Working Capital Flashcards
What is the working capital equation?
current assets - current liabilities
The is the purpose of working capital management?
to ensure business has sufficient funds on hand to carry out daily operations
crucial part of short-term planning process
what are 3 components of current assets and current liabilities working capital management is concerned with?
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
Management of inventories
what is the purpose of inventory management?
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
Management of inventories
distinguish inventory in manufacturing and retailing
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
Management of inventory
list 4 ways
What is essential when forecasting future demand?
• 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)
Management of inventory
financial ratios
inventory turnover period =
(Average inventory/cost of sales)* days in the period (365)
Management of inventory
what does management of inventory in a business of any size require?
an effcient system to record inventory movements, purchases and sales
Management of inventory
what is lead time?
the time between placing of an order and the receipt of goods
Management of inventory
recording and reordering systems
what is the effect of holding a buffer inventory?
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.
Management of inventory
recording and reordering systems
what does the amount of buffer/ safety inventory depend on?
buffer depends on
- degree of uncertainty
- likely costs of running out of an item
- the cost of olding the buffer inventories
Management of inventory
recording and reordering systems
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.
Management of inventory
Levels of control
what is the purpose of ABC system of inventory control?
to categorise inventories and direct management effort according to the inventory value
Management of inventory
Levels of control
What are the 3 categories in ABC system of inventory control?
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
Management of inventory
Levels of control
‘ABC’ system – a method of applying selective
levels of control to different categories of inventory
Management of inventory
list 4 ways
- forecast of future demand
- financial ratios
- recording and reordering systems
- levels of control
why is it important to manage accounts receivable?
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
accounts receivable management
When a business offers to sell on credit, it must have
clear policy concerning:
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
management of accounts receivable,
why is it important to determine which customers should receive credit?
to reduce risk of bad debts, that is non-payment for goods or services supplied
management of accounts receivable, which customers should receive credit?
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
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?
- 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)
management of accounts receivable
cash discounts (early settlement)
alternatively, the business can charge… but…
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
management of accounts receivable
cash discounts (early settlement)
advantages and disadvantages
• 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 _
How to calculate reduction in accounts receivable?
- 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
- 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
Management of accounts receivable
Benefits of policy (savings)
• Interest saved
• Administration costs saved
• Bad debts reduced
how to calculate interest saved?
reduction in accounts receivable x cost of loan facility
accounts receivable management
what is an aging schedule of accounts receivable?
a report dividing accoutns receivable into categories, depending on the length of time outstanding
accounts receivable management
what are some tactics that can be included in the business’s collection policy to encourage prompt payment
- 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
hwo to calculate account settlement period?
Average acc rec settlement period = (average
accounts receivables/sales)* days in the period
what does an aging schedule of accounts receivable outstanding look like?
what does pattern of receipts for credit sales look like?
cash management
why hold cash?
• Most businesses hold cash but the amount held
varies considerably
• There are three reasons for holding cash:
• Transactionary
• Precautionary
• Speculative
cash management
how much cash should be held?
• 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
cash management
Use of upper and lower control limits to control the
cash balance:
what does this assume?
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
cash management
Use of upper and lower control limits to control the
cash balance:
what does this model rely heavily on?
• 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
cash management
Use of upper and lower control limits to control the
cash balance:
what happens if the outer limit is exceeded?
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
cash management
Use of upper and lower control limits to control the
cash balance:
what does this model propose?
The model proposes the use of two upper and two lower limits
what purpose do budgeted cash flows serve for management of cash
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
cash flow management, what should managers produce?
budgeted cash flows in addition to cash flow statement
management of cash
what is the operating cash cycle?
The time period between the outlay of
cash to purchase suppliesand the ultimate receipt of cash from the sale of goods
number of days cash is tied up in the operations of the business
what must cash management be aware of to effectively manage cash?
To effectively manage cash, there must be
awareness of the operating cash cycle
management of cash
what do managers seek from the operating cash cycle?
Management seeks to shorten the time and reduce
cashrequired in the cycle
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
management of cash
what is the operating cash cycle equation?
Operating cash cycle = inventory turnover in days +
accounts receivable turnover in days – accounts
payable turnover in days
processes in operating cash cycle
Acquire inventory –> store inventory –> sell inventory (sale of goods) —> collect cash —> acquire inventory
formula for turnover in days when the only information provided is turnover in times?
Turnover in days = days in the period/turnover in times
eg. 365/7
Comment on the company’s management of
working capital:
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
management of accounts payable
what is trade credit often associated with? what are the costs?
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 lower priority in terms of delivery dates
• Administration costs associated with dealing with
invoices and confirming receipt of goods / service
management of accounts payable
rise in trade credit is consistent with?
rise in sales
management of accounts payable
what may the business use?
use trade credit
how may you control trade credit?
• 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
management of accounts receivable
what is trade credit?
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.
Management of accounts payable
what should businesses try to do
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
