An ideal capital allocation has been focused on by corporate financial management in present days. This report addresses key issues related to the working capital management and capital investment. The main aims of the report are analyze these issues for two different companies listed in Hong Kong and to identify the ways in which the finance function can contribute to an efficient and effective financial decision process in the companies and make recommendation for the company.
Background of chosen companies
This report is going to compare two companies:
San Miguel Brewery Hong Kong Ltd. (Stock code 0236)
KINGWAY Brewery Holdings Limited (Stock code 0124)
The companies have both established beer brand with major businesses in Hong Kong and China. The long-term objective of KINGWAY is to develop a brewery enterprise with annually growing production capacity and sales volume of beer while SAN MIGUEL's mission is to become beer business leader by growing its volume, market share and profits.
Working Capital Management
To ensure the above business aims are accomplished, adequacy of capital liquidity is fundamental. The function of working capital management then plays an important role. In short, working capital management is the day to day management activity that focuses on the company's funds held in current assets and the financing for supporting operations. Line managers with the assist of accountants would decide what current assets should be held and how to finance these items.
Broadly speaking, working capital management determines and manages the deployment of current assets and current liabilities efficiently, for instance, controlling cash, inventories, accounts receivable and short-term liability.
Working capital requirement in San Miguel and KINGWAY
When forecasting an optimal level of working capital, managers of San Miguel and KINGWAY should consider several factors.
Nature of business
Both San Miguel and KINGWAY are the manufacturing companies which need to invest a lot in stocks (beer), doubtful receivables, and highly liquidity cash for turnover. Therefore, working capital requirement is high.
Production policies
Both the companies are producing tones of beer throughout the year. Adequate working capital is needed ready for supporting excessive production capacity or coping with operational difficulties caused by snowstorm and heavy rainfall. Also, working capital is needed for supporting streamlined production, functional departments and the full-scale operation plants.
Size of business and growth prospects
The larger the size of business, the higher the working capital requirement is. In KINGWAY, beer is distributed to local China market and oversea like South-east Asia, Canada, etc, so more working capital is required for sales and distribution. In contrast, San Miguel (HK) aims to distribute beer and increase market shares mainly in Hong Kong and South China, so less working capital is needed when comparing with KINGWAY.
Business environment
Both the companies had experienced the financial tsunami in 2008. This change in economy may reduce the demand of working capital since companies may reduce their activities during the depression.
There are more factors affecting working capital requirement. It includes the length of operating cycle, current assets policy and credit policy. Where operating cycles for the companies are long, more working capitals are required. Where companies adopt conservative assets policies, more working capital is required. Where companies are given short credit period from bank or suppliers, working capital requirements are lower.
Calculation of working capital:
KINGWAY
($000)
San Miguel
($000)
　
CURRENT ASSETS
　
　
Inventories
199,995
61,106
Trade and bills receivables
39,419
108,426
Prepayments, deposits and other receivables
28,149
-
Pledged bank balances
209
-
Pledged time deposits
136,128
-
Amounts due from holding companies and fellow subsidiaries
-
12,864
Current tax recoverable
-
101
Cash and cash equivalents
393,420
357,109
Total current assets
797,320
539,606
　
Less: CURRENT LIABILITIES
Trade and bills payables
371,797
223,696
Deferred revenue
93,358
-
Tax payable
3,282
-
Other payables and accruals
284,115
-
VAT payable
12,995
-
Derivative financial instrument
14,200
-
Due to the immediate holding company
190
4,454
Due to fellow subsidiaries
37,878
Interest-bearing bank borrowings
179,500
220,246
Total current liabilities
997,315
448,396
　
NET WORKING CAPITAL
-199,995
91,210
Working capital analysis
According to the above calculation, the position of working capital is poor in KINGWAY which shows a negative net working capital of $199,995,000. This company is undercapitalized where shortage of working capital makes the company unable to meet its liabilities. The large amount of liabilities ($997,315,000) shows that KINGWAY is using credit facilities by creditors. This is favorable but if KINGWAY continually does not handle this matter well, this large amount of liabilities would lead to higher risk of insolvency.
When comparing with KINGWAY, San Miguel shows better working capital position that it has net working capital of $91,210,000. However, San Miguel must be aware of the problem of overcapitalization. If too much funds is available, lower rate of return may be resulted.
Ratio analysis
Ratio analysis can also be used to see whether the working capital of the company is managed efficiently. Efficiency in this case means to obtain a balance between costs and benefits of increasing or reducing stock levels, cash in hand, accounts receivables and payables.
Some typical ratios that is suitable to analyze the effectiveness and efficiency of the management of San Miguel and KINGWAY:
Ratios:
San Miguel
KINGWAY
1. Stock turnover:
5.2
2.5
costs of sales/average stocks
Receivables periods:
121days
19.2days
trade receivables/salesx365days
3. Creditors turnover:
129.9%
64.5%
Trade payables/costs of sales
4. Current ratio:
1.2
0.8
total current assets/total current liabilities
5. Quick ratio:
0.95
0.6
(total current assets-inventory)/total liabilities
6. Working capital ratio:
1.9
-2.9
Cost of sales/working capital
Interpretations:
A higher stock turnover ratio in San Miguel is favorable because there is efficient management of inventory. The stocks are sold more frequently and less amount of money is required to finance the inventory.
There is better cash flow in KINGWAY than San Miguel because its receivables period is 19.2days which is far shorter than that of KINGWAY (121days). It indicates that KINGWAY has received debts from customers promptly which may be resulted from better debtor control policy.
There is lower creditor turnover ratio in KINGWAY (64.5%) than San Miguel (129.9%) that means KINGWAY has granted long credit period by creditors. Therefore, cash flow position in KINGWAY is better.
Current ratios in both companies are 1.2:1 and 0.8:1 respectively which are below standard of 2:1. It implies that the financial stability is low in the companies.
San Miguel and KINGWAY have a quick ratio of 0.95 and 0.6 respectively. It indicates that both the companies are below standard, but the liquidity position of San Miguel is better than KINGWAY.
For the calculation of working capital ratio, there is higher ratio in San Miguel (1.9) where that of KINGWAY is a negative result (-2.9). It indicates that KINGWAY has invested highly in working capital but the profitability resulted is relatively low. This means that this company has poor management in working capital and capital budgeting.
Analysis of Current Assets Level
In general working capital management assists in optimal assets level setting. For San Miguel and KINGWAY, it should be aware that working capital would have impacts on several issues as shown in the following.
Liquidity
Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price.
By simply looking at the amount of current assets, KINGWAY generates higher liquidity than San Miguel because the amount of current assets in KINGWAY is $797,320,000 which is more than that of SAN MIGUEL ($539,606,000), where assuming other things being constant.
Expected Profitability
Excessive levels of working capital would lead to substandard Return on Investment (ROI). ROI shows the efficiency of an investment can be evaluated where ROI = Net profit/ (current assets + fixed assets).
San Miguel ($000)
KINGWAY ($000)
Net Profit/(Loss)
($31,846)
$9,107
Current Assets
$539,606
$797,320
Fixed Assets
$1,428,370
$3,149,005
Total Assets
$1,967,976
$3,946,325
Return on Investment(ROI)
-1.62%
0.23%
From the above calculation, both the amount of San Miguel's current assets and total assets are lower than KINGWAY, the ROI will normally higher, however, since there is huge loss for the period in San Miguel, it provides lower and negative return on investment.
Risk
Lower level of current assets will lead to higher risk level. More risks involved when there are strict credit policies because the companies will loss sales and customers. Also, there will be higher risk if companies hold lower stock levels because of higher opportunity for shortage of stocks and loss of sales revenue. For example, the stock value of KINGWAY is $199,995,000 while stock value of San Miguel is $61,106,000 which is far lower than KINGWAY. Therefore, there is higher risk in San Miguel.
Moreover, company with less cash will have higher risk. For example, in San Miguel, cash and cash equivalents are $357,109,000 which is lower than that of KINGWAY ($393,420,000). Therefore, risk level is higher in San Miguel because the company may not able to fulfill its financial obligations.
Recommendation
Best practice of working capital management
Optimum and effective working capital management may result in significant effect on risk, return and share price of the company. It will also assists managers to decide optimal level of investment in working capital assets, optimal mix of short-term and long term capital, and appropriate means of short term financing. Therefore San Miguel and KINGWAY should manage the operating cycle of companies well.
Operating cycle, as shown in Figure 1, involved the time lag that required for converting the materials into finished goods and changing into cash again. A cash-conversion cycle is the important part of this concept. A cash conversion cycle, as shown in Figure 2, involved a number of intermediate stages from the outlay on inputs and the receipts of money from sales of products. Companies should have a short cash-conversion cycle which does not impair the daily operations.
Ways for managing cash conversion cycle:
Debtors management
Managers of both companies should adopt appropriate credit policy that to check credit worthiness or payment history of customers. Regarding collection policy, managers should follow up old account receivables more forceful by phone call, in writing, hire debts collection agency, or through legislative procedure.
Inventory management
Managers should examine inventory levels to see where overstocking occurs. This is to ensure the smooth of production. Managers should identify optimal re-ordering level of inventories in order to reduce ordering cost. Also, managers should try to negotiate with supplier to minimize material costs.
Cash management
For handling cash, managers should meet daily operation expenses with less cash holding costs. The checking of disbursement and collection procedures should be taken and to slow down the disbursement for creditors.
Apart from these, companies should maintain sound assets management and management for short-term financing. Short-term financing should identify the most suitable source of financing.
Appendix
fdrfrfr
Reading, Research and Reference
Unaudited Interim Financial Report of KINGWAY Brewery Holdings Limited
Unaudited Interim Financial Report of San Miguel Brewery HK Ltd
Glen Arnold, 4th Edition, Corporate Financial Management, FT/Prentice Hall
