Working capital and cash flow Flashcards
What is working capital?
Value of current assets less value of current liabilities
What are the main objectives of working capital management?
- Increase the profits of a business
- To provide sufficient liquidity to meet short-term obligations as they fall due
What is liquidity?
What determines a business’s ability to survive
How can a business’s liquidity position be assessed?
- Ratios
- Via cash operating cycle
Compared with the same company in previous periods/other companies in the same industry
What is inventory turnover period and how is it calculated?
Shows the average length of time that inventory is held for.
(Average inventory / cost of sales) x 365
What is the rate of inventory turnover?
Monitors how many times inventory turns over during the trading period. Want it to be as high as possible.
Cost of sales / average inventory
What is the receivables collection period?
Monitors how long on average it takes to collect debts. The shorter the period, the lowest the capital cost of money invested in receivables.
= (average receivables / annual sales revenue) x 365
What is the payables payment period?
Monitors how long on average the company waits before paying its suppliers. This should be as long as possible.
(Average payables / annual purchases) x 365
N.B. if annual purchases isn’t available, COS can be used
What is the current ratio?
Measures the ability to meet short-term liabilities from easily or quickly realisable current assets. A higher ratio is generally preferable.
Current assets / current liabilities
What is the quick test?
AKA liquidity or acid test. Excludes inventory from the current assets.
(Current assets - inventories) / current liabilities
What is the cash operating cycle?
The period of time between the outflow of cash to pay for raw materials and the inflow of cash from customers.
What is the cash operating cycle also known as?
Working capital or cash conversion cycle
How do you calculate the cash operating cycle?
Raw materials holding period \+ Average production period \+ Average inventory-holding period \+ Average receivables collection period - Average payables payment period
How do you calculate raw materials holding period?
(Average inventory of raw materials/annual usage) x 365
What is average production period?
(Average inventory of work in progress / annual cost of sales) x 365
What happens to the level of investment in working capital over the period of the working capital cycle?
It increases considerably due to the timing of cash inflows and outflows.
What influences the level of investment in working capital?
- timing of cash inflows and outflows
- growth
- inflation
What are the limitations of using ratios or the working capital cycle to assess a business’s liquidity position?
- Balance sheet values at a particular point in time may not be typical
- Balances for a seasonal business will not represent average levels
- Such measures concern the past, not the future.
In addition to ratios and the working capital cycle, what should be considered with regards to a business’s liquidity position?
Trends and industry averages
When will the amount of cash required to fund the cash operating cycle increase? What is this known as?
When:
- Cycle gets longer
- Sales (and hence purchases of inventory required) increases
Known as OVERTRADING
Why may overtrading occur at the start of a new business?
- Rapid growth, have to offer credit to customers
- May be getting little credit from suppliers due to poor credit rating
What may be the consequences of overtrading?
- Need to find extra finance to cover working capital needs
- Need to sell assets
- Insolvency
What are the solutions to liquidity problems?
Aim to REDUCE the length of the cash operating cycle.
- Reduce inventory-holding period
- Reduce the production period
- Reduce customers’ credit period and tightening up on cash collection
- Extending period of credit taken from suppliers
What are the costs associated with holding inventory?
- Purchase price
- Holding costs
- Ordering costs
- Shortage costs (i.e. if you run out of stock)
What is a re-order level system for inventory management?
Fixed quantity will be ordered whenever inventory falls to a predetermined level.
Aims to minimise costs while providing necessary supply to users.
What is a periodic review system for inventory management?
Inventory levels are reviewed at fixed time intervals to fit in with production schedules. Variable quantities are ordered as appropriate. (Manual system)
What is an ABC system for inventory management?
Aims to reduce work involved in a business which may have several thousand types of inventory items.
Inventory is categorised into classes A, B or C according to the annual cost of the usage of that inventory item OR the difficulty of replacements OR the importance to the production processes.
Class A takes most of the inventory control effort, B less and C the least.
What is the economic order quantity model for inventory management?
EOQ quantifies the costs involved in inventory management and calculates the order quantity which minimises the total inventory costs (holding + ordering).
EOQ is calculated using the formula to give the annual demand.
What are the terms used in the economic order quantity model?
D = Annual demand in units Co = Cost of placing an order Ch = Annual cost of holding one unit in inventory
What are the drawbacks of the EOQ model?
- Ignores fluctuations in demand (assumes it occurs evenly throughout the year)
- Ignores the benefit of holding inventory to customers
- Ignores the benefit of bulk-buying discounts.
What are the disadvantages of using trade credit as a source of finance?
- Supplier may refuse to supply
- May have to pay penalties / lose discounts
- Damages credit rating, making finance more expensive
What are the advantages of using trade credit?
- Convenient and informal
- Can be used by businesses that do not qualify for credit from financial institutions
- It can represent a virtual subsidy or sales promotion device offered by the seller (to attract customers)
- It can be used on a very short-term basis to overcome unexpected cash flow crises
At what level should credit control and collection policies be set?
Board level
What are credit control and collection policies influenced largely by?
Trade custom
On which documents should a company communicate its credit terms to customers?
- Orders
- Invoices
- Statements
What are early settlement discounts largely influenced by?
Custom and practice within the industry
What should businesses compare early settlement discounts to?
The cost of other sources of short-term finance, e.g. bank overdraft
In which ways could trade receivables collection be sped up?
- Clear procedures
- Suspending supplies if customer does not pay on time
- Use debt collection agency or factor
- Prompt issue of credit notes
- Set targets fr accounts receivables ledger team
- Pay commission to sales people based on cash collected instead of sales made
- Build good relationships with customers
What are the ways of financing trade receivables?
- Invoice discounting
- Receivables factoring
What is invoice discounting?
Invoices are sold to a discounting company for a cash sum. The discounter is then repaid when the debtor pays the invoice.
The business receives less from the discounter than it pays to the discounter.
Business retains full responsibility for the sales ledger, credit control and collection functions.
What three elements are contained in receivables factoring?
- Accounting and collection
- Credit control
- Finance against sales (i.e. get money early)
What are the usual fees for receivables factoring?
2-3% of an invoice value as an administration charge, plus a charge for cash advances
What are the disadvantages of using a receivables factor?
- Expensive
- Loss of customer contact (may think the company is in trouble)
What is good practice in receivables management?
- Look after key accounts: 20% of customers usually represent 80% of the debts, these customers must receive special attention.
- Manage time scales: attempt to reduce time between placement of order and receipt of cash from the customer, and eliminate any cases of disputes or non-payments.
What is trade credit insurance?
It insures a business against the possible default and insolvency of its credit customers and, where exports are involved, political risk.
Useful tool in credit management as it helps to minimise possible problems from late payment and bad debts.
What is the primary aim of good cash management?
Have the right amount of cash at the right time
What does good cash management involve?
- Accurate cash budgeting/forecasting
- Planning short-term finance when necessary
- Planning investment of surpluses when necessary
- Cost-efficient cash transmission
If a cash deficit is forecast, what are sources of short-term finance that businesses may use?
- Receivable factoring and invoice discounting
- Bank overdrafts
- Short-term bank loans
- Operating leases
What factors should be considered when choosing how to invest surplus funds?
- Risk vs return
- Length of time required
How may surplus funds be invested?
In order of increasing length of time:
- Treasury bills
- Deposits
- Gilts
- Bonds
- Equities
What is a cash budget?
A statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
What do cash budgets enable?
- Management to make any forward planning decisions that may be needed
- An indication of potential problems that may arise and gives management an opportunity to take action to avoid them.
