3.4.2 Working Capital management

Question 1

Define working Capital

Answer 1

Working capital is the difference between current assets and current liabilities

Working capital = Current assets - Current liabilities

Question 2

Why is working capital needed?

Answer 2

Working capital is needed so that a business can extend credit to customers, buy stock and inventory and meet its current debts or financial commitments

Question 3

Why does working capital need to be managed?

Answer 3

Working capital needs to be managed for a business to remain in operation. If there is too little working capital, then there will be liquidity difficulties. If there is too much working capital, then it limits the options of growth, profit and expansion.

Question 4

In regard to working capital identify three strategies that can be used for control of current assets

Answer 4

• Cash
• Receivables
• Inventories

Question 5

Why is it necessary to monitor and control cash in a business?

Answer 5

Cash is necessary to meet the operating costs of the business. Cash budgets are an effective way to control cash as they help a business prepare for shortfall and surpluses in cash at different points of the year. Cash shortfalls may be overcome by organising overdrafts and lines of credit, and cash surpluses may be health with using investment options.

Question 6

Why is it necessary to manage receivables?

Answer 6

It is important for a business to manage and control these accounts receivable so that the business has more cash flow.

Question 7

Identify some strategies to encourage customers to pay back their accounts receivable sooner

Answer 7

• Discounts for cash and early payments
• charges for late payments
• sending out invoices and reminders more regularly (fortnightly rather than monthly)
• Offering outside credit facilities, such as payment by credit card
• Having a clear credit policy that includes details of the credit checks and collection policy
• Factoring

(All of these methods will cost the business money but it is essential that a business does not allow accounts receivable to become so large that working capital and liquidity of the business are threatened.

Question 8

Outline inventories control

Answer 8

Inventory control requires a balance between too much and too little stock. Effectively controlling inventory allow a business to keep costs low.

Question 9

Identify strategies that can be used to control inventory

Answer 9

• Regular and ongoing stocktaking
• Control systems such as the perpetual inventory system (as used in supermarkets and the just in time inventory supply system - minimum inventory
• use of sales to convert stock into cash

Question 10

Why is it important to manage short term laiblities?

Answer 10

Managing short term liabilities is critical to the business because a business must be able to meet their short term debts in order to maintain effective liquidity for the business

Question 11

Define accounts payable and strategies used to manage this

Answer 11

Accounts payable are the amounts a business owes to other businesses that need to be paid in a relatively short time. Strategies used to control payables include

• Payment on time (to avoid late fee charges)
• taking advantage of early payment discounts
• maintaining a good credit rating for continuing access to lines of credit provided by suppliers

Question 12

Define overdrafts

Answer 12

Overdrafts can be very useful to a business in managing its working capital. When the cash budget indicates that there will be a shortage of cash, the business can use its overdrafts to pay its accounts and other short-term debts. Interest is paid on outstanding overdraft balances and banks can ask for overdrafts to be paid in full immediately if overdrafts consistently exceed the agreed amounts.

Question 13

In addition to controlling current assets and current liabilities what other two common strategies are there?

Answer 13

Leasing and sale and lease back

Question 14

Define leasing

Answer 14

Leasing is a financial management that allows a business to use an asset in return for payments over a set period. By leasing an asset the business maintains more working capital to invest in other assets and opportunities to aid the expansion of the business

Question 15

Define Sale and Leaseback

Answer 15

Sale and leaseback involve the selling of assets such as building and equipment and leasing them back from the purchaser. This allows the business to raise finance without incurring new debt. The advantage of this to managing working capital is that the business has sold and asset and received cash.