Chapter 7 - Working capital management

Question 1

what is working capital management?

Answer 1

the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets

Question 2

What is working capital?

Answer 2

the capital available for conducting the day-to-day operations of an organisation; normally the excess of current assets over current liabilities

Question 3

Investing in working capital has what cost?

Answer 3

• the cost of funding it
• the opportunity cost of lost investment opportunities because cash is tied up in working capital and unavailable for other uses

Question 4

What is the main objective of working capital management?

Answer 4

to get the balance of current assets and current liabilities right

Question 5

what is the trade off between getting the current assets and current liabilities right?

Answer 5

Liquidity - ensuring current assets are sufficiently liquid to minimise the risk of insolvency
Profitability - investing in less liquid assets in order to maximise return

Question 6

What are the two approaches to the level of working capital investment made by a company?

Answer 6

Aggressive and conservation

Question 7

What is an aggressive approach?

Answer 7

low levels of working capital (low inventory, low receivables, low cash, high payables)

Question 8

What is a conservative approach?

Answer 8

High levels of working capital (high inventory, high receivables, high cash, low payables)

Question 9

What is the funding cost for an aggressive approach?

Answer 9

low- less cash tied up in working capital

Question 10

What is the funding cost for a conservative approach?

Answer 10

high - more cash tied up in working capital

Question 11

What are the risks associated with an aggressive approach?

Answer 11

higher - short credit periods may put customers off. Low inventory means sales are lost. Low cash may mean no money to pay unexpected bills

Question 12

What are the risks associated with a conservative approach?

Answer 12

lower - inventory obsolescence

Question 13

What is the reason for having an aggressive approach?

Answer 13

management tolerance for risk is high. cash needs are relatively predictable. cash is freed up to be invested elsewhere

Question 14

What is the reason for having a conservative approach?

Answer 14

management tolerance for risk is low. cash needs are erratic

Question 15

What does excessive current assets and low current liabilities mean?

Answer 15

that the business is over-capitalised. There has been an over investment by the business in current assets. Profitability will suffer as a result

Question 16

Healthy trading typically leads to what?

Answer 16

• increased profitability and
• the need to increase investment in NCA and working capital

Question 17

If the business does not have access to sufficient capital to fund the increase what is it said to be?

Answer 17

to be overtrading

Question 18

What are indicators of overtrading?

Answer 18

• rapid increase in revenue
• an increase in values of the working capital days, particularly receivables collection and payables payment periods
• most of the increase in assets being financed by credit
• a dramatic drop in the liquidity ratios

Question 19

What is the current ratio?

Answer 19

this measures how much of the total current assets are financed by current liabilities

Question 20

How do we calculate the current ratio?

Answer 20

current assets / current liabilities

Question 21

what is the Quick (acid test) ratio?

Answer 21

measures how well current liabilities are covered by liquid assets

Question 22

When is the quick (acid test) ratio useful?

Answer 22

where inventory holding periods are long

Question 23

How do we calculate the quick (acid test) ratio?

Answer 23

(current assets - inventory) / current liabilities

Question 24

What is the working capital cycle?

Answer 24

the length between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods.

Question 25

What is the calculation for the working capital cycle?

Answer 25

Raw materials holding period X
Less: payables payment period (X)
WIP holding period X
Finished goods holding period X
Receivables collection period X
Working capital cycle X

Question 26

Factors affecting the length of the cycle depend on what?

Answer 26

• liquidity vs profitability decisions
• terms of trade
• management efficiency
• industry norms e.g., retail vs construction

Question 27

What is the basic equation structure (days)?

Answer 27

(SFP figure / SPL figure) x 365

Question 28

What does the inventory holding period show?

Answer 28

how long the inventory is held before it is sold

Question 29

How do we calculate the inventory holding period?

Answer 29

(Inventroy / cost of sales) x 365

Question 30

How do we calculate the raw material inventory holding period?

Answer 30

(Raw material inventory/ material usage) x 365

Question 31

If detailed raw materials usage figures aren’t available what figures should we use instead?

Answer 31

cost of sales

Question 32

What is the WIP holding period calculation?

Answer 32

(WIP inventory held / production cost) x 365

Question 33

How do we calculate the finished goods inventory holding period?

Answer 33

(finished goods inventory held / cost of goods sold) x 365

Question 34

How do we calculate the trade receivables collection period?

Answer 34

(Trade receivables / credit sales) x 365

Question 35

How do we calculate the trade payables payment period?

Answer 35

(trade payables / credit purchases) x 365

Question 36

How do we calculate the working capital turnover?

Answer 36

Sales revenue / working capital

Question 37

What does the working capital turnover show?

Answer 37

how many times a company converts its working capital into sales. higher number is better