Working Capital Flashcards
What is working capital and why is it’s management important?
Working capital is basically the capital (Current assets less Liabilities) available to the business to fund operations. It is comprised of the following elements:
- Bank balance/overdraft
- Trade receivables
- Trade payables
- Inventory - including Raw materials, WIP and Finished Goods.
Working capital is managed to achieve best utilisation of the assets balanced with liquidity (maximise return while minimising risk)
Where might the objectives of working capital management conflict?
Working capital management is a balance between liquidity and profitability:
- Assets need to be liquid enough to minimise risk of insolvency:
- Short/no credit terms for customer
- Long/delayed payments to suppliers
- But assets also need to provide best returns:
- Longer credit terms - increase sales but reduce liquidity of Trade receivables.
- Working capital management may be:
Aggressive - lower working capital/higher risk. So no credit customers, delay paying suppliers, JIT inventory
Conservative - Longer credit terms to attract sales, prompt or early payments to suppliers, inventory buffer stock.
What is the cash operating cycle?
Also known as the working capital cycle, relates to the flow of capital through the business from the receipt of raw materials to payment receipt from customers. Faster flow better working capital.
At it’s simplest it is - Inventory holding days plus Receivables days less payables days.
Inventory holding period may expand to cover Raw materials/WIP/Finished Goods holding periods.
Holding periods are all basically calculated as SFP item/SPL item x 365
What are the two liquidity rations used in working capital management and what is their relevance?
Current Ratio - Current Assets/ Current Liabilities. Measures how much of the current assets are finance by current liabilities. so 2:1 would mean that current liabilities could be paid twice out of current assets.
Quick (Acid) Ratio - Current Assets (less inventory)/current liabilities. As above but taking inventory which is less liquid than cash or receivables out of the equation. Handy when inventory holding periods are long.
What are the objectives of Inventory management?
Inventory management is a balancing act between:
- Minimising working capital held in inventory by running lower stock levels (Liquidity), and
- Maximising stock availability to be able to meet demand (Profitability)
Various factors will need to be considered in establishing inventory ordering policies and levels:
- Lead times for orders of inventory items.
- Expected demand
- Economic order quantity.
- Stock holding costs.
How is Economic order quantity calculated both with and without quantity discounts?
Basic EOQ is calculated as - √(2CoD/Ch)
Where:
- Co = Cost per order
- D = Demand
- Ch = Cost of holding 1 unit for 1 year.
Where a quantity discount is available the total annual inventory costs both with and without the discount should be compared and the lowest cost option chosen.
Total Annual Inventory cost = Purchase cost + Order cost + Holding cost.
NOTE - with holding costs watch out for cost of capital. Need to add the cost of capital for one unit to the holding costs.
How are reorder levels determined and how would differing inventory management systems affect this?
Where demand and lead time are known reorder level is simply - Demand in lead time
Where demand is variable reorder level is - Max demand x Max lead time.
Some inventory management systems operate with “Buffer stock” which should be taken in to account when identifying re order level.
JIT - “Just in Time” inventory is a system which minimises or totally removes stock holding, so inventory is received just in time for demand.
When establishing a credit policy what considerations must a business make, and how would the policy be implemented?
- Demand for Products
- Competitors terms
- Level of risk of irrecoverable debts
- Financing costs
- Costs of Credit control.
A credit policy is implemented by:
- Assessing credit worthiness - Credit reports/Trade references etc
- Determine and communicate credit limit.
- Invoice promptly and collect overdue debts.
- Review credit position.
What are the implications of offering early settlement discounts and how can the cost be calculated?
Early settlement discounts essentially result in receipts from receivables occurring sooner but a %age of the original invoice value will be given as discount.
The annual cost of a settlement discount is calculated as:
(1 + (Discount/O/S Balance))total periods/periods less -1
Where the periods may be days weeks or months.
When calculating a saving consider which costs are replaced by the discount and which will still apply.
Where a settlement discount is available on a payable balance the formula above can still be used, switch the figures in the “power of”.
NOTE also consider that taking a discount will mean cash leaving sooner so the amount saved with the discount should be offset against the cost for the additional working capital.
What are Invoice discounting and Factoring?
Invoice Discounting - finance is raised against the receivables
- Increases short term cash flow
- Increased cost to use
- May reduce admin cost, but usually admin is still carried out by the business.
- Customer wil not be aware of the arrangement, avoiding the stigma of invoice factoring.
Invoice factoring - a third party will carry out the credit control, usually will advance a % of the receivables value with balance when payment received.
- Increases short term cash flow
- Advance is usually made at an interest rate, so cost to the business.
- Reduce admin costs as credit control process are carried out by the factor.
- May present an unfavourable image of the business cash flow and damage customer relationships.
Why does a business need to hold cash?
A business will have three main reasons for holding cash:
- Transaction - to meet day to day planned expenses
- Precautionary - to meet unexpected/planned expenses.
- Speculative - to be able to take advantage of short term investment opportunities.
What is the difference between a cash forecast and a cash budget and how would they be used?
Cash Forecast - this is expected future cashflows based on current circumstances and known information.
Cash Budget - is basically the cash forecast adjusted to bring it in line with the business objectives.
The use of cash budgets:
- To plan for surplus or deficit of cash/liquidity.
- Asses and Integrate operating budgets.
- compare with actual spend.
What is the Baumol cash management model and what does it show?
The Baumol cash management model is calculated using the EOQ formula:
Q = √2CoD/Ch
Where:
- Co = Transaction costs
- D = Demand for cash over the period (watch out for period length)
- Ch = Cost of holding cash (Interest rate)
Following on from this the opportunity cost of holding cash is:
Ch x (Q/2)
The aim of the model is to minimise the cost/ maximise return associated with movements between current and interest bearing accounts by determining the timing and value of the movements of cash.
Value is calculated by the formula, timing = annual movement/ movement value (no of movements in year).
The model assumes consistent cash flows during the year.
What is the Miller-Orr cash management model and how is it used?
Miller- Orr calculation is:
Spread = 3{(0.75 x Transaction cost x Var in cash flows)/interest rate]⅓
Return point = Lower limit + (⅓ x spread)
Upper limit = Lower limit + spread.
This model relates to irregular cash movements.
When the balance hits either lower or upper limit then cash is moved to bring the account balance back to the return point.
If variance in cash flows is expressed as standard deviation on daily cash this figure should be squared.
What is the difference between permanent and fluctuating current assets?
Permanent Current assets - essentially fixed values. Buffer inventory, minimum receivables and cash balances.
Fluctuating Current Assets - assets that change e.g. variations in inventory and receivables balances.
