Chapter 7 - Working Capital Management

Question 0

Cash flow versus profit

Answer 0

Unprofitable companies can survive if they have liquidity.

Profitable companies can fail if they run out of cash to pay their liabilities.

Examples are:-
1. Purchase of non-current assets for cash.
The cash will be paid in full to the supplier when the asset is delivered however profits will be charged gradually via depreciation.

2. Sale of goods on credit.
   Profits will be credited in full once the sale has been confirmed however the cash may not be received for some considerable period afterwards.
3. Tax payments may cause timing differences between reported profit and cash flow.

Question 1

Working capital

Answer 1

Working capital is the capital available for conducting the day to day operations of an organisation, normally the excess of current assets over current liabilities.

Working capital management is the management of both current assets and current liabilities to minimise the risk of insolvency while maximising the return on assets.

Question 2

Profitability versus liquidity

Answer 2

Liquidity means having enough cash to meet all payment obligations when these fall due, e.g.

1. Cash in the bank.
2. Short term investments cashed in easily and quickly.
3. Cash inflows from normal trading operations (cash sales, credit sales).
4. An overdraft facility or other ready source of extra borrowing.

The basis is where a company is able to improve profitability but at the expense of tying up cash, e.g.

1. Receiving a bulk purchase (improved profitability) for buying more than is required (reduced liquidity).
2. Offering credit to customers.

Question 3

Overtrading

Answer 3

Where the business does not have access to fund the increase.

A rapid increase in turnover.
A rapid increase in the volume of current assets.
Most of the increase in assets being financed by credit.
A dramatic drop in the liquidity ratios.

Question 4

Working capital ratios - liquidity

Answer 4

1. Current ratio = Current assets/ Current liabilities

Measures how much of the total current assets are financed by current liabilities.
A measure of 2:1 means that current liabilities can be paid twice over our existing current assets.

2. Quick ratio (acid test) = (Current assets - Inventory)/ Current liabilities

Measures how well current liabilities are covered by liquid assets.
A measure of 1:1 means that the company is able to meet existing liabilities if they fall due at once.

Question 5

The cash operating cycle

Answer 5

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

Question 6

Calculation of the cash operating cycle

Answer 6

For a manufacturing business:

Raw materials holding period x
Less: payables payment period (x)
WIP holding period x
Finished goods holding period x
Receivables collection period x
—
X
—

For a wholesale or retail business:

Inventory holding period x
Less: payables payment period (x)
Receivables collection period x
—
X
—

Question 7

Inventory holding period

Answer 7

1. Inventory holding period - The length of time inventory is held between purchase and sale.

Inventory holding period = Inventory/ Cost of sales x 365 days

Question 8

Raw material inventory holding period

Answer 8

2. Raw material inventory holding period - The length of time raw materials are held between purchase and being used in production.

Raw material inventory holding period = Raw material inventory/ material usage x 365 days

Question 9

WIP holding period

Answer 9

3. WIP holding period - The length of time goods spend in production.

WIP holding period = Work in progress inventory held/ Production cost x 365 days

Question 10

Finished goods inventory period

Answer 10

4. Finished goods inventory period - The length of time finished goods are held between completion or purchases of sale. A low ratio is a good sign of working capital management.

Finished goods inventory period = Finished goods inventory held/ Cost of goods sold x 365 days

Question 11

Trade receivables days

Answer 11

5. Trade receivable days - The length of time credit is extended to customers. Shorter credit periods are better generally but will depend on the business.

Trade receivables days = Receivables/ Credit sales x 365 days

Question 12

Trade payables days

Answer 12

6. Trade payables days - The average period of credit extended by suppliers. Generally increasing payables days suggests advantage is being taken of available credit but there are risks e.g.
   - losing supplier goodwill.
   - losing prompt payment discounts.
   - suppliers increasing the price to compensate.

Trade payables days = Trade payables/ Credit purchases x 365 days

Question 13

Working capital turnover

Answer 13

7. Working capital turnover - Measures how efficiently management is utilising its investment in working capital to generate sales.

Working capital turnover = Sales revenue/ Net working capital

Question 14

Working capital investment levels

Answer 14

8. Working capital investment levels:

Trade receivables balance = Trade receivables days/ 365 x Credit sales