Chapter 12 - Working Capital Management

Question 1

What is the working capital cycle (WCC)?

Answer 1

Working capital = receivables + cash + inventory – payables. Inventories can be further classified into raw materials (RM), work in progress (WIP) and finished goods (FG)

Working capital is the total amount of cash tied up in current assets and current liabilities.

WCC = time taken by an organisation to convert its net current assets into cash. Determined by adding up the days required to complete each stage in the cycle.

WCC = inventory holding period ÷ storage period + debtor collection period – creditor payment period

Assuming there are 365 days in a year, WCC is the sum of the following:

1) Receivable days = (average receivables ÷ credit sales) x 365
2) PLUS: Inventory days
a. FG = (average FG ÷ cost of sales) x 365
b. WIP = (average WIP ÷ cost of production or sales) x 365
c. RM = (average RM ÷ RM purchases) x 365
3) LESS: payable days = (average payables ÷ credit purchases) x 365

Question 2

What is the inventory holding period?

Answer 2

The number of days taken to process or sell inventory.

3 stages:
1) Raw material holding period = average stock of RM ÷ average cost of production per day

2) WIP holding period = average WIP inventory ÷ average cost of production per day
3) Finished goods storage period = average stock of FG ÷ average cost of goods sold per day

Question 3

What is the debtors collection period?

Answer 3

The average number of days taken to realise the payments of credit sales

Debtors collection period = average trade debtors ÷ average credit sales per day

Question 4

What is the creditors payment period?

Answer 4

The average number of days taken to make payment to trade creditors/suppliers

Creditors payment period = average trade creditors ÷ average credit purchase per day

Question 5

Working capital management: profitability vs liquidity

Answer 5

High levels of working capital = idle funds with unnecessary costs = overcapitalisation.

Low working capital = not able to meet day-to-day demands = insolvency

Overtrading = rapid increase in turnover that is not supported by sufficient working capital

Question 6

What is the current ratio?

Answer 6

(Current Assets)/(Current Liabilities) ∶ 1

Measure of a company’s ability to repay short-term liabilities using current assets. 1 or more = full cover to meet liabilities

Question 7

What is the quick ratio?

Answer 7

(Current Assets-Inventories)/(Current Liabilities) ∶ 1

Ability of company to meet short-term liabilities using most liquid assets. 1 or more = full cover to meet liabilities

Question 8

What is the asset turnover ratio?

Answer 8

Sales/(Net Assets) (x times)

Ability of the business to generate revenue from its assets. Low number = assets not utilised efficiency and high number = more investments are needed

Question 9

What is the inventories turnover ratio?

Answer 9

(Cost of goods sold p.a)/(Average inventories)

Measures the effectiveness of inventory management. Indicates how quickly inventory is being sold or used during the period

Question 10

What is the receivable turnover ratio?

Answer 10

(Credit sales p.a)/(Average receivables)

Measures how quickly debts are being collected

Question 11

What is the payables turnover ratio?

Answer 11

(credit purchases p.a)/(Average payables)

Measures how quickly payables are being paid

Question 12

What is the problem with holding too little inventory?

Answer 12

Face liquidity issues and costs of stock-outs including re-order costs, setup costs and lost quantity discounts.

Key task of inventory management is finding a balance between the two.

Question 13

What are the 5 inventory management techniques?

Answer 13

1) economic order quantity (EOQ)
2) ABC inventory control
3) just-in-time (JIT) systems
4) fixing the inventory levels
5) vital, essential and desirable (VED) analysis.

Question 14

What is economic order quantity (EOQ)?

Answer 14

EOQ provides the optimum inventory order size based on the annual inventory requirement for which both the ordering cost and carrying cost are kept at a minimum Makes the following assumptions:

Holding costs
Assumes it costs a certain amount to hold a unit of inventory for a year = holding cost. As the average level of inventory increase, so will the holding costs which are calculated as:

Holding cost per unit x average inventory
Ordering costs
Fixed costs of placing each order. Include costs of transportation, inspection, insurance etc. as the order quantity increases, the total ordering cost reduces and can be calculated as:

Order cost per order x number of orders p.a.
Calculation of EOQ

EOQ = (√(2 x c x d))÷h
Where:
D = annual demand
C = ordering costs per order
H = holding costs per order

Assumptions :

• Demand and lead times are constant. Model will be ineffective for businesses whose demand fluctuates frequently
• Purchase price, ordering and holding costs remain constant
• No buffer inventory is held or needed
• Seasonal fluctuations can be ignored
• Inventory levels are continuously monitored

Question 15

How should companies determine whether quantity discounts should be pursued?

Answer 15

EOQ must be compared with the quantity needed for quantity discounts.

Companies must consider whether the order size should be increased above the EOQ to get the benefit of quantity discounts from a larger quantity if the overall inventory cost is lower.

Question 16

What is the “determining inventory levels” technique?

Answer 16

Categorised into four levels:

1) Minimum level: ensures production won’t be suspended due to lack of materials. Time required for delivery and daily consumption should be considered.

2) Re-order level: when determining, minimum level and rate of consumption have to be considered.
Re-order level = minimum level + (rate of consumption x re-order period)

3) Maximum level: if level of inventory exceeds maximum, it increases carrying costs and is treated as overstocking.
Maximum level = re-order level + re-order quantity – (minimum rate of consumption x minimum re-order period)

4) Danger level: fixed below minimum. Immediate action must be taken when inventory reaches danger level.
Danger level = rate of consumption x maximum re-order period in case of emergency

Question 17

What is the “JIT” system and what are its pros and cons?

Answer 17

Aim = to reduce inventory to an absolute minimum or eliminate it altogether by manufacturing at the exact time customers require, in the exact quantities they need and at competitive prices.

Pros:
• Improved inventory control and reduced inventory waste
• Reduced storage and labour costs
• Lower lead time
• Long-term relationship with suppliers
• Better customer service
• Better control over manufacturing processes.

Cons:
• Price fluctuations of raw materials could make JIT system costlier
• Not helpful in cases of excess and unexpected demand as there is no stock of finished good
• Production is highly reliant on suppliers. If not delivered on time it can be expensive for the business
• May need investment in technology that links information systems of company and suppliers

Question 18

What is the ABC inventory control system?

Answer 18

Classifies inventory items based on the items’ consumption monetary values. Materials are divided into 3 categories:

1) “A” category: require high level of investment but only represent small amounts in terms of inventory. Usually only represent 15% to 20% of inventory items but have a high consumption rate. Due to high value and potential to reduce costs or losses, they are closely monitored and controlled to ensure the items are not over or under stocked
2) “B” category: represents 30% to 35% of inventory items by item type and about 20% of the value of consumption. Relatively less important than A and will be maintained with good records and regular attention.
3) “C” category: remaining items of stock with relatively low value of consumption. Usually make up to 10% of total value of consumption. Ordered on a half-yearly or yearly basis.

Question 19

What is VED analysis

Answer 19

Vital, Essential, Desirable (“VED”) analysis.

Popular technique for companies at a start-up stage working with limited resources and small budgets. Key objective = identify the criticality of inventory items that the business cannot operate without. Classed based on degree of criticality:

1) Vital: without these the production activities will come to a halt. These items should always be stocked.
2) Essential: essential spare parts whose non-availability may not adversely affect production. These parts may be available from multiple sources within the country and procurement lead time may not be long
3) Desirable: items whose stock-out or shortage causes only a minor disruption for a short duration in the production schedule. Cost incurred is very nominal.

Question 20

What is the purpose and objectives of the management of receivables?

Answer 20

To meet competition and to increase sales and profits as long as the costs of funding the additional credit do not exceed returns. Objectives are:

1) To control the costs associated with collection and management of receivables. Admin costs include maintenance of records, collection costs, defaulting costs and writing off bad debts
2) To achieve and maintain an optimum level of receivables in accordance with the company’s credit policy
3) To achieve an optimum level of sales

Question 21

What are the 5 factors that affect the size of receivables?

Answer 21

1) Size of credit sales: receivables increase with the increase in credit sales
2) Terms of trade: sometimes credit sales are made at higher prices than the usual cash sale price. This gives an opportunity to make extra profit. If longer credit periods are allowed, receivables will increase
3) Credit policies: major determinant. Liberal credit policy will create more receivables whilst conservative or strict policy will reduce receivables
4) Collection policies: strong and well-equipped credit collection system is required. Periodical reminders should be sent to customers to reduce the receivable outstanding amounts. Additional costs are incurred for follow-ups or write off of bad debt
5) Expansion plans: companies looking to expand their business encourage credit sales to attract customers. During early stages of expansion, credit sales are usually high.

Question 22

What factors should be considered while developing a marketing policy?

Answer 22

1. level of credit sales required to optimise profits
2. market conditions
3. competition
4. credit period
5. terms of trade
6. discounts
7. efficiency in record keeping

Question 23

What are The key elements or variants of

credit policy that should be considered?

Answer 23

1) Terms of credit - agreement between buyer and seller re timing and amount of payments (incl. discounts).
2) Assessing creditworthiness - credit checks on new customers and ongoing monitoring

3) Collection policies - follow-up procedures required. A stringent collection procedure = expensive due to high costs but reduces bad debts.
A lenient collection process attracts customers, but has a higher risk of bad debt losses.
Balance is key.

Question 24

What factors must be considered in making the decision for the management of payables?

Answer 24

• Maintaining good relations with regular suppliers is important to ensure continuing supplies
• Flexibility of available credit should be considered as it can be used as a source of short term finance
• Delaying payments can risk credit status with suppliers and creates a bad image
• Delaying payments can result in the loss of settlement discounts for early payment
• Other factors: e.g. is interest charged on late payment?
• Early settlement discounts should be taken where possible
• Ensure there is sufficient liquidity to guarantee that payables can be paid when they fall due.