Week 9a - Working Capital

Question 1

What is Working Capital?

Answer 1

Working Capital = Current Assets - Current Liabilities

Question 2

What is working capital also known as?

Answer 2

Net Current Assets

Question 3

What does working capital (net current assets) show about a business?

Answer 3

How likely it is that the company can pay its short-term bills

Question 4

Draw a diagram illustrating the nature and purpose of Working Capital. Categorise each of the major elements into their corresponding groups.

Answer 4

Major elements (Current assets)

• Inventories
• Trade receivables
• Cash (in hand and at bank)

Major element (Current liabilities)
- Trade payables

Working Capital = Current Assets - Current Liabilities

Diagram shown on page 5 week 9a

Question 5

Calculate the working capital given the following information

Current assets = £175,000
Current liabilities = £120,000

Answer 5

Working Capital = Current Assets - Current Liabilities

= £175,000 - £120,000 = £55,000

Question 6

Calculate the working capital given the following information

Current assets = £145,000
Current liabilities = £60,000

Answer 6

Working Capital = Current Assets - Current Liabilities

= £145,000 - £60,000 = £85,000

Question 7

Why is working capital important?

Answer 7

• A lower level of working capital can increase profitability
• A higher level of working capital leads to higher solvency
• There is no normal level of working capital
• There is a need to balance solvency (i.e. risk) against profitability (i.e. reward)

Question 8

What is overtrading?

Answer 8

• Overtrading = Overstretching
• Trying to do too much with too little money
• Having too little working capital
- Business tries to increase sales but has insufficient cash
- Rapid build up of receivables
- Pressures mount
- High discount to encourage cash from receivables
- Late payments of bills… supplier problems
- Assets may have to be sold off to raise cash

Question 9

State the basic working capital cycle

Answer 9

• Cash in
• Payments to suppliers/employees/cash
• Goods produced
• Goods sold

Circular flow diagram available on page 10 week 9a

Question 10

State the four elements of working capital management

Answer 10

Receivables
Inventories
Cash
Payables

Question 11

State briefly how each aspect of working capital must be managed

Answer 11

•Manage Receivables
- (Debtors – how much others owe to you)
•Manage Inventories 
- (Stock)
•Manage Cash
•Manage Payables 
- (Creditors – how much you owe to others)

Question 12

State how receivables, an element of working capital, must be managed

Answer 12

•Benefits of offering customers credit

• Marketing tool
• Increased sales

•Costs of holding receivables

• Cost of money tied up in receivables (i.e. cost of capital), e.g. lost interest
• Administration of customers’ accounts
• Possible bad debts
• Cost of assessing customers’ creditworthiness

Question 13

Managing Receivables: Accepting Credit Customers

What are the various ways of assessing customers’ creditworthiness?

Answer 13

• Personal judgement
• Banker’s reference
• Business annual reports and accounts
• Ask other creditors
• Credit rating agencies

Question 14

Managing Receivables – How Much Credit To Allow

How should the credit amount be limited?

Answer 14

The credit amount should be limited in four ways:

• Time 
- How long customers are allowed to pay
• Amount of money
- A credit limit for each customer, based on their size and creditworthiness
• Maximum for an individual receivable 
• Maximum total receivables’ figure

Question 15

Managing Receivables – Collecting the Money

How should payment from trade receivables be collected?

Answer 15

•First step is to send out the paperwork promptly,
and for it to be clear when payment is due
•Offering cash discounts for prompt payment
- The cost of offering the discounts should be calculated
•Charging interest on late payment
•Credit control system
- Costs vs. benefits

Question 16

Offering Discounts for Prompt Payment

Vinelia Building Company’s turnover was £12m
• It could offer a 4% discount for prompt payment

• This would reduce Receivables by £1.5m, and would save paying 15% interest rate on this overdraft

Is offering a discount worth it?

Answer 16

Annual cost of discount: 4%£12m = £480,000
Annual interest savings on reduction: 15%£1.5m = £225,000

Offering a discount is not worth it

Question 17

Offering Discounts for Prompt Payment

• ABC Company’s turnover was £10m
• It could offer a 3 per cent discount for prompt payment

• This would reduce Receivables by £2.5m, and would save paying 10% interest rate on this overdraft

Is offering a discount worth it?

Answer 17

Annual cost of discount: 3%£10m = £300,000
Annual interest savings on reduction = 10%%2.5m = £250,000

Offering a discount is not worth it

Question 18

State how inventories, an element of working capital, must be managed

Answer 18

Managing Inventories (Raw Materials And Finished Goods)

•Holding inventory is expensive
- A company that on average holds an inventory of
£100,000 may incur costs of about £25,000 a year (i.e. 25%)
• Costs of holding inventory
- Warehousing costs
- Opportunity cost of money invested in stock
- Obsolescence risks (i.e. inventories of goods become out of date)
- Physical deterioration possibilities

Question 19

Give an example of an inventory control method

Answer 19

Just in Time (JIT)

Economic Order Quantity (EOQ)

Question 20

What is the JIT inventory control method?

Answer 20

Just in Time (JIT)
• Aim for zero inventory
• Goods are purchased or produced only when they are needed
• A JIT policy requires: (1) reliable sales forecasting and (2) good relationship with suppliers for quick delivery

Question 21

What is the EOQ inventory control method? Use a graph to help explain if necessary

Answer 21

The EOQ is the quantity at which the holding costs = ordering costs. Total costs are minimised. It shows how
many supplies to order each time.

x-axis = Average inventories level (units)
y-axis = Annual costs (£)

Graph available page 20 week 9a

Question 22

State the formula for calculating the EOQ

Answer 22

EOQ = sqrt(2DC/H)

where:
D = the annual demand for the inventories item (expressed in units of the inventory item);
C = the cost of placing an order;
H = the cost of holding one unit of the inventories item for one year

Question 23

The EOQ Model: Example

Demand = 10,000 units
Ordering cost = £200
Price per unit = £0.50
Stockholding costs = 25% per annum = 0.25

Calculate the EOQ using the information provided

Answer 23

EOQ = sqrt(2*Annual Demand*Ordering Cost/Price per unit*Stockholding cost)
EOQ = sqrt(2*10,000*200/0.50*0.25) = 5,657

Question 24

The EOQ Model: Challenge

Demand = 5,000 units
Ordering cost = £500
Price per unit = £2.50
Stockholding costs = 15% per annum = 0.15

Calculate the EOQ using the information provided

Answer 24

EOQ = sqrt(2*Annual Demand*Ordering Cost/Price per unit*Stockholding cost)
EOQ = sqrt(2*5,000*500/2.50*0.15) = 3,651

Question 25

State how cash, an element of working capital, must be managed

Answer 25

Managing Cash
The reasons for holding cash:
• To meet day-to-day commitments
- Cash is the lifeblood of a business
- A business must have sufficient cash to pay its debts when they fall due (e.g. wages, purchased goods, etc.)
• To deal with uncertain future cash flows
- E.g. a major customer who owes a large sum to the business may be in financial difficulties
• To exploit profitable opportunities
- E.g. acquire a competitor’s business at an attractive price

Question 26

Briefly state some of the factors influencing the amount of cash held

Answer 26

Possible factors may include:

The nature of the business
The opportunity cost of holding cash
The level of inflation
The availability of near-liquid assets
The availability of borrowing
The cost of borrowing
Economic conditions
Relationships with suppliers

Question 27

Explain why the nature of the business is a factor which influences the amount of cash held

Answer 27

• The nature of the business

• Cash flows are predictable and reasonably certain (e.g. utility companies) = lower cash balances
• The cash flows of a seasonal business may vary according to the time of year = accumulate cash during the high season to meet commitments during the low season

Question 28

Explain why the opportunity cost of holding cash is a factor which influences the amount of cash held

Answer 28

• The opportunity cost of holding cash

- If there are profitable opportunities, it may not be wise to hold a large cash balance

Question 29

Explain why the level of inflation is a factor which influences the amount of cash held

Answer 29

• The level of inflation

- Holding cash during a high inflationary period will lead to a loss of purchasing power

Question 30

Explain why the availability of near-liquid assets is a factor which influences the amount of cash held

Answer 30

•The availability of near-liquid assets
- If a business has marketable securities or inventories
that may easily be liquidated, high cash balances may
not be necessary

Question 31

Explain why the availability of borrowing is a factor which influences the amount of cash held

Answer 31

•The availability of borrowing
- If a business can borrow easily (and quickly), there is
less need to hold cash

Question 32

Explain why the cost of borrowing is a factor which influences the amount of cash held

Answer 32

• The cost of borrowing

- When the interest rate is high, the option of borrowing (as an external source of financing) becomes less attractive

Question 33

Explain why the economic conditions is a factor which influences the amount of cash held

Answer 33

• Economic conditions

• In a recession, businesses may hold cash which can be invested when the economy improves
• During a recession, businesses may experience difficulties in collecting trade receivables = hold higher cash balances to meet commitments

Question 34

Explain why relationships with suppliers is a factor which influences the amount of cash held

Answer 34

Relationships with suppliers

- Too little cash may hinder the ability to pay suppliers promptly

Question 35

State how payables, an element of working capital, must be managed including the costs and benefits

Answer 35

Managing Payables
(Money you owe to others)

•Benefits of taking credit
- Extra source of funding that can be used to finance
operations
- If a company has a short-term liquidity problem, it may delay paying the trade payables

•Costs of taking credit (or excessive delay in paying
creditors)
- Higher prices
- Reputation as being a poor payer

Question 36

State some good working capital management practices in order to effectively manage trade payables

Answer 36

Managing Payables
• Careful selection of suppliers
• Maintain good relationships with suppliers
• Aim to delay payment as long as possible while keeping supplier goodwill
• Take any worthwhile discounts