Chapter 15 - Working capital management Flashcards
What is the primary objective of working capital management?
Strike a balance between current liabilities and assets
Trade off between cash flows and profits
What are the consequences of poor working capital management?
- Inability to meet due bills
- Demands on cash during periods of growth
- Over-stocking or stock-outs
What are some examples of a transaction that has a trade off between cash flow and profit?
- Purchase of non-current assets for cash
- Sale of goods on credit
- Tax payments
What are the main sources of liquidity?
- Cash in the bank
- Short-term investments
- Cash inflows
- Overdraft
How can liquidity be sacrificed for better profitbaility?
- Bulk purchase discount
- Offering credit to customers
What does the working capital cycle reflect?
Firm’s investment in working capital as it moves throughout production
What factors affect the length of the working capital cycle?
- Liquidity vs profitability
- Management efficiency
- Industry norms
What does an increase in sales mean for the amount of cash needed to fund the working capital cycle?
Amount of cash needed increases
What does an increase in the length of the working capital cycle mean for cash?
More cash needed to fund cycle
What factors affect the amount of working capital required?
- Industry firm operates in
- Type of products sold
- Whether products are manufactured or bought
- Level of sales
- Policies towards working capital management
What factors affect the level of investment in working capital?
- Nature of business
- Uncertainty in supplier deliveries
- Overall activity level
- Credit policy
- Length of cycle
- Credit policy of suppliers
What are the 3 policies used to manage working capital?
- Aggressive
- Conservative
- Moderate
What is an aggressive policy?
Reduce costs by holding lowest levels of cash, inventory and receivables
What are the benefits of an aggressive policy?
- Lower levels of current assets means lower financing costs
- Lower financing costs mean better profitability
- Quicker cash turnover means reinvestment
- Greatest returns
What are the negatives of an aggressive policy?
The greatest risk of liquidity
What is a conservative policy?
Reduces risk by holding high levels of cash, inventory and receivables
What are the benefits of a conservative cycle?
- Lower liquidity risk
- Greater ability to meet demand surges
- More relaxed credit policy for receivables may improve sales
What is the negative of a conservative policy?
High costs
What is a moderate policy?
Middle ground between aggressive and conservative
What degree will short term finance be used if an entity takes an aggressive approach?
All fluctuations and some permanent investment financed by short term finance
What degree will short term finance be used if an entity takes a conservative approach?
All permanent and portion of fluctuation investment financed by long term finance
Short term financed only used for part of fluctuation
What degree will short term finance be used if an entity takes a moderate approach?
Fluctuating investment financed by short-term finance and permanent investment financed by long-term
What are the typical indicators of overtrading?
- Rapid increase in turnover
- Rapid increase in volume of current assets
- Most of the increase in assets being financed by credit
- Dramatic drop in liquidity ratios
What are the solutions to overtrading?
- Raise more long-term capital
- Slow down growth
- Improve working capital management
