Chapter 3: Working Capital Flashcards
Objectives of working capital (liquidity v profitability)
Liquidity objective - to ensure that the organisation always has sufficient cash to pay its liabilities as they become due.
The profitability objective - to ensure that the organisation is as efficient as possible by, amongst other things, ensuring all capital is invested to earn the maximum return.
The cash operating cycle
Average time raw materials are in stock
Average time work in progress is in production
Average time finished goods are in stock
(inventory days)
+
Average collection period
(receivable days)
-
Average payable period
=
Cash operating cycle
Current ratio
Current assets / current liabilities
Quick ratio (acid test)
(current assets - inventory) / current liabilities
Inventory turnover ratio
Cost of sales / Average Inventory
Average inventory period
average inventory / cost of sales x 365
Average collection period
Average Trade receivables / credit sales turnover x 365
Average payable period
Average trade payables / credit purchases or cos x 365
Sales revenue/Net working capital ratio
Sales revenue / Net working capital
what is overtrading?
what can it be indicated by?
Overtrading occurs when a business expands its operations too quickly without having enough working capital or financial resources to support the growth. This can lead to liquidity problems despite the business appearing profitable.
Indicated by:
-A rapid increase in turnover
-An increase in inventory days
-An increase in receivables
-An over reliance on short term sources of finance, incl trade payables and leasing
-A decrease in the current ratio
-A decrease in the quick ratio
-A decrease in profit caused by selling more at lower prices
Undercapitalisation
Undercapitalization occurs when a business does not have enough equity or long-term financing to support its operations. This forces the business to rely excessively on short-term borrowing, making it financially unstable.
