Week 8 - Working Capital 1 Flashcards
What is working capital?
Is a measure of the shirt term financial health of a company indicating to investors whether a firm is being run properly or not
What is the formula for working capital?
Working capital = Current assets - current liabilities
What are current assets? (2)
• A current asset is an asset which is either cash or can be turned into cash within 12 months
• Examples: Cash, Inventory (stock) that can be sold, receivables (money owed to you from other people/firms)
What are current liabilities?
• Current liabilities are a firms obligations due within 12 months
• Short term loans, payables (money we owe others)
Formula for the working capital ration
WC Ratio= Current assets/current liabilities
Interpretations of working capital ratios (3)
• Ideally it should be between 1.2 and 2.0
• If it is less than 1.0 then the firm has insufficient short term assets to pay off its short term liabilities which can lead to a crisis
• If it is greater than 2.0 then the firm may be holding too much cash or stock (therefore high overdraft is likely and it’s operating inefficiently)
What was working capital depend on? (7)
• Lead times for products
• Retail or online
• Level of competition for your products
• Level of pressure/incentive which can be brought for expended payments/reduced time for receivables
• Degree of growth present in the firm and the cash needed
• Degree of potential for shocks
• The need for liquidity
Example working capital cycle
What is the benefit for getting receivables quickly? (3)
• If they don’t pay quickly firms may have to borrow money to pay payables to suppliers
• The longer receivables take to come in the longer money will have to be borrowed which will increase with interest
• Therefore receivables (this who owe money) essentially benefit from a free loan
Ways to increase speed of receivable payments + slow down payables (2 + 1)
• Reduce inventory conversion period - through improved production planning, outsourcing or using Just-in-Time (JIT) Inventory
• Reduce trade receivables period through incentives such as early payment discounts or enforcing stricter credit policies (contracts) and follow up on late payments (high pressure tactics/penalties threatening)
• Slow down payables by increasing trade payables deferral period - negotiate longer payment terms with suppliers, but avoid damaging supplier relationships
Formula for the amount of time taken to get paid receivables
Average amount receivable / current annual sales x 365
Formula for working capital saved when reducing the payment period
The new number of days the payment must be paid/365 x current annual sales
What are early settlement discounts?
Early settlement discounts are the reduced level of receivables needed to overcome the loss of income
What two objectives does the effectiveness of working capital depend on?
• Profitability - Ensure investments in current assets generate an acceptable return contributing to shareholder wealth maximisation
• Liquidity - Maintaining enough cash to meet short term obligations and keep the business running
What is the key challenge in working capital management? (3)
• The key is balancing liquidity and profitability
• While profitability requires investment in assets for higher returns, liquidity ensures the business can meet short-term obligations
• Liquid assets generate low returns so managers must carefully maintain the right balance in a constantly changing economic environment
Why is it important for companies to have clear working capital policies? (2)
• Clear policies allow firms to manage inventory, trade receivables, cash and short-term investments effectively
• This prevents poor decisions such as giving credit to unreliable customers or overstocking raw materials
What are the key elements of working capital policies? (2)
• Overall investment level in current assets and how much is allocated to each type
• financing approach - short-term or long-term funds
What is the impact of managing trade payables on supplier relationships? (2)
• Longer credit terms can improve cash flow but may increase costs if suppliers charge more
• Late payments harm relationships, which can impact supply reliability and business success
What is the cash conversion cycle?
Is the time between paying for raw materials and receiving cash from sales determining the amount of cash needed for operations
What are the 3 types of working capital investment policies?
• Aggressive - lower inventory, trade receivables and cash to increase increase profitability but raises risk of shortages
• Conservative - Higher cash reserves, more generous credit terms, and larger inventories reducing the financial risk but lowering profitability
• Moderate - a balance between aggressive and conservative
What are the risks of extending trade payables? (3)
• May incur interest on overdue accounts
• Could damage supplier relationships or lead to a refusal of future credit
• Large firms can use bargaining power to extend terms, but smaller suppliers may suffer
What is overtrading, and why does it occur?
- Overtrading (or undercapitalization) happens when a company tries to support too much trade with too little working capital.
- It occurs when funds fail to meet business growth needs, leading to liquidity crises even if the company is profitable.
What are the main causes of overtrading? (3)
- Rapid turnover growth – e.g., from a successful marketing campaign without sufficient funding.
Insufficient start-up capital
– common in new businesses expecting early profits. - Capital base erosion – failing to replace long-term loans after repayment.
What are consequences of overtrading?
- Liquidity crises, making it hard to pay debts.
- Excess cash being absorbed by inventory and receivables.
- Serious financial instability despite profitability.
