7. Working Capital Flashcards
What is working capital?
Working capital (sometimes referred to as net working capital) is the money your business needs to be able to operate from day to day
What is the general equation for working capital?
What are the two main concerns for the management of working capital?
- the liquidity position of the company
- the profitability of the company
Outline actions that can be taken to improve liquidity and actions that can be taken to improve profitability with the following: i) cash, ii) receivables, iii) inventory, iv) payables
What values can we use to compare a businesses liquidity position?
- Ratios
- Cash operating cycle
These can be compared with:
* The same company in previous periods
* Other companies in the same industry
Define the average inventory period ratio, including an equation
The average length of time that inventory is held for - the higher the number, the longer the inventory is held
We can calculate separate ratios for the three types of inventory (raw materials, work in progress and finished goods).
NOTE: If calculating raw materials inventory period (and if you have the information available), you should use materials purchases as the denominator (rather than cost of sales, which includes non-materials production costs)
Define the average inventory turnover ratio, including an equation
The rate of inventory turnover monitors how many times inventory turns over during the trading period - the higher the number, the more inventory turnovers in the period
We can calculate separate ratios for the three types of inventory (raw materials, work in progress and finished goods).
NOTE: If calculating raw materials inventory turnover (and if you have the information available), you should use materials purchases as the denominator (rather than cost of sales, which includes non-materials production costs)
Define the receivables collection period ratio, including an equation
How long on average it takes for credit customers to pay - the lower the number the quicker the customers pay
NOTE: If you have the information available, it would be best to use credit sales as the denominator (as receivables only relate to credit sales).
Define the payables collection period ratio, including an equation
How long on average the company waits before paying its suppliers - the lower the number the quicker the business pays its suppliers
NOTE: If you have the information available, it would be best to use purchases as the denominator (cost of sales will include costs that aren’t paid on credit terms, such as labour costs).
Define the current ratio, including an equation
The ability to meet short-term liabilities from easily or quickly realisable current assets - the higher the value, the more liquid the business
Why is the quick ratio sometimes preferred over the current ratio?
Inventory is the most illiquid of current assets (difficult to sell for cash)
Define the quick ratio, including an equation
It is common to calculate this ratio by excluding inventory from current assets. This gives a quick / acid-test ratio.
What is the issue with a very high current ratio?
If a business has a very high ratio this may indicate that funds are tied up in current assets unnecessarily
What is the cash operating cycle? Outline a suitable diagram
A cycle that describes the length of time between an organisation paying out cash for its raw materials and other input costs and receiving the cash for goods or services supplied.
Outline the pro-forma to use when calculating the length of the cash operating cycle
What is meant by overtrading and illiquidation?
If an organisation is illiquid, it will be unable to meet its liabilities and will fail. When a business is growing its profits will increase, but it will also require more capital to pay for the increased levels of working capital. If this extra capital (additional funding for the business) is not raised in time, the business will become illiquid. This situation is commonly referred to as ‘overtrading’ as the growth in trade is what necessitated the extra capital, which if not raised leads to the business failing.
What are the limitations for these working capital performance measures? (3)
- the balance sheet values at a particular point in time may not be typical.
- balances used for a seasonal business will not represent average levels, eg, summer holiday travel business.
- such measures concern the past not the future.
Outline how to approach questions that give you ratios and ask for a value such as inventory, receivables,payables, etc.
It’s best to start by writing down the calculations for any ratios you’ve been given.
Then identify any ratios where you know the result and all but one of the inputs – work to then find that input by re-arranging the equation and use that input in another ratio calculation.
Proceed methodically by substuting the values previosuly calcualted to arrive at the value required by the question
Define the costs associated with holding inventory (3)
Define the control systems available to control inventory levels (5)
Why are trade payables important for a business in terms of cash flow?
Credit periods for the buyer are a source of short-term finance. For example, if a buyer decides not to pay its trade debts for a further month, it has obtained a further month’s use of its cash
What are the advantages (3) and drawbacks (2) of trade payables?
Drawback:
* Suppliers may withdraw credit status if payments are not made on time
* Delayed payment may lead to increased supplier prices or lost discounts
Advantages:
* It is convenient and informal
* Useful where businesses do not qualify for traditional credit sources (e.g. from lenders)
* Can be used on a very short-term basis to overcome unexpected cash flow crises
What is meant by good payment practice?
Paying suppliers in a reasonable amount of time and not delaying payment and taking advantage of the credit terms offered by the supplier in order to increase cash flow
What is the trade off for a business with regards to trade receivables?
- The costs of extending credit to customers – these include finance costs, irrecoverable debts and administrative costs of the credit control department.
- The benefits of granting credit – in their simplest form these are larger profits due to the increased sales generated because of the credit terms offered.
What are settlement discounts given to customers and why might businesses offer them?
Discounts offered to customers for early settlement
Businesses might offer them in order to insentivise customers to pay earlier and thus increasing the businesses cash flow
What must businesses consider when offering early settlement discounts?
The business must ensure the cost does not outweigh the benefit, and should compare it with the cost of other sources of short-term finance, e.g. overdraft.
What is meant by credit risk with regards to trade receivables?
The risk that customers buying on credit will not be able to repay these debts
How can businesses reduce the credit risk of trade receivables?
By using credit ratings, these can be determinedby analysing financial statements of the customers or reviewing past trading experience against the customer, they can also be determined with reference to external sources of information (such as credit rating agencies and trade / bank references).
Credit terms limits can then be set based on this information
What are the ways a business can finance trade receivables? (2)
- Invoice discounting
- Receivables factoring
What is invoice discounting?
This involves selling the invoices to a discounting company for a cash sum (less than 100% of the face value of the receivable), then repaying the discounter when the debtor pays the invoice:
- You sell goods or services to your customers as usual and raise an invoice.
- An invoice discounting company lends less than 100% of the face value of the invoices (~95%).
- The customers pay you according to your normal payment terms (it’s your responsibility to chase late invoice payments – you remain the credit controller).
- Once you’ve received payment from your customers, you repay the loan to the invoice discounting company, plus an agreed fee to cover costs, risk and interest (~1-3%).
What is receivables factoring?
This involves selling unpaid invoices to a third-party factoring company at a discount. The factoring company then pays the business a portion of the invoice value and collects the full amount from the customer:
- You sell goods or services to your customers as usual and raise an invoice.
- You “sell” the raised invoices to a factoring company. The factoring company pays you the bulk of the invoiced amount immediately, (~80-90%) of the value
- Your customers pay the factoring company directly. The factoring company chases invoice payment if necessary (they become the credit controller).
- The factoring company pays you the remaining invoice amount – minus their fee – once they’ve been paid in full.
What is trade credit insurance?
Trade credit insurance insures a business against the possible default and insolvency of its credit customers and, where exports are involved, political risk. Businesses can:
* Insure all or part of its receivables ledger against default by a customer
* Include a ‘first loss’ (or excess) on its accounts to be insured
* Be insured only up to a ceiling (‘credit limit’)
* The premium paid will vary in accordance with the above factors
What is the trade off for a business with regards to holding cash?
- The cost of holding cash includes the opportunity cost of what else could be done with the money (as cash is an idle asset and earns no return for the company).
- The costs of running out of cash vary, depending upon the circumstances of the business, but could lead to the cessation of trade (if the business cannot pay staff, suppliers and its taxes).
What are a business options for short term finance (5) and options for investment (5)?
What is a cash budget?
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
Outline how to approach preparing a cash budget
METHOD
Outline the matrix businesses can use ti respond to the four different cash positions: short-term surplus, long-term surplus, short-term deficit, long-term deficit
