Managing Working Capital

Question 1

What is Working Capital:

Answer 1

Current Assets (inventory, receivables and payables) - Current Liabilities

Question 2

What type of business has a short working capital cycle?

Answer 2

• Supermarket for example, because they buy and then sell products that go out of date quickly.

Question 3

What type of business has a long term capital cycle?

Answer 3

• Heavy engineering, the cycle from initial purchase of resources to selling the finished product is long.

Question 4

What causes irrecoverable debt?

Answer 4

The more you sell on credit, the higher the chance.

Question 5

What are the risks of a High Level of Working Capital: (Conservative approach)

Answer 5

usually uses more long-term finance

Inventory:
- High holding costs for inventory.
- Cash tied up in unsold inventory
- Products may go out of fashion or out of date

Receivables
- higher risk of irrecoverable debt

Cash
- Is not gaining any interest

It’s overall expensive

Question 6

Low level of Working Capital: (Aggressive approach)

Answer 6

• usually uses more short-term finance
• Higher profitability
• But lower level of liquidity
• it’s less expensive
• Biz not able to respond to change in demand

Cash: delay payment to suppliers as much as possible.

Question 7

How to finance Working Capital - conservative.
High working capital

Answer 7

• Usually long-term finance, which is cheaper.
• Have a buffer level of permanent current assets (inventories and receivables)
• Fluctuating current assets: increase/decrease receivables/payables.

Question 8

How to measure Working Capital:

Answer 8

By using liquidity ratios and efficiency ratios:

Liquidity ratios:
- Current ratio
- Quick ratio

Efficiency ratios:
Inventory Days
Receivables Days
Payable Days

Question 9

What is Current ratio: (liquidity ratio)

Answer 9

Current Assets / Current Liabilities

Should be greater than 1. 1.6 or 1.7 tends to be the norm.
Then the biz is liquid.

(In a very low working capital cycle, it may sometimes be smaller than 1 and the company is still liquid. For example supermarkets, who have a lot of power over suppliers, so they have long payables cycles.)

Question 10

Quick ratio (Acid test): (liquidity ratio)

Answer 10

(Current assets - Inventory) / current liabilities:

Question 11

Inventory Days = (efficiency ratio)

Answer 11

( Inventory / Cost of Sales per annum ) x 365

Question 12

Trade receivables collection period / days: (efficiency ratio)

Answer 12

(Trade receivables/ credit sales or revenue) x 365

Preferably use credit sales.

Question 13

Trade Payables Days: (efficiency ratio)

Answer 13

= Trade payables / credit purchases or cost of sales x 365

Preferably use credit purchases.

Question 14

How to work out how much Working Capital is required if Efficiency ratios are given in days:

Answer 14

Working capital required for Inventory in £
+ Working Capital required for Receivables in £
-/- Working Capital required for Payables in £

Question 15

How to work out Working Capital required for Inventory Days:

Answer 15

(Inventory Days / 365) x Cost of Sales

Question 16

How to work out Working Capital required based on Receivables Days:

Answer 16

(Receivables Days / 365) x Revenue (or Credit Sales)

Question 17

How to work out Working Capital required based on Payables Days:

Answer 17

= (Payables Days / 365) x Cost of Sales (or Credit Purchases)

Question 18

What is the Operating Cycle:

Answer 18

It’s the number of days between the biz paying for raw materials to receiving cash for finished goods.

It’s the number of days that the company is without cash, due to:

Inventory days + Receivable Days - Payable Days