Management of working capital

Question 1

What is working capital, what does it represent and what are the critical factors of it?

Answer 1

• Usually defined as current assets less current liabilities
• Represents a net investment in short-term assets
• There are costs incurred by holding too much and too little of each element
• Working capital needs are likely to change over time

Question 2

Why might inventories vary between businesses and over time?

Answer 2

• Manufacturing businesses tend to hold a high proportion of their assets as inventory
• Retail businesses would try and minimise their inventories because of storage, financing and opportunity costs
• Seasonality may vary inventory holdings over a year

Question 3

What is the main mechanism used for the management of working capital?

Answer 3

ABC system

Question 4

What is the ABC system?

Answer 4

• A method of applying selective levels of control to different categories of inventory
• Category A
  
  • High levels of control and recording would apply to high value, low volume items
• Category B
  
  • Lower levels of recording would apply to lesser-value, higher volume items
• Category C
  
  • Lowest levels of control and recording would apply to low value, high volume items

Question 5

Why is management of accounts receivable important?

Answer 5

Selling on credit incurs costs including admin, bad debts and opportunity costs foregone in using the funds

Question 6

What questions should be addressed by management of accounts receivable?

Answer 6

• Which customers should receive credit
• How much credit should be offered
• What length of credit it is prepared to offer
• Whether discounts will be offered for prompt payment (early settlement)
• What collection policies should be adopted
• How the risk of non payment can be reduced

Question 7

How do we answer the question of which customers should receive credit concerning the management of accounts receivable?

Answer 7

Five C’s of Credit

Question 8

How do we answer the question of how much credit should be offered concerning the management of accounts receivable?

Answer 8

Five C’s of Credit

Question 9

What are the Five C’s of Credit?

Answer 9

• Capital
  
  • The customer must appear to be financially sound before credit is expended
• Capacity
  
  • The customer must seem able to pay amounts owing
• Collateral
  
  • Can the customer offer satisfactory security if requires
• Conditions
  
  • How the industry and general economic environment the customer operated in affects their ability to pay amounts owing
• Character
  
  • A subjective assessment made by the business of factors such as honesty, integrity

Question 10

What questions do the five c’s of credit address?

Answer 10

• Which customers should receive credit

* How much credit should be offered

Question 11

How do we answer the question of what length of credit to offer concerning the management of accounts receivable?

Answer 11

• Typical credit terms operating in the industry
• Bargaining power of particular customers
• Risk of non-payment
• Capacity of the business to offer credit
• Marketing strategy of the business

Question 12

In deciding whether to offer discounts for prompt payments concerning the management of accounts receivable (working capital), what are the costs that need to be weighted?

Answer 12

The interest cost, little impact on problem customers, danger that customers will be slow to pay and still take the discount offered

Question 13

In deciding whether to offer discounts for prompt payments concerning the management of accounts receivable (working capital), what are the benefits that need to be weighted?

Answer 13

Less funds tied up in debtors, fewer bad debts, lower credit administration costs

Question 14

What is the working for deciding whether to offer discounts for prompt payment?

Answer 14

• Cost of discount
• Benefits of policy
• Net cost of policy

Question 15

How do we work out the costs of offering discounts for prompt payments?

Answer 15

(normal sales x discount taking customers rate) x discount rate

Question 16

How do we work out the benefits of offering discounts for prompt payments?

Answer 16

Interest saved = reduction in acc receivable x interest rate

+ admin costs saved + bad debts reduced etc.

Question 17

Concerning the benefits of offering discounts for prompt payments, how do we work out the reduction in accounts receivable from the policy?

Answer 17

Reduction in acc rec = average acc rec under existing policy - level of acc rec under proposed policy

Question 18

Concerning the benefits of offering discounts for prompt payments, how do we work out the the average accounts receivable under the existing policy?

Answer 18

• Sales x (Accounts receivable turnover in days/365)

- B/C acc rec. turnover in days = 365 x (average acc rec./sales)

Question 19

Concerning the benefits of offering discounts for prompt payments, how do we work out the the average accounts receivable under the proposed policy?

Answer 19

(Proportion of sales from non-discount taking customers x (new-slow account rec turnover period/365))

+ (Proportion of sales from discount taking customers x (new-fast accounts rec. turnover period/365)

Question 20

How do we answer the question of what collection policy should be adopted concerning the management of accounts receivable?

Answer 20

• Develop customer relationships
• Publicise credit terms
• Issue invoices promptly
• Monitor outstanding debts
• Produce a schedule of aged debtors
• Answer queries quickly
• Deal with slow payers
• Identify the monthly pattern of receipts from credit sales

Question 21

What is a schedule of aged debtors?

Answer 21

A report dividing accounts receivable into categories, depending on the length of time outstanding

Question 22

What is identifying the monthly pattern of receipts from credit sales?

Answer 22

Monitoring the percentage of accounts receivable paid (and the percentage of debts that remain unpaid) in the month of credit sales and the percentage paid in subsequent months (of credit sales in the base month)

Question 23

Why do businesses hold cash?

Answer 23

• Transactionary
• Precautionary
• Speculative

Question 24

How do businesses determine how much cash to hold?

Answer 24

• No set formula, different businesses will have different views
• Amount held can be reduced if funds can be raised quickly or assets (such as shares) held that can easily be converted to cash
• The more liquid your assets, the lower tha mount of cash you can have

Question 25

How can the cash balance be controlled?

Answer 25

• Upper and lower control limits

* Cash flow statement

Question 26

What is using upper and lower control limits to control the cash balance?

Answer 26

• Uses two upper and two lower limits
• If an outer limit is exceeded, managers must decide if the balance is likely to return over the next few days to within the inner limits, if not managers must take actions (purchase or sale of securities) to restore the cash balance to within limits
• Relies heavily on management judgement to determine where the control limits are set and what time limits for breaches are acceptable

Question 27

How can the cash flow statement be used to control the cash balance?

Answer 27

• It is useful for a business to prepare a cash flow statement and/or a cash budget
• Comparison of budgeted cash flows to cash flow statement will identify variances for action
• Expected cash surpluses and deficits can have a course of action decided upon by management prior to them occurring

Question 28

What is the main component in the management of cash?

Answer 28

Operating cash cycle

Question 29

What is the operating cash cycle, how is it computed and what will be managements intent for it?

Answer 29

• The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash from the sale of goods
• Operating cash cycle = inventory turnover in days + accounts receivable turnover in days - accounts payable turnover in days
• Management seeks to shorten the time and reduce cash required in the cycle

Question 30

What are the important aspects in the management of accounts payable?

Answer 30

• Trade credit is an important source of finance for many businesses
• Tends to increase in line with an increase in sales
• Widely regarded as free finance, however there are costs

Question 31

What are the costs concerning accounts payable as a form of free finance?

Answer 31

• Costs of goods may rise as credit needs to be paid for
• May be given lower priority in terms of delivery dates
• Admin costs associated with dealing with invoice and confirming receipt of goods/serivces

Question 32

How can trade creditors be controlled in the context of working capital management?

Answer 32

• Average settlement period method
• Ageing schedule
• Pattern of credit payments

Question 33

What is the Average settlement period?

Answer 33

Average acc. payable settlement period = (average accounts payable/purchases) x days in period