Working capital (7)

Question 1

State the working capital formula

Answer 1

Current assets - current liabilities

Question 2

State the equations used to assess a business’ liquidity position

Answer 2

Current ratio = current assets/ current liabilities
- a ratio of less than 1 indicates a business will struggle to pay its current liabilities

Quick ratio = current assets - inventory/ current liabilities
- a more realistic measure of a business’ ability to meet its short-term commitments

Question 3

State the equations used to identify the causes of a liquidity problem

Answer 3

Inventory period (in days) = inventory/cost of sales x 365

Receivables collection period (in days) = receivables/sales x 365

Payables payment period (in days) = payables/ cost of sales x 365

Question 4

Define the working capital cycle

Answer 4

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

Question 5

State the formula for calculating the working capital cycle

Answer 5

Receivables collection period + raw materials inventory holding period + WIP inventory holding period + finished goods inventory holding period - payables payment period

Question 6

State the receivables collection period formula

Answer 6

Receivables collection period = (average receivables/annual sales revenue) x 365

Question 7

State the raw materials inventory holding period formula

Answer 7

Raw materials inventory holding period = (average inventory of raw materials/annual usage) x 365

Question 8

State the WIP inventory holding period

Answer 8

WIP inventory holding period = (average inventory of WIP/ annual cost of sales) x 365

Question 9

State the finished goods inventory holding period

Answer 9

Finished goods inventory holding period = (average inventory of fin goods/annuals cost of sales) x 365

Question 10

State the payments payable period

Answer 10

Payables payment period = (average payables/annual purchases) x 365

Question 11

Define the Economic Order Quantity (EOQ) model and state the formula

Answer 11

The EOQ 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)^0.5
where c = cost of placing one order
d = demand for the item over the period
h = holding cost of one unit of inventory for that period

Question 12

There are four reasons why a company would want to hold cash in a cash float or a bank current account, state them

Answer 12

Transactions motive - to meet day-to-day obligations e.g. payroll
Finance motive - to cover major items
Precautionary motive - to cover against unexpected outlays
Investment/speculative motive - to take advantage of new investment opportunities

n.b. - profitability objective would minimise the holdings of cash, the liquidity objective would maximise the holdings of cash to ensure that the firm’s cash obligations can always be met

Question 13

Define a cash budget and state its two main objectives

Answer 13

A cash budget is a detailed budget of estimated cash inflows and outflows incorporating both revenue and capital items

The preparation of cash budgets or budgeted cash flow statements has two main objectives:

• to 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