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.
What is the cash operating cycle?
The cash operating cycle (also known as the working capital or cash conversion cycle) is the period of time between the outflow of cash to pay for raw materials and the inflow of cash from customers. Want this to be SHORT
Cash operating cycle formula
Cash operating cycle = Receivable days + inventory days - payable days
What are the key stages in the cash operating cycle?
- Purchases of raw materials
- Production
- Storage in warehouse
- Sales (credit sales)
- Cash inflow from receivables.
Why is the cash operating cycle important?
It helps businesses understand how long cash is tied up in working capital before being converted into cash from sales.
How is the cash operating cycle calculated?
Cash Operating Cycle = Inventory Holding Period + Receivables Collection Period - Payables Payment Period.
Length of Cycle Proforma
Length of Cycle Proforma
Raw materials holding period = (Average inventory of raw materials/Annual usage) √ó 365
Average production period = (Average inventory of work in progress/Annual cost of sales) √ó 365
Average inventory-holding period = (Average inventory of finished goods/Annual cost of sales) √ó 365
Average receivables collection period = (Average receivables/Annual sales revenue) x 365
LESS
Average payables payment period = (Average payables/ Annual purchases) √ó 365
= Length of cycle
Raw materials holding period formula
Raw materials holding period = (Average inventory of raw materials/Annual usage) √ó 365
Average production period formula
Average production period = (Average inventory of work in progress/Annual cost of sales) √ó 365
Average inventory-holding period formula
Average inventory-holding period = (Average inventory of finished goods/Annual cost of sales) √ó 365
Average receivables collection period formula
Average receivables collection period = (Average receivables/Annual sales revenue) x 365
Average payables payment period formula
Average payables payment period = (Average payables/ Annual purchases) √ó 365
What factors influence the length of the cash operating cycle? 4
- Industry norms
- Business size
- Supply chain efficiency
- Credit terms with suppliers and customers.
What are common strategies to reduce the cash operating cycle? 3
- Reducing the inventory holding period
- Improving receivables collection efficiency
- Extending payables payment period.
What are the consequences of a long cash operating cycle? 3
- Increased working capital requirements
- Higher financing costs
- Greater risk of liquidity issues.
What must users of ratios or the working capital cycle must consider regardng these measures? 3
However, the use of ratios or the working capital cycle must consider the following:
• The balance sheet values at a particular point in time may not be typical.
• Balances for a seasonal business will not represent average levels.
• Such measures concern the past, not the future.
Therefore, measures should not be considered in isolation. Trends and industry averages are important.
What is overtrading?
Overtrading occurs when a business expands rapidly without sufficient working capital, leading to cash flow problems. Trade so much can’t keep up.
Why can overtrading often happen at the start of a new business? 4
No history, unknown trends
Offer credit to customers to entice them
Sunk costs
Short term credit from supplier as no reputation built up
What might be some consequences of overtrading? 6
Insolvency
Run out of cash
Can’t make payments when they fall due
Refuse Orders
Sell assets - you are less effective
Getting a new loan or extra finance as a new business is even trickier
What are the risks of overtrading? 3
- Longer cash cycle
- Increased funding requirements
- Higher risk of insolvency.
What are solutions to liquidity problems? 4
- Reducing the inventory-holding period
- Reducing the production period
- Reducing customers’ credit periods
- Extending suppliers’ credit periods.
What are the types of inventory control systems? 3
- Re-order level system
- Periodic review system
- ABC system (categorizing inventory based on importance).
What are the costs associated with holding inventory? 4
- Purchase price
- Holding costs (opportunity cost, insurance, obsolescence, warehousing)
- Ordering costs (transport, admin expenses).
4.Shortage costs - lack of RM, stock-out costs for FG, Emergency re order costs (come at premium)
What is the Re-order level system?
Re-order level system
A fixed quantity will be ordered whenever inventory falls to a predetermined level (the re-order level). This system aims to minimise costs while providing the necessary supply to users.
What is the Periodic review system?
Periodic review system
Inventory levels are reviewed at fixed time intervals to fit in with production schedules, and variable quantities are ordered as appropriate.
What is the ABC system?
ABC system
The aim here is to reduce the work involved in inventory control in a business which may have several thousand types of inventory items. Inventory is categorised into classes A, B or C according to the annual cost of the usage of that inventory item, or the difficulty of replacements, or the importance to the production process. Class A will then take most of the inventory control effort, Class B less and Class C less still.
How does trade payables act as a source of short-term finance?
Businesses can delay payments to suppliers, allowing them to use cash for other operations before paying debts.
What costs might be incurred in using trade payables as a source of finance? 4
Charged interest for late payments
Damage relationship/goodwill with supplier so decrease in credit terms, or no discount, or fees/ penalties
Can be taken to court
Damage credit score
What are the advantages of trade credit? 4
- Convenient and informal
- Useful for businesses that don’t qualify for bank credit
- Acts as a short-term financing tool to overcome unexpected cash flow
- It can represent a virtual subsidy or sales promotion device offered by the seller
How can working capital ratios be manipulated?
Companies can adjust inventory, receivables, and payables policies to change liquidity ratios and improve financial appearances.
What are the limitations of using ratios for liquidity analysis? 3
- Balance sheet values may not be typical.
- Seasonal businesses may have fluctuating values.
- Ratios reflect past performance, not future expectations.
What are trade receivables?
Amounts owed by customers to a business for goods or services sold on credit.
What is the trade-off in managing trade receivables?
Balancing the cost of extending credit to customers against the benefits of increasing sales and customer retention.
What are best practices in managing trade receivables? 3
- Set clear credit terms on orders, invoices and statements.
- Offer early settlement discounts.
- Monitor and manage key customer accounts.
What are ways in which collection of amounts owed by customers could be speeded up? 6
- Reduce receivables ledger days
- Early settlement discounts
- Reduced credit offered
- Send SOAs and payment reminders
- Penalties/ Fees
- Credit check
What are financing options for trade receivables? 2
- Invoice discounting
- Receivables factoring.
What is invoice discounting?
Selling invoices to a discounting company for immediate cash, with repayment when customers pay the invoices. Note that the business retains full responsibility for sales ledger, credit control and collection functions.
What is receivables factoring?
A method where businesses sell their receivables to a factor, who manages collections and provides immediate cash advances.
This contains three closely integrated elements:
* Accounting and collection
* Credit control
* Finance against sales
The usual fees are about 2–3% of invoice value as an administration charge, plus a charge for cash advances.
What are the disadvantages of receivables factoring? 5
- High fees (2-3% of invoice value)
- Business loses control over credit collection
- May impact customer relationships.
- Signals financial difficulty and can end up with less cash
- Customers might still default
What are best practices in receivables management? 2
- Monitor key accounts (as 20% of customers often account for 80% of debts).
- Manage time scales for collection effectively.
Why is Trade credit insurance useful?
Trade credit insurance insures a business against the possible default and insolvency of its credit customers and, where exports are involved, political risk. It is therefore a useful tool in credit management, helping to minimise possible problems from late payment and bad debts.
What is the primary aim of good cash management? 4
The primary aim of good cash management is to have the right amount of cash available at the right time. This involves:
• Accurate cash budgeting/forecasting
• Planning short-term finance when necessary
• Planning investment of surpluses when necessary
• Cost-efficient cash transmission
What are the key components of short-term finance? 4
- Receivable factoring and invoice discounting
- Bank overdrafts
- Short-term bank loans
- Operating leases.
What should a business do with a short-term surplus of funds?
Invest the surplus in short-term financial products like treasury bills, deposits, or short-term bonds to earn a return.
What are some options for investing surplus funds?
- Treasury bills
- Deposits
- Gilts
- Bonds
- Equities.
What factors should be considered when choosing investments for surplus funds?
- Risk
- Return
- Liquidity
- Duration of surplus
- Matching investment to surplus duration (short-term to short-term, long-term to long-term).
What is trade credit insurance?
Insurance that protects a business from defaults and insolvency of its credit customers, and political risks in exports.
What are the advantages of trade credit insurance?
- Minimizes risks from late payments and bad debts
- Provides assurance in extending credit to new customers
- Protects against political risks in international trade.
How can treasury management help in managing working capital?
By optimizing cash flows, reducing borrowing costs, and ensuring sufficient liquidity for operations.
Where can surpus funds be invested? 5
Surplus funds can be invested in various financial products. Increase in length of time as you go down list
• Treasury bills - short term, low risk, gov bonds
• Deposits - bank, building
• Gilts - fixed interest loan securites leased by the UK gov, long term
• Bonds - issued by companies, longer term
• Equities - shares, long term
When choosing where to invest suprlus funds, what factors should be considered? 6
- ROI - best return
- How long is the money ‘locked away’
- Do we have any big outgoings? e.g. corp tax
- Max short or long term profit
- Risk vs reward attitudes and strategies
- Trends - e.g. Netflix has put out Blockbuster out of business
What is the importance of matching investment duration to the surplus duration?
To ensure that the business has access to funds when needed and to optimize returns based on risk and liquidity preferences.
What is a cash budget?
A cash budget is a statement in which estimated future cash receipts and payments are tabulated to show the forecast cash balance of a business at defined intervals.
What are the key uses of cash budgets? 3
- Helps management make forward planning decisions
- Provides an indication of potential cash flow problems
- Allows businesses to take preemptive actions to avoid issues.
What are the key components of a cash budget? 3
- Estimated cash receipts (e.g., sales, loan funds, asset disposal proceeds)
- Estimated cash payments (e.g., supplier payments, wages, loan repayments, rent, overheads)
- Net cash flow calculation (receipts minus payments).
Which items should be included in a cash budget? 3
- Funds from the receipt of a bank loan
- Receipt of dividends from outside the business
- Share dividends paid.
Which items should NOT be included in a cash budget? 3
- Revaluation of a non-current asset
- Depreciation of distribution vehicles
- Bad debts written off.
How should cash flow timing be considered when preparing a cash budget?
Cash flows should be recorded when they actually occur, not when they are incurred, especially regarding payments to suppliers and receipts from customers.
What are common sources of cash inflows in a cash budget? 3
- Sales revenue (cash and credit receipts)
- Loan receipts
- Proceeds from disposal of non-current assets.
What are common sources of cash outflows in a cash budget? 4
- Supplier payments
- Employee wages
- Loan repayments
- Rent and overheads.
Why should notional (non-cash) items be excluded from a cash budget?
Notional items like depreciation do not involve actual cash movement and thus do not affect cash flow.
How does a cash budget help in managing liquidity?
It allows businesses to plan for potential shortfalls and surpluses, ensuring they have sufficient cash to meet obligations.
Why is accurate cash flow forecasting essential for business stability?
It helps prevent liquidity crises, ensures smooth operations, and supports strategic financial planning.
