Topic 4 - Working Capital and Cash Flow Flashcards
COS Formula
COS = Sales - Gross Profit
What is working capital?
Working capital is the value of current assets less the value of current liabilities.
What are current assets?
Cash, inventory, and receivables.
What are current liabilities?
Payables, loans falling due within 1 year, and overdrafts.
What are the two main objectives of working capital management?
- To increase the profits of a business
- To provide sufficient liquidity to meet short-term obligations as they fall due.
Why is liquidity important?
Liquidity determines a business’s ability to survive.
How does liquidity differ from profitability?
A business can make accounting profits while suffering a dramatic decline in cash balance, and vice versa.
Why is it important to maintain a sound liquidity position?
To ensure that the business can meet its short-term obligations and continue operating effectively.
What are key techniques for monitoring liquidity?
Cash budgeting and performance measurement are essential techniques for monitoring and controlling liquidity.
How can a business assess its liquidity position?
Liquidity position can be assessed using ratios and the cash operating cycle.
What are the key liquidity ratios used for assessment?
- Inventory turnover
- Receivables collection period
- Payables payment period
- Liquidity ratios (current ratio, quick ratio).
What is the formula for Inventory Turnover Period? 2 methods
Inventory turnover period = Inventory/cost of sales (or purchases) x 365 days
OR
Inventory turnover period = 1/rate of inventory turnover x 365 days
What does the Inventory Turnover Period indicate?
It shows the average length of time that inventory is held for. A shorter period means lower stock holding costs. Lower the better as we sell quickly and get cash in.
What is the formula for the Rate of Inventory Turnover?
Rate of Inventory Turnover = Cost of Sales / Average Inventory.
Why is a high rate of inventory turnover desirable?
A high turnover rate indicates that inventory is being sold quickly, reducing storage costs and improving cash flow.
What is the formula for the Receivables Collection Period?
Receivables Collection Period = (Average Receivables / Annual Sales Revenue) × 365.
What does the Receivables Collection Period measure?
It measures how long it takes to collect debts. A shorter period reduces capital tied up in receivables and the risk of bad debts.
What is the formula for the Payables Payment Period?
Payables Payment Period = (Average Payables / Annual Purchases) × 365.
Why should the Payables Payment Period be as long as possible?
A longer payment period helps in maintaining cash flow by delaying cash outflows, reducing the need for short-term financing.
What is the formula for the Current Ratio?
Current Ratio = Current Assets / Current Liabilities.
Why is a higher Current Ratio generally preferred?
A higher ratio indicates better short-term financial health, as it shows a company can easily meet its short-term obligations.
What is the formula for the Quick (Liquidity/Acid Test) Ratio?
Quick Ratio aka acid test = (Current Assets - Inventory) / Current Liabilities.
Why is the Quick Ratio useful?
It provides a stricter measure of liquidity by excluding inventory, which may not be easily converted into cash.
How can working capital ratios be used in reverse calculations?
Ratios can help determine required sales levels, overdraft needs, and other financial planning measures.