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.