Working Capital

Question 1

What is working capital?

Answer 1

= Current Assets - Current liabilities
= Inventory + receivables + cash - payables

Question 2

Why is Profitability important?

Answer 2

For long-term growth and return to investors.

E.g. lots of sales

Question 3

Why is Liquidity important?

Answer 3

For short-term survival.

E.g. paying next month’s wage bill

Question 4

What is the classic textbook rule of thumb regarding ‘How to finance an investment in working capital?’

Answer 4

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)

Question 5

What are the advantages of short-term finance?

Answer 5

Cheap (shorter period of risk exposure to lenders, trade credit comes interest free)
Flexible

Question 6

What are the disadvantages of short-term finance?

Answer 6

Renewal risk - overdraft may be recalled on demand.
Interest rate risk - short term rates can fluctuate.

Question 7

How can Current Ratio analyze a company’s liquid position?

(3)

Answer 7

1. Measures how much of total CA are financed by CL.
2. Higher - business is more liquid, able to meet its CL as they fall due.
3. Lower (<1) - struggle to pay CL as they fall due.

Question 8

What can Liquidity ratios be compared to?

Answer 8

Previous periods for the same company.
Industry averages.

Question 9

How can Quick Ratio analyze a company’s liquid position?

Answer 9

More realistic measure of ability to meet short-term commitments due to how long it takes to turn inventory into cash.

Question 10

What is the formula for Quick (or liquidity) ratio ?

Answer 10

= (CA - Inventory) / CL
= (Receivables + Cash) / CL

Question 11

How can ‘Inventory holding period’ analyze a company’s liquid position?
Assuming finished goods

(2)

Answer 11

Shows average time inventory is held.
Shorter period = lower associated costs of holding inventory.

WE WANT SHORT KINGS!

Question 12

How can ‘Rate of Inventory Turnover’ analyze a company’s liquid position?
(2)

Answer 12

Higher rate = Lower level of inventory / holding costs.

Inventory levels too low > demands for goods may not be met.

Question 13

How can ‘Receivables Collection Period’ analyze a company’s liquid position?
(2)

Answer 13

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.

Question 14

How can ‘Payables Payment Period’ analyze a company’s liquid position?

Answer 14

Longer = Better.
Too long = Supplier goodwill lost.

Question 15

What is the formula for ‘Payables Payment Period’ in days?

Answer 15

= Payables / Annual purchases x 365

Purchases ~ COS

Question 16

What is the formula for ‘Receivables collection period’ in days ?

Answer 16

= Receivables / Revenue x 365

Question 17

What is the formula for ‘Rate of Inventory turnover’ ?

Answer 17

= COS / Inventory

Question 18

What is the formula for ‘Inventory period in days’ ?

Answer 18

= Inventory / COS x 365

Question 19

What is the Working Capital Cycle ?

Answer 19

the length of time between paying for the purchase of raw materials and receiving cash for the sale of those goods supplied.

Question 20

How can The Working Capital Cycle be worked out?

Answer 20

= Rec collection period + Raw materials inv holding period + WIP inv holding period + FG inv holding period - Payables payment period.

Question 21

What can be reduced by working out The Working Capital Cycle?

Answer 21

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.

Question 22

What is the significance of The Cash Operating Cycle?

(2)

Answer 22

Cycle gets longer & sales increase = more cash is tied up in cycle.
Cycle is out of balance = extra short-term finance is needed.

Question 23

What can cause Liquidity problems?

Answer 23

Overtrading - can occur when firm grows quickly on small capital base.

Question 24

Why would a firm run out of cash despite revenue and profits being healthy?

(2)

Answer 24

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.

Question 25

What are some cures for Liquidity problems?

(4)

Answer 25

1. Inject further long-term capital.
2. Raise cash by selling NE NCA.
3. Decrease rate of growth.
4. Reduce cycle length by:
   Lower levels on Inventory.
   Faster collection of debts.
   Slower payment of debts.
   Increasing cash sales.