Chapter 3.1 Working Capital

Question 1

Objectives of WC

Answer 1

1. Profitability [Increase profit in a business]
2. Liquidity [ Ensure sufficient liquidity to meet its short-term obligations as they fall due]

Question 2

1. Profitability

Answer 2

• Excessively low WC may lead to problems
• Low inventory; delivery lead times are longer, cannot meet demand during peak as not enough inventory (lost of revenue)
• Low receivables; overly strict credit term, not being made available to its customers (lost of revenue)
• Funds tied up in WC earn little to no return; company may fail to achieve the ROCE expected by investors

Concern: How much to invest to address the problem above? (WC investment decision)

Question 3

2. Liquidity

Answer 3

• Need adequate resources to maintain day-to-day cash flow
• Money tied up to inventory, receivable&raquo_space; can cause problems if not managed well
• Can be maintained by ensuring cash tied up is not excessive
• A business with insufficient WC will be unable to meet obligations as they fall due; late payment to employees, suppliers.
  [Finance decision]

Question 4

Importance of WC

Answer 4

Represents net CA available for day-to-day operating activities
Successful management of WC is essential to remain in business
Requires great care due to potential interactions between its components
WC management is central to the effective management of a business bcs:
- CA comprise the majority of the total assets of some companies
- SH wealth is more closely related to cash generation than accounting profits
- Failure to control WC, and hence to manage liquidity, is a major cause of corporate collapse