7: Working Capital Flashcards
What is working capital!
What a company invests in to oil the wheels of the business
Current assets - current liabilities
CAs: inventory + receivables + cash
What balance needs to be struck with working capital?
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
The general rules with funding?
Long term assets financed by long term funds
Short term assets financed by short term funds
Working capital should be self financing
Ads and Dis of short term finance?
Ads:
- relatively cheap
- flexible
Dis:
- renewal risk (may be recalled)
- interest rate risk (might fluctuate)
What are liquidity ratios used for?
Liquidity ratios can be used to assess a business’s liquidity position
Can be compared with:
- previous periods for same company
- industry averages
What is the current ratio?
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
What is the quick ratio?
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
What is the inventory holding period?
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
What is the inventory turnover rate ratio?
Coat of sales / average inventory
Higher the rate, lower level of inventory and lower the holding costs.
How efficiently company uses inventory.
What extra ratios do manufacturing industries have?
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
What is the receivables collection period ratio?
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
What is the payables payment period ratio?
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
What are the six ratios you need to learn?
Current ratio
Quick ratio
Inventory turnover period
Inventory turnover rate
Receivables collection period
Payables payment period
What do you need to be able to do with the ratios?
You need to be able to rearrange them to get:
- inventory
- receivables
- payables
- assets
- liabilities
What is the cash operating cycle?
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
What is working capital calculated as:
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
What is the significance of the cash operating cycle?
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
What is the cause of liquidity problems, and why?
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
What are the cures for liquidity problems?
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
5 systems for inventory control?
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
Managing trade payables?
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
Managing trade receivables?
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
4 methods in credit control and collection policies?
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
4 reasons why a business would want to hold cash?
Transactions - meet day to day obligations
Finance - cover major items
Precautionary - cover against unexpected outlays
Investment/speculative - new investment opportunities
2 essential elements in cash management?
Efficient cash transmission processes
Cash budget
What is a cash budget, and what are the two objectives?
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
4 elements of a cash budget pro forma?
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
What are the four cash positions (and actions to take)?
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
