Week 9a - Working Capital Flashcards
What is Working Capital?
Working Capital = Current Assets - Current Liabilities
What is working capital also known as?
Net Current Assets
What does working capital (net current assets) show about a business?
How likely it is that the company can pay its short-term bills
Draw a diagram illustrating the nature and purpose of Working Capital. Categorise each of the major elements into their corresponding groups.
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
Calculate the working capital given the following information
Current assets = £175,000
Current liabilities = £120,000
Working Capital = Current Assets - Current Liabilities
= £175,000 - £120,000 = £55,000
Calculate the working capital given the following information
Current assets = £145,000
Current liabilities = £60,000
Working Capital = Current Assets - Current Liabilities
= £145,000 - £60,000 = £85,000
Why is working capital important?
- 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)
What is overtrading?
• 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
State the basic working capital cycle
- Cash in
- Payments to suppliers/employees/cash
- Goods produced
- Goods sold
Circular flow diagram available on page 10 week 9a
State the four elements of working capital management
Receivables
Inventories
Cash
Payables
State briefly how each aspect of working capital must be managed
•Manage Receivables - (Debtors – how much others owe to you) •Manage Inventories - (Stock) •Manage Cash •Manage Payables - (Creditors – how much you owe to others)
State how receivables, an element of working capital, must be managed
•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
Managing Receivables: Accepting Credit Customers
What are the various ways of assessing customers’ creditworthiness?
- Personal judgement
- Banker’s reference
- Business annual reports and accounts
- Ask other creditors
- Credit rating agencies
Managing Receivables – How Much Credit To Allow
How should the credit amount be limited?
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
Managing Receivables – Collecting the Money
How should payment from trade receivables be collected?
•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
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?
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
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?
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
State how inventories, an element of working capital, must be managed
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
Give an example of an inventory control method
Just in Time (JIT)
Economic Order Quantity (EOQ)
What is the JIT inventory control method?
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
What is the EOQ inventory control method? Use a graph to help explain if necessary
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
State the formula for calculating the EOQ
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
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
EOQ = sqrt(2*Annual Demand*Ordering Cost/Price per unit*Stockholding cost) EOQ = sqrt(2*10,000*200/0.50*0.25) = 5,657
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
EOQ = sqrt(2*Annual Demand*Ordering Cost/Price per unit*Stockholding cost) EOQ = sqrt(2*5,000*500/2.50*0.15) = 3,651
State how cash, an element of working capital, must be managed
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
Briefly state some of the factors influencing the amount of cash held
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
Explain why the nature of the business is a factor which influences the amount of cash held
• 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
Explain why the opportunity cost of holding cash is a factor which influences the amount of cash held
• The opportunity cost of holding cash
- If there are profitable opportunities, it may not be wise to hold a large cash balance
Explain why the level of inflation is a factor which influences the amount of cash held
• The level of inflation
- Holding cash during a high inflationary period will lead to a loss of purchasing power
Explain why the availability of near-liquid assets is a factor which influences the amount of cash held
•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
Explain why the availability of borrowing is a factor which influences the amount of cash held
•The availability of borrowing
- If a business can borrow easily (and quickly), there is
less need to hold cash
Explain why the cost of borrowing is a factor which influences the amount of cash held
• The cost of borrowing
- When the interest rate is high, the option of borrowing (as an external source of financing) becomes less attractive
Explain why the economic conditions is a factor which influences the amount of cash held
• 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
Explain why relationships with suppliers is a factor which influences the amount of cash held
Relationships with suppliers
- Too little cash may hinder the ability to pay suppliers promptly
State how payables, an element of working capital, must be managed including the costs and benefits
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
State some good working capital management practices in order to effectively manage trade payables
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
