8.3: Working Capital Management Flashcards
What is working capital, and how is it calculated?
Working capital is defined as the difference between current assets and current liabilities.
It is calculated by subtracting current liabilities from current assets.
In the case of Starbucks at the end of fiscal year 2021, the working capital was calculated as $9,756.40 million (current assets) - $8,151.40 million (current liabilities) = $1,605.00 million.
Why is working capital management important for businesses, and what are the risks associated with insufficient or excessive working capital?
Working capital management is crucial because insufficient working capital may lead to an inability to meet obligations to creditors, while excessive working capital can tie up resources in unproductive assets and incur additional costs.
For example, excess inventory ties up funds and incurs storage costs.
Businesses aim to strike a balance between having enough liquidity to meet obligations and not tying up excessive amounts of money in nonproductive assets.
: How do changes in working capital accounts impact cash flows, and what role does the quick ratio play in evaluating liquidity?
Changes in working capital accounts directly impact cash flows from operating activities reported on the statement of cash flows.
**The quick ratio, a measure of liquidity, compares the most-liquid assets (cash, short-term investments, and net receivables) to current liabilities. **
It provides a conservative assessment of a company’s ability to meet its short-term obligations, considering only the most liquid assets in the ratio, unlike the current ratio, which includes all current assets.
What is the quick ratio, and how is it calculated?
The quick ratio is an indicator of the amount of quick assets (cash, short-term investments, and net receivables) available to satisfy current liabilities. It is calculated as follows:
Quick ratio = (Quick assets) / (Current liabilities
How do you interpret the quick ratio, and what does a high or low ratio indicate?
A high quick ratio typically suggests good liquidity, indicating that a company has sufficient quick assets to cover its current liabilities.
However, a ratio that is too high may suggest inefficient use of resources. Some strong companies intentionally maintain low quick ratios by minimizing funds invested in current assets.
A low quick ratio may indicate that a company could struggle to meet its short-term obligations
What are some cautions to consider when using the quick ratio as a measure of liquidity?
The quick ratio can be influenced by small variations in the flow of transactions. For instance, the repayment of a large bank loan just before the close of the fiscal year can significantly impact the ratio.
Managers can manipulate the quick ratio by engaging in specific types of transactions before the preparation of financial statements, such as paying creditors immediately to improve the ratio.
Therefore, analysts need to consider the timing and nature of transactions when interpreting the quick ratio.
