13. Working Capital Management Flashcards
What is working capital?
The capital represented by net current assets which is available for day-to-day activities. It normally includes inventories, trade receivables, cash and cash equivalents, less trade payables.
What are the two main objectives of working capital management?
- To ensure that the organisation has sufficient liquid resources to continue in business.
- To increase its profitability.
Note that there is a trade-off between the two.
Differentiate between over trading and over-capitalisation.
Over trading - insufficient working capital to support the level of business activity. Aka under-capitalisation and is characterised by an increasing proportion of short-term to long-term finance.
Over-capitalisation - an excessive level of working capital, leading to inefficiency.
Outline the following types of current assets investment policies:
1. Conservative
2. Aggressive
3. Moderate
- Conservative approach - utilised when management is highly risk-averse. Appropriate when cash flows are erratic and unpredictable and hence a margin of safety is needed. It is characterised by holding high inventory, offering generous credit terms to customers, paying suppliers promptly and holding high levels of cash. Disadvantages include inventory obsolescence and high financing costs for the high level of assets.
- Aggressive approach - management has high tolerance for risk and drives down inventory levels, receivables and surplus cash holdings. Appropriate when there are predictable cash flows. Problems include, running out of inventory during periods of fluctuating demand, losing customers to competitors who give more credit and being less able to meet unexpected expenses.
Moderate approach - in between conservative and aggressive approach.
Why may some proportion of current assets be considered permanent in nature?
- Holding of buffer stock.
- Holding precautionary cash for unexpected expenses.
- A minimum level of trade receivables over business cycle.
What is the matching policy of financing working capital? Advise how this would be different under aggressive and conservative financing strategies.
Permanent proportion of current assets should be matched by long term finance and the fluctuating segment should be matched with short term finance. (Moderate approach)
Aggressive strategy - short term finance is used for both fluctuating and permanent aspects of current assets.
Conservative strategy - long term finance is used for both fluctuating and permanent aspects of current assets.
Outline the following efficiency ratios. State their formulas:
1. Inventory turnover
2. Inventory holding period
3. Receivables collection period
4. Payables payment period
5. Sales/working capital
- Inventory turnover shows how quickly inventory is sold, with higher turnover reflecting faster moving inventory.
Inventory turnover = COS/Average Inventory - Inventory holding period - estimates the time taken for inventory to be sold. Lower usually is better.
Inventory holding period = (average inventory / cost of sales) * 365 days
- Receivables collection period - estimates time taken for a customer to pay. Lower usually is better.
Receivables collection period = (average accounts receivable/annual credit sales) * 365
- Payables payment period estimates the time taken to pay suppliers. Higher usually is best but not too high.
Payables payment period = (average accounts payable / annual credit purchases ) * 365
- Sales/working capital indicates how efficiently a business uses its work g capital to generate sales. Usually better to increase.
Sales/working capital = annual sales / average working capital
What is the working capital/cash conversion/cash operating cycle? Why would the business want to reduce this cycle?
This is the number of days between paying suppliers and receiving cash from customers. It can be found from standard ratios as:
Inventory holding period + receivables collection period - payables payment period
A business will want to reduce the length of its working capital cycle, thereby reducing its exposure to liquidity problems. The longer the cycle, the greater the level of resources tied up in working capital and the greater cash flow difficulties an organisation will face.
What are some factors affecting cycle length?
- Type of industry - supermarket chain may have negative operating cycle because it receives cash from customers before it pays suppliers. A construction may have a long cycle because of high levels of WIP.
- Industry norms - if competitors give long credit periods, it will be difficult to reduce the receivables collection period without losing business.
- Power of suppliers - an attempt to delay payments could lead to supplier demanding cash on delivery. This may cause the payables payment period to fall to zero.
- Efficiency of working capital management (eg weak credit control and holding excess inventory will both lead to longer working capital cycle).
- Terms of trade, such as the credit period offered to customers.
For manufacturing entities, there are three types of inventory that must be considered for the cash operating cycle. Identify the relevant ratios for these inventories and state their formulas.
- Finished goods holding period = (finished goods inventory/annual cost of sales)*365
- WIP days (length of production process) = (WIP/annual COS) * 365
- Raw materials holding period = (raw material inventory/annual raw material purchases) * 365
What are some indicators of over trading?
- Declining liquidity
- Rapidly increasing revenue
- Increasing inventory holding period
- Increasing accounts receivable days
- Increasing short-term borrowing and declining cash holdings
- Large and rising overdraft
- Declining profit margin
- An increasing ratio of sales to non-current assets
Outline the following types of working capital strategies:
- Conservative investment
- Aggressive investment
- Conservative financing
- Aggressive financing
- Conservative investment - high current assets
- Aggressive investment - low current assets
- Conservative financing - little short term finance
- Aggressive financing - high short term finance
