Chapter 3.2 Working Capital Planning

Question 1

Influences on the level of investment on WC

Answer 1

1. General factors
   - Nature of industry
   - Policies of competitors
   - Seasonal factors
2. Company specific factors
   - Net WC depends on a company’s sales and its WC strategy
   - Aggressive (minimises net WC) / Conservative (maximises net WC)

Question 2

WC Ratios

Answer 2

1. Inventory days
2. Inventory turnover
3. Receivable days
4. Payable days
5. Cash operating days
6. Sales to net WC ratio
7. Current ratio
8. Acid test ratio

Question 3

1. Inventory days

Answer 3

Amount of days of sales/production held as inventory
Time taken for inventory to be sold

= (Finished goods/Cost of good sold) * 365

Question 4

2. Inventory turnover

Answer 4

Shows how quickly inventory is sold; higher turnover = faster-moving inventory
Easier to interpret as “days” as opposed to “turnover”

= (Cost of sales/Average inventory)

Question 5

3. Receivable days

Answer 5

Estimates the time taken for customers to pay

= (Average Receivables/Annual credit sales) * 365

Assumptions:
- Year-end receivables are representative of average figure
- All sales are made on credit

Question 6

4. Payable days

Answer 6

Estimates the time taken to pay suppliers

= (Average Payables/Annual credit purchases) * 365

Assumptions:
- Year-end payables are representative of the average figure
- Cost of sales approximates annual credit purchases
- All purchases are made on credit

Question 7

5. Cash operating cycle

Answer 7

• Number of days between paying suppliers and receiving cash from sales
• The longer the operating cycle the greated level of resources ‘tied up’ in WC
• Analyse impact of higher sales on WC
• No optimal length for every company
• Compare one period to another/one company to another; to identify unwelcome trend
• Can be used to identify possibility of cash shortfall if sales rise too rapidly
• Influenced by the nature of business

= Cash to be received - cash to be paid out

Question 8

Cash to be received & Cash to be paid out

Answer 8

Cash to be received = Inventory days + receivable days

Cash to be paid out = Payable days

Question 9

6. Sales to net WC ratio

Answer 9

Indicates how efficiently WC is being used to generate sales
Shows level of net WC (exc cash) required to support sales
Eg. Ratios = 5, then for every $5 increase in sales, extra $1 of cash needed to finance the required increase in net WC
Key ratio in demonstrating a company’s overall WC investment policy

= (Sales revenue/Receivables + Inventory - Payables)

!! Exclude cash !!

Question 10

7. Current ratio

Answer 10

• If falls below 1, does not guarantee liquidity. Particularly if inventory is slow moving.
• Very high CR is not encouraged as it may indicate inefficient use of resources
• Heavily influenced by nature of business

= (CA/CL)

Question 11

8. Quick ratio/Acid test ratio

Answer 11

• Relevant when inventory is slow moving

= (CA-Inventory)/CL