Chapter 13

Question 1

Working capital management

Answer 1

capital represented by net current assets which is available for everyday operating activities - the difference between a company’s net current assets and current liabilities

Question 2

Function of working capital management

Answer 2

support the liquidity of the company including purchasing inventory, collecting receivables and paying vendors

Question 3

Consequences of too little working capital

Answer 3

exceeding an agreed overdraft limit
failing to pay suppliers on time
inability to take advantage of discounts for prompt payment

Question 4

Consequences of too much working capital

Answer 4

earning a lower than expected rate of return on capital employed

Question 5

Objectives of working capital

Answer 5

increase profitability
ensure the organisation has sufficient liquid resources to continue in business

Question 6

Short term finance: Accounts payable

Answer 6

Appears cheap, but refusing settlement discounts can be expensive.
Taking excessive credit may lead to lost goodwill with supplier and even penalties for late payment.
Trade credit can disappear

Question 7

Trade off between liquidity and profitability

Answer 7

Too high liquidity results in high investment in working capital management making it more liquid but less profitable
Too high profitability results in low working capital management asking it less liquid

Question 8

Over trading or under capitalization

Answer 8

When an organization is engaged in rapid sales. insufficient working capital to support the level of business activity.

Question 9

Overcapitalisation

Answer 9

an excessive level of working capital, leading to inefficiency.

Question 10

Conservative approach

Answer 10

If management is highly risk-averse it will take a conservative approach to the level of investment in current assets. This is more appropriate if cash flows are erratic and unpredictable and hence a margin of safety is needed. It is associated with:
maintaining relatively high levels of inventory to ensure availability;
offering generous credit terms to customers to encourage demand;
paying suppliers promptly to ensure goodwill/minimise stockouts; and
holding high precautionary levels of cash.
Problems with such an approach include inventory obsolescence and a high financing cost for the high level of assets

Question 11

Aggressive approach

Answer 11

If management has a higher tolerance for risk, it would adopt an aggressive approach and drive down the levels of inventory, receivables and holdings of surplus cash. It is more appropriate if cash flows are very predictable. This policy would potentially be more profitable because of the lower level of investment in current assets. However, this would also be more risky due to, for example:
running out of inventory in periods of fluctuating demand;
losing customers to competitors who offer more generous credit; or
being less able to meet unexpected expenses.

Question 12

Whatever level of current assets the business decides to hold, they must be matched by liabilities

Answer 12

True

Question 13

It is generally true that the cost of short-term finance is below the cost of long-term finance

Answer 13

True

Question 14

Short term finance: Overdraft

Answer 14

Usually expensive, but flexible (i.e. level of finance fluctuates to meet requirements).
Variable interest rate exposes entity to rate rises.
Repayable on demand.

Question 15

Short term finance: short term loans

Answer 15

Usually lower interest rate than long-term debt (unless yield curve is inverted − see Chapter 2).
Renegotiation risk (i.e. bank may refuse to refinance on maturity).

Question 16

How can short term finance disappear

Answer 16

The bank may ask for the overdraft to be repaid.
Key suppliers may put a customer on a “stop list” and refuse further deliveries until all outstanding invoices are paid

Question 17

Long term finance: Equity

Answer 17

New share issues or, to avoid issue costs, retained profits.
No legal commitment to repay (i.e. no renegotiation risk).

Question 18

Long term finance: loans

Answer 18

Loan note issues and/or long-term bank loans.
If interest rates are fixed, provides protection against rising rates (until maturity).

Question 19

Reasons why current assets ,ay be permanent

Answer 19

Holding of “buffer stock” (i.e. a minimum level of inventory held throughout the year as protection against “stock-outs”);
Holding a minimum “precautionary” balance of cash to meet any unexpected payments;
A minimum level of trade receivables over the business cycle. Over the year the total level of current assets will naturally fluctuate above the minimum permanent level − only this excess is truly short-term in nature.

Question 20

Matching policy to the financing of working capital

Answer 20

permanent segment of current assets should be matched with long-term finance and the fluctuating segment of current assets be matched with short-term finance

Question 21

Current ratio

Answer 21

If the current ratio falls below 1.0, this may indicate problems in meeting obligations as they fall due. Even if the current ratio is above 1.0, it does not guarantee liquidity, particularly if inventory is slow moving. On the other hand, a very high current ratio is not to be encouraged as it may indicate inefficient use of resources

Question 22

Quick acid test ratio

Answer 22

The quick ratio is particularly relevant where inventory is slow moving and so cannot be converted into cash quickly. A company with slow-moving inventory should ideally have a quick ratio of at least 1. For companies with fast-moving inventory, the quick ratio can be less than 1 without suggesting that the company is facing cash-flow problems.

Question 23

Inventory turnover

Answer 23

Inventory turnover shows how quickly inventory is sold, with higher turnover reflecting faster moving inventory.

Question 24

Inventory holding period

Answer 24

estimates the time taken for inventory to be sold.

Question 25

Sales working capital ratio

Answer 25

how efficiently a business uses its working capital to generate sales

Question 26

Cash operating cycle

Answer 26

the number of days between paying suppliers and receiving cash from customers

The longer the cycle the greater the level of resources tied up in working capital. Although it is desirable to have as short a cycle as possible, it is often difficult to differ significantly from competitors in the same trade.

Question 27

Factors affecting the length of cash cycle

Answer 27

Type of industry a supermarket chain may have low inventory holding period, low receivables collection period and significant payables payment period (taking credit from small farmers). In this case, the operating cycle could be negative (i.e. cash is received from sales before suppliers are paid). On the other hand, a construction company may have a very long operating cycle due to the high levels of work in progress.
Industry norms − if competitors offer long periods of credit it may be difficult to reduce the receivables collection period without losing business.
Power of suppliers − an attempt to delay payments could lead to a supplier demanding “cash on delivery” (i.e. causing the payables payment period to fall to zero rather than rising).
Efficiency of working capital management (e.g. weak credit control and holding of excess inventory will both lead to a longer working capital cycle).

Question 28

Cash operating cycle for manufacturer

Answer 28

Receivables collection period = ​Accounts receivable over Annual credit sales​ × 365 = x
Payables payment period = ​Accounts payable over Annual credit purchases​ × 365 = (x)
Finished goods holding period = ​Finished goods inventory over Annual cost of goods sold​ × 365 = x
WIP (length of production process) = ​Work in progress over Annual cost of goods sold​ × 365 = x
Raw materials holding period = ​Raw materials inventory over Annual raw materials purchases​ × 365 = x

Question 29

Importance of preparing a cash budget

Answer 29

will indicate the flow of receipts and payments and will forecast periods of surplus and deficit cash balances, thereby reducing the level of uncertainty. If a large surplus is forecast, cash can be invested in an interest earning account until it is required. If a deficit is forecast, the business can arrange a bank overdraft or loan. Wherever possible, however, overdrafts and loans should be avoided due to their high cost

Question 30

Why does overtrading occur

Answer 30

there is no reputation to attract customers, so a long credit period is likely to be extended to break into the market;
if the business has found a “niche market”, rapid sales expansion may occur; or
smaller companies which are growing quickly often will lack the management skills to maintain adequate control of the debt collection period and the production period.

Question 31

Indicators of overtrading

Answer 31

declining liquidity;
rapidly increasing revenue;
increasing inventory holding period;
increasing accounts receivable days;
increasing short-term borrowing and declining cash holdings;
large and rising overdraft;
declining profit margin; and/or
an increasing ratio of sales to non-current assets.

Question 32

Ways to reduce cash cycle

Answer 32

reducing the inventory holding period for both finished goods and raw materials;
reducing the production period (this is not easy to do but it might be worth investigating different machinery or working methods);
reducing the credit period extended to accounts receivable and tightening up on cash collection;
increasing the period of credit taken from suppliers;
increasing the level of long-term finance (i.e. an equity or debt issue, with a new share issue being probably preferable to increasing debt in a risky company); and/or
reducing the level of sales growth to a more sustainable level.

Question 33

Which working capital financing policy would expose a company to the greatest risk of being unable to meet its obligations as they fall due?

Answer 33

: A working capital financing policy that finances permanent current assets with short-term debt exposes a company to the greatest risk of being unable to meet its maturing obligations. This aggressive strategy creates “rollover risk” (i.e. the risk that the short-term debt cannot be refinanced)

Question 34

Formula for Baoumol model

Answer 34

Square root of 2 x annual cash required x cost of ordering cash / net interest cost of holding cash

Question 35

A weakness of IRR

Answer 35

cash flows from the investment are assumed to be reinvested at the IRR