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Chapter 6: Working Capital Management
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:
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:
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 organisation’s 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.
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.
Explanation of the
calculations
Explanation of the figures
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.
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.
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:
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 CD’s and cassettes, and of greeting cards with a view to finding solutions. While lessons can be learned, there are major differences: CD’s, cassettes and greeting cards
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 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:
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.
The table below lists items, which influence Working
Capital levels favourably and adversely
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.
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.
** 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.
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.
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