Working Capital and Operating cycle Flashcards
Define Working capital
Short-term assets and liabilities
- capital available to fund the day-to-day operations of an entity
- excess of your current assets over current liabilities
What does working capital management involve
The balance between the requirement to minimise the risk of insolvency (due to insufficient cash)
and the requirement to maximise profits (through minimising costs and maximising returns)
What is the working capital cycle?
Period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser
also known as the cash cycle/ operating cycle
How is the working capital cycle calculated?
Inventory days + Receivables days - Payable days
=Number of days of ‘cash’ we need
What does the inventory days ratio show
How long on average goods are held in inventory before they are sold
Generally the lower the better
When an entity is manufacturing business what elements are in the inventory days ratio
Raw material days, Work-in-progress days, Finished good days
Inventory Days Ratio Formula
(Average Inventory/ Cost of Sales) x 365 Days
How to work out average Inventory
Opening Balance - Closing balance / 2
How to find inventory ratio in days
Average inventory/ cost of sales x 12
What does an increasing trend in inventory days show
Increasing ratio: slowdown in trading - business should take action
Or due to an active decision to build up inventory by management
Need to compare to an industry average to identify potential issue
Define Receivable days
Shows how long on average customers take to pay for goods bought on credit
Receivable days ratio formula
Average Receivables/ Credit sales x 365 days
What are the risks of receivables
-Cash tied up in inventory
- Risk of Debt
- Slow Payment risks
What considerations are there for the receivables ratio?
Receivables days raito should compared with an entity’s credit terms to determine effectiveness
An increasing ratio could indicate that customers are having financial difficulty
What is the payable day ratio formula?
Average Payable days/ Credit purchases x 365 days
What does the payables days ratio show
On average how long does the business take to pay for goods they have bought on credit
How to work out Raw material days
Average raw materials/ Raw materials purchased or used x 365
How to work out WIP days
Average WIP/ Cost of production (factory costs) x 365
How to work out working capital
Raw materials period + WIP period + Finished good periods + Receivables period - Payables period = working capital
How to work out Finished good days
Average finished goods/ cost of sales x 365
What are actions that could be taken to decrease working capital?
- Reduce Raw materials ordered or just in time order (risk of not having enough stock)
- Reduce WIP days by speeding production (costs involved to speed up)
- Reduce FG days- extra marketing, reduce prices (costs incurred decrease in profits)
- Reduce receivable days - offer discounts and chase for payments (upsetting customers, costs incurred)
- Increase time to pay suppliers to increase payables (discounts lost, risk of losing suppliers)
What does liquidity measure
An entity’s ability to meet its debts as they fall due
Current Ratio
How many times an entity’s current assets cover its current liabilities
Current Assets/ Current Liabilities
What current ratio is ideal for most businesses
At least 1 and ideally 2
Quick Ratio formula/Acid test ratio
- more prudent than the current ratio
(Current Assets- not including Inventory )/ Current liabilities
What is the ideal quick ratio for business
at least 1
What is the point of calculating liquidity and working capital ratios
To compare them to prior periods to identify trends (3 lots of figures)
To set budgets and targets
To compare against competitors
To compare against industry averages
To decide if any action needs to be taken
What is a markup price
Markup is the difference between the cost of goods and the price you are selling it for
What are the risks of not monitoring working capital
Over capitalisation
Over trading
What is meant by over-capitalisation
The entity has an excess of working capital - too much cash
Carry too much inventory, receivables and cash with few payables so have over-invested in current assets
What is meant by overtrading
Condition of a business which enters into commitments in excess of its available short-term resources
- even if trading profitability
- Lack resources and cash to pay debts and can go into liquidation
How are current assets split?
Permanent current assets - core levels of cash and inventory that will be maintained
Fluctuating current assets - these vary from period to period depending on level of activity
What does financing working capital involve
A mixture of short term and long-term funding
- Businesses with higher level of risk will hold fewer permanent current assets
What possible policies exist to finance working capital
- Conservative policy
- Aggressive policy
- Moderate POlicy
What is the conservative policy of financing working capital
All permanent assets (current and nca) and some fluctuating current assets are financed by long-term funding
What is an aggressive policy of financing working capital
All of the fluctuating and part of the permanent current assets are financed by short-term funding
What is the moderate policy of financing working capital?
Short-term funding is used to finance fluctuating current assets and permanent assets (current and nca) are financed by long-term funding
What are the symptoms of an entity that is over trading
- Increasing current liabilities
-Increasing inventory, trade recievables and current liabilities
