Chapter 7 - Working capital management Flashcards
what is working capital management?
the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets
What is working capital?
the capital available for conducting the day-to-day operations of an organisation; normally the excess of current assets over current liabilities
Investing in working capital has what cost?
- 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
What is the main objective of working capital management?
to get the balance of current assets and current liabilities right
what is the trade off between getting the current assets and current liabilities right?
Liquidity - ensuring current assets are sufficiently liquid to minimise the risk of insolvency
Profitability - investing in less liquid assets in order to maximise return
What are the two approaches to the level of working capital investment made by a company?
Aggressive and conservation
What is an aggressive approach?
low levels of working capital (low inventory, low receivables, low cash, high payables)
What is a conservative approach?
High levels of working capital (high inventory, high receivables, high cash, low payables)
What is the funding cost for an aggressive approach?
low- less cash tied up in working capital
What is the funding cost for a conservative approach?
high - more cash tied up in working capital
What are the risks associated with an aggressive approach?
higher - short credit periods may put customers off. Low inventory means sales are lost. Low cash may mean no money to pay unexpected bills
What are the risks associated with a conservative approach?
lower - inventory obsolescence
What is the reason for having an aggressive approach?
management tolerance for risk is high. cash needs are relatively predictable. cash is freed up to be invested elsewhere
What is the reason for having a conservative approach?
management tolerance for risk is low. cash needs are erratic
What does excessive current assets and low current liabilities mean?
that the business is over-capitalised. There has been an over investment by the business in current assets. Profitability will suffer as a result
Healthy trading typically leads to what?
- increased profitability and
- the need to increase investment in NCA and working capital
If the business does not have access to sufficient capital to fund the increase what is it said to be?
to be overtrading
What are indicators of overtrading?
- 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
What is the current ratio?
this measures how much of the total current assets are financed by current liabilities
How do we calculate the current ratio?
current assets / current liabilities
what is the Quick (acid test) ratio?
measures how well current liabilities are covered by liquid assets
When is the quick (acid test) ratio useful?
where inventory holding periods are long
How do we calculate the quick (acid test) ratio?
(current assets - inventory) / current liabilities
What is the working capital cycle?
the length between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods.
