Working Capital Flashcards
What is working capital?
= Current Assets - Current liabilities
= Inventory + receivables + cash - payables
Why is Profitability important?
For long-term growth and return to investors.
E.g. lots of sales
Why is Liquidity important?
For short-term survival.
E.g. paying next month’s wage bill
What is the classic textbook rule of thumb regarding ‘How to finance an investment in working capital?’
Long-term assets should be financed by long-term funds (share capital, bank loans etc.)
Short-term assets should be financed by short-term funds (credit from suppliers, bank overdraft)
What are the advantages of short-term finance?
Cheap (shorter period of risk exposure to lenders, trade credit comes interest free)
Flexible
What are the disadvantages of short-term finance?
Renewal risk - overdraft may be recalled on demand.
Interest rate risk - short term rates can fluctuate.
How can Current Ratio analyze a company’s liquid position?
(3)
- Measures how much of total CA are financed by CL.
- Higher - business is more liquid, able to meet its CL as they fall due.
- Lower (<1) - struggle to pay CL as they fall due.
What can Liquidity ratios be compared to?
Previous periods for the same company.
Industry averages.
How can Quick Ratio analyze a company’s liquid position?
More realistic measure of ability to meet short-term commitments due to how long it takes to turn inventory into cash.
What is the formula for Quick (or liquidity) ratio ?
= (CA - Inventory) / CL
= (Receivables + Cash) / CL
How can ‘Inventory holding period’ analyze a company’s liquid position?
Assuming finished goods
(2)
Shows average time inventory is held.
Shorter period = lower associated costs of holding inventory.
WE WANT SHORT KINGS!
How can ‘Rate of Inventory Turnover’ analyze a company’s liquid position?
(2)
Higher rate = Lower level of inventory / holding costs.
Inventory levels too low > demands for goods may not be met.
How can ‘Receivables Collection Period’ analyze a company’s liquid position?
(2)
Shorter = faster receiving payment from customers = reduce risk of bad debt.
Credit period too low / short ? Customers may switch to a company offering better credit terms.
How can ‘Payables Payment Period’ analyze a company’s liquid position?
Longer = Better.
Too long = Supplier goodwill lost.
What is the formula for ‘Payables Payment Period’ in days?
= Payables / Annual purchases x 365
Purchases ~ COS
What is the formula for ‘Receivables collection period’ in days ?
= Receivables / Revenue x 365
What is the formula for ‘Rate of Inventory turnover’ ?
= COS / Inventory
What is the formula for ‘Inventory period in days’ ?
= Inventory / COS x 365
What is the Working Capital Cycle ?
the length of time between paying for the purchase of raw materials and receiving cash for the sale of those goods supplied.
How can The Working Capital Cycle be worked out?
= Rec collection period + Raw materials inv holding period + WIP inv holding period + FG inv holding period - Payables payment period.
What can be reduced by working out The Working Capital Cycle?
Cycle can be measured in days, weeks, months.
The faster the firm can ‘push’ items around the cycle = the lower its investments in WC will be.
What is the significance of The Cash Operating Cycle?
(2)
Cycle gets longer & sales increase = more cash is tied up in cycle.
Cycle is out of balance = extra short-term finance is needed.
What can cause Liquidity problems?
Overtrading - can occur when firm grows quickly on small capital base.
Why would a firm run out of cash despite revenue and profits being healthy?
(2)
The amount of cash needed to fund operating cycle increases as
Sales (purchase of inventory) increases.
Longer cycle = suppliers demand shorter credit periods / customers demand long credit periods.
What are some cures for Liquidity problems?
(4)
- Inject further long-term capital.
- Raise cash by selling NE NCA.
- Decrease rate of growth.
- Reduce cycle length by:
Lower levels on Inventory.
Faster collection of debts.
Slower payment of debts.
Increasing cash sales.
