Working Capital

Question 1

What is the working capital equation?

Answer 1

current assets - current liabilities

Question 2

The is the purpose of working capital management?

Answer 2

to ensure business has sufficient funds on hand to carry out daily operations

crucial part of short-term planning process

Question 3

what are 3 components of current assets and current liabilities working capital management is concerned with?

Answer 3

The main elements of current assets are:
 Cash (in hand and at bank)
 Accounts receivable (trade debtors)
 Inventory
 The main elements of current liabilities are:
 Accounts payable (trade creditors)
 Bank overdrafts

Question 4

Management of inventories

what is the purpose of inventory management?

Answer 4

hold enough inventory to meet daily requirements of its customers and production, while also minimizing inventory levels to reduce costs eg. storage and handling costs, financing costs, obsoloscence

Question 5

Management of inventories

distinguish inventory in manufacturing and retailing

Answer 5

Manufacturing businesses tend to hold a high
proportion of their assets as inventory:
• Raw materials
• Work-in-progress
• Finished goods
 Seasonality may vary inventory holdings over
a year, other businesses’ inventory levels may remain stable throughout the year

Question 6

Management of inventory

list 4 ways

What is essential when forecasting future demand?

Answer 6

• Accurate forecasts are key when business produces forecasts of future demand to ensure that inventory is available to meet future sales
• Can use statistical approaches or judgment of
sales and marketing staff / managers (relying on past trends or expected demand according to economic condition)

Question 7

Management of inventory

financial ratios

Answer 7

inventory turnover period =

(Average inventory/cost of sales)* days in the period (365)

Question 8

Management of inventory

what does management of inventory in a business of any size require?

Answer 8

an effcient system to record inventory movements, purchases and sales

Question 9

Management of inventory

what is lead time?

Answer 9

the time between placing of an order and the receipt of goods

Question 10

Management of inventory

recording and reordering systems

what is the effect of holding a buffer inventory?

Answer 10

raise the inventory level and cost

however, holding cost must be weighed up against the cost of running out of inventories, in terms of lost sales, production problems etc.

Question 11

Management of inventory

recording and reordering systems

what does the amount of buffer/ safety inventory depend on?

Answer 11

buffer depends on

• degree of uncertainty
• likely costs of running out of an item
• the cost of olding the buffer inventories

Question 12

Management of inventory

recording and reordering systems

Answer 12

Efficiency is key, should be monitored regularly

• Period checks may be required to see if the amount of physical inventory held is consistent with the inventory reocrds

• Decision authority for purchase and issue of inventory should be confined to a few senior staff to avoid problems of duplication and lack of coordination
• Lead-times and likely demand is required to determine when inventory should be reordered
• maintain buffer (safety inventory level) to deal with uncertainty and problems.

Question 13

Management of inventory

Levels of control

what is the purpose of ABC system of inventory control?

Answer 13

to categorise inventories and direct management effort according to the inventory value

Question 14

Management of inventory

Levels of control

What are the 3 categories in ABC system of inventory control?

Answer 14

 Category A: high levels of management control and recording would apply to high-value, low-volume items

eg. 10% volume, 65% value, you would need more stringent controls and closer monitoring as this accounts for 65% of inventory’s total value
 Category B: lower levels of recording and management control would apply to lesser-value, higher-volume items
 Category C: lowest levels of management control and recording
would apply to low-value, high-volume items

Question 15

Management of inventory

Levels of control

Answer 15

‘ABC’ system – a method of applying selective
levels of control to different categories of inventory

Question 16

Management of inventory

list 4 ways

Answer 16

1. forecast of future demand
2. financial ratios
3. recording and reordering systems
4. levels of control

Question 17

why is it important to manage accounts receivable?

Answer 17

Selling goods or services on credit incurs costs,
including administration, bad debts and opportunity
forgeone in using the funds for more profitable purposes

but these costs must be weighed up against the benefits of increased sales gained by allowing customers to delay payment

Question 18

accounts receivable management

When a business offers to sell on credit, it must have
clear policy concerning:

Answer 18

Which customers should receive credit

How much credit should be offered
What length of credit it is prepared to offer
Whether discounts will be offered for prompt payment
What collection policies should be adopted
How the risk of non-payment can be reduced

Question 19

management of accounts receivable,

why is it important to determine which customers should receive credit?

Answer 19

to reduce risk of bad debts, that is non-payment for goods or services supplied

Question 20

management of accounts receivable, which customers should receive credit?

Answer 20

The ‘five Cs’ of credit:

1. Capital - must appear to be financially sound before credit is offered. if customer is a business, look at profitability, liquidity and any onerous financial commitments
2. Capacity - must seem able to pay amounts owing (examine payment record / history)
3. Collateral - can the customer offer satisfactory
security if required for goods supplied on credit
4. Conditions - how the industry and general economic environment the customer operates in affects their ability to pay amounts owing
5. Character - a subjective assessment made by the business of factors such as honesty, integrity etc if company, examine directors’ character. satsified customer is willing to make every effort to pay amount owing

Question 21

management of accounts receivable,

A business must determine what credit terms it is prepared to offer is customers

what may the length of credit offered by influenced by?

Answer 21

• The typical credit terms operating in the industry
• The degree of competition in the industry
• The bargaining power of particular customers
• The risk of non-payment
• The capacity of the business to offer credit
• The marketing strategy of the business (increase market share, liberalise its credit policy to stimulate sales)

Question 22

management of accounts receivable

cash discounts (early settlement)

alternatively, the business can charge… but…

Answer 22

business can charge interests on overdue accounts/ late payments, but this is only possible if the business is in strong position with its customers. otherwise, risk losing customer

Question 23

management of accounts receivable

cash discounts (early settlement)

advantages and disadvantages

Answer 23

• Benefits: encoruages prompt payment

• less funds tied up in debtors
• bad debts reduced
• lower credit administration cost
• interest saved

• Costs:

• sacrifice the face value that could have been received
• _little impact on problem customers _

Question 24

How to calculate reduction in accounts receivable?

Answer 24

1. Existing level of average accounts receivable

accounts receivable turnover in days = accounts receivable/ sales x365

accounts receivable = (sales x accounts receivable turnover in days) x 365 = 767,123

2. Level of accounts receivable under proposed policy

= $2,000,000 * 80/365 + $2,000,000 * 30/365 = $ 602,740
3. Reduction in acc rec = Average acc rec under the existing policy - Level of acc rec under the proposed policy = 767123-602740= 164383

Question 25

Management of accounts receivable Benefits of policy (savings) • Interest saved • Administration costs saved • Bad debts reduced how to calculate interest saved?

Answer 25

reduction in accounts receivable x cost of loan facility

Question 26

accounts receivable management what is an aging schedule of accounts receivable?

Answer 26

a report dividing accoutns receivable into categories, depending on the length of time outstanding

Question 27

accounts receivable management what are some tactics that can be included in the business's collection policy to encourage prompt payment

Answer 27

* Develop customer relationships * Publicise credit terms * **Issue invoices** promptly * Monitor outstanding debts * ratio for average settlement period for account receivable. *_but this ratio may be distorted by few customers who are very slow payers_* • Produce an aging schedule of accounts receivable * Deal with slow payers (set procedures in dealing with them. little point in incurring legal costs from suing customer if they cannot pay damages) * Identify the monthly pattern of receipts from credit sales

Question 28

hwo to calculate account settlement period?

Answer 28

Average acc rec settlement period = (average accounts receivables/sales)\* days in the period

Question 29

what does an aging schedule of accounts receivable outstanding look like?

Answer 29

Question 30

what does pattern of receipts for credit sales look like?

Answer 30

Question 31

cash management why hold cash?

Answer 31

• Most businesses hold cash but the amount held varies considerably • There are three reasons for holding cash: • **Transactionary • Precautionary • Speculative**

Question 32

cash management how much cash should be held?

Answer 32

• No set formula - different businesses will have different views • Amount held can be reduced if business is able to quickly borrow** **or *_assets (marketable securites eg. sares in stock exchange listed companies, government bonds) held that can easily be converted_* to cash

Question 33

cash management Use of upper and lower control limits to control the cash balance: what does this assume?

Answer 33

Assumes business will invest in marketable investments that can **easily be liquidated. **investments will be purchased or sold, as necessary, to keep cash balance within control limits

Question 34

cash management Use of upper and lower control limits to control the cash balance: what does this model rely heavily on?

Answer 34

• Model relies heavily on the management's judgement such as past experience to determine **where the control limits are set** and what **time limits for breaches are acceptable**

Question 35

cash management Use of upper and lower control limits to control the cash balance: what happens if the outer limit is exceeded?

Answer 35

managers must decide if the balance is likely to return over the next few days to within the inner limits**, if not,** managers must take actions (e.g., purchase or sale of securities) to *_restore the cash balance to within limits_*

Question 36

cash management Use of upper and lower control limits to control the cash balance: what does this model propose?

Answer 36

The model proposes the use of two upper and two lower limits

Question 37

what purpose do budgeted cash flows serve for management of cash

Answer 37

Comparison of budgeted cash flows to cash flow statements will identify variances **for action** • *_Expected cash surpluses and deficits_* can have a course of action decided upon by management prior to them occurring eg. cash deficit expected --\> managers borrow, liquidate assets, reschedule cash payments

Question 38

cash flow management, what should managers produce?

Answer 38

budgeted cash flows in addition to cash flow statement

Question 39

management of cash what is the **operating cash cycle**?

Answer 39

The time period between the ***_outlay of cash to purchase supplies_***and the ***_ultimate receipt of cash from the sale of goods_*** ***_number of days cash is tied up in the operations of the business_***

Question 40

what must cash management be aware of to effectively manage cash?

Answer 40

To effectively manage cash, there must be awareness of the operating cash cycle

Question 41

management of cash what do managers seek from the operating cash cycle?

Answer 41

Management seeks to shorten the time and r**educe cash**required in the cycle ## Footnote so that they can use cash to acquire more purchases or pay debt and other expenses longer the operating cycle --\> the greater the **_financing requirements and financial risks_**

Question 42

management of cash what is the operating cash cycle equation?

Answer 42

Operating cash cycle = i**nventory turnover in days** + **accounts receivable turnover in days** – **accounts payable turnover in days**

Question 43

processes in operating cash cycle

Answer 43

Acquire inventory --\> store inventory --\> sell inventory (sale of goods) ---\> collect cash ---\> acquire inventory

Question 44

formula for turnover in days when the only information provided is turnover in times?

Answer 44

Turnover in days = days in the period/turnover in times eg. 365/7

Question 45

 Comment on the company’s management of working capital:

Answer 45

The number of days between the outlay for inventory and the cash receipt from sales has increased by 38 days over the four years. • This deterioration of 38 days is reflected in all three aspects of working capital management:  Receivables 7.8 days  Inventory 17.4 days  Payables 12.8 days

Question 46

management of accounts payable what is trade credit often associated with? what are the costs?

Answer 46

Widely regarded as ‘free’. However, there can be costs associated with taking credit: • **Cost of goods may rise** as credit needs to be paid for • customers who pay on creidit may be given l**ower priority in terms of delivery dates** • **Administration costs** associated with dealing with invoices and confirming receipt of goods / service

Question 47

management of accounts payable rise in trade credit is consistent with?

Answer 47

rise in sales

Question 48

management of accounts payable what may the business use?

Answer 48

use trade credit

Question 49

how may you control trade credit?

Answer 49

• Using the average settlement period method Average acc payable settlement period (accounts payable turnover in days) = (average accounts payable/purchases)\* days in the period  Alternative approaches: • **Ageing schedule • Pattern of credit payments**

Question 50

management of accounts receivable what is trade credit?

Answer 50

Trade credit is the **credit extended to you by suppliers** who let you buy now and pay later.(represent a form of interest-free loan) Any time you take delivery of materials, equipment or other valuables without paying cash on the spot, you're using trade credit.

Question 51

Management of accounts payable what should businesses try to do

Answer 51

business should try to extend their credit to keep funds in the business but ensure they do not continuously strive to increase the number of days as this may cause them to lose good terms with the creditor