Working Capital Management

Working capital management is management for the short-term. This is of critical importance to a firm. As pointed out in the text, managers spend about 70% managing for the short-term. This makes sense. Every day companies take in money, write receipts, balance checkbooks, record receivable records, manage inventory and the like. Also, short-term management should not be discounted. As the old saying goes, "If you can make it in the short-term long enough, you don't need to worry about the long-term." Cash budgets may be utilized in managing working capital.

Working capital has to do with the short-term accounts of a firm current assets and current liabilities. Net working capital is defined as current assets less current liabilities. The secret to good working capital management is simple "use someone else's money every chance you get and don't let anyone else use yours." Within reason, of course. To do that, the following strategies might be employed; again within reason. A company wouldn't want to stretch out its payables for so long a period that it's forced out of business.

Stretch out accounts payable as long as possible. If a bill is due on the 13th, don't pay it on the 10th. If a company has enough clout, they can negotiate longer terms with vendors. Turn receivables as quickly as possible. Make it easy for customers to pay. Lockboxes, prepaid envelopes, discounts, etc. may be utilized. Turn inventories as quickly as possible. Inventories may be a big investment for a firm and they earn no interest. Just-in-time inventory methods and some other strategies are used to hold down a firm's investment in inventories.

Some cycles and ratios that may aid in these strategies are:

Cash Conversion Cycle Operating Cycle Accounts Receivable Period Average Payment Period Receivables Investment Amount Inventories Investment Amount

Some methods for investing excess cash are to invest in liquid securities and other short-term securities such as:

U.S. Treasury Bills Commercial Paper Certificates of Deposit Bankers' Acceptances Eurodollars Money Market Accounts

It should be remembered that these funds will be required in the short-run and cannot be tied up in assets with long maturities.

Efficient management of working capital is extremely important to any organisation. Holding too much working capital is inefficient, holding too little is dangerous to the organisations survival. Working capital is the everyday term for what accountants call net current assets. The working capital figure is the total of current assets minus the total of current liabilities. The main current assets are stock, debtors and cash. The current liabilities are creditors and accrued expenses. The key factor in the word Current is that they are expected to turn into cash, or be paid from cash, within twelve months. As a general rule the organisation wants as little money tied up in working capital as possible. However, there are always trade-offs. The most obvious problem is running out of cash so you cannot pay the wages, or being unable to provide a service because you have run out of a vital resource: for example, a meals service being unable to produce the required number of meals because they did not have enough foodstuffs in stock. Each of the areas of working capital has different problems and these are discussed separately in the following sections:
Stock control Debtor control Cash flow management guidelines Creditor control

In order to assess whether you have a safe amount of working capital there are two important calculations you can make:
The Current Ratio

The Current Ratio is the relationship between the total current assets and the total current liabilities. Generally speaking a service organisation should have about 1.25 current assets for every 1 of current liabilities. If there are significant trading operations such as shops or mail order selling then the ratio should be closer to 2 of current assests for every 1 of current liabilities.
The Quick Ratio or "Acid Test"

The Quick Ratio is the relationship between the total of debtors and cash compared with current liabilities. Generally the debtors and cash together should approximately equal the current liabilities.

Working Capital Management

Source: studyfinance.com

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. It focuses on three main issues come under the working capital management such as: holding cash, float and managing cash. Read the article and explore all the links to get the details.

Reducing working capital is a fundamental means to address liquidity and credit constraints. In a period of rising capital costs, eliminating idle assets from your balance sheet is more critical than ever. In fact, your organization may have excess liquidity trapped within financial processes. Are your billing processes as efficient as they could be? Is the float associated with your incoming cash flows as low as possible? Have you converted enough of your customers to electronic payment alternatives? Are your collection mechanisms effective? Are you applying best practices in managing working capital? If you are uncomfortable with any of your answers to the above questions, Treasury Strategies is uniquely positioned to assist you. For further information about how we can provide value to your organizReducing working capital is a fundamental means to address liquidity and credit constraints. In a period of rising capital costs, eliminating idle assets from your balance sheet is more critical than ever. In fact, your organization may have excess liquidity trapped within financial processes. Are your billing processes as efficient as they could be? Is the float associated with your incoming cash flows as low as possible? Have you converted enough of your customers to electronic payment alternatives? Are your collection mechanisms effective? Are you applying best practices in managing working capital? If you are uncomfortable with any of your answers to the above questions, Treasury Strategies is uniquely positioned to assist you. For further information about how we can provide value to your organization, contact: ation, contact:

Software Developer
For a $150 million maker of e-business software, Treasury strategies performed a review of cash and investment processes and controls. The review was sponsored by the Board of Directors, which wanted to be certain that it was following best practices in the handling of its cash and investments. In addition, the company wanted to ensure the appropriate controls were in place to prevent fraud.

Working capital management involves the relationship between a firm's short-term assets and its shortterm liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Treasury Strategies performed a review, sponsored by the companys Board of Directors, that benchmarked the companys cash and investment processes against our database of over 100 Best Prac

Why Firms Hold Cash

The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity. Speculation Economist Keynes described this reason for holding cash as creating the ability for a firm to take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount that is greater than the carrying costs of holding the inventory. Precaution Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for. Transaction Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.

tices.

Float
Float is defined as the difference between the book balance and the bank balance of an account. For example, assume that you go to the bank and open a checking account with $500. You receive no interest on the $500 and pay no fee to have the account. Now assume that you receive your water bill in the mail and that it is for $100. You write a check for $100 and mail it to the water company. At the time you write the $100 check you also record the payment in your bank register. Your bank register reflects the book value of the checking account. The check will literally be "in the mail" for a few days before it is received by the water company and may go several more days before the water company cashes it. The time between the moment you write the check and the time the bank cashes the check there is a difference in your book balance and the balance the bank lists for your checking account. That difference is float. This float can be managed. If you know that the bank will not learn about your check for five days, you could take the $100 and invest it in a savings account at the bank for the five days and then place it back into your checking account "just in time" to cover the $100 check. Time Book Balance Bank Balance

Time 0 (make deposit) $500 $500 Time 1 (write $100 check) $400 $500 Time 2 (bank receives check) $400 $400 Float is calculated by subtracting the book balance from the bank balance. Float at Time 0: $500 - $500 = $0 Float at Time 1: $500 - $400 = $100 Float at Time 2: $400 - $400 = $0

The projects conclusion resulted in hard dollar savings equivalent to the cost of the project, the refinement of the companys controls to prevent fraud and the enhancement of its disaster recovery plans.

Financial Management Study Notes EK 335 Working Capital Management

INTRODUCTION
Most companies concentrate their managerial effort on controlling profit. They try to increase sales revenue, reduce their production cost and control their overheads. Operational budgets are drawn up, standard costs are set and considerable effort is expended on identifying and rectifying variances of actual results against these budgets and standards.

However, too few companies worry very much about managing another, possibly equally important, part of their business - the area of working capital management. But, managing the area of working capital can make the difference between business survival and business failure. Many profitable companies fail each year because their management teams fail to manage the area of working capital. They may be profitable, but they are not able to pay the bills. WORKING CAPITAL
Working Capital is the name given to the "short-term" area of the balance sheet. Working Capital includes four balance sheet items: stock - stocks of raw materials, partly completed production and finished goods awaiting sale debtors - amounts owed TO the company, mainly from customers in respect of sales made on credit creditors - amounts owed BY the company, mainly to suppliers of raw materials, services (electricity, water, telephone, rent, etc.) but also, possibly, unpaid tax demands, unpaid dividends and other items cash - bank balances, cash holdings and short term investments

Working Capital includes the current assets and current liabilities areas of the balance sheet. Working Capital can be called by its alternative name - "Net Current Assets". AN EXAMPLE OF WORKING CAPITAL
Imagine that the following figures have been extracted from a company's balance sheet: () CURRENT ASSETS Stocks 2,700,000

Debtors Cash TOTAL CURRENT ASSETS CURRENT LIABILITIES Creditors NET CURRENT ASSETS

4,000,000 5,000 6,705,000 1,705,000 5,000,000

What do these figures tell us?

Certainly, there are stocks but, surely, a company needs stocks if it is to run its business. Certainly, there are debtors but, surely, that is just a consequence of making credit sales. There does not seem to be much cash available so, maybe, the directors should be considering taking a loan or issuing more shares. There are creditors, but it does take the accounts department a little time to process incoming invoices.

That is probably the total amount of analysis that many companies would make.

Let's take one step further and realise that THE COMPANY HAS 5 MILLION TIED UP IN WORKING CAPITAL. MONEY THAT IS THE PROPERTY OF THE COMPANY. MONEY THAT MAY NOT BE EARNING ITS KEEP. TOWARDS MANAGING THE WORKING CAPITAL
Let us look at the figures again but, this time, include some basic financial ratios, such as stock days, debtor days and creditor days. () CURRENT ASSETS Stocks Debtors Cash TOTAL CURRENT ASSETS CURRENT LIABILITIES Creditors NET CURRENT ASSETS 1,705,000 5,000,000 35 days 2,700,000 4,000,000 5,000 6,705,000 75 days 70 days

We now see that the company is holding enough stock to run the business for 75 days, allows its customers an average of 70 days to pay their bills, yet pays its own bills in only 35 days. Stock is expensive to keep. The more stock there is, the larger the warehouse needs to be (more rent, electricty, heat, etc.), the more people have to be employed in the warehouse (more salaries, social security, etc.), the more chance there is of the stock becoming obsolete and damaged - or, even, stolen.

The longer the debtor period, the more chance there is that debts will turn out to be bad debts, or will take considerable effort (and, thus, cost) to collect. THIS IS IN ADDITION TO THE COSTS OF FINANCING THE WORKING CAPITAL. Surely, it would not be too unreasonable for the company to only carry only 40 days stock and to insist on our customers paying within 35 days. The company's own payment period of 35 days already seems reasonable. Implementation of these suggested stock and debtor periods would decrease the stock from 2,700,000 (75 days) to 1,440,000 (40 days). The debtors would fall from 4,000,000 (70 days) to 2,000,000 (35 days). Let us include these revise the figures in the figures that we have already examined.
() CURRENT ASSETS Stocks Debtors Cash TOTAL CURRENT ASSETS CURRENT LIABILITIES Creditors NET CURRENT ASSETS 1,705,000 5,000,000 35 days 1,440,000 2,000,000 3,265,000 6,705,000 40 days 35 days

Note that the effect of adopting these more reasonable working capital policies is to increase the cash from a mere 5,000 to a much more reasonable 3,265,000. This is company money - it has previously been used to finance excess stocks and excess debtors. This extra 3.26 million of cash could be invested. If it was to earn a return of only 10% per annum, there would be 326,000 extra profit in a full year - in addition to savings in warehouse rent, warehouse salaries, warehouse services, bad debts and debt administration. POSSIBLE PROBLEMS WITH IMPROVED WORKING CAPITAL MANAGEMENT
The more that a company reduces its raw material stock, the more risk there will be that the company would have to discontine production, due to stock unavailablity. Ceasing production for this reason is expensive - the company will still have to pay the wages and may be short of finished stock for a period.

The more that a company reduces its finished goods stock, the more chance there is that customers will have to be sent to competitors due to shortage of stock available for sale. The company would lose profit and there is a chance that the customer would stay with the competitor.

The quicker that customers are required to pay, the more chance there is that they will buy from competitors who are offering better (i.e. longer) credit terms. But, if a customer only comes to your company because you are offering long credit terms, do you really want that customer ? Do you want to concentrate on QUALITY of sales rather than QUANTITY of sales ? The longer that a company takes to pay its own suppliers' invoices, the lower the amount that the company has invested in working capital. But, if the period is too long, what happens during periods of supply difficulty. The company's suppliers will supply those who pay invoices in a reasonable time - if a company is unduly tardy in paying its invoices, it may not get supplies and this may be expensive in terms of lost production, lost sales and lost profit. FURTHER CONSIDERATIONS
There are further discussions on this topic:

Chapter 6: Working Capital Management

Working Capital is the money used to make goods and attract sales. The less Working Capital used to attract sales, the higher is likely to be the return on investment. Working Capital management is about the commercial and financial aspects of Inventory, credit, purchasing, marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to be the level of Working Capital tied up in creating and selling titles. The faster that we create and sell the books the higher is likely to be the return on investment. Thus when we have been using the word investment in the chapter on pricing, we have been discussing Working Capital. In the earlier chapter on Accounting concepts we showed a sample Balance Sheet. The Balance Sheet comprises Long term Assets (real estate, motor vehicles, machinery) and Net Current Assets. The word Working Capital is often used for Net Current Assets. In this chapter we will exclude Cash in Bank from our definition. Thus our Balance Sheet appears as follows:

Long Term Assets Working Capital Cash in Bank Total Capital

6,000 28,000 1,000 35,000

We defined Net Current Assets as Total Current Assets less Total Current Liabilities. In this book we shall subtract current liabilities items from current assets as follows: Inventory Receivables Prepayments Payables Customer Prepayments Working Capital Young 15,000 17,000 6,000 (9,000) (1,000) 28,000

Using this format we can state than any reduction in the Working Capital figure, other than for provisions for write-offs and write-downs, will generate the same amount of cash. Thus if a customer pays US$ 500 that he owes to the organisation, the Working Capital figure will fall be

US$ 500, and the cash figure will be increased by the same figure. This revised format is useful when designing spreadsheet financial planning models for business plans or for internal reporting. The Working Capital cycle, or Cash Conversion cycle as it is also called is usually expressed in terms of the number of days. This figure is the average time that it takes to turn investment in books into cash and profit. We studied Payback in the previous chapter. Payback expresses the number of days required to recoup the original investment on a single title. In the organisations Balance Sheet there will be the costs of paper, titles still under development, author advances of books already and not yet published. In addition there will be the cost of stocks of unsold books, Accounts Receivable, and Accounts Payable.

Example: Osiris publishers

In order to illustrate the concept I have adapted slightly the example used in the chapter on Accounting concepts. The Young scenario has the same Income Statement but I have adapted the Prepayments figure within the Balance Sheet in order to illustrate more elements of Working Capital. I have divided the Prepayments figure of 6,000 into Prepayments to authors and Prepayments to printers. The totals are the same.

Income Statement Turnover Cost of Sales Royalties Gross Profit Distribution costs Promotion Write-offs Administration costs Operating Profit Balance Sheet

Osiris 100,00 0 (57,000 ) (18,000 ) 25,000 (5,000) (2,000) (3,000) (10,000 ) 5,000 Analysis Osiris Working Capital / Sales % 28.00%

Inventory Receivables Prepayments: authors Prepayments : printers Payables Customer Prepayments Working Capital

15,000 17,000 3,000 3,000 (9,000) (1,000) 28,000

Inventory in days Receivables in days Prepayments in days: authors Prepayments in days : printers Payables Customer Prepayments Working Capital Cycle in days

96 62 61 19 (36) (4) 198

Explanation of the calculations

Working Capital figure Inventory in days

Explanation

(Inventory / Cost of Sales) x 365 = 96 days. More correctly the purchases figure, if available should be used, in this case excluding royalties. Thus the publisher holds approximately 2 months of unsold inventory Accounts receivable in (Receivables / Turnover) x 365 = 62 days. days Assuming the turnover is phased evenly throughout the year, this means the on average customers take 62 days to pay Prepayments in days (Prepayment: authors / Royalties) x 365 = 61 authors days. In practice royalties will be earned that reduce this figure while new advances are also paid to other authors. Prepayments in days (Prepayment: printers / Cost of sales) x 365 = 19 printers days. In practice part of the Cost of Sales figure would be new title pre-press costs not carried out at the printer. This item relates to cases where advance payments are made to printers as a deposit or for paper. The purchases figure if available would give a more accurate figure. Accounts Payable in (Payables /(All purchases) x 365 days (9,000 / (57,000 + 18,000 + 5,000 + 2,000 + 10,000) x 365 = 36 days The purchases (investment) rather than the cost of sales figure should be used if available. I have assumed that this figure includes money owed to authors (see prepayment: authors) Customer Prepayments (Customer Prepayments / Turnover) * 365 = 4 days Working Capital cycle in96 + 62 + 61 + 19 - 36 - 4 = 198 days

Working Capital / Sales 28,000 / 100,000 = 28% %

Explanation of the figures

On average it takes Osiris 198 days to turn an investment into cash and profit. New tiles will use more Working Capital than reprints On average Working Capital equates to 28% of turnover The percentage of Working Capital to turnover varies according to the type of publishing Trade publishing in developed countries may have a figure of between 35- 45 % of turnover. Academic publishing is higher. Professional publishing uses a lower Working Capital % figure Working Capital is also a measure of risk

This figure may include new titles, reprints, foreign language coeditions, licence sales. The figure would be different for each of these. Within the total Balance Sheet, the Working Capital figure will vary throughout the year according to the phasing of new titles and the sales cycle. Publishers should know the typical Working Capital cycle and the level of Working Capital as a % of turnover for each market or distributor, for each category of book.

The relevance of Working Capital to publishing in young economies

In the FSU Working Capital levels were controlled at government rather than factory level. Invoices were settled on standard credit terms. Non or slow payment was not a major problem for printers and publishers. Risk was a government problem. Authors were paid standard royalty rates and terms. Inventory levels and print runs were according to a formula: in textbook publishing, 150% of the textbook requirement would be printed in year 1, the remaining 50% would be used for replacement copies in subsequent years. Publishers, printers and distributors would negotiate for annual cash budgets but did not have to concern themselves about Working Capital questions except where budget moneys were delayed. Printing capacity was sufficient to produce local and other agreed requirements. Thus textbook printing would commence in November for the following September. In a competitive open economy printers would have to offer discounts and credit to persuade publishers to take the risk

of early ordering. Schools would demand the latest up-to-date editions. Publishers would have to borrow money from the bank or shareholders to pay for the inventory. For young economies, the implications are as follows. 1. In young economies the first industries to develop are those with low or negative Working Capital % to sales. Negative Working Capital is where the organisation uses supplier credit or customer Prepayments to fund their day to day needs. E.G. banks and financial services, retailers, distribution, industries with cash sales or advance payments on signature of contract (e.g. printers). Organisations with negative Working Capital use the money from their customers with which to invest and to pay suppliers. 2. Competition is fiercest among industries with low or negative Working Capital / sales % figures. Financial entry barriers are lower and these industries are easier to expand. However profit margins are often lower because of the competition (but not always!) and the failure rate among such industries among developed countries is usually higher. 3. Banks are attracted to industries with low or negative Working Capital / sales % figures as cash and profits are earned more quickly 4. Entrepreneurs are attracted to industries with low or negative Working Capital % figures 5. Most marketing innovations in book publishing have come about through the application of the above Working Capital concepts to creating additional sales and expanding the market. Most of the innovations introduced at the end of the previous chapter were created by reduced the level of Working Capital and the time schedule of creating and selling books. 6. The customers, suppliers and authors of book publishers also want to operate to a low or negative Working Capital / sales %. Thus printers ask for advance payments e.g. for paper, distributors will try to withhold payment until they have received money from their customers. 7. Printers are loath to change from their dominant position where they could dictate prices and schedules according to price scales formulated at state level. These price scales were geared to maximum production output, not to satisfying publishers and their customers under national or international competition. 4-colour printing would cost 4-times the cost of single colour printing, despite the introduction of modern 4-colour sheet-fed presses. Printers will change their attitude to pricing and print-runs only in a crisis. In many young economies printers have not co-operated

with publishers (partly the fault of the publishers) and faced near collapse as publishers have purchased printing overseas. 8. In developed countries publishers have sometimes allowed retail groups extra credit (= higher Working Capital for publishers) in order to encourage them to expand into new outlets or sell more books. It is essential to distinguish between genuine expansion cases and opportunistic entrepreneurs. The more a publisher is actively engaged in marketing and distribution, the less likely is the publisher to have to rely on offering credit as an incentive. 9. The concept applies equally to state enterprises and non-profit making organisations. If cash and profits are generated more quickly, new titles can be commissioned sooner, staff and suppliers paid promptly. Bank interest is reduced. 10. Where producers are dominant, their customers will have to accept higher levels of Working Capital. Where customers are dominant, the producers have to accept a greater burden. In some young economies, the government may have a policy of holding key organisations in the state sector or as majority owned state enterprises rather than encouraging a free-for-all enterprise policy. This may affect printers, publishers and distributors. This policy will affect the evolution of the Working Capital cycle and may tilt it more in favour of producers.

Working Capital levels in book publishing in developed countries

Working Capital is a major problem in book publishing. Most publishers solve the question on a temporary basis by negotiating credit with printers and other suppliers. Their own customers solve the problem by negotiating credit with publishers or demanding sale or return terms. Sale or return terms make planning and cash forecasting much more difficult. Most publishers rightly prefer to offer a slightly higher discount for a firm sale. Retailers will argue that they would not purchase many new titles without their risk being mitigated by a sale-or-return policy The central issues, which must be solved, are:

Investment decisions rely too heavily on economies of scale e.g. in printing prices, by amortising first edition costs against larger print runs Publishers produce too many titles, which receive too little promotional effort and thus sell slowly or not at all. These can be solved only through long term changes in publishing strategy and greater attention to the value chain where suppliers,

publishers, wholesalers and retailers co-operate to mutual benefit and shared risk. On demand publishing may reduce inventory levels but does not solve the marketing aspects. Many publishers have studied the publishing of music CDs and cassettes, and of greeting cards with a view to finding solutions. While lessons can be learned, there are major differences: CDs, cassettes and greeting cards

Are all high margin projects Carry much heavier promotion budgets and commitment to marketing Are standardised in format Enjoy few economies of scale so short run and on-demand manufacture are the norm Sell to a more wide variety of retailers Sell on a less seasonal basis

Paperback publishers have adopted some of these aspects and have fought successfully to overcome the low price perception of paperbacks. Paperbacks can now sell in many cases at the same price as a hardback edition. The creation of hit-parades or Top 10 listings has been adopted for books of different categories and has attracted significant media attention thus making books more fashionable. As a result books may sell faster, perhaps at higher prices and thus reduce Working Capital levels.

Book Packagers
Book packagers create books under contract to publishers, bookclubs or foreign distributors. They evolve as part of the specialisation process especially when publishers become larger and more bureaucratic. Publishers buy the rights for a territory for a period of years or number of printings (provided that the title stays in print). The financial attraction to publishers is that they can buy smaller print runs at economic cost. Most publishers will make advance payments to the packagers but may be able to approve the content and design. Most packagers prefer to sell finished books rather than licence titles on a film and royalty basis. Packagers buy at low prices from printers because they create only a small number of titles but each title will have a large print run. Packagers often stay loyal to printers who reward them with long credit

and, in many cases, lower printing prices than those paid by their publisher customers. In the TV world many program companies will create programs for several networks while TV companies concentrate on distributing the programs. The production companies will retain the rights and earn fees for repeat-shown programs. A similar situation exists in the multimedia field. Thus packagers are specialists who are not involved in marketing and distribution. Subsequently a small number of them have decided to become publishers and done so very successfully after re-financing. Most stay as packagers. Compared with publishers, these packagers have little market value in acquisition terms. Thus packagers are very similar to many private publishers in young economies but with important differences as the table below shows:

Book Packagers

Private publishers in young economies - Founders are creatively rather - Founders are creatively rather than than market driven; enjoy market driven; enjoy freedom freedom - International printers offer - Printers tend to give better prices to them low prices and credit; established publishers printers have often offered credit to allow packagers to start up, sometimes with dire Some publishers may be closely linked results for the printer with a printer. The printer may demand advance payment - Packagers usually allow - Publishers will not involve customers publishers to approve content in the book content except in special cases e.g. textbooks and Ministry of Education, University Publishing Houses - Receive advance payments - Are paid after delivery from publishers - Hold no Inventory but reprints - Will often sell the total print run to a make high profits single or small number of distributors - Purchase rights from authors - Sell books with no transfer of rights and designers, and sell territorial or other rights to a number of customers

The Working Capital cycle in both cases is similar in both cases. The reason is perhaps the same. Neither the book packager nor the young

private publisher is adequately financed; both enjoy the creative aspects but do not want to expand if it means losing control. There are few potential buyers for book packagers. The cost of starting such organisations is much lower. Working Capital is lower because they are involved only in creating the books. They influence distributors, retailers and consumers only so long as they generate saleable new ideas. While book packagers can of course sell foreign rights, their potential to sell reprints is lower.

Making more efficient use of Working Capital

The table below lists items, which influence Working Capital levels favourably and adversely

Items that reduce Working Capital levels for publishers - Increased profit margins - Customers who pay promptly - Advance payments by customers

Items that increase Working Capital levels for publishers - Lower profit margins - Long print runs except where all the books are required on publication e.g. School and university textbooks - Inventory which is sold and paid - Slow authors who deliver late for quickly by customers after and whose manuscripts require publication substantial editing - Lower Inventory levels by reducing - Holding paper stock unless print quantities and working with market conditions demand and the printers who will deliver quickly and savings are large produce low print runs economically - Slow schedules for the development of new titles - Successful promotion that speeds - Making advance payments to up the rate of sale printers - Seasonal sales except where the publishers prints only for the season - Licensing (but problematic in young economies) - Paying suppliers on completion with credit - Authors who deliver manuscripts on disk ready for computer make-up - Incentives to staff , authors , suppliers, customers , sales staff and agents to speed up the rate of sale and of developing new books, delivering manuscripts on schedule

The attention of readers is again drawn to the examples at the end of the previous chapter, which illustrate ways in which publishers have produced affordable books through a marketing initiative. The concepts of this chapter apply in each example.

The danger of averaging Working Capital levels

Osiris has a Working Capital to Sales figure of 28%. However the figure will be the average of the organisations different activities. Let us assume that there are three divisions that produce different types of books for different markets and use different methods of distribution. The table below shows how each division generates much Net Contribution and also how much Working Capital is used in each division. The cost of sales, royalty, distribution, promotion costs and write-off figures differ in each case as a percentage of sales although not all the costs are necessarily variable. The term Net Contribution is the amount of money that each division generates towards the central administration cost of the company and hence to profit. Items below Net Contribution is not relevant to our analysis unless administration cost vary according to each market. Interest on bank loans could however be usefully charged against each division to give an even more meaningful figure. Although a Balance Sheet item, Working Capital is shown under Net Contribution to highlight the relevance of comparing Net Contribution and Working Capital levels by division.

Income Statement Division A Division B Division C Turnover 60,000 30,000 10,000 Cost of Sales (33,000) (18,000) (6,000) Royalties (10,800) (6,200) (1,000) Gross Profit 16,200 5,800 3,000 Distribution costs (3,900) (1,000) (100) Promotion (1,100) (900) 0 Write-offs (1,700) (1,100) (200) Net Contribution** 9,500 2,800 2,700 Working Capital 19,200 7,800 1,000

Total 100,000 (57,000) (18,000) 25,000 (5,000) (2,000) (3,000) 15,000 28,000

** Gross Profit less distribution, promotion and write-offs. The contribution to administration costs and profit from publishing activities

The analysis of the above sheds useful light on profitability and use of Working Capital by division. This is discussed in detail below. Analysis of the net contribution

The table below shows each cost item included in the Net Contribution calculation expressed as a percentage of turnover.

Cost of Sales % to Turnover Royalty % to turnover Gross profit margin % Distribution % to turnover Promotion % to turnover Write-off % to turnover Net Contribution % to turnover Working Capital / Turnover %

Division A 55.0% 18.0% 27.0% 6.5% 1.8% 2.8% 15.8% 32.0%

Division B 60.0% 20.7% 19.3% 3.3% 3.0% 3.7% 9.3% 26.0%

Division Averag C e 60.0% 57.0% 10.0% 18.0% 30.0% 25.0% 1.0% 5.0% 0.0% 2.0% 2.0% 3.0% 27.0% 15.0% 10.0% 28.0%

Turnover The turnover figure is the sum of the sales invoices issued during the year by division. Any returns or invoice queries would be shown separately under write-offs in order to highlight to management the extent of returns and invoices queries. The company will invoice either by charging an agreed discount off the recommended retail price, or by using an agreed unit price. If transport is included in the invoice price, the charge for transport will be shown as an expense under distribution. Free samples or extra jackets may also be included in the invoice price. Cost of sales The percentage to turnover is influenced by the sales mix, the balance of new and reprint titles, and the length of print runs. A larger print run might increase the gross margin % but also increase Working Capital levels and hence reduce the cash in bank figure. Some organisations will charge new title costs in different percentages to each market. The aim is to demonstrate that certain markets are profitable, but only on a marginal costing basis. If an organisation has to increase prices to local bookshops as a result of charging all new title costs against the home market, the organisation runs the risk of losing market share and profitability in the home bookshop market Other publishers, often the more progressive, may therefore regard new title costs as research and development, and charge e.g. 1/12th each month following publication against the Income Statement. This policy

means that inventory is valued at a cost excluding new title costs and reduces the need for write-offs. This policy also gives a better view of trends in gross margins, as the figure is not distorted by changes in the new title / reprint mix. The Net Income will fall. Countries may have specific policies for writing off first edition costs against profits, as they are similar in concept to research and development expenditure. Royalty figures The royalty figures differ because in the case of division A and B, the royalty is charged on the basis of the retail price, while in the case of division C, the royalty payable is based on net receipts, i.e. the unit price charged net of discounts. As markets expand, the need to negotiate royalty terms based on net receipts will grow in order that publishers exploit new markets. Without such author contractual terms, publishers might have to reject otherwise profitable deals. Thus the author might lose also. It is common for net receipts royalty rates to be agreed for deals above a certain discount rate, e.g. bookclub, export deals, coeditions, and licences. Gross margin Definition: Turnover minus cost of sales and royalties payable. Gross margin, the percentage of gross profit to turnover is widely used in book publishing as a parameter for book pricing. Where an organisation produces books with a similar cost profile, in similar print runs, and with a constant sales mix, gross profit may be a useful criterion. Here the figures highlight also that the use of gross margin as a criterion is not always useful and can be misleading although the division C, with the highest gross margin, also has the highest net contribution. Use of gross margin ignores distribution, promotion and write-offs, which will usually differ by division or type of book.

Chapter 6: Working Capital Management

Working Capital is the money used to make goods and attract sales. The less Working Capital used to attract sales, the higher is likely to be the return on investment. Working Capital management is about the commercial and financial aspects of Inventory, credit, purchasing, marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to be the level of Working Capital tied up in creating and selling titles. The faster that we create and sell the books the higher is likely to be the return on investment. Thus when we have been using the word investment in the chapter on pricing, we have been discussing Working Capital. In the earlier chapter on Accounting concepts we showed a sample Balance Sheet. The Balance Sheet comprises Long term Assets (real estate, motor vehicles, machinery) and Net Current Assets. The word Working Capital is often used for Net Current Assets. In this chapter we will exclude Cash in Bank from our definition. Thus our Balance Sheet appears as follows:

Long Term Assets Working Capital Cash in Bank Total Capital

6,000 28,000 1,000 35,000

We defined Net Current Assets as Total Current Assets less Total Current Liabilities. In this book we shall subtract current liabilities items from current assets as follows: Inventory Receivables Prepayments Payables Customer Prepayments Working Capital Young 15,000 17,000 6,000 (9,000) (1,000) 28,000

Using this format we can state than any reduction in the Working Capital figure, other than for provisions for write-offs and write-downs, will generate the same amount of cash. Thus if a customer pays US$ 500 that he owes to the organisation, the Working Capital figure will fall be

US$ 500, and the cash figure will be increased by the same figure. This revised format is useful when designing spreadsheet financial planning models for business plans or for internal reporting. The Working Capital cycle, or Cash Conversion cycle as it is also called is usually expressed in terms of the number of days. This figure is the average time that it takes to turn investment in books into cash and profit. We studied Payback in the previous chapter. Payback expresses the number of days required to recoup the original investment on a single title. In the organisations Balance Sheet there will be the costs of paper, titles still under development, author advances of books already and not yet published. In addition there will be the cost of stocks of unsold books, Accounts Receivable, and Accounts Payable.

Example: Osiris publishers

In order to illustrate the concept I have adapted slightly the example used in the chapter on Accounting concepts. The Young scenario has the same Income Statement but I have adapted the Prepayments figure within the Balance Sheet in order to illustrate more elements of Working Capital. I have divided the Prepayments figure of 6,000 into Prepayments to authors and Prepayments to printers. The totals are the same.

Income Statement Turnover Cost of Sales Royalties Gross Profit Distribution costs Promotion Write-offs Administration costs Operating Profit Balance Sheet

Osiris 100,00 0 (57,000 ) (18,000 ) 25,000 (5,000) (2,000) (3,000) (10,000 ) 5,000 Analysis Osiris Working Capital / Sales % 28.00%

Inventory Receivables Prepayments: authors Prepayments : printers Payables Customer Prepayments Working Capital

15,000 17,000 3,000 3,000 (9,000) (1,000) 28,000

Inventory in days Receivables in days Prepayments in days: authors Prepayments in days : printers Payables Customer Prepayments Working Capital Cycle in days

96 62 61 19 (36) (4) 198

Explanation of the calculations

Working Capital figure Inventory in days

Explanation

(Inventory / Cost of Sales) x 365 = 96 days. More correctly the purchases figure, if available should be used, in this case excluding royalties. Thus the publisher holds approximately 2 months of unsold inventory Accounts receivable in (Receivables / Turnover) x 365 = 62 days. days Assuming the turnover is phased evenly throughout the year, this means the on average customers take 62 days to pay Prepayments in days (Prepayment: authors / Royalties) x 365 = 61 authors days. In practice royalties will be earned that reduce this figure while new advances are also paid to other authors. Prepayments in days (Prepayment: printers / Cost of sales) x 365 = 19 printers days. In practice part of the Cost of Sales figure would be new title pre-press costs not carried out at the printer. This item relates to cases where advance payments are made to printers as a deposit or for paper. The purchases figure if available would give a more accurate figure. Accounts Payable in (Payables /(All purchases) x 365 days (9,000 / (57,000 + 18,000 + 5,000 + 2,000 + 10,000) x 365 = 36 days The purchases (investment) rather than the cost of sales figure should be used if available. I have assumed that this figure includes money owed to authors (see prepayment: authors) Customer Prepayments (Customer Prepayments / Turnover) * 365 = 4 days Working Capital cycle in96 + 62 + 61 + 19 - 36 - 4 = 198 days

Working Capital / Sales 28,000 / 100,000 = 28% %

Explanation of the figures

On average it takes Osiris 198 days to turn an investment into cash and profit. New tiles will use more Working Capital than reprints On average Working Capital equates to 28% of turnover The percentage of Working Capital to turnover varies according to the type of publishing Trade publishing in developed countries may have a figure of between 35- 45 % of turnover. Academic publishing is higher. Professional publishing uses a lower Working Capital % figure Working Capital is also a measure of risk

This figure may include new titles, reprints, foreign language coeditions, licence sales. The figure would be different for each of these. Within the total Balance Sheet, the Working Capital figure will vary throughout the year according to the phasing of new titles and the sales cycle. Publishers should know the typical Working Capital cycle and the level of Working Capital as a % of turnover for each market or distributor, for each category of book.

The relevance of Working Capital to publishing in young economies

In the FSU Working Capital levels were controlled at government rather than factory level. Invoices were settled on standard credit terms. Non or slow payment was not a major problem for printers and publishers. Risk was a government problem. Authors were paid standard royalty rates and terms. Inventory levels and print runs were according to a formula: in textbook publishing, 150% of the textbook requirement would be printed in year 1, the remaining 50% would be used for replacement copies in subsequent years. Publishers, printers and distributors would negotiate for annual cash budgets but did not have to concern themselves about Working Capital questions except where budget moneys were delayed. Printing capacity was sufficient to produce local and other agreed requirements. Thus textbook printing would commence in November for the following September. In a competitive open economy printers would have to offer discounts and credit to persuade publishers to take the risk

of early ordering. Schools would demand the latest up-to-date editions. Publishers would have to borrow money from the bank or shareholders to pay for the inventory. For young economies, the implications are as follows. 1. In young economies the first industries to develop are those with low or negative Working Capital % to sales. Negative Working Capital is where the organisation uses supplier credit or customer Prepayments to fund their day to day needs. E.G. banks and financial services, retailers, distribution, industries with cash sales or advance payments on signature of contract (e.g. printers). Organisations with negative Working Capital use the money from their customers with which to invest and to pay suppliers. 2. Competition is fiercest among industries with low or negative Working Capital / sales % figures. Financial entry barriers are lower and these industries are easier to expand. However profit margins are often lower because of the competition (but not always!) and the failure rate among such industries among developed countries is usually higher. 3. Banks are attracted to industries with low or negative Working Capital / sales % figures as cash and profits are earned more quickly 4. Entrepreneurs are attracted to industries with low or negative Working Capital % figures 5. Most marketing innovations in book publishing have come about through the application of the above Working Capital concepts to creating additional sales and expanding the market. Most of the innovations introduced at the end of the previous chapter were created by reduced the level of Working Capital and the time schedule of creating and selling books. 6. The customers, suppliers and authors of book publishers also want to operate to a low or negative Working Capital / sales %. Thus printers ask for advance payments e.g. for paper, distributors will try to withhold payment until they have received money from their customers. 7. Printers are loath to change from their dominant position where they could dictate prices and schedules according to price scales formulated at state level. These price scales were geared to maximum production output, not to satisfying publishers and their customers under national or international competition. 4-colour printing would cost 4-times the cost of single colour printing, despite the introduction of modern 4-colour sheet-fed presses. Printers will change their attitude to pricing and print-runs only in a crisis. In many young economies printers have not co-operated

with publishers (partly the fault of the publishers) and faced near collapse as publishers have purchased printing overseas. 8. In developed countries publishers have sometimes allowed retail groups extra credit (= higher Working Capital for publishers) in order to encourage them to expand into new outlets or sell more books. It is essential to distinguish between genuine expansion cases and opportunistic entrepreneurs. The more a publisher is actively engaged in marketing and distribution, the less likely is the publisher to have to rely on offering credit as an incentive. 9. The concept applies equally to state enterprises and non-profit making organisations. If cash and profits are generated more quickly, new titles can be commissioned sooner, staff and suppliers paid promptly. Bank interest is reduced. 10. Where producers are dominant, their customers will have to accept higher levels of Working Capital. Where customers are dominant, the producers have to accept a greater burden. In some young economies, the government may have a policy of holding key organisations in the state sector or as majority owned state enterprises rather than encouraging a free-for-all enterprise policy. This may affect printers, publishers and distributors. This policy will affect the evolution of the Working Capital cycle and may tilt it more in favour of producers.

Working Capital levels in book publishing in developed countries

Working Capital is a major problem in book publishing. Most publishers solve the question on a temporary basis by negotiating credit with printers and other suppliers. Their own customers solve the problem by negotiating credit with publishers or demanding sale or return terms. Sale or return terms make planning and cash forecasting much more difficult. Most publishers rightly prefer to offer a slightly higher discount for a firm sale. Retailers will argue that they would not purchase many new titles without their risk being mitigated by a sale-or-return policy The central issues, which must be solved, are:

Investment decisions rely too heavily on economies of scale e.g. in printing prices, by amortising first edition costs against larger print runs Publishers produce too many titles, which receive too little promotional effort and thus sell slowly or not at all. These can be solved only through long term changes in publishing strategy and greater attention to the value chain where suppliers,

publishers, wholesalers and retailers co-operate to mutual benefit and shared risk. On demand publishing may reduce inventory levels but does not solve the marketing aspects. Many publishers have studied the publishing of music CDs and cassettes, and of greeting cards with a view to finding solutions. While lessons can be learned, there are major differences: CDs, cassettes and greeting cards

Are all high margin projects Carry much heavier promotion budgets and commitment to marketing Are standardised in format Enjoy few economies of scale so short run and on-demand manufacture are the norm Sell to a more wide variety of retailers Sell on a less seasonal basis

Paperback publishers have adopted some of these aspects and have fought successfully to overcome the low price perception of paperbacks. Paperbacks can now sell in many cases at the same price as a hardback edition. The creation of hit-parades or Top 10 listings has been adopted for books of different categories and has attracted significant media attention thus making books more fashionable. As a result books may sell faster, perhaps at higher prices and thus reduce Working Capital levels.

Book Packagers
Book packagers create books under contract to publishers, bookclubs or foreign distributors. They evolve as part of the specialisation process especially when publishers become larger and more bureaucratic. Publishers buy the rights for a territory for a period of years or number of printings (provided that the title stays in print). The financial attraction to publishers is that they can buy smaller print runs at economic cost. Most publishers will make advance payments to the packagers but may be able to approve the content and design. Most packagers prefer to sell finished books rather than licence titles on a film and royalty basis. Packagers buy at low prices from printers because they create only a small number of titles but each title will have a large print run. Packagers often stay loyal to printers who reward them with long credit

and, in many cases, lower printing prices than those paid by their publisher customers. In the TV world many program companies will create programs for several networks while TV companies concentrate on distributing the programs. The production companies will retain the rights and earn fees for repeat-shown programs. A similar situation exists in the multimedia field. Thus packagers are specialists who are not involved in marketing and distribution. Subsequently a small number of them have decided to become publishers and done so very successfully after re-financing. Most stay as packagers. Compared with publishers, these packagers have little market value in acquisition terms. Thus packagers are very similar to many private publishers in young economies but with important differences as the table below shows:

Book Packagers

Private publishers in young economies - Founders are creatively rather - Founders are creatively rather than than market driven; enjoy market driven; enjoy freedom freedom - International printers offer - Printers tend to give better prices to them low prices and credit; established publishers printers have often offered credit to allow packagers to start up, sometimes with dire Some publishers may be closely linked results for the printer with a printer. The printer may demand advance payment - Packagers usually allow - Publishers will not involve customers publishers to approve content in the book content except in special cases e.g. textbooks and Ministry of Education, University Publishing Houses - Receive advance payments - Are paid after delivery from publishers - Hold no Inventory but reprints - Will often sell the total print run to a make high profits single or small number of distributors - Purchase rights from authors - Sell books with no transfer of rights and designers, and sell territorial or other rights to a number of customers

The Working Capital cycle in both cases is similar in both cases. The reason is perhaps the same. Neither the book packager nor the young

private publisher is adequately financed; both enjoy the creative aspects but do not want to expand if it means losing control. There are few potential buyers for book packagers. The cost of starting such organisations is much lower. Working Capital is lower because they are involved only in creating the books. They influence distributors, retailers and consumers only so long as they generate saleable new ideas. While book packagers can of course sell foreign rights, their potential to sell reprints is lower.

Making more efficient use of Working Capital

The table below lists items, which influence Working Capital levels favourably and adversely

Items that reduce Working Capital levels for publishers - Increased profit margins - Customers who pay promptly - Advance payments by customers

Items that increase Working Capital levels for publishers - Lower profit margins - Long print runs except where all the books are required on publication e.g. School and university textbooks - Inventory which is sold and paid - Slow authors who deliver late for quickly by customers after and whose manuscripts require publication substantial editing - Lower Inventory levels by reducing - Holding paper stock unless print quantities and working with market conditions demand and the printers who will deliver quickly and savings are large produce low print runs economically - Slow schedules for the development of new titles - Successful promotion that speeds - Making advance payments to up the rate of sale printers - Seasonal sales except where the publishers prints only for the season - Licensing (but problematic in young economies) - Paying suppliers on completion with credit - Authors who deliver manuscripts on disk ready for computer make-up - Incentives to staff , authors , suppliers, customers , sales staff and agents to speed up the rate of sale and of developing new books, delivering manuscripts on schedule

The attention of readers is again drawn to the examples at the end of the previous chapter, which illustrate ways in which publishers have produced affordable books through a marketing initiative. The concepts of this chapter apply in each example.

The danger of averaging Working Capital levels

Osiris has a Working Capital to Sales figure of 28%. However the figure will be the average of the organisations different activities. Let us assume that there are three divisions that produce different types of books for different markets and use different methods of distribution. The table below shows how each division generates much Net Contribution and also how much Working Capital is used in each division. The cost of sales, royalty, distribution, promotion costs and write-off figures differ in each case as a percentage of sales although not all the costs are necessarily variable. The term Net Contribution is the amount of money that each division generates towards the central administration cost of the company and hence to profit. Items below Net Contribution is not relevant to our analysis unless administration cost vary according to each market. Interest on bank loans could however be usefully charged against each division to give an even more meaningful figure. Although a Balance Sheet item, Working Capital is shown under Net Contribution to highlight the relevance of comparing Net Contribution and Working Capital levels by division.

Income Statement Division A Division B Division C Turnover 60,000 30,000 10,000 Cost of Sales (33,000) (18,000) (6,000) Royalties (10,800) (6,200) (1,000) Gross Profit 16,200 5,800 3,000 Distribution costs (3,900) (1,000) (100) Promotion (1,100) (900) 0 Write-offs (1,700) (1,100) (200) Net Contribution** 9,500 2,800 2,700 Working Capital 19,200 7,800 1,000

Total 100,000 (57,000) (18,000) 25,000 (5,000) (2,000) (3,000) 15,000 28,000

** Gross Profit less distribution, promotion and write-offs. The contribution to administration costs and profit from publishing activities

The analysis of the above sheds useful light on profitability and use of Working Capital by division. This is discussed in detail below. Analysis of the net contribution

The table below shows each cost item included in the Net Contribution calculation expressed as a percentage of turnover.

Cost of Sales % to Turnover Royalty % to turnover Gross profit margin % Distribution % to turnover Promotion % to turnover Write-off % to turnover Net Contribution % to turnover Working Capital / Turnover %

Division A 55.0% 18.0% 27.0% 6.5% 1.8% 2.8% 15.8% 32.0%

Division B 60.0% 20.7% 19.3% 3.3% 3.0% 3.7% 9.3% 26.0%

Division Averag C e 60.0% 57.0% 10.0% 18.0% 30.0% 25.0% 1.0% 5.0% 0.0% 2.0% 2.0% 3.0% 27.0% 15.0% 10.0% 28.0%

Turnover The turnover figure is the sum of the sales invoices issued during the year by division. Any returns or invoice queries would be shown separately under write-offs in order to highlight to management the extent of returns and invoices queries. The company will invoice either by charging an agreed discount off the recommended retail price, or by using an agreed unit price. If transport is included in the invoice price, the charge for transport will be shown as an expense under distribution. Free samples or extra jackets may also be included in the invoice price. Cost of sales The percentage to turnover is influenced by the sales mix, the balance of new and reprint titles, and the length of print runs. A larger print run might increase the gross margin % but also increase Working Capital levels and hence reduce the cash in bank figure. Some organisations will charge new title costs in different percentages to each market. The aim is to demonstrate that certain markets are profitable, but only on a marginal costing basis. If an organisation has to increase prices to local bookshops as a result of charging all new title costs against the home market, the organisation runs the risk of losing market share and profitability in the home bookshop market Other publishers, often the more progressive, may therefore regard new title costs as research and development, and charge e.g. 1/12th each month following publication against the Income Statement. This policy

means that inventory is valued at a cost excluding new title costs and reduces the need for write-offs. This policy also gives a better view of trends in gross margins, as the figure is not distorted by changes in the new title / reprint mix. The Net Income will fall. Countries may have specific policies for writing off first edition costs against profits, as they are similar in concept to research and development expenditure. Royalty figures The royalty figures differ because in the case of division A and B, the royalty is charged on the basis of the retail price, while in the case of division C, the royalty payable is based on net receipts, i.e. the unit price charged net of discounts. As markets expand, the need to negotiate royalty terms based on net receipts will grow in order that publishers exploit new markets. Without such author contractual terms, publishers might have to reject otherwise profitable deals. Thus the author might lose also. It is common for net receipts royalty rates to be agreed for deals above a certain discount rate, e.g. bookclub, export deals, coeditions, and licences. Gross margin Definition: Turnover minus cost of sales and royalties payable. Gross margin, the percentage of gross profit to turnover is widely used in book publishing as a parameter for book pricing. Where an organisation produces books with a similar cost profile, in similar print runs, and with a constant sales mix, gross profit may be a useful criterion. Here the figures highlight also that the use of gross margin as a criterion is not always useful and can be misleading although the division C, with the highest gross margin, also has the highest net contribution. Use of gross margin ignores distribution, promotion and write-offs, which will usually differ by division or type of book.

Distribution costs Distribution costs will include the following:

Cost of own warehouse in handling the years sales

Cost of using someone elses warehouse for the same purpose Using a contractor who handles your organisations distribution on a percentage of turnover basis for warehousing, transport, packing, invoicing but not selling.

Transport and postage costs Packing materials Handling returned copies

Sales invoicing and credit collection (in some developed countries)

The percentage cost will vary according to the method of market distribution used. If the books are sold to a distributor who buys the books on a firm-sale basis and who will sell, warehouse and transport the books to customers, then distribution costs will be low or nil. The publishers influence and control over the market will also however be low or zero also. In the case of a bookclub, the bookclub will demand delivery to their warehouse in bulk and distribution costs for the publisher will thus be limited to transport costs to the bookclubs warehouse. Promotion costs This includes the costs of promotion and selling whether carried out by the publishers or by other companies who carry out the publishers instructions. The following will be included:

Publishers own sales force

Sales commission to agents who sales on a commission basis only or to sales staff who are paid partly by salary, partly on commission

Advertising agency costs

Some publishers may include samples under this heading

Write-offs Write-offs are provisions against things that are likely to go wrong. The rule is that bad news has to be charged to the Income Statement as soon as known whereas good news e.g. a large sales order for future delivery is not shown as a profit until realised The following would be included

Doubtful debt provisions Bad debts

Inventory that will not recover the cost of producing it

Sales invoice queries

Returned books (these are often shown separately as part of the turnover figures e.g.

Gross turnover 105,000 Returns provision 5,000 Sales turnover 100,000

Currency losses (or gains) on sales and purchase invoices

Royality advance write-offs

Net Contribution Definition: Gross profit minus distribution and promotion costs, and write-offs The Net Contribution shows the contribution from publishing activities of each division or market. While the figure is immensely useful, the percentage figure must be used with caution as both fixed and variable costs have been deducted from turnover. Licensing Income would also be shown, if significant, as a separate item and not necessarily as part of turnover. While licensing can be risky in young countries, it is a significant part of publishing in developed countries where the legal system or local publishing association will be active in protecting publishers rights. Showing licensing Income as part of turnover has misled publishers for years over the value of rights income to profitability and to an acceptable return on capital %. Net Contribution from Book Sales 15,000 Licensing Income (net of royalties payable) say 500 Total Net Contribution from publishing activities 15,500

Analysis of Working Capital levels by division

After a rather long diversion we now revert to Working Capital using the same example. The table below shows how efficient each division is in using Working Capital.

% Sales Turnover % Net Contribution /total Net contribution % Working Capital Net Contribution / Working Capital % Net Contribution per 1 USD Working Capital

Division Division Division Averag A B C e 60.0% 30.0% 10.0% 100.0% 63.3% 18.7% 18.0% 15.0% 68.6% 49.5% 49.48 27.9% 35.9% 35.90 3.6% 100.0% 270.0% 53.6% 270.00 53.57

Explanation using division C as an example While generating only 10% of total turnover, but 18% of total Net Contribution, Division C uses only 3.6% of the total Working Capital tied up in the company. Division C makes US$ 2.70 Net Contribution for every 1 US$ of Working Capital used in Division C. For both entrepreneurs and for publishers unable to borrow more money from the bank or shareholders, the Net Contribution per 1 US$ of Working Capital is vital. If we were to add the Working Capital cycle (198 days in the case of Osiris earlier in the chapter) for each division, the report that we have just studied would be even more useful.

Growth opportunities
The following analysis of the same data shows the importance of Working Capital levels in generating cash as well as profit. Using the above data we can extract the following

Impact of USD 1,000 increase in sales volume Increase in Contribution Increase in Working Capital

Division Division Division Average A B C 158 93 270 150 320 260 100 280

For every additional US$ 1,000 of turnover, US$ 320 of Working Capital is required in Division A, US$ 260 in division B, and only US$ 100. It is rare that the division with the lowest Working Capital requirement will also have the highest net contribution % but that is what division C offers. Division C might perhaps consist of reprints or foreign language editions only.

Calculating cashflow using Working Capital

We can project future cashflows using the Working Capital data. We are assuming that there are no additional purchases of long term assets involved. Any other additional items of expenditure that are required to support the change would also be included e.g. an additional editor, a new personal computer. (a) using the Osiris average net contribution and Working Capital / turnover percentages In the first case we will calculate the future cashflows over a three-year period using the average net contribution percentage and average Working Capital % for Osiris. It shows the impact on cashflows starting with sales of US$ 1,000 in the first year.

Assumption Turnover growth % Net Contribution % Working Capital % to turnover Osiris Analysis Turnover Net Contribution Working Capital Cashflow Bank figure 15% 28% xxxx1 1,000 150 280 (130) (130) 10% 15% 28% xxxx2 1,100 165 308 137 7 10% 15% 28% xxxx3 1,210 182 339 151 158

As we are studying the cashflow on an incremental basis, the opening Working Capital figure, as for a new project, would be zero. The calculation for cashflow in the first year is as follows: Cashflow: Capital ** = 150 +0 Cashflow: Cashflow: year 1 = Net Profit Contribution** plus increase in Working 280 = (130) year 2 = 165 +280 308 = 137 year 3 = 182 + 308 339 = 151

** Plus any purchases of long term assets and additional administration expenses required as a result of the decision. Net profit contribution is used instead of profit because we are studying the impact on cashflow of increasing sales turnover. Only incremental costs and sales are included.

(b) using the net contribution and Working Capital / turnover percentages for Division C which has both the highest net contribution % and the lowest Working Capital / turnover %

Assumption Turnover growth % Net Contribution % Working Capital % to turnover Division C Analysis Turnover Net Contribution Working Capital Cashflow Bank figure 27% 10% xxxx1 1,000 270 100 170 170 10% 27% 10% xxxx2 1,100 297 110 287 457 10% 27% 10% xxxx3 1,210 327 121 316 773

Thus an expansion in Division C of USD 1,000 in turnover, and thereafter an increase of 10% per year cumulative, generates USD 773 of additional cash as compared with USD 158 in the average scenario for Osiris. The difference is explained as follows: Increase in Bank figure: Osiris average 158 Additional net contribution from division C 397 Cash improvement due to lower Working Capital % in division C 218 Closing Bank figure for division C : year 3 773 Most of the increase in the bank position is the resulting of higher profits but the lower level of Working Capital in division C also results in an additional cashflow improvement of US$ 218. Notes on the Cashflow calculations In practice we would add back to the net contribution figures that part of write-offs that was included for future problems. This is because such provisions do not affect cashflow. We can apply the same concepts for the preparing of spreadsheetgenerated Business Plan forecasts. In such cases all Income Statement and Balance Sheet items would be included. Cashflow can be forecast using the Balance Sheet rather than through a tale of Receipts and payments. The resulting cashflow figure will be the same under either method. Using the Balance Sheet figure above, different scenarios can be studied, as the spreadsheet model can be parameter driven. Thus

changes in credit terms, inventory levels, margins can be studied quickly. Pareto's Law - the 80/20 rule This rule states that invariably time, sales, costs, or problem areas occupy a disproportionately high percentage of time or money. In publishing we might use the rule as follows:
80% of inventory held is for only 20% of the titles published 80% of our profits are made by 20% of the titles we publish 80% of our turnover is made from 20% of our customers 80% of our slow payments are caused by 20% of our customers 80% of our Working Capital relates to 20% of our list or 20% of sales turnover. 80% of out time is spent on 20% of our titles

This general rule can be applied in so many ways to financial management in book publishing.

A detailed Look at the elements of Working Capital

Inventory Inventory will consist of:

Un-printed paper Flat printed sheets New books and reprints under development Finished Inventory Publishing plant (discussed in chapters 4 and ) Unprinted paper

In young economies paper may represent 40-50% of the price of a book while in developed countries the percentage may be 10 15% of the selling price. Thus in young economies, economic purchase of paper is a major issue. In some countries paper is a scarce commodity with prices at a premium. In developed countries publishers will uses several printers in different countries. The normal procedure for book publishers, except for publishers of standard format paperbacks is to negotiate prices with printers, which include an agreed paper specification. Newspaper and magazine publishers, who print to a single format using reels will

normally purchase paper in order to secure the lowest possible prices and in order to guarantees supplies. Paper is a commodity, but, unlike most commodities, is not traded on commodities' exchanges across the world. Attempts are being made to develop a Futures Market for pulp. As a result there is no market price for each paper grade. Large users will negotiate significant discounts on published price lists. but such data is not published. Only for newsprint is there an open discussion on prices. Countries with strong economies and currencies will negotiate the best prices, while countries with no local pulp industries will distort price levels by panic buying. Young ambitious economies will require increasing levels of paper, as education, packaging and advertising become high priorities. Where a country has an indigenous pulp and papermaking industry, this increase in demand causes paper shortages and leads to higher prices. Consumers become more demanding and require higher quality papers, which are not available locally. Controlled paper distribution means that local users may pay a higher price for local paper than their counterparts in developed countries. Unless subject to special trade agreements or supported by their local governments e.g. for credit risk, foreign pulp and paper mills may charge higher prices to young economies because of the credit risk and because they do not always represent a major market to the mills. Local distributors are unlikely to inform publishers that world paper prices are falling. Local distributors will often seek to limit alternate sources of supply. There is thus often a large difference between prices charged by local distributors and those charged by the foreign paper mills who are prepared to supply direct. Many publishers in young economies will not purchase paper through the printer for two key reasons. Printers will often make a surcharge of up to 25% as well as demanding advance payment. In addition printers may give priority to customers prepared to pay higher prices for printing and paper and thus jeopardise printing schedules. Thus publishers in young economies face three problems:

Paying no more than market prices for paper (with guaranteed quality)
Guaranteeing supplies of paper and thus books. Printers may give priority to publishers with paper stocks.

Finding cash or loans to pay for the paper

Much of the comment on book inventory applies also to paper stocks. It is cheaper and less risky to hold an inventory of paper than of books.

Flat printed sheets These are flat printed sheets, which can be bound as hardback, paperback or other editions at a later date. By not binding immediately the publisher also delays the cost of binding but will usually have to pay the printer for storage. Wastage rates are higher when the binding is not carried out as a single run. Many publishers of short run editions will print extra 4-colour covers for later printings. A further use is where 4-colour illustration sheets are printed for later over-printing in other languages. New books and reprints under development (Work-in-Progress or WIP) This represents all the costs of creating new titles and reprints up to the stage where the books ready for sale. Editorial and design salaries will be included. As competition among publishers increases, publishers are forced to create more added value to manuscripts and this increases the amount of new title costs and also WIP levels. Faster schedules will reduce WIP levels. This can be achieved by better scheduling, use of in-house DTP and scanning equipment, offering incentives to authors (for supplying manuscript on disk) or to staff and supplier for shorter lead-times. One publishing survey indicated that those publishers who worked to short schedules also had the lowest levels of typesetting corrections. Seeing the finished book on which they have worked motivates certainly many publishing staff.

Finished Inventory Entrepreneurs and bankers are not attracted to many types of publishing because of the high Inventory levels. In developed countries these are still high, but falling, for the following reasons:

Profit margins in publishing are not high

Printers offer significant economies of scale for longer print runs. Publishers are persuaded to print too many copies for too long a sales period. Publishers believe that book prices must rise if they pay a higher unit cost for printing. Most publishers in the FSU also share this view Publishers will not always look at the Cashflow and Balance Sheet implications when making decisions on print runs Publishers price books on the basis of a single printing

Publishers are optimists Publishers do not invest heavily in promotion

Most publishing courses teach full-cost costing for the pricing of investment decisions

Book sales are highly seasonal

Production staff are chosen for their design and technical rather commercial skills. The trend in most industries is for professional buyers, not (printbuying) specialists in a particular industry

In younger economies publishers face a different scenario. Publishers in developed economies will print in several countries either for financial reasons or in order to print at a source close to customers e.g. North America; Asia for the Australasian markets. Printers in young economies will seek to export printing to developed countries to earn hard currency In order to break into these markets they will quote low prices on short print-runs in order to enter the market. However, their local publishers are often forced to operate to the printers terms of trade and pay higher prices. In order not to lose sales by being out-of-stock, publishers may print excessively large print runs. In addition, the culture of printing for 3 or 5 years as was the norm in the FSU, prolongs these attitudes especially among state publishers. The subject of inventory levels and optimum print runs is so central to book publishing that it is discussed in great detail in chapter 7 The following will assist in reducing inventory levels:

Ways of reducing Explanation Inventory Closer co-operation with Publishers co-operate closely with one or 2

partnership printers

Market Research and advance selling Increased promotional activity promotion Use of series and standard formats

printers; contract on an annual basis; forward plan together. A partnership but with no final investment in the other partner. Pre-selling before books are printing allows publishers to fix more exact print runs Promotion and greater sales effort in less obvious areas e.g. smaller towns, may cost less than interest payments to banks The use of standard (or a small number of) formats means that capacity can be booked with printers, paper purchased in bulk. The exact print quantities per title are fixed later on a monthly basis. This is used for standard format paperbacks. This policy is as much about purchasing policy as printing machinery constraints. This was the procedure in the FSU. Today most of these state distributors have collapsed or split up. Distributors will demand large discounts for carrying the risk. In many cases they will sell in the capital city and large towns only. The distributor is needed for expanding sales into smaller towns and rural areas. The use of more than a single channel of distribution encourages competition and improved sales It may be appropriate to offer larger discounts or incentives to customers and distributors The negotiation of price schedules with equal emphasis on low make-ready costs

Selling stock firm to an exclusive distributor

Sales Incentives, discounts Printing contracts

Accounts Receivable
Obtaining money promptly from customers is a major problem in publishing (and all industries) worldwide. Market leaders and dominant organisations will be paid more promptly as their customers fear losing the profits that they earn from such sales. In many countries over 10,000 new titles are published each year. Bookshops will sell several thousand titles. The rate of sale of books is slow. In order to encourage booksellers to stock titles credit is offered. With newspapers and magazines the product has a short shelf life but the cash cycle is short. In addition there are only a small number of

magazines or newspapers relative to the number of books published. Customers ask for their regular magazine or newspaper. When selling to more distant customers e.g. in another country, credit is offered to take account of the time required to transport and distribute the books. In some countries the supplier has the statutory right to demand interest on overdue invoices. These schemes are in practice less useful than they appear as customers may use suppliers as a bank. Another key reason is that most customers in the book trade are underfinanced. Rather than raise additional share capital or bank loans, they use trade credit with their suppliers, the publishers. This is partly because many customers may be privately owned but also because the low return on capital from bookselling does not attract investment easily. In order to encourage booksellers to buy new books, publishers will often offer to sell on a sale-or-return or sale and exchange basis. Under sale-or-return basis the bookseller may send back stock not sold after an agreed number of months. The bookseller must settle the invoice on the agreed date and will subtract returns from subsequent invoices. In the case of sale-or-exchange the bookseller may return unsold titles in exchange for purchasing the same number of similar new titles. This is used widely for paperbacks and is particularly prevalent in North America for hardback editions also. The Accounts Receivable figure must take account of the fact that the amount invoiced may exceed the amount that will later be paid. This makes cashflow forecasting difficult. Most publishers prefer to agree larger discounts but sell firm. Booksellers who pay late are in fact taking a larger discount. If the publisher earns a 25% Return on Capital, or approximately 2% a month, the bookseller is thus taking an additional 2% discount for every month that payment is delayed. Incentives are frequently offered for prompt or early payment. Many customers will pay late and take the discount, however! The value of such discounts can be assessed either by using the IRR or NPV function on a spreadsheet or by the following formula:

The supplier offers credit terms of 30 days from delivery and acceptance. The supplier will accept a 2.5% discount of the invoice amount if the invoice is settled in 7 days.

The following ways of reducing Receivables are used in book publishing and other industries in developed countries

Method High Margin products

Comment If Retailers make a large profit from selling a suppliers goods, they may lose that profit if they do not pay on time Market leadership As for high margin products Credit checking before This checks the credentials of the customer. the contract is Many Associations of Publishers operate a accepted credit committee for their members. Banks offer a credit reference service also Frequent and prompt If customers know that they can obtain books delivery quickly and reliably, they can hold lower levels of inventory. Many publishers focus on selling books into rather than out of the bookshops Formal methods of Bank drafts, Bills of Exchange, Letters of Credit, payment guarantees. Bonds Retention of ownership The accounts department In some countries ownership does not pass to the customer until the goods have been paid for. Invariably the accounts department will be expected to chase customer payments. Private publishers will give it high priority and owners will do it personally. It is quite different to most financial accounting work and is a key priority for firms. Firm persuasion is needed rather than accounting skills. These may expand the market and cost less than bank interest payments

Joint promotions, merchandising

Methods of payment

Banks, suppliers and their customers are forced to find more complex payment methods in order to gain competitive advantage. These are needed to expand trade and to give confidence to encourage suppliers to enter into contracts. In order to stimulate credit trade, banks created more formal payment methods. These are only as good as the financial standing and reputation of each bank, supplier and customer. The aims of these payments methods include the following:
To protect the supplier To encourage the supplier to offer credit and more attractive prices To convince the supplier that he will be paid once the customer has taken delivery To act as collateral to the supplier in particular to obtain bank overdrafts or lower rates of interests To reinforce the legal contract between supplier and customer To encourage foreign trade; to obtain governmental credit insurance

In practice young publishers are more likely to encounter formal methods of payment when negotiating with foreign printers. Typical documents include the following:

Method of Payment Bills of Exchange

Explanation Checks drawn on the customer by the supplier for payment at a future date. The supplier will hand over delivery and customs documents once the Bill of Exchange has been signed by the customer (for new customers) or perhaps immediately with trusted customers. The Bill may be deposited with the suppliers bank and allow a lower rate of overdraft interest. Alternatively Bills may be endorsed in order to pay a supplier. Bills normally assure prompt payment but do not guarantee payment The use of Bills of Exchange must be agreed by both parties during negotiations The customer signs these at contract stage. The customer undertakes to pay in full provided certain listed conditions are fulfilled. The conditions must be capable of clear non-subjective interpretation by courts. They are widely used in North America. In other parts of the world they tend to be used for larger and longer contracts than Bills of Exchange. They are usually

Letters of Credit

Bankers checks

regarded as more reliable than Bills of Exchange. A bank, after debiting the customers account, will issue a check to the supplier drawn on the same date.

The situation in young economies is quite different. Many of the items in the first table concerning the collection of Receivables may not apply. Banks may not offer financial instruments such as Bills of Exchange. Cash or deposits may be demanded wherever possible but distributors survive on supplier credit. Often government departments will be slow payers. Publishers must therefore take carefully researched risks and enter into alliances of mutual benefit.

Author royalties
Authors receive advances against future royalty earnings. They serve also to pay the author while writing. In most cases they are nonreturnable. Thus if sales are low or slow to emerge, the advance may be in excess of earned royalties and perhaps paid 2 years before the total sum is earned from sales. In developed countries, trade publishers and paperback publishers will expect to write-off large amounts of unearned royalty advances each year. The payment of high royalty advances, as publishers bid for market share, is cyclical. The advance will be against earnings over the term of the contract which will be for several years and several printings and editions. In many types of publishing, the publisher will find an author who will be contracted to write to a specification; Artists, photographers and photo agencies will be contracted to provide illustrations and photographs. The publisher than provides more added value by the author. In such cases the level of advances and royalty rates will be lower. In other fields, e.g. academic publishing, authors may write for no or minimal advance as the incentive is to increase their academic reputation. Publishers should regularly e.g. quarterly or twice a year, review those titles where advances have not been earned. Reprints may require the payment of no further royalties in cashflow terms. In young economies the local Society of Authors may insist on standard royalty terms and advances regardless of the type of book or print run. The terms appropriate to approved textbooks (print-run 100,000 plus) are quite different to those suitable for university publishing (print-run 500-2000) or to authors of original novels. Established authors benefit hugely but resist competition from new authors. Subject to the laws of the country and the availability of good authors, most countries will

need to study variations on standard author contracts if authors, publishers distributors are to benefit from expanded book markets. Computer programs exist for the monitoring and payment of author royalties. These are suitable for publishers with large number of titles with complex contracts. However for most young publishers a spreadsheet can be used to calculate the royalties earned, and payments due.

Prepayments to supplier
In developed economies publishers may buy coeditions for the exclusive licence to publish in a language from foreign publishers or book packagers. Packagers concentrate on creating multi-language titles but sell the language rights to foreign and local publishers; they do not involve themselves in the marketing or distribution of books. Typical contractual terms for packager and coedition contracts involve stage payments, on signature, on approval for press and on delivery. Publishers who buy from coeditions or packager products can publish smaller print runs more economically and without using their own editors. For rights deals, the publisher will purchase film and pay a royalty advance. In FSU countries, many printers still demand payment in advance whereas in developed countries 60-90 days credit would be given to publishers. These are also Prepayments.

Payables
In developed countries where printers compete aggressively on an international basis, credit of 30 - 120 days is used to encourage publishers. Private publishers will remain loyal to one or more printers who offer substantial credit. This credit reduces Working Capital levels and replaces loan capital in many cases. Private publishers will often negotiate lower printing prices than larger publishers will.

Customer payments in advance

Coeditions have already been discussed under Prepayments. Where publishers sell coeditions to foreign publishers they will receive advance payments which will be owed to their customers until the books are delivered and accepted.

Summary
In developed economies, companies are forced to find innovative ways of reducing Working Capital levels in order to maintain an acceptable Return on Capital Employed and in order to survive. In most cases those companies, which are most market, oriented and involved in market distribution e.g. retail groups will dictate terms to the producers. Where such compa-nies are successful in expanding the market, the suppliers may benefit also.
EXAMPLE In developed countries retailers of high priced items and items with slow stock turn, may refuse to purchase inventory and will accept only merchandising deals where the inventory belongs to the supplier until the products are purchased by a consumer. The retailer is this acting as a commission sales agent only. The supplier is paid once the goods have been sold. Investors, banks and suppliers support such companies provided that they are successful and expanding. In many countries professional retailers are taking an increasing market share of bookselling proving that bookselling is attractive to entrepreneurs. Booksellers compete against other successful booksellers, against supermarkets, bookclubs. Printers, publishers, wholesalers and retailers operate in a value chain. However in young economies there is little understanding of the value chain or teamwork. Printers, publishers, distributors and bookshops operate independently for survival. In the FSU, printers, publishers and distributors operated like watertight compartments with no overlap of responsibilities and reporting to different ministries. Working Capital was not a significant problem for individual enterprises Printers are accustomed to operating large factories and have to possess management, commercial and accounting skills. Their long-term assets may be used as collateral for loans. At the other end of the chain many state distributors have collapsed, as their vast inventories became unsaleable; many book retailers deserted bookselling to sell higher margin goods. The publisher is the least experienced business member of the chain: printers have business skills, distributors have a short Working Capital cycle and collect cash. Publishers Balance Sheets offer little potential for bank collateral. As a result publishers in young economies may feel initially at a disadvantage to their printers and distributors.

Working Capital characteristics of different types of publishing

Publisher School

Developed country Young economy Medium. High WIP but for a High WIP; Low Inventory if

textbooks

small number of titles; low but seasonal Receivables; Author advances low; Payables average and seasonal

University textbooks

Professional books

Trade Publishers

Academic publishers

books are successful; Receivables low and seasonal. Printer advances high as print runs are often long. However printers are attracted to the long runs and the guaranteed market and will start to offer credit Medium. Similar to school High. Publishers will print textbooks; larger lists. for several years. Pricing competitive Receivables low as many books are sold for cash in university bookshops. Low. High WIP but small High WIP and Inventory. lists; Receivables low as Professional may pay a many books are sold direct high price for imported books but not for local books High perhaps 35 40% of Medium if books are sold turnover. Large inventory to distributors on due to need to sell to a wide publication: high WIP as market and due to use of many titles; high author colour; High author advances. Low advances and Receivables Receivables. compensated by high Payables Very high. This is making Very high. Similar the Internet and other characteristics to electronic medium university textbooks but attractive to Academic Working Capital levels publishers and their higher customers

Factors that reduce Working Capital levels

From the table above we can infer the following checklist of reducing Working Capital level in developed countries
Small numbers of titles Need to buy rather than want to buy titles with unique information Use of standard formats for paper printing and binding Direct marketing Closer involvement in market distribution Publishing for clearly identifiable markets e.g. schools, doctors, accountants, lawyers Short run printing Book packaging Titles where printing costs are a low % of the selling price

Whether the same list will apply to young economies will depend on average wages levels and other economic data such as the percentage of urban population to rural population. In developed countries profitability for such publishers is linked to their ability to charge a premium price for need-to-buy books. Computer books are a typical example: a typical PC will cost in excess of US$1,000. Thus the selling price of a book that assists the user to make better use of the computer and its software is linked to the benefit. In many young economies that may not yet be the case.

The Value Chain - Supply and Marketing Decisions

This chapter concludes by applying these concepts to the Value Chain printers, publishers, distributors and retailers and concludes by studying in detail the title investment decision. Most market innovations have arisen through co-operation between suppliers in the Value Chain, and by the application of Return on Capital pricing. In general the supplier taking the greater risk will be relieved of much of the Working Capital burden in order that the risk taker can invest in selling and promotion costs to enlarge the market.

Company Printers

Comment Fixed costs are high. Profit Contribution % is high if labour is regarded as a fixed cost. Working Capital % of turnover low. (assumes that publishers supplies paper). Printers now compete on an international basis using similar machinery. Many reproduction prices have fallen by over 1000% in the last 15 years. Distributor Profit Contribution % low. (who stores, Working Capital as % of transports and turnover also low. sells) Payback period short. Distributors will usually have a very low capitalisation. If they do not sell enough books,

Implications for publisher Even if a printer adds only a 10% profit margin, the return on capital may be high. Fast jobs are very profitable when measured in terms of return on Working Capital. Because of the large fixed costs, printers can vary prices if they need to attract more work to fill their factories. Book printing is regarded as one of the more profitable parts of the printing industry Distributors will concentrate on selling the more saleable titles into the largest towns. Therefore many titles are never seen in many parts of the market unless the territory is divided up between distributors.

Commission Sales Agents

Retailers

Bookclubs

Publishers own sales force

Direct marketing

they cannot pay publishers or buy new stock Low profit per 1USD of Only one profit margin is turnover but almost no added as the publisher sells Working Capital involved directly to the retailer rather than to distributors. The publisher carries the total Working Capital burden. Contribution % quite The prices and profit margin high, Working Capital % on books are both low. of turnover medium if the shop is reasonably successful. Low Receivables; high Bookclubs create and Inventory; Very high maintain a customer base entry costs before bookclubs make a profit and generate cash. Advertising costs high Higher fixed costs as Publishers can sell direct to salary costs have to be the larger shops in large paid but faster turnover towns of inventory follows if sales turnover increases Higher fixed and variable Higher contribution and costs but, if successful, reduced Working Capital this is amply levels. Higher Break-even compensated by the point absence of a discount to distributors of retailers

Possible Solutions
In financial terms there are three main choices:

To raise more finance in order to be able to take a longer term view of publishing To develop innovative solutions involving the use of Working Capital to make books more affordable to more people and hence expand the market. This has to be linked to a marketing campaign carried out jointly with distributors, bookshops and other sales agents. To change publishing policy and publish for different more attractive markets; develop teamwork with partners who have common needs

It is interesting to note that many publishers in young economies have chosen to diversify into trade book, often in colour and with long print

runs, in order to pay for overheads. As the table above shows, trade publishing, based on the developed country model, usually has the highest level of Working Capital.

Case studio Portfolio

The following case studies provide lessons into critical success factors in book publishing. The reader may believe that they are not all relevant to their country at the present time. Such views should be made very cautiously as most developments in book publishing have taken place as a result of new entrants into publishing. Most of these entrepreneurs, viewed, at the time, as outsiders to the book publishing industry, saw book publishing as the profitable medium for achieving their business goals. In order to compete with these entrepreneurs, book publishers need to stay ahead by exploiting distribution channels, and customer and author relationships, for joint profit, by identifying and supplying new areas of demand for books. Book publishing is not an island either nationally or internationally! Other lessons concern the skills needed in successful book publishing, Sales or marketing skills are essential. A balanced team is needed which combines sales, creative and business and organisational skills. Authors must select publishers who will best market their titles over the longer term. Publishers must demonstrate to these authors that their literary skills are complemented with commercial and marketing skills, and more importantly, by success. However readers may note that in all cases the publisher identifies a profitable market gap rather than relying on authors to submit manuscripts.

Case study 1
A teacher worried how few little young children read books. She carried out a personal study of story books available for pre-school children. She found almost no small short storybooks at affordable prices and decided to develop cheap simple books for them to read. As a teacher she insisted that the texts would also have an educational value as well as being enjoyable to read. Storylines and illustrations would be simple and friendly. As the books would be aimed at young children, the books would be small enough for them to hold when reading e.g. a bedtime story. To make them interesting the books would

be in full-colour even though most childrens books at the time were printed in single or two-colour. The books had to be strong, as they would be subject to rough treatment by the young readers. Case binding was therefore essential. Authors and artists would be commissioned on a fee basis rather than on a royalty basis. Both had to work to a strict brief and style. The teacher wanted children to learn to enjoy reading. Repeat sales were essential. If the children enjoyed the books, they would try to persuade their parents to buy more books. If the books were affordable, parents would encourage this. As children became older, they could buy the books with pocket money. The teacher realised that parents would be unlikely to be frequent visitors to bookshops but would visit toyshops under pressure from their children. She decided to sell through toyshops and general stores. She approached a local printer. Together they devised a small format, which would be economic in both printing and binding. All books would be books as a series and in the same format. Bookshops would be sold a range of titles; not single titles in order that children would have a choice of repeat purchases. Over a period of years the series became very successful and has remained a huge success for several decades. It is now one of the strongest brands in many countries. Books continue to be produced locally. Many publishers have sought to compete by seeking cheap printing sources in remote parts of the world where labour costs are cheaper than European printing. Few have found ways of competing with these publishers whose books sell at the price of a Greeting card, a packet of cigarettes, or a hamburger, the cost of 3 newspapers. a metro journey Now part of a public company, the companys main failure occurred when sought to make changes with new formats and more modern illustrations. Lessons
Demand was identified outside traditional bookshop customers The retail price was affordable. This encouraged repeat sales The publisher created sales potential outside traditional bookshops; sales support for such customers was provided through good merchandising The books appealed to new readers who did not purchase books A single format (same size and page extent) was used making short prints runs over several titles economic (and hence low inventory (and risk) levels. A local printer was used Brand loyalty. The series is well-known outside book publishing

Export markets purchase coeditions Later variations on the standard format failed

Case study 2
A refuge from another country started to sell books in street markets. Finding this profitable and noticing that publishers paid little attention to marketing old titles or backlists, he started to buy overstocks from publishers at low prices. People said that he was a brilliant salesman. After a few years successful trading he found that few quality overstock titles were becoming available for him to sell. He decided to create his own titles. He recruited two people to join him. One was the chief book buyer for a major national department store who would take charge of creating the books and for administration, the other a marketing specialist with vision and sales contacts. Our entrepreneur used his selling skills to persuade printers from his home country to print for him; He offered large volumes in standard formats and in return received fantastically low prices and long credit. Payment would be in part by barter. The project became a huge success. Books, sold through retail chains rather than through bookshops, were for the first time available at affordable prices in full colour. People who did not frequent bookshops became book buyers. The subjects were confined initially to cookery, gardening and art. The entrepreneur sold the company to an international group who was seeking an expert to rationalise their book publishing interests that they had acquired. Our entrepreneur did not enjoy being employed and had to attend numerous meetings. The companys overheads and bureaucracy increased and the company expanded its product range. His fellow directors on the board of the parent company had very different backgrounds and understood little of the skills needed to succeed in selling in the real world outside corporate life. Bored by the administrative chores, the entrepreneur later resigned from the directorship of the public company. He later started again using the same principles and recruited a number of his former staff. The second firm was later acquired for the second time by the same public company for a vast amount of money with perfect timing, He is now the major shareholder in that public company,

one of the largest, most successful media groups in the world. He runs a charity fund to assist publishing in young economies. Note: I am proud and grateful to have been trained by this entrepreneur and later to have helped his companies. Lessons
The vision, charisma and dynamism of an entrepreneur who started by selling books on street stalls The vision to recognise personal weaknesses and to appoint complementary skills for the marketing and commercial aspects of the business; talented staff were attracted to the company The publisher developed new markets for books by attractive design, affordable pricing and by selling to non-bookshop outlets The advantage of being the first to develop a new market The entrepreneur had a sound understanding of risk The entrepreneur had sales rather than marketing skills. He did not understand, or want to understand specialist niche book publishing The entrepreneur was not happy within larger organisations; he was not a bureaucrat He set up large printing contracts with printers in Central Europe and Asia

Case study 3
A motorist was frustrated that he could not find any manuals explaining how to repair his motor car. The only manuals were those produced by manufacturers and these were very technical and aimed at garage mechanics. On investigating further he found that this was true for most car manufacturers and that many other motorists found this a problem. Garages did not want to encourage motorists to carry out their own repairs. He decided that there was a huge potential demand and that he should take advantage of the potential. He started to publish car repair manuals for individual car models. They were strongly bound because the books would be kept in the car. The price was not the key issue as the purchase was linked to the investment in the car and the potential saving on carrying simple repairs. Car repair experts were commissioned to write the books for a fee. Photographers were commissioned to take photographs. He obtained statistics of new car sales by model and of car registration of older second-hand models. From these statistics he was able to forecast which books would be most saleable. Motorists who owned popular older cars would be more likely to buy.

He sold the titles direct to motor accessory shops, general stores and later to bookshops. As new card models entered the market, he quickly produced repair manuals. His customers knew that any motorist seeking a repair manual could find the appropriate book. They in turn were encouraged to carry a wide range of his titles. His sales force called frequently on customers to check stock levels. His warehouse delivered the books quickly to the shops thus reducing the stock risk. His books become a well-known brand. Competitors tried to enter the market but never with great success. He took no involvement in the activities of the local Publishers Association believing that he was in the car market. The company, two decades later, is a public company quoted on the stock exchange. Lessons
The entrepreneur again saw a market gap for a new product New distribution channels were used not the traditional bookshop Buyers would not be regular visitors to bookshops Editors were technical experts not literary figures The entrepreneur did not try to diversify into other areas, other than into international markets A standard format was used with local printers The books were marketed as a single specialist list or series rather than individual titles;

Case study 4
Two employees at the offices of the local ministry observed that the ministry spent a large amount of manuals on training conferences and training manuals. As experts themselves they were invited to speak at such conferences. They came into contact with the key speakers at such conferences. Conference proceedings were often published after the end of each seminar. They noticed that the same people attended the seminars. They were able to obtain lists of people who had been invited but did not attend, and of people in similar jobs throughout the country. As Guest University lecturers they knew which universities specialised in their area of expertise. They quickly realised that a market opportunity existed. They knew the top experts who could be authors. They knew many of the potential readers. They started to publish seminar manuals and books for professionals and for university students in that field. The manuals were sold by direct marketing to these customers.

They found the publishing world increasingly interesting and decided to enrol on industry publishing courses under government funded schemes for small businesses. They started to publish books for sale through bookshops They bought the publishing titles of two competitors at very low prices. They discovered that books were more price-sensitive than manuals. Bookshops only ordered when they received an enquiry from a customer. Stock levels rose. They enjoyed the cultural world of publishing. A consultant who had advised on their acquisitions persuaded them to focus on their customers and on manuals and conferences. Books had a lower perceived value than manuals; the directors knew far more about the potential customers than bookshops. Thus they should sell direct. They accepted the advice, ceased their book publishing activities, and concentrated on learning direct marketing techniques. They run specialist conferences and publish specialist manuals direct to delegates and other experts. They operate 100 kilometres from the capital city and have no contact with book publishers. Rather they focus on their council and student customers, and on running conferences. Their customer database is a top priority. Lessons
A team of two well-balanced members makes it easier to start a new publishing company The team started as experts in their target markets, but not as publishers They saw a market gap They offered conferences which generated revenue, new authors and potential book buyers They did not rely on - the book format - raditional book distribution channels (preferring direct marketing) All publishing activities are delegated to freelance specialist editors. All sales functions are in-house

Case study 5
X was one of the major literary figures. He became a book publisher. Top authors were delighted to be published by X. The books were reviewed by the literary reviewers of the national newspapers and sold only through bookshops. Books were published when the publisher was satisfied with the editorial quality.

X gave personal attention to all his authors. Each work was perfected before publication. High literary standards were essential. X and several other literary figures became the centre of the publishing industry. These publishers became brand names in literary circles. Paperback publishers started to buy the paperback rights of their titles. These publishers became more and more dependent on the paperback publishers advances. With little attempt to expand the hardback market, print runs of hardback tiles started to fall due to their poor marketing skills. These imprints are internationally known in publishing circles but are not brands except to a minute literary market. Most have been acquired or rescued by international publishing groups. Their sales and profits are minuscule by comparison with most book publishing companies that have started in the last 30 years. X met the same fate. An international publisher later saved it, Lessons
X lacked business and marketing skills X failed to realise the need for marketing and business skills X was a specialist not a manager; he was too close to the authors and the titles; the list was a personal selection X failed his authors who backed his new company

Case study 6
Company Z is an international book publisher selling consumer books through the book trade. Every year the stock exchange expects everhigher profits. Their profits are dependent are dependant on finding several new best-sellers for which vast advances are paid to authors and for which large promotional budgets have to be spent. The company has prestigious offices in the capital city, and a large automated warehouse. It has offices in 3 other countries. Every year the company has to publish a larger number of titles to pay for the overheads. The company is worried about the erosion of territorial rights, the growth of the Internet bookshops. It has a constant problem of paying for its high overheads and for the declining margins caused by lower print runs and by demands from bookshops for higher discounts. In addition the bookshops expect to return all books not sold after 90 days, and to discount book prices.

A further problem is that its share price has fallen consistently over several years despite increasing profits. Another media group made a hostile take-over bid recently but later withdrew its interest. The share price has fallen further since the hostile take-over bid. Lessons
General trade publishing is less attractive to investors than specialist need-tobuy publishers sold through direct marketing. (unless the share price falls) The company is vulnerable to non-printed substitutes form other media; in terms of replacement, margins and sales volumes; the company is less attractive as an investment opportunity than publishing groups focused on specific target markets The company is not moving with the times

Case study 7
An accountant who had studied for 5 years to pass his professional examinations identified a need for intensive training sessions for accountancy student about the sit the 3 stages of their examinations. Due to the pressure of time many students studied at home in the evenings. He commissioned the writing of textbook manuals for each examination that the students had to study for. The manuals would attract further students to his training seminars as well as allowing him to increase turnover without increasing his classroom overheads. All customers were attracted by regular advertisements in professional magazines. Manuals were supplied as part of an overall sales training package. Only later did the company start to supply small quantities through the bookshops The formula became very successful and the company was floated on the stock market. It expanded its operations into the field of legal training. It later acquired a well-known educational book publisher. The shares sell at much higher profit multiples to most other book publishers Lessons
The owners understand excellently the needs of the stock markets; their company has risen significantly in share value since flotation The company sees itself as a specialist supplier to specialist students; it does not see itself as a publisher. It focuses its advertising at specialist markets. There is fierce competition for the same market It recently acquired specialist book publisher The company has recently diversified into legal publishing

Note: the message here is a marketing message, not about solidarity among financial experts!

Counting the Benefits of Working Capital Management

by Richard H. Gamble | page 1 of 5

Even though interest rates are low, companies that can squeeze cash out of the orderto-receipt process see big advantages over competitors with inefficient processes. Cash may be worth less than 2 percent in today's anemic marketplace, but shrewd finance executives are treating it like a treasure. They're searching for ways to shrink their investment in working capital, and they're using the cash they gain to pay down debt or build their investment portfolio. "In the go-go days of the 1990s, cash was considered a drag on earnings," notes Lee Epstein, president and CEO of Money Market One, a San Francisco-based institutional broker dealer, and Decision Analytics, a treasury investment consultancy. "Today cash is earnings. Cash is king again. It's certainly worth more than inventory. Financial managers try to maximize it whenever possible." Eric Wright, president for the Americas of REL Consultancy Group in Purchase, N.Y., agrees. "The interest in maximizing cash flow is way up due to the economy," he reports. "That's a top priority in the minds of financial executives. One of the best ways to do that is to reduce working capital." Whenever the economy is tough, companies want to free up cash that is trapped in their business processes, points out Maria D'Alessandro, senior vice president and working capital practice leader in Wachovia's treasury and financial consulting group in Atlanta. "It's not just accounts receivable but the whole order-to-receipt process. And it's not just manufacturers; even service companies and not-for-profits are going after working capital," she says. Michael Gallanis, principal of Treasury Strategies Inc. in Chicago, just finished a working capital reduction project for a $2.5 billion company that freed up $1 million of cash through tighter management of inventory and payment terms, especially A/R collections, he says. The company has now invested this found money. REL specializes in working capital reduction, so Wright makes his living helping large and middle-market corporations find ways to wring out cash that's absorbed in business operations, primarily in inventory and A/R. An organization can access that cash, he advises, by making everything work faster. "Always look for ways to accelerate your business," he recommends.

For companies that are relatively unsophisticated, that means overhauling operations to speed up processes and eliminate mistakes that lead to delays. Improvements can be as basic as reengineering billing procedures so that accurate bills go out the same day orders are shipped, with all pertinent information included, in ways that fit smoothly into the customer's A/P system -- which can reduce the number of payments that have to be processed as exceptions, suggests Wright. Sophisticated companies that have mastered the fundamentals of working capital should take a broader approach; they should look for ways to speed up the whole supply chain, Wright says. "Working capital is money the business process consumes. The longer the process takes, the more money is consumed," he notes. Contrasts between companies that use best practices in working capital management and those that don't are dramatic, Wright observes. Working capital at Barnes & Noble averages 56 days, while Amazon.com has reduced that number to minus 28 days. At Hewlett-Packard, working capital is 69 days; Dell has it down to negative 32 days. "Dell, Amazon and some others ... turn everything around very quickly," Wright explains. "When you configure, order and pay for a computer from Dell, you trigger a production process that operates on no inventory and carries no receivable."

Sales Trade-off
That's not to say the best companies always have the least working capital, of course. In theory, it's easy to eliminate working capital by requiring customers to pay in advance, but that's not how business works in many sectors. Extended payment terms may be necessary to retain customers or may be a shrewd way to increase sales. "Working capital balloons on the balance sheet when you let customers pay later, but if that's a deliberate strategy that works, carrying a lot of working capital can be a good thing," Wright observes. Some organizations that have historically had trouble shrinking A/R are finding that technology is now on their side. The more automated the order and settlement system -and the stronger the company's track record for always delivering the right merchandise at the right time in the right way -- the more the buyer will be willing to settle on the spot. Buyers who used to fight for every last penny of float are starting to realize that the benefits of paying slowly may be worth less than the savings they could gain from a more efficient process. Automation reduces the demands on the buyer's A/P operation and shrinks overhead, Wright notes. Sending documents back and forth is expensive for both parties, so interest in electronic invoice presentment and payment (EIPP) projects that expedite settlement is growing among both buyers and sellers, he points out. Companies whose customers are not interested in process efficiencies can still shrink working capital to near zero by securitizing receivables, Wright explains. Receivablesbased financing traditionally has been considered expensive, but it doesn't have to be when the receivables are high-quality. "If the receivables are very clean and you can demonstrate strong controls and discipline, securitization can be a quite efficient way to reduce working capital," he says. "You have to give up a little margin, but it can be worth it."

Inventory Wars
Of course, managing working capital requires oversight of inventory as well as A/R. The less time a company holds inventory, the lower its working capital investment will be. There is a magic threshold, Wright notes, beyond which the length of time the seller needs to acquire materials and make and ship a product is less than the length of time between order placement and when the customer expects to receive the product. If a business can cross that line, as Dell has, it can completely eliminate inventory and acquire exactly the right materials after each sale has been made. But many companies can't operate under this model. Those that sell time-sensitive items have to have materials, if not finished products, on hand to satisfy the expectations of the customer who needs an order right away, Wright points out. Still, every organization can find value by shrinking the production cycle and reducing the size of inventory or the length of time it is held, Wright says. "Lean on your suppliers to deliver quicker," he advises.

The Payables Card

Ironically, some companies looking to take working capital off the balance sheet nurture slow, inefficient or even obstructive A/P processes. "It's one case where negligence can improve your financial performance," Wright observes. "But squeezing your vendors is a short-sighted policy," he insists. A better strategy is to shrink your vendor base radi-cally, then use your clout to negotiate longer terms with the vendors you keep. "Vendor rationalization is a process that can pay off in a big way," he says. Wright concedes that if he's helping one client improve A/R and, at the same time, helping another optimize A/P, "what we recommend can come back and bite us" if they do business with each other. "Everyone looks at the equation for their own benefit," he adds. The working capital equation clearly favors dominant businesses like Microsoft and WalMart. "Wal-Mart can get away with telling its suppliers, 'You carry my inventory for me, and then let me pay you in 90 days,' " Wright explains. "It's a cost of doing business with Wal-Mart. When we have a client who sells to Wal-Mart, we concentrate on execution -delivering a perfect invoice so that nothing will slow down its processing. If you can't get paid for 60 days, you make sure you don't have to wait 61 days." Today's low interest rates bleed away some of the urgency in tightening working capital management, Wright concedes. "The value is reflected in the opportunity cost of money, and lower interest rates reduce the reward." In Japan, where rates have been very low for a long time, there is little incentive to reduce working capital. But reducing working capital will always be your cheapest source of capital. "It's the only money that is free," he insists. Plus, when low rates accompany a weak economy, lower revenue and tighter credit standards supply the incentive to conserve cash by shrinking working capital, he points out.

How WPP Almost Eliminates Working Capital

WPP, the global collection of ad agencies and other media service firms, lives or dies by the size of its working capital. Altogether, the company collects $30 billion a year in gross revenue from its clients, usually well before it pays the media on their behalf. "We have to collect fast and pay slow," summarizes John A. Forster, treasurer of WPP Group USA in New York City. "We live and breathe payment timing -- not paying until we get paid." As a result, the company keeps working capital very low; it's even negative during some parts of the year. WPP is highly decentralized, but corporate sets and monitors working capital targets for each business unit, Forster explains. "Every unit has its target. They know that we watch it closely and will be all over them if they're off by much. So they hit their targets consistently, and we let them run their businesses their way," he says. The company's business units know that they must measure up in three areas: they must hit a

very low target of average working capital divided by annualized revenue; they must hit a very low target for receivables due more than 90 days after the invoice date; and they must hit a high target for positive cash flow. "All it takes is the discipline to set targets, monitor them monthly and send the right message -- that if you miss your targets, you go on the problem list, and that is not a good thing," Forster emphasizes. Its careful working capital management makes WPP ambivalent about electronic payments. The business collects electronically whenever it can but almost always pays by check, and the slower the better. "To disburse electronically could hurt our working capital, and we can't afford to do that," Forster explains. While WPP keeps its working capital investment very lean, it remains a net debtor for much of a typical year. Investable cash accumulates seasonally, usually around the end of the year, and is invested "very short and very safe," Forster notes. Summer (TV rerun season) often finds the company drawing on its working capital lines of credit. Later in the year, it uses the cash squeezed out by its tight working capital management to pay down debt.

The Investor's Challenge

Companies that are able to accumulate cash face a real challenge in making the most of that money in today's low-interest-rate environment. Some finance departments are just taking low yields and waiting for rates to rise, but others are taking an active approach to getting all they can in the current market, Money Market One's Epstein reports. They're more likely than the average company to segment their portfolio and go medium-term with their strategic reserves. (See LSI Logic Goes for High Returns below.) They're more likely to allocate some of their cash to an outside investment manager who will work full-time to maximize returns. And they're more likely to move to lower-rated credits with their highly liquid investments. Does this strategy work? "Generally, it has paid off, although medium-term, fixed-income investors had their heads handed to them last July, when rates shot up and market value went down," Epstein concedes. "Some lost principal, although the true working capital buy-and-hold investors only had paper losses. Their principal was safe as long as they didn't sell the securities." Corporate investors who insist on AAA short-term paper are overpaying for their comfort, Epstein suggests. "The more savvy investors know that they don't need AAA, which is a very limiting criterion. They will buy split-rated commercial paper or A or even BBB corporate paper." Dutch-auction products also produce relatively good yield for minimal risk, he notes

A recent survey conducted by Treasury Strategies reveals that many companies are lengthening the maturities of investments they buy in order to increase returns without taking on more credit risk, Gallanis reports. They're also using more vendors and rateshopping more aggressively, he says. However, Derek Chauvette, national sales manager of corporate investment services with Cleveland-based McDonald Investments, a subsidiary of KeyCorp., has found that businesses are staying short with their liquidity reserves. They're investing heavily in institutional money-market funds and tax-free floaters, he reports. On longer-term strategic funds, they're picking up yield with instruments such as four- to five-year callable agencies, Chauvette adds. Some short-term investors are surprised to discover that their best investment may be their bank's earnings credit rate (ECR) on funds left on deposit. An above-market bank ECR is "an anomaly, an arbitrage opportunity in this market when that rate doesn't fall as fast as the rest of the cash market," Epstein explains. "The world is upside down right now. Rates are so low that what usually makes sense doesn't necessarily make sense anymore. When we come out of it -- and we will -- and rates go back up to 3 to 4 percent, things will return to normal." The returns corporate investors are currently seeing do not reflect the full value of cash, Wachovia's D'Alessandro insists. "Look at the savings as an investment in your business," she advises. Cash gained today from better working capital management can be used to profitably reinvest in the business once the economy starts to recover. As long as banks are cautious about whom they lend to, companies will appreciate having some cash of their own to protect them from trouble and to help them capitalize on opportunities, she says. That's why although cash may be cheap, it's priceless.

LSI Logic Goes for High Returns

LSI Logic Corp., the $1.8 billion Milpitas, Calif., supplier of specialty semiconductors, used to invest extensively in expensive equipment. However, since the company changed its business strategy and began outsourcing manufacturing, the amount of cash in its corporate coffers has increased by $1.1 billion. Now that it's a big investor, LSI Logic has split its portfolio, keeping just 10 percent in highly liquid money market instruments and putting the rest in a strategic portfolio invested for longer durations, explains Anita Prasad, vice president of treasury and tax. The reward: A stunning return between 7 percent and 9 percent on the strategic portfolio. "Until early 2001, we were a capital-intensive company with small cash balances, a buyand-hold investor that kept maturities short -- nothing beyond the 90- to 180-day range," she

explains. "Now we have a real incentive to maximize our investment returns." Solid working capital management has helped LSI build its cash hoard. "We're reasonably efficient at managing our receivables and payables," Prasad explains. "We benchmark favorably to our peers. And about half our business is in customized products we can't prebuild, so that helps us keep our inventory fairly lean." Originally printed in the March 2004 issue of Business Finance

Working capital management

by Philip E Dunn 26 Jul 2001 Accounting Technician Scheme Relevant to Paper C5

Within the C5 syllabus Managing Finances, there is reference to working capital in both the aims, objectives and content. Students need a knowledge of how organisations optimise their use of working capital, the principles of effective working capital management and the working capital cycle. Certified Accounting Technicians need to develop competence in this important area of financial management, so that they can guide senior management in an effective way, and thus make a positive contribution to this value adding activity within any organisation. Successful business centres on investing in innovatory ideas, the right equipment and skilled human resources. To invest business needs capital either from owners, retained profits or from others willing to advance credit or loans. There are two types of capital need: for fixed capital to invest in things such as buildings, plant and equipment; and working capital principally to pay for stock and to cover the amount of credit extended to customers. Fixed capital, as the name implies, tends not to vary in the short term but to move up (or down) in jumps when major investment decisions are made (or assets sold). Working capital, on the other hand, is much more fluid and fluctuates with the level of business. The working capital cycle links directly with the cash operating cycle. Working capital comprises short term net assets: stock, debtors, and cash, less creditors. Working capital management then is to do with management of all aspects of both current assets and current liabilities, so as to minimise the risk of insolvency while maximising return on assets. Value added conversion work in progress Even profitable companies fail if they have inadequate cash flow. Liabilities are settled with cash not profits. The primary objective of working capital management is to ensure that sufficient cash is available to:

meet day-to-day cash flow needs; pay wages and salaries when they fall due; pay creditors to ensure continued supplies of goods and services; pay government taxation and providers of capital dividends; and ensure the long term survival of the business entity.

Poor working capital management can lead to:

over-capitalisation (and therefore waste through under utilisation of resources and hence poor returns); and overtrading (trying to maintain a level of sales which is higher than working capital can sustain for businesses which extend credit terms, more sales means more debtors and higher working capital demands).

Characteristics of over-capitalisation are excessive stocks, debtors, and cash, low return on investment with long term funds tied up in non-earning short term assets. Overtrading leads to escalating debtors and creditors, and if unchecked, ultimately to cash starvation. Taking control of working capital means focusing on its main elements. Control of the debtors element (the amount owed the business in the short term) involves a fundamental trade-off between the cost of providing credit to customers (which includes financing bad debts and administration), and the additional net revenue that can be earned by doing so. The former can be kept to a minimum with effective credit control policies which will require:

setting and enforcing credit terms; vetting customers prior to allowing them credit; setting and reviewing individual credit limits; efficient invoicing and statement generation; prompt query resolution; continuous review of debtors position (generating aged debtors report); effective chasing and collection procedures; and limits beyond which legal action will be pursued.

Before allowing credit to a new customer trade and bank references should be sought. Accounts can be asked for and analysed and a report including any county court judgements against the business and a credit score asked for from a credit rating business (such as Dun and Bradstreet). Salesmens views can also be canvassed and the premises of the potential customer visited. The extent to which all means are called upon will depend on the amount of the credit sought, the period, past experiences with this customer or trade sector, and the importance of the business that is involved. But this is not a one-off requirement. One classic fraud is to start off with small amounts of credit, with invoices being settled promptly, eventually building up to a huge order and a disappearing customer. Credit checking, even for established customers, should therefore feature in regular procedures. When the creditworthiness of a new customer is established, positive credit control calls for the setting of a credit limit, any settlement discounts, the credit period, and credit charges (if any). The Late Payment of Commercial Debts (Interest) Act now allows small businesses to charge large interest on late payment of business debts by companies and public sector organisations. From last November they were also able to take similar action against other small businesses. Nevertheless, it is wise to inform customers this right will be exercised. Collection is a vital element of credit control and must include standard, polite and well constructed reminder letters, and effective telephone or e-mail follow up. Use of collection agencies should be considered, as could factoring in its most comprehensive form a loan facility based on outstanding invoices plus a sales ledger and debtors control service. Efficient control of debtors will assist cash flow, and help keep overdraft or other loan requirements down, and hence reduce interest costs. Debtors represent future cash or they should do if proper credit control policies are pursued. Likewise stock will eventually become cash, but in the meantime represents working capital tied up in the business. Keeping levels to the minimum required for efficient operations will keep costs down. This means controlling buying, handling, storing, issuing, and recording stock. Inherent in any system of inventory control is the concept of appropriate stock levels normally expressed in

physical units sometimes in monetary terms. The objective of establishing control levels is to ensure that excessive stocks are never carried (and working capital thereby sacrificed) but that they never fall below the level at which they can be replenished before they run out. Figure 1: the working capital cycle

The factors to consider when establishing the control levels are:

working capital available and the cost of capital; average consumption or production requirements; reordering periods the time between raising an order and receiving delivery of goods; storage space available; market conditions; economic order quantity (including discounts available for quantity); likely life of stock bearing in mind the possibility of loss through deterioration or obsolescence; and the cost of placing orders including generating and checking the necessary paperwork as well as physical checking and handling procedures.

Control policies should include designating responsibility for raising and authorising orders, signing delivery notes and authorising payment of invoices. Four basic levels will need to be established for each line/category of stock. There are the:

maximum level achieved at the point a new order of stock is physically received; minimum level the level at point just prior to delivery of a new order (sometimes called buffer stocks those held for short term emergencies); reorder level point at which a new order should be placed so that stocks will not fall below the minimum level before delivery is received; and the reorder quantity or economic order quantity the quantity of stock which must be reordered to replenish the amount held at the point delivery arrives up to the maximum level.

Once these controls are implemented an efficient system of recording receipts and issues is vital to exercise

full control of inventories. Trade creditors, amounts owed by the business for supplies and services, are a plus in the working capital equation. The higher the figure, the more has been extended by others (usually at no cost) towards working capital needs. But there are limits to the good news. Firms that go beyond agreed credit limits run into trouble; they lose out on cash discounts, can incur interest charges, upset their suppliers who may refuse future orders, may damage their credit rating, and even find themselves in court with additional costs and penalties to pay. Credit periods vary from industry to industry with usual terms range from 28 days to 95. Just as in credit control, a settlement policy has to be in place so that invoices are properly authorised for payment (after any queries have been answered and credits claimed), and so that they can be paid when due with appropriate discounts deducted. Again, an eye has to be kept on the overall position with appropriate reports generated. Cash is both the balancing figures between debtors, stock and creditors, and also the control element. It is not possible to extend credit, order stock or pay creditors if there is not the cash available to meet working capital demands. There are two levels of control. The first concerns efficient banking making sure money received is banked as soon as possible, making payments the most efficient way, and ensuring any surplus balances are put to interest earning use. Here the liquidity, risk and return of investments must all come into play with the length of time before funds are needed playing an important role. More fundamental than this is cash flow control making sure funds are available when needed. In the short term this is best achieved by preparation of weekly or monthly forecasts for comparison with actual results. If these forecasts indicate unacceptable balances or deficits are likely at some point, it will be necessary to decide how these can be covered. Immediate solutions will include increased borrowing, rescheduling plans and payments, or even sale of an asset. Longer term cash flow control will embrace all aspects of the business including working capital and fixed capital control, capitalisation, trading and dividend policy. For example it may be able to improve cash flow by improvements in operating efficiency or higher sales prices, improved working capital control, or revised fixed asset investment plans. Cash flow forecasts form an integral part of the budgeting process. The objectives of the cash budget are to:

integrate trading and capital expenditure budgets with cash plans; anticipate cash surpluses and deficits in time to generate plans to deal with these; and provide a facility for comparison between budget and actual outcomes.

Accountants have an important part to play in all aspects of working capital control through internal control procedures (such as invoice authorisation) and through reporting processes (such as production of aged debtors lists and cash flow forecasts). They can also bring analytical skills into play, typically by use of ratio analysis. Various ratios are considered important indicators of working capital strength (and can be applied internally or to potential customers). A broad indication of a firms short term ability to finance its continued trading can be obtained by applying the current ratio. This is a straight comparison of current assets and current liabilities. If the latter should be less than the former, it is worth looking further. Many businesses operate this way when they start, often for

long afterwards, sometimes always. Much will depend on the type of trade and the nature of both current liabilities and current assets. For example a large element of prepayments in creditors will mean they will not be repaid but will be earned over time. On the other hand, debtors escalating at a faster rate than sales growth could indicate poor credit control and possible bad debt problems. Generally when it comes to current assets, cash is the most valuable element (it is immediately available to settle bills), and debtors are more value than stock (they are nearer to being turned into cash). Hence the tougher test the acid test excludes the stock element from current assets. If current assets less the stock element total less than current liabilities the business, on the face of it, may not be able to settle its creditors as they fall due. And that suggests more finance might be needed, better working capital control will be required, or insolvency may be looming. Dr Philip E Dunn, Esk Valley Business School

Chapter Two: Working Capital Management

Defining Working Capital
The term working capital refers to the amount of capital which is readily available to an organisation. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organisational commitments for which cash will soon be required (Current Liabilities). Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business". Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business". Thus: WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES In a department's Statement of Financial Position, these components of working capital are reported under the following headings: Current Assets Liquid Assets (cash and bank deposits) Inventory Debtors and Receivables

Current Liabilities Bank Overdraft Creditors and Payables Other Short Term Liabilities

The Importance of Good Working Capital Management

Working capital constitutes part of the Crown's investment in a department. Associated with this is an opportunity cost to the Crown. (Money invested in one area may "cost" opportunities for investment in other areas.) If a department is operating with more working capital than is necessary, this over-investment represents an unnecessary cost to the Crown. From a department's point of view, excess working capital means operating inefficiencies. In addition, unnecessary working capital increases the amount of the capital charge which departments are required to meet from 1 July 1991.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum balance of each of the working capital components. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible, thereby maximising the interest earned. However, such cash may more appropriately be "invested" in other assets or in reducing other liabilities. Working capital management takes place on two levels: Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management (see Chapter Three). The individual components of working capital can be effectively managed by using various techniques and strategies (see Chapter Four).

When considering these techniques and strategies, departments need to recognise that each department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to department. For example, some departments have significant inventory levels; others have little if any inventory. Furthermore, working capital management is not an end in itself. It is an integral part of the department's overall management. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance.

On Working Capital Management Balasubramaniam EarnestPartner, 2/28 Lakshmi Colony, T.Nagar, Chennai : 600 017 Phone: 044-8226424, 8280793 Email : earnpart@rediffmail.com

Reportedly one of the largest computer companies in the world Dell computers had a inventory turnover ratio of 7 days and turns over its inventory by over 52 times in a year. The entire cycle from production to dispatch will take 7 days and inventory at all stages The company has been able to reduce the cycle time of production dramatically that it can almost built computers to order. This system driven manufacturing operation leads to saving in interest or capital cost and improves shareholder value. The company would follow the best supply chain management practice that links supplier of raw material to its end customer order. To put in simple terms a supply chain management system is a practice of horizontally integrating all processes, systems and procedures in a company from supply stage to the shipment and collection stage. In this system the company would know exactly how much of what to produce and what the anticipated demand would be. [this is easier said then done] This would mean getting sales forecasts in place, tying them with raw material procurement and linking the same with production. This would ensure optimum inventory and optimum production planning. This in turn linked to the companys marketing strategy and product push in the market place. Working capital is the capital required for day to day running of the business. Receivables, Inventory, expenses payable are some working capital assets. Some of these assets are funded by companies own funds, from parties who extent credit and from banks. Illustration I Working Assets Raw materials [Inventory] Expenses [courier, telephone etc] Other inputs to production Funded by Capital/Income/Bank Creditors Capital/Creditors/Bank

Obviously what liability [funding source] the company would use would depend on its own cash flow cycle. How well it collects its receivables, the cost of bank credit or creditor and market forces will drive the extent of use of each of the source of working capital funding. This being defined, loosely as above, in a real life situation the business will exactly know what the requirements are and will plan in advance the most appropriate funding source given its profitability projections and return envisaged in the business Efficient use of short-term assets and liabilities enables higher liquidity in the system and improves profitability and return on capital. Normally reduction in the current asset build

up results in savings in interest cost or capital cost, since the company does not have pay the carrying cost for receivables and inventories...Typically a Market leader in any segment [result of premier products that command significant market share] will have liquidity flowing in the system with low receivables low debtors and perhaps will be extended credit by his supplier. While in a competitive market place the manufacturer may have to extend credit that may lead to higher receivables and inventory and this will impact the profitability and profit margins. While the market determines the receivable levels , there is a lot of scope to control inventories. Receivables with no additional burden of interest on the buyer are nothing but inventories stored in the buyers location [legal definitions apart] Also there are industry peculiarities, where the composition of current assets and liabilities can vary as in the case of the food and restaurant business which is predominantly cash sales driven and consequently will have low receivables .In the case of the capital goods sector the company working capital requirements would consist of work in progress and raw material stocks and receivable position would be dictated by industry dynamics such as competition, oligopoly, monopoly etc consequently working capital build up could be high. So lower the ratio expressed in days better is the asset utilization [as the ratio would indicate.] within the gamut of industry peculiarities. This is true of the Inventory turnover ratio [closing inventory/Cost of Goods sold] * 365 .of 7 days means that the company is turning over its inventory 52 times in a year. It is also likely that at the date of the balance sheet when the company chooses to convert its inventory into sales, the inventory carried on its books on balance sheet date may be low and it would seem that the company is efficiently managing its inventory. But the reduction in one current asset, inventory could mean an increase in another current asset, Receivables. Breaking up inventory turnover ratio into raw material, work in progress and finished goods, will enable the company to identify the areas where inventory management needs to be streamlined where lacunae exists From an analytical point of view working capital ratios such a days receivables would reveal any collection problems building up. An ageing analysis [debtors broken up into < 1month, 1-3months etc] over the spectrum and customers will provide the analyst where the problem lies [if any]. The ageing analysis would enable the company to reward its good clients and structure payment terms in a different manner for others. Companies may choose to pass the cost of supporting receivables to the clients in the form of lower sales discounts or higher sale price. .. The days creditors ratio reveals to a lender or another supplier how well the company has been servicing its existing supplier. A high days creditor may not necessarily mean the company is delaying its creditors to conserve cash, it could imply its market position . So no ratio can be understood on a stand alone basis but need to be looked at in conjunction with other ratios of the company, its peers, the companys balance sheet and profit and loss account etc.