13) Working capital management

Question 1

What is working capital?

Answer 1

Working capital is the CAPITAL available for conducting the day-to-day operations of an organisation; normally the excess of (current assets -current liabilities).

Working capital management is the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets.

Question 2

Working capital has a cost which can be expressed as?

Answer 2

the cost of funding it, or

the opportunity cost of lost investment opportunities because cash is tied up and unavailable for other uses.

Question 3

What is the objective of working capital management?

Answer 3

Balancing of the current assets and liabilites right. This can also be seen as trade off between cash flow vs profits. or liquidity vs profitability

Liquidity: Ensuring current are sufficiently liquid to minimise the risk of insolvency

Profitability: Investing in less liquid assets in order to maximise return

Question 4

What is an example of a trade off between liquidity and profitability?

Answer 4

Receiving a bulk purchase discount (improved profitability) for buying more inventory than is currently required (reduced liquidity)

Offering credit to customers (attracts more customers so improves profitability but reduces liquidity)

Question 5

What is an example of a trade off between cash flow and profits?

Answer 5

(a) Purchase of non-current assets for cash. The cash will be paid in full to the supplier when the asset is delivered; however the cost will be charged to profits gradually over the life of the asset in the form of depreciation.
(b) Sale of goods on credit. Profits will be credited in full once the sale has been confirmed; however the cash may not be received for some considerable period afterwards.
(c) With some payments such as tax there may be a significant timing difference between the impact on reported profit and the cash flow.

Question 6

What is an aggressive working capital management approach?

Answer 6

Keeping working capital levels to a minimum (Including cash) in order to improve profitability is termed an aggressive approach to working capital management.

An aggressive approach will result in lower working capital funding costs and higher risk,

Question 7

What is a conservative working capital management approach?

Answer 7

Maintaining a high level of net working capital (including cash) in order to avoid liquidity problems is termed a conservative approach to working capital management.

Conservative approach will result in higher working capital funding costs and lower risk.

Question 8

What does over capitalisation mean?

Answer 8

If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be an over-investment by the company in current assets. Working capital will be excessive and the company will be over-capitalised.

Question 9

What does over trading mean?

Answer 9

For example, healthy trading growth typically produces:
 increased profitability
 the need to increase investment in non-current assets and working capital.

If the business does not have access to sufficient capital to fund the increase, it is said to be ‘overtrading’.

Question 10

What are the symptoms of an overtrading company?

Answer 10

A rapid increase in revenue
An increase in the values of the working capital days, particularly receivables and payables
Most of the increase in assets being financed by credit
A dramatic drop in the liquidity ratios

Question 11

What are the types of working capital ratios?

Answer 11

Liquidity and efficiency (forming the operating cycle)

Question 12

What are liquidity ratios and the types?

Answer 12

Two key measures, the current ratio and the quick ratio, are used to assess SHORT-term liquidity. Generally, a higher ratio indicates better liquidity.

Question 13

What is the current ratio and the formula

Answer 13

The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations.

The current ratio measures a company’s ability to pay current, or short-term, liabilities (debt and payables) with its current, or short-term, assets (cash, inventory, and receivables).

The higher the ratio, the better as it is more liquid

Current ratio= Current Assets ÷ Current Liabilities

A measure of 2:1 means that current liabilities can be paid twice over out of existing current assets.

Question 14

What is the quick ratio/ Acid test and the formula

Answer 14

The quick or acid test ratio:
measures how well current liabilities are covered by liquid assets
 is particularly useful where inventory holding periods are long and therefore distort the current ratio. e.g. car manufacturing companies

Acid test = (CA- Inventory)÷ CL

A measure of 1:1 means that the company is able to meet existing liabilities if they all fall due at once.

Question 15

How are liquidity ratios used/taken for?

Answer 15

These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds that it is unable to renew its short-term liabilities (for instance if the bank suspends its overdraft facilities) there will be a danger of insolvency unless the company is able to turn enough of its current assets into cash quickly.

However, the numbers are not very meaningful without taking into account the type of ratio expected in a similar business or within a business sector. Any assessment of working capital ratios must take into account the nature of the business involved.

Question 16

.What kind of business may have a low current ratio?

Answer 16

supermarket business operating a just in time system will have little inventory and since most of sales are for cash they will have few receivables. In addition, the ability to negotiate long credit periods with suppliers can result in a large payables figure. This can result in net current liabilities and a current ratio below 1 – but does not mean the business has a liquidity problem.

Some companies use an overdraft as part of their long-term finance, in which case the current and quick ratios may appear worryingly low. In such questions, you could suggest that the firm replace the overdraft with a loan. Not only would this be cheaper but it would also improve liquidity ratios.

Question 17

What is the cash operating cycle?

Answer 17

The cash operating cycle is the length of time between the company’s outlay/expenditure on raw materials, wages and other expenditures and the inflow of cash from the sale of goods.

It also reflects a firm’s investment in working capital as it moves through the production process towards sales. The investment in working capital gradually increases, first being only in raw materials, but then in labor and overheads as production progresses.

This investment must be maintained throughout the production process, the holding period for finished goods and up to the final collection of cash from trade receivables.

(Note: The net investment can be reduced by taking trade credit from suppliers.)

The faster a firm can ‘push’ items around the cycle the lower its investment in working capital will be.

Question 18

What is the calculation of the cash operating cycle for manufacturing businesses?

Answer 18

Raw materials holding period
Work in progress holding period
Finished goods holding period
Trade receivable days
( Payables payment period )

Question 19

What is the calculation of the cash operating cycle for wholesale or retail businesses?

Answer 19

There will be no raw materials or WIP holding period so the cycel simplifies to

Inventory holding period
( Payables payment period )

Question 20

What is the calculation of the cash operating cycle for wholesale or retail businesses?

Answer 20

There will be no raw materials or WIP holding period so the cycel simplifies to

Inventory holding period
( Payables payment period )

Question 21

What is the optimum level of working capital?

Answer 21

the optimum level of working capital is the amount that results in no idle cash or unused inventory, but that does not put a strain on liquid resources.

Question 22

What are the factors affecting the length of the operating cycle?

Answer 22

 liquidity versus profitability decisions
 terms of trade
 management efficiency
 industry norms, e.g. retail versus construction.

Question 23

..

Answer 23

..

Question 24

The amount of cash required to fund the operating cycle will increase due to what?

Answer 24

The amount of cash required to fund the operating cycle (and therefore the funding cost for working capital) will increase as either:

the cycle gets longer
the level of activity/sales increases.

Question 25

What is the inventory holding period?

Answer 25

The length of time inventory is held between purchase and sale.

Inventory days= (Inventory ÷ Cost of Sales) x 365

Question 26

What is the raw material holding period?

Answer 26

The length of raw materials are held between purchase and being used in production.

Material days= (Material ÷ Purchases) x 365

Question 27

What is the WIP holding period?

Answer 27

The length of time it takes to get from raw material to finished goods (average production time)

WIP = (WIP ÷ Cost of sales/ Production cost ) x 365

Question 28

What is the finished goods holding period?

Answer 28

The length of time finished goods are held between completion or purchase and sale.

FGD = (Finished Goods÷ Cost of sales/ Production cost ) x 365

Question 29

For these ratios, is high or low value prefered?

Answer 29

a low ratio is usually seen as a sign of good working capital management. It is very expensive to hold inventory and thus minimum inventory holding usually points to good practice.

Question 30

For these ratios, is high or low value prefered?

Answer 30

a low ratio is usually seen as a sign of good working capital management. It is very expensive to hold inventory and thus minimum inventory holding usually points to good practice.

Question 31

What is the trade receivables days?

Answer 31

The length of time credit is extended to customers

TRD = (Receivables ÷ Credit Sales ) x 365

shorter credit periods are seen as financially sensible but the length will also depend upon the nature of the business. Keeping these days short reduces the average level of current assets for a certain volume of production and sales

Question 32

What is the trade payables days?

Answer 32

The length of time credit is extended by suppliers

TPD = (Payables ÷ Credit purchases) x 365

Generally, increasing payables days suggests advantage is being taken of available credit. The longer the trade payables days, then the more efficiently working capital is being managed. Longer days increases the average level of current liabilities and reduces the net working capital.

However, there are risks:

losing supplier goodwill
losing prompt payment discounts
suppliers increasing the price to compensate.

Question 33

What are the limitations of ratios?

Think of where the numbes come from for these formulas for the operating cash cycles

Answer 33

– the financial position statement values at a particular time may not be typical
– balances used for a seasonal business may not represent average levels, e.g. a fireworks manufacturer
– ratios can be subject to window dressing/manipulation
– ratios concern the past (historic) rather than the future
– figures may be distorted by inflation and/or rapid growth.

Question 34

What is the working capital turnover and the formula?

Answer 34

This measures how efficiently management is utilising its investment in working capital to generate sales and can be useful when assessing whether a company is overtrading. It must be interpreted in the light of the other ratios used.

= Sales revenue ÷ Net working capital

Question 35

Working capital ratios can be used to predict future levels of investment required(The financial statement position figure).

How is this done?

Answer 35

Working capital ratios can be used to predict future levels of investment required(The financial statement position figure). This can be done by rearranging the formulas e.g.

Trade receivable balance = (Trade receivable days ÷ 365) x Credit sales

Question 36

The level of working capital required is affected by what factors?

Answer 36

(1) The nature of the business, e.g. manufacturing companies need more inventory than service companies.
(2) Uncertainty in supplier deliveries. Uncertainty would mean that extra inventory needs to be carried in order to cover fluctuations.
(3) The overall level of activity of the business. As output increases, receivables, inventory, etc. all tend to increase.
(4) The company’s credit policy. The tighter the company’s policy the lower the level of receivables.
(5) The length of the operating cycle. The longer it takes to convert material into finished goods into cash the greater the investment in working capital
(6) The credit policy of suppliers. The less credit the company is allowed to take, the lower the level of payables and the higher the net investment in working capital.

Question 37

What is gross profit formula?

Answer 37

Sales Revenue - Cost of sales

Question 38

.In terms of financing the working capital, what is the conservative approach

Answer 38

Finance all non-current assets, all permanent current assets and a proportion of fluctuating current assets using long term financing methods

This is very good from a liquidity and solvency point of view (i.e. low risk of the company running out of cash!) It is, however, bad from a profitability point of view

Question 39

.In terms of financing the working capital, what is the aggressive approach

Answer 39

Finance all fluctuating current assets and a proportion of permanent current assets using short term financing methods e.g. a bank overdraft

This improves profitability because the overdraft can be reduced as the level of fluctuating current assets falls and, in theory, interest payable on a bank overdraft is lower than interest payable on a term bank loan

This approach is, however, risky. An overdraft is repayable on demand and therefore there is a higher risk of a company running out of cash!

Question 40

As sales increaes, will working capital increase or decrease?

Answer 40

Working capital will naturally increase with sales as more inventory is needed to satisfy demand and more credit is offered to more customers. Payables will also increase, reducing working capital but to a lower degree

Question 41

increasing the cash operating cycle leads to?

Answer 41

Lengthening of the operating cash cycle will lead to cash being out of the business for longer and more funding therefore needed to cover this

Question 42

What is undercapitalisation?

Answer 42

Overtrading (undercapitalisation) is where the business doesn’t have enough cash funding to sustain the level of trading activity.

Question 43

What is undercapitalisation?

Answer 43

Overtrading (undercapitalisation) is where the business doesn’t have enough cash funding to sustain the level of trading activity.

Question 44

‘Credit sales’ under ‘Receipts’- What does thisi imply

Answer 44

‘Credit sales’ under ‘Receipts’ implies receipts from credit customers. So it has ALREADY BEENN PAID so remember this when calculating the cash budget

Question 45

‘Credit sales’ under ‘Receipts’- What does thisi imply

Answer 45

‘Credit sales’ under ‘Receipts’ implies receipts from credit customers. So it has ALREADY BEENN PAID so remember this when calculating the cash budget

Question 46

what is commercial paper

Answer 46

It is a short term IOU

unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities. Maturities on commercial paper typically last several days, and rarely range longer than 270 days.1

 Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.

Commercial paper will be issued at a discount and then repaid at nominal value on the settlement date. It is short term and traded on the money market

company can issue this if they are looking for short term money-

Question 47

What is the operating/ operating cycle?

Answer 47

It is the period of time when a company settles it’s accounts payable and when it receives cash from it’s accounts receivable.

Operating activities during this period need to be financed and as the operating period lengthens, the amount of finance needed increases. Companies with comparatively longer operating cycles than others in the same industry sector, will therefore require comparatively higher levels of investment in current assets.

Question 48

discuss factors which determine the level of a company’s investment in working capital

Answer 48

• The nature of the industry and the length of the working capital cycle

Some businesses have long production processes which inevitably lead to long working capital cycles and large investments in working capital. Housebuilding, for example, requires the building company to acquire land, gain government permission to build, build houses and when complete, sell them to customers. This process can often take more than a year and require large investment in work-in-progress and therefore in working capital.

Other industries, such as supermarkets, buy goods on long credit terms, have rapid inventory turnover and sell to customers for cash. They often receive payment from customers before they need to pay suppliers and therefore have little (or negative) investment in working capital

• Working capital investment policy

Some companies take a conservative approach to working capital investment, offering long periods of credit to customers (to promote sales), carrying high levels of inventory (to protect against stock-outs), and paying suppliers promptly (to maintain good relationships).

This approach offers many benefits, but it necessitates a large investment in working capital. Others take a more aggressive approach offering minimal credit, carrying low levels of inventory and delaying payments to suppliers. This will result in a low level of working capital investment.

• Terms of trade

These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, and any penalties for late payment. A company whose terms of trade are more generous than another company in the same industry sector will therefore need a comparatively higher investment in current assets

• Efficiency of management and terms of trade

If management of the components of working capital is neglected, then investment in working capital can increase. For example, a failure to apply credit control procedures such as warning letters or stop lists can result in high levels of accounts receivable.

Failure to control inventory by using the EOQ model, or JIT inventory management principles, can lead to high levels of inventor