15.1 Working capital management

Question 1

Working capital is the

Answer 1

capital available for conducting the day to day operations in an org (normally the excess of current assets over current liabilities)

Question 2

Working capital calculated as

Answer 2

Inventory + Receivables + Cash = Current assets - Trade payables = Working capital

Question 3

Working capital management is the

Answer 3

• management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets
• the optimum level of working capital is the amount that results in no idle cash or unused inventory but does not put a strain on liquid resources

Question 4

Investing in working capital has a cost which can be expressed as either

Answer 4

• the cost of funding it, or
• the opportunity cost of lost investment opportunities because cash is tied up an unavailable for other uses

Question 5

The main objective of working capital management is

Answer 5

to get the balance of current assets and current liabilities right (the trade off between cash flow versus profits)

• Liquidity - ensure current assets are liquid enough to minimise risk of insolvency
• Profitability - maximise the return on capital employed (ROCE) therefore minimising investment in working capital

Question 6

The consequences of poor working capital management include

Answer 6

• Unable to meet bills as they become due
• Demands on cash during periods of growth being too great (overtrading)
• Over stocking or stock outs

Question 7

Advantages of high elements of working capital

Answer 7

• Inventory - Few stockouts, bulk purchase discounts, reduced ordering costs
• Receivables - Customers like credit (profitable as attracts more sales)
• Cash - Able to pay bills on time, take advantage of unexpected opportunities, avoid high borrowing costs
• Trade payables - Preserves own cash (cheap source of finance)

Question 8

Advantages of low elements of working capital

Answer 8

• Inventory - Less cash tied up in inventory, lower storage costs
• Receivables - Less cash tied up, less chance of irrecoverable debts, reduced costs of credit control
• Cash - Can invest surplus to earn high returns, less vulnerable to takeover
• Trade payables - Likely taken advantage of early settlement discounts, less strain on cash balances with fewer short term liabilities to fall due

Question 9

Working capital cycle (aka cash operating cycle)

Answer 9

is the length of time between the entitys outlay on raw materials, wages and other expenses and the inflow of cash from the sale of goods

Working capital cycle = Inventory days + Trade receivable days - Trade payable days

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

Question 10

Factors affecting the length of the working capital cycle include

Answer 10

• Liquidity versus profitability decisions
• Management efficiency
• Industry norms (eg. regail versus construction)

Question 11

The amount of investment required in working capital will depend on many factors such as

Answer 11

• The industry the firm operates in - customers pay expect long payment periods vs cash payments being the norm (eg: retail will have low receivables and high inventory VS manufacturing company will have high receivables and high wip)
• They type of products sold - a business selling perishables will have to keep lower level of inventory
• Whether products are manufactured or bought in - manufacturing will have high levels of raw material, wip and finished goods
• The level of sales - if sales are high it is likely that receivables will be high too
• Policies on working capital management - different entities will have different strategies on working capital management

Question 12

An appropriate amount of working capital must be

Answer 12

• budged to meet anticipated future needs
• in uncertainty an entity must hold a minimum level of cash and inventories based on expected revenue, plus a safety buffer

Question 13

The choice of working capital management policy is a

Answer 13

matter for managerial judgement and depends to an extent on the cost vs risk trade off

Question 14

Three possible policies exist to manage working capital

Answer 14

• Aggressive policy - attempts to reduce costs by holding the lowest levels of cash, inventory and receivables as possible (produces a short operating cycle) - caries the greatest risk of illiquidity and gives the greatest returns
• Conservative policy - attempts to reduce risk by holding high levels of cash, inventory and receivables (produces a longer operating cycle) - risks such as stock outs or liquidity or low but costs are higher
• Moderate policy - this adopts a middle ground between aggressive and conservative approaches

Question 15

We can split the investment required for working capital into two elements

Answer 15

• Permanent - the base level of working capital required during the year
• Fluctuating - the portion above the base level that allows for seasonality and other short term changes

Question 16

The base level of working capital required will be governed by

Answer 16

the entity’s approach to managing the level of working capital (an aggressive approach means a lower base level than a conservative approach)

Question 17

The level of working capital an entity requires needs to be financed by either

Answer 17

• Short term finance - which is generally cheaper because interest rates are generally lower than long term rates (but price paid for reduced cost is an increased risk for the borrower)
• Long term finance

An entity will use a combination of both short term and long term finance

Question 18

Increased risk of short term financing for borrower:

Answer 18

• Renewal problems - short term finance may need to be continually renegotiated as various facilities expire and renewal may not always be guaranteed
• Stability of interest rates - if the entity is constantly having to renew its funding arrangements it will be at the mercy of fluctuations in short term interest rates

Question 19

The degree to which short term finance is used will depend on the entity’s attitude towards risk, but will typically follow the following pattern:

Answer 19

• If entity uses an aggressive approach, typically all of the fluctuating and some of the permanent investment will be financed with short term finance
• If an entity uses a conservative approach, typically all of its permanent and a portion of its fluctuating investment will be financed with long term finance and part of the fluctuating investment with short term
• If an entity uses a moderate approach, typically the fluctuating investments will be financed with short term finance and the permanent investment with long term finance

Question 20

Healthy trading growth typically leads to

Answer 20

• increased profitability
• the need to increase investment in non current assets and working capital

Question 21

Overtrading

Answer 21

• If the business does not have access to sufficient capital to fund an increase in trading growth is is said to be overtrading (when an entity tries to grow too quickly with too small of a capital base)
• This can cause serious trouble for the business if it is unable to pay its business payables