Working Capital Flashcards
Working capital equation
current assets - current liabilities
(receivables + inventory + cash - payables)
Advantages and disadvantages of short term finance
- The advantages are it is relatively cheap (shorter period of risk exposure for lenders, so less interest rates) and it is flexible (for example a bank overdraft).
- The disadvantages is a renewal risk (an overdraft can be recalled on demand) and an interest rate risk as short-term rates can fluctuate.
Current Ratio
Current ratio: current assets / current liabilities
- a ratio of less than 1 indicates a business will struggle to pay its current liabilities as they fall due
Quick (or liquidity) ratio
current assets – inventory / current liabilities
– more realistic measure of business’ liquidity to meet short-term debts.
Inventory turnover period (in days)
inventory / cost of sales x 365
- shows the average length of time that inventory is held for
- the shorter the period, the lower the associated costs of holding inventory
Rate of inventory turnover
cost of sales /average inventory
- the higher the rate, the lower the level of inventory and lower the holding costs
- customer demands may not be met
Manufacturing inventory holding periods
- Raw materials inventory holding period: (average inventory of raw materials / annual usage) x 365
- WIP inventory holding period: (average inventory of WIP / annual cost of sales) x 365
- Finished goods inventory holding period: (average inventory of finished goods / annual cost of sales) x 365
receivables collection period (in days)
receivables / annual sales revenue x 365
- the shorter the period, the faster receivables are paying their debts, reducing the risk of bad debts
payables payment period (in days)
payables / credit purchases x 365
- longer period is preferable
- if figure for purchases isn’t available, use cost of sales
how can the working capital cycle be calculated as?
- The working capital cycle (cash operating cycle) is defined as the length of time between paying for the purchase of goods and receiving cash for the subsequent sale. It can be calculated as:
- Receivable’s collection period + raw materials inventory holding period + WIP inventory holding period + finished goods inventory holding period – payables payment period
Significance of cash operating cycle
- As the cycle gets longer and sales increase (inventory and purchases increase), more cash it tied up in the cycle (less cash in bank)
- If cycle is out of balance, extra short term finance is needed
Liquidity problems - causes
- Overplanning - small business grows quickly but on a small capital base, business runs out of cash
Liquidity problems - cures
- Inject some further long-term capital into the business
- Raise cash by selling off non-essential non-current assets
- Slow down the rate of growth of the business
- Reduce the length of the cash operating cycle through lower levels of inventory, faster collection of debts from credit customers, increasing the proportion of cash sales and slower payment of debts to suppliers.
Managing the components of working capital (inventory)
Inventory: levels of inventory a business holds is the result of judging the right balance between the benefits from holding inventory (continuity of production or sales) and the costs of holding inventory (warehousing and capital tied up). The two issues are how much to order and when to order.
The economic order quantity model calculates how much inventory to order each time if the objective is to minimise the costs that are directly affected by the order size (annual inventory holding costs plus annual inventory order costs).
EOQ = √ 2cd/h
Where:
- C is the cost of placing one order
- D is the demand for the inventory item over the particular period (usually annual demand)
- H is the holding cost of one unit of inventory for that period
This model does not factor bulk-discounts for higher order sizes. Other systems for inventory control are:
Managing the components of working capital (trade payables)
Trade credit is a cheap form of short-term finance. If the business does not pay debts for a month, it obtains a further month’s use of its cash. Excessive use of this facility for liquidity reasons have consequences on profitability:
- Favoured customer status is lost and future supplies disrupted
- Supplier raises prices to compensate for the extra interest being incurred
- Opportunity of a cash discount for prompt payment has been forgone