Module 5: Liquidity Management Flashcards
State the components of working capital
Current assets (e.g cash, inventory of raw materials, inventory of work in progress, inventory of finished goods, trade accounts receivable, marketable securities) and current liabilities (e.g. trade accounts payable, taxation payable, dividend payments due, short-term loans, long-term loans maturing within one year, lease rentals due within one year)
What is meant by the trade-off between profitability and liquidity in respect of the working capital decision?
The two objectives of profitability and liquidity will often conflict as liquid assets give the lowest
returns.
Current liabilities are often a cheap method of finance (trade accounts payable do not usually carry an
interest cost). Companies may therefore consider that, in the interest of higher profits, it is worth accepting
some risk of insolvency by increasing current liabilities, and taking the maximum credit possible from
suppliers.
Therefore with most working capital decisions, there is a trade-off between profitability and liquidity.
What is the cash operating cycle?
The period of time between the point at which cash begins to be
expended on the production of a product and the collection of cash from the customer who
purchases it.
Name three ways that a company could ease a short-term cash shortage
Postponing capital expenditure**
Some new non-current assets might be needed for the development and growth of the business,
but some capital expenditure might be delayed without serious consequences. If a company’s
policy is to replace company cars every two years, but the company is facing a cash shortage, it
might decide to replace cars every three years.
Accelerating cash inflows which would otherwise be expected in a later period
One approach would be to try and collect accounts receivable earlier. Often, this policy will result
in a loss of goodwill and problems with customers. It might be possible to encourage accounts
receivable to pay more quickly by offering discounts for earlier payment or using factoring/invoice
discounting as described above.
Reversing past investment decisions by selling assets previously acquired
Some assets are less crucial to a business than others. If cash flow problems are severe, the option
of selling investments or property might have to be considered.
Negotiating a reduction in cash outflows, to postpone or reduce payments
There are several ways in which this could be done:
– Longer credit might be taken from suppliers. Such an extension of credit would have to be
negotiated carefully: there would be a risk of having further supplies refused.
– Loan repayments could be rescheduled by agreement with a bank.
– A deferral of the payment of company tax might be agreed with the taxation authorities. They
will however charge interest on the outstanding amount of tax.
– Dividend payments could be reduced. Dividend payments are discretionary cash outflows,
although a company’s directors might be constrained by shareholders’ expectations, so that
they feel obliged to pay dividends even when there is a cash shortage.
If a company adopts a moderate approach to working capital management, how is it likely to finance its investment in short term and long term assets?
A moderate working capital management policy is a middle way between the aggressive and
conservative approaches.
What is a conservative approach?
A conservative working capital management policy aims to reduce the risk of system breakdown by
holding high levels of working capital.
Customers are allowed generous payment terms to stimulate demand, finished goods inventories are
high to ensure availability for customers, and raw materials and work in progress are high to minimise
the risk of running out of inventory and consequent downtime in the manufacturing process. Suppliers
are paid promptly to ensure their goodwill, again to minimise the chance of stock-outs.
The cumulative effect on these policies can be that the firm carries a high burden of unproductive
assets, resulting in a financing cost that can destroy profitability. A period of rapid expansion may also cause severe cash flow problems as working capital requirements outstrip available finance. Further
problems may arise from inventory obsolescence and lack of flexibility to customer demands.
What is an aggressive approach?
An aggressive working capital management policy aims to reduce this financing cost and increase
profitability by cutting inventories, speeding up collections from customers, and delaying payments to
suppliers.
The potential disadvantage of this policy is an increase in the chances of system breakdown through
running out of inventory or loss of goodwill with customers and suppliers.
However, modern manufacturing techniques encourage inventory and work in progress reductions
through just-in-time policies, flexible production facilities and improved quality management.
Improved customer satisfaction through quality and effective response to customer demand can also
mean that credit periods are shortened.
