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
Managing the components of working capital (trade receivables)
The only benefit from granting trade credit to customers comes from maintaining/increasing sales volumes. The costs of extending credit are:
- Finance costs of capital tied up in trade receivables
- The risk of irrecoverable debts
- Administrative costs of running a credit control department
Policies need to be established for the control and collection of customer debts. These include:
- Setting the terms of credit: the length of the credit period and whether a cash discount is to be offered. This can be an expensive form of short-term finance
- Assess the risk the customer won’t pay by giving it a credit rating
- Consider whether to outsource credit collection and/or financing through receivables factoring (factor advance x% of the funds immediately and takes responsibility for collecting the debt efficiently) and invoice discounting (no outsourcing of debt collection but the debts are sold at a discount for an immediate cash sum)
- Minimise the time taken between the placement of the order and the receipt of cash from the customer. This can involve encouraging on-line ordering, prompt despatch of goods, invoices and reminder statements and preparation of credit control reports which highlight slow-paying customers.
- Consider whether to take out trade credit insurance against the possible default and insolvency of its credit customers
Treasury (cash) management
There are four reasons why a company would want to hold cash either in a cash float or a bank current account:
- Transaction’s motive: meet day to day obligations
- Finance motive: cover major items
- Precautionary motive: to cover against unexpected outlays
- Investment/speculative motive: take advantage of new investment opportunities
The profitability objective would minimise the holdings of cash – as an idle asset, profit is being forgone by failing to invest the funds.
The liquidity objective would maximise the holdings of cash to ensure the firms cash obligations would be met – payments of supplier’s invoices, wages to staff and dividends to shareholders.
Therefore, the primary aims of cash management is to have the right amount of cash available at the right time. The elements in this process are:
- Efficient cash transmission procedures: prompt banking of receipts and the allowing of 3-4 days before the funds can be drawn upon
- The preparation of timely and accurate cash budgets
Cash budgets
A cash budget is a detailed budget of estimated cash inflows and outflows incorporating both revenue and capital items. The preparation has two main objectives:
- Provide periodic budgeted cash balances for the budgeted balance sheet
- To anticipate cash shortages/surpluses and thus provide information to assist management in short- and medium-term cash planning and longer-term financing for the organisation
Potential cash positions
If in a short-term surplus, management should pay suppliers early, increase spending and make investments.
If in a short-term shortfall, management should delay payments, tighten credit control and use an overdraft.
If in a long-term surplus, management should make investments, acquisitions, pay dividends, replace assets and offer a share buy-back.
If in a long-term shortfall, management should raise new finance, debt or equity, sell assets, divest or close the business.
reorder level system
when inventory falls to a predetermined level
periodic review system
regular inspections of inventory levels
ABC system
inspections now prioritised according to importance of each item - so used when there are many different items in inventory
Just in time system
give supplier the customer order book on a regular basis
perpetual inventory system
automatically generated by computerised system with each receipt/issue
managing trade payables
- source of short term finance
- excessive use of this can be an issue as favoured customer status is lost, may lose supplier
transactions motive
to meet day to day obligations
finance motive
to cover major items
precautionary motive
to cover against unexpected outlays
investments/speculative motive
take advantage of new investment opportunities
invoice discounting
selling the invoices to a discounting company for a cash sum, then repaying the discounter when the debtor pays the invoice
receivables factoring
takes over the management of the trade debts owed to its client on the clients behalf. Factor company collects the debts and provides an immediate cash advance of a proportion of the money it is due to collect
examples of short term finance
- receivable factoring and invoice discounting
- bank overdrafts
- short-term bank loans
- operating leases
