Chapter 13 - Working capital Flashcards
What is working capital defined as?
The excess of current assets over current liabilities
What are the two main objectives of Working Capital Management?
- Liquidity
- Profitability
What is the conservative approach to Working Capital Management?
Maintaining high levels of working capital to avoid liquidity problems
What is the aggressive approach to Working Capital Management?
Keeping working capital to a minimum in order to improve profitability
What is the conservative approach to Working Capital Financing?
Finance all NCA, permanent CA and a proportion of fluctuating CA using long term financing methods. ie bank loan
What is the aggressive approach to Working Capital Financing?
Finance a proportion of permanent CA and fluctuating CA with short term financing methods ie bank overdraft.
What the advantage of the conservative approach to Working Capital Financing?
Good for liquidity.
What the advantage of the aggressive approach to Working Capital Financing?
Good for profitability
What the disadvantage of the conservative approach to Working Capital Financing?
Bad for profitability ie high bank loan interest
What the disadvantage of the aggressive approach to Working Capital Financing?
High risk of running out of cash
What are the two types of working capital ratios?
Liquidity
Efficiency
What is the current ratio?
(Current assets) ÷ (Current liabilities)
What is the quick ratio? (acid test)
(Current assets - inventory) ÷ (Current liabilities)
Inventory days?
(Inventory) ÷ (Cost of sales) x 365
What are the three elements that inventory days can be broken down to?
Raw materials days
WIP days
Finished goods days
Raw materials days?
(Raw materials) ÷ (Purchases) x 365
WIP days? (Average production time)
(WIP) ÷ (Cost of sales) x 365
Finished goods days?
(Finished goods) ÷ (Cost of sales) x 365
Trade receivables days?
(Trade receivables) ÷ (Sales) x 365
Trade payables days?
(Trade payables) ÷ (Purchases) x 365
For payables and receivable days, what should ideally be used?
Credit sales/purchases over total sales/purchases.
What is the cash operating cycles description?
The length of time from purchasing inventory to receiving cash from the sale of the related finished goods.
What is the cash operating cycles formula?
Trade receivables days x Raw materials days x WIP days x Finished goods days x Less: Trade payables days (x)
Cash operating cycle x
If there is an over investment in current assets, what is this termed as?
Over-capitalization
When a company grows too quickly and as a result runs out of finance and hence cash, what is this termed as?
Over trading
What are four things to look for if asked if a company might be overtrading?
- Rapid increase in revenue
- Increase in working capital days (especially receivables and payables)
- Most of the increase in assets financed by credit
- A dramatic drop in liquidity ratios
When calculating gearing, if you are told to use book value you include…
Retained earnings
When calculating gearing, if you are told to use market value you do not include…
Retained earnings
Why do you not include retained earnings in gearing when using market values?
Because its already included in the value of the shares.
The faster a firm can ‘push’ items around the cycle the lower its investment in …
Working capital
What are four factors that the length of the cash operating cycle depend on?
- Liquidity verses profitability decisions
- Terms of trade
- Management efficiency
- Industry norms ie construction
Working capital turnover formula
Sales revenue / net working capital
