7: Working Capital

Question 1

What is working capital!

Answer 1

What a company invests in to oil the wheels of the business

Current assets - current liabilities

CAs: inventory + receivables + cash

Question 2

What balance needs to be struck with working capital?

Answer 2

Profitability - long term growth and returns to investors
- demand generous credit terms and high receivables
- want to minimise holdings of cash

Liquidity - short term survival
- demands cash sales and no receivables
- maximise holdings of cash

Question 3

The general rules with funding?

Answer 3

Long term assets financed by long term funds

Short term assets financed by short term funds

Working capital should be self financing

Question 4

Ads and Dis of short term finance?

Answer 4

Ads:
- relatively cheap
- flexible

Dis:
- renewal risk (may be recalled)
- interest rate risk (might fluctuate)

Question 5

What are liquidity ratios used for?

Answer 5

Liquidity ratios can be used to assess a business’s liquidity position

Can be compared with:
- previous periods for same company
- industry averages

Question 6

What is the current ratio?

Answer 6

Current assets / current liabilities

How much of total current assets are financed by current liabilities

Higher value: business is more liquid and is able to meet its current liabilities
GOOD

Lower value: indicates a business will struggle to pay its current liabilities
BAD

Question 7

What is the quick ratio?

Answer 7

Current assets exc. inventory
/ current liabilities

A more realistic measure of a business’s ability to meet its short-term commitments due to the length of time to turn inventory into cash

Appropriate level depends on type of business

Question 8

What is the inventory holding period?

Answer 8

Inventory / cost of sales x 365

Shows the average length of time inventory is hold for

Shorter the period, the lower the associated costs of holding inventory

Question 9

What is the inventory turnover rate ratio?

Answer 9

Coat of sales / average inventory

Higher the rate, lower level of inventory and lower the holding costs.

How efficiently company uses inventory.

Question 10

What extra ratios do manufacturing industries have?

Answer 10

Inventory holding period

Average inventory of raw materials / annual usage x 365

Average inventory of WIP materials / annual CoS x 365

Average inventory of finished goods / annual CoS x 365

Question 11

What is the receivables collection period ratio?

Answer 11

Receivables / annual sales revenue x 365
(In days)

Shorter the period, fast receivables are paying their debts

Terms cant be too low, or customers will switch to better payment terms

Question 12

What is the payables payment period ratio?

Answer 12

Payables / annual purchases x 365

Longer period is preference

Cant be too long other supplier goodwill may be lost

If purchases not available, use CoS

Question 13

What are the six ratios you need to learn?

Answer 13

Current ratio

Quick ratio

Inventory turnover period

Inventory turnover rate

Receivables collection period

Payables payment period

Question 14

What do you need to be able to do with the ratios?

Answer 14

You need to be able to rearrange them to get:

• inventory
• receivables
• payables
• assets
• liabilities

Question 15

What is the cash operating cycle?

Answer 15

Defined as the length of time between:

paying for the purchase of raw materials
and receiving cash for the subsequent sale of those goods or services supplied

Question 16

What is working capital calculated as:

Answer 16

All the periods
(Payables payment period)

Can be in days, weeks, months

Faster a firm can ‘push’ items around the cycle, the lower its investment in working capital can be

Question 17

What is the significance of the cash operating cycle?

Answer 17

As the cycle gets longer and sales increase, more cash is tied up in the cycle

If cycle is out of balance, short term finance is needed

Question 18

What is the cause of liquidity problems, and why?

Answer 18

Overtrading - small business grows quickly, but soon runs out of cash

Happens because amount of cash needed to fund the cash operating cycle increases
- sales increase
- cycle gets longer as suppliers want short credit and customers want long credit

Question 19

What are the cures for liquidity problems?

Answer 19

Inject some further long-term capital

Raise cash by selling non-essential assets

Slow down growth rate of business

Reduce length of cash operating cycle
- lower levels of inventory
- faster collection of debts from credit customers
- increase proportion of cash sales
- slower payment of debts to suppliers

Question 20

5 systems for inventory control?

Answer 20

Re-order level system
- pre-calculated economic order size
- when inventory falls to predetermined level

Period review system
- regular inspections of inventory levels

ABC system
- inspections prioritised according to importance of each item

Just in time system
- supplier delivers to customer order
- gives supplier the customer order book

Perpetual inventory size
- automatically generated with computerised system

Question 21

Managing trade payables?

Answer 21

Excessive use of payables for short term finance can have consequences:
- favoured customer status lost
- supplier raises prices to compensate for the extra interest
- opportunity for prompt payment discounts gone

Prompt payment is essential: ethically, and countries have a legal obligation to report their payment practices and policies

Good payment practices:
- late payment is ethically unacceptable
- businesses have right to receive correct full payment
- payment processes should be clear

Question 22

Managing trade receivables?

Answer 22

Only benefit to granting credit is increasing sales volume

Costs:
- finance costs get tied up in receivables
- risk of irrecoverable debts
- admin costs of running a credit department

Control done by credit control policies

Question 23

4 methods in credit control and collection policies?

Answer 23

Credit ratings - assess the risk customer wont pay

Outsource credit collection
- receivables factoring
- invoice discounting

Minimise time taken between placement of order and receipt of cash from customer
- online ordering
- prompt dispatch of goods
- preparation of credit control reports

Credit insurance against possible default and insolvency

Question 24

4 reasons why a business would want to hold cash?

Answer 24

Transactions - meet day to day obligations

Finance - cover major items

Precautionary - cover against unexpected outlays

Investment/speculative - new investment opportunities

Question 25

2 essential elements in cash management?

Answer 25

Efficient cash transmission processes

Cash budget

Question 26

What is a cash budget, and what are the two objectives?

Answer 26

Detailed budget of estimated cash inflows and outflows, incorporating both revenue and capital items

• to provide period cash balances for budgeted balance sheet
• anticipate cash shortages/surpluses

Question 27

4 elements of a cash budget pro forma?

Answer 27

Estimated cash receipts
- receivables
- cash
- proceeds on disposal of NCAs

Estimated cash payments
- payables
- other purchases
- dividends
- NCAs
- loan repayments

Net cash inflow/outflow
+ opening cash balance

Closing cash balance

Remember: leave out depreciation and bad/irrecoverable debts

Question 28

What are the four cash positions (and actions to take)?

Answer 28

Short term surplus
- pay suppliers early
- increase spending
- make investments

Short term shortfall
- delay payments
- tighten credit control
- overdraft

Long term surplus
- make investments
- acquisition
- pay dividend
- replace assets
- share buy-back

Long term shortfall
- raise new finance, debt or equity
- sell assets
- divest
- close business