Chapter 11 - Cash Operating Cycle Flashcards
Cash and Working Capital
Even though most business transactions are credit, they eventually have to be settled with cash.
When companies go into liquidation or stop trading, it’s not because they stopped making profit, it’s because they ran out of cash.
Overtrading
When businesses try to expand to rapidly without having sufficient working capital. The order book will be larger than their cash to support the level of business.
This often happens at the end of a recession, when companies take more orders than they can take.
Firms in these circumstances are are forced to rely on their payables and their bank overdraft to survive.
Characteristics of an overtrading business
- increase in sales revenue
- increase in inventory
- increase in trade receivables
- increase in trade payables
- business of volume (more orders)
But inadequate working capital means that liquidity problems will arise, cash bank decreases, and trade receivables and payables will take longer. Leading the business to be unable to pay its debts and consequently into liquidation.
The opposite of overtrading
This is when a company doesn’t receive sufficient order to be able to continue operating.
- Sales decline
- Fall in receivables
- low cash inflows
- insufficient working capital to pay suppliers and daily operating costs
Operating Cycles
All firms have a trading cycle of supplying and selling goods to customers.
Manufacturer Operating Cycle
Purchase raw materials
Process into finished product
Hold inventory
Sell to customer
(restart from the beginning)
Operating Cycle as a cycle of money
There are various ancillary departments involved in the cycle, and they all need cash.
This is how the cash operating cycle for the manufacturer looks like:
- pay for raw materials
- pay for production costs
- pay overheads
- receive cash from customers
Cash Operating Cycle meaning
Period of time that elapses between money paid for inventory or raw materials and the receipt of cash from customer.
The shorted the operating cycle, the best the company is performing.
Factors that determine the length of the Cash Operating Cycle
- how long raw materials are held before being sold
- how long material is held in stockrooms before being sold
- how long production processes take
- how long finished goods are sold before resale
- how long customers take to pay their accounts
Management of working capital and the cash operating cycle
It involves the three elements of working capital:
inventory
receivables
payables
Cash Operating Cycle Formula
Inventory Turnover + Receivables Collections (days) - Payment Settlement in Days = Cash Operating Cycle (days)
Inventory Turnover Formula
Average Inventory / Cost of Sales x 365
This will the result of days it takes to buy and replace the average inventory level.
Average Inventory Formula
Opening Inventory + Closing inventory / 2
In some cases where the opening inventory is not given, the closing inventory can be used to replace the average inventory
Receivable Collection Period
Formula is
Trade Receivables/ sales revenue x 365
This is the average days taken to collect a payment
Payables Settlement Period
Trade payables / purchases x 365
