Unisa)
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FIN2603 – Finance for Non-Financial Managers (2023)Study Unit 08: Financing (PB: Chapter 8)
A firm has to manage its inventory, accounts receivable and cash prudently. Working capital is one of
the most crucial managerial aspects of any firm, due to the impact it has on liquidity. Too much
liquidity in a firm may lower profitability, while poor liquidity may lead to technical insolvency.
❖ Working capital - management of a firm’s current assets and current liabilities
❖ Net working capital - the difference between current assets and current liabilities (also
referred to as net current assets) (If the current assets exceed the current liabilities, the
firm is said to have a positive net working capital.)
❖ Positive net working capital - suggests that the firm has adequate current assets
available which could be used to pay its creditors.
❖ Liquidity - refers to the ability to pay.
❖ Turnover - sales of inventory for cash or in credit
Where the debtors pay their accounts promptly, the firm has cash available which can be used to
continue operations. Some refer to this as the firm's "money merry-go-round': because of the
continuous cash inflow and outflow.
• The firm is continuously involved in a cycle of cash inflows and outflows. A firm has to make a cash
outflow for purchasing, inter alia, goods or raw materials (in the case of a manufacturing firm). It is
through sound marketing that goods which have been manufactured or purchased are sold in
order to generate cash inflows.
• The cycle should be as short as possible because of the time value of money.
• The firm would like to see the cycle occur as frequently as possible in order to generate profit and
cash flow.
Lyana Petzer Page 1 of 19
, FIN2603 – Finance for Non-Financial Managers (2023)
1. The cash conversion cycle (CCC):
The objective of the financial manager is to manage the cash conversion cycle (CCC) efficiently in order
to maintain adequate levels of cash, thereby contributing to the maximisation of the firm's value.
The operating cycle:
The operating cycle (OC) may be described as the period that elapses between the building up
of inventory and the collection of cash from the sale of that inventory.
The cycle comprises 2 components, namely the following:
1. The average age of inventory (AAI)
2. The average collection period (ACP)
OC = AAI + ACP
EXAMPLE
Assume a firm sells all its products on credit. The firm has determined that it takes an average of 10
days from stocking a final product to selling it - the AAI is thus 10 days. On average, accounts
receivable is collected after 90 days.
OC = AAI + ACP
= 10 + 90
= 100 days
Managing the CCC:
The CCC represents the total number of days in the operating cycle of the firm less the APP:
CCC = AAI + ACP - APP
CCC is also the difference between the number of days the resources are tied up in the
Operating Cycle and the number of days the firm can use spontaneous financing before
payment has to be made.
EXAMPLE
A firm has an AAI of 10 days, an ACP of 90 days and an APP of 30 days.
CCC = AAI + ACP - APP
= 10 + 90 -30
= 70 days
The firm's money is tied up for 70 days - the period between the cash outflow to pay accounts payable
(on day 30) and the cash inflow from the collection of accounts receivable (on day 100).
Firms experiencing positive CCCs have to use negotiated forms of financing, such as unsecured short-
term loans, to support the CCC. This is obvious since the CCC is the difference between the number of
days the resources are tied up in the OC and the number of days the firm can use spontaneous
financing before payment has to be made. Spontaneous financing arises from the normal operations of
the firm, that is buying goods and services from creditors and paying their accounts later.
Lyana Petzer Page 2 of 19
, FIN2603 – Finance for Non-Financial Managers (2023)
2. Managing inventory:
Inventory is the asset that is least liquid and consequently needs to be managed carefully in
order to contribute to the wealth maximisation of the firm.
❖ Financial manager’s - keep inventory levels as low as possible, thereby saving costs
and providing an opportunity to undertake more investments that are profitable.
❖ Production managers - keep inventory levels as high as possible to fulfil production
requirements.
❖ Marketing managers - keep inventory levels as high as possible to prevent loss of sales.
❖ Procurement managers - responsible for the provision of correct quantity and quality
of goods to the production and marketing departments.
The following methods can be used to manage inventory to contribute to wealth maximisation
of the firm:
1. Managing inventory as an investment
A firm must make funds available for the purchase and maintenance of inventory, including
investment in warehouses and storage facilities. There is an opportunity cost attached to the
holding of inventory, which refers to the rate of return that could have been earned by
investing the funds in other assets with more or less the same risk.
The types and levels of inventories depend on the marketing strategies and the expected level
of sales.
Any errors in estimating inventory levels may lead to one or more of the following problems:
• Overstocking, which may lead to:
➢ Opportunity cost of money tied up in stock.
➢ Storage costs
➢ Problems of obsolescence
➢ Danger of fire and theft
➢ Price fluctuations
• Understocking, which may lead to:
➢ Loss of sales because of out-of-stock situations
➢ Loss of customers to competitors who stock the same product.
2. Classification of inventory
Inventory may be classified into 3 basic classes namely:
• Raw materials
• Work in progress
• Finished goods.
1. Raw materials:
Inventories include products to be changed through the production process into work-
in-process and finished goods, such as iron or to produce steel.
A firm carries raw materials for the following reasons:
Lyana Petzer Page 3 of 19
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