Finance - Working Capital

Question 1

Working Capital - Calculation

Answer 1

Working Capital = Current Assets – Current Liabilities.

• The working capital formula tells us the short-term liquid assets available after short-term liabilities have been paid off.
• which calculates whether a company has enough liquid assets to pay its bills that will be due within a year. (note: When a company has excess current assets, that amount can then be used to spend on its day-to-day operations.)

Question 2

Positive Working Capital

Answer 2

-Having positive working capital can be a good sign of the short-term financial health of a company because it has enough liquid assets remaining to pay off short-term bills and to internally finance the growth of its business.

Question 3

Negative Working Capital

Answer 3

• Negative working capital means assets aren’t being used effectively and a company may face a liquidity crisis.
• Even if a company has a lot invested in fixed assets, it will face financial and operating challenges if liabilities are due.
• Negative working capital may lead to more borrowing, late payments to creditors and suppliers, and, as a result, a lower corporate credit rating for the company.
• With a working capital deficit, a company may have to borrow additional funds from a bank or turn to investment bankers to raise more money

Question 4

Reason for holding Cash

Answer 4

Firms have many motives for holding cash balances as summarized below.

• The speculative motive reflects the desire to take advantage of bargain opportunities such as discounts on purchases, attractive interest rates, and favourable foreign-exchange rate fluctuations.
• The precautionary motive reflects the desire for a financial reserve to meet contingent cash needs as they arise. Cash reserves insure the firm against the risk of failing to pay creditors, suppliers, or employees as payments come due (liquidity risk).
• The transaction motive reflects the desire to have cash on hand to pay specific bills or is the result of the non-voluntary holding of cash because of the timing of collections. As cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, a firm will often have idle cash. Electronic funds transfers and other high-speed, paperless payment mechanisms can alter the timing of cash inflows and outflows, affecting the amount of cash holdings.
• Another motive is the need to comply with loan requirements, which may stipulate a compensating balance. A compensating balance is the minimum specified amount that a borrower must maintain in a bank account as required by the lender.

Question 5

Criteria for an investment to qualify as a cash equivalent

Answer 5

Investment to qualify as a cash equivalent for reporting purposes, it must have a maturity date of three months or less from the date of purchase and have insignificant risk. If an investment does not qualify as a cash equivalent, it will be recognized as a marketable security for reporting purposes.

Question 6

Account Receivable Mgmt.

Answer 6

An entity can shorten its cash cycle by collecting its accounts receivable as quickly as possible. This can be done by: (1) shortening the credit period extended to customers; (2) implementing discounts for early payments; and (3) monitoring customer accounts to ensure that customers pay on time.

Question 7

Various methods that entities may use to optimize volumes of inventory.

Answer 7

Some companies use the Economic Order Quantity (EOQ) model to determine the optimal inventory level that should be held and when inventory should be reordered. This model allows for delivery lead times and for uncertainties due to varying demand and shipping delays by incorporating a certain allotment for safety stock.

• Just-In-Time inventory management is a management technique that is used to minimize the amount of inventory carried by a company by shifting the costs of maintaining inventory to suppliers. This requires close collaboration with suppliers to coordinate deliveries. This inventory management system is often a component of a lean manufacturing process.

Consignment is another arrangement that impacts the amount of inventory carried by a company. A consignment arrangement is where the inventory is shipped to the buyer, but the seller retains ownership and a sale is not yet recorded. The sale is not recorded until the buyer has made a final sale.

Question 8

Cost of carrying inventory

Answer 8

storage

• handling (receiving and shipping)
• obsolescence
• spoilage
• theft or shrinkage
• insurance
• financing costs
• ordering costs

Question 9

Key measures to inventory effectiveness

Answer 9

• the key measures of inventory management effectiveness are inventory turnover and average inventory period (also known as days’ sales in inventory).
• The greater the turnover is, the more effective management of inventory will be.
• The average inventory period measures how many days the items are in inventory before being sold. The longer the inventory period is, the less effective management will be at managing its inventories.