Working Capital Management

Question 1

What is Working Capital Management?

Answer 1

The capital available for conducting the day-to-day operations, normally the excess of current assets over current liabilities.

Management of current assets and liabilities to minimise the risk of insolvency while maximising return on assets

Question 2

What do CA’s require?

Answer 2

Funding - reducing funding levels e.g. cash t buy inventory, cash delayed from offering credit

Question 3

What do Current Liabilities provide?

Answer 3

Funding: consider increasing levels of funding e.g. cash delayed from accepting credit from a supplier.

Question 4

Does investing on working capital have a cost?

Answer 4

Yes: cost of funding it, the high opportunity costs of lost investment opportunities because cash is tied up in working capital and not available for other uses

Question 5

What is the main objective of working capital management?

Answer 5

Balance of current assets and current liabilities. Otherwise seen as a trade off between profitability and liquidity.

Question 6

If a business has large amounts of cash available to pay bills, what is it known as?

Answer 6

Liquid- liquidity is the priority

Question 7

If a company has high liquidity, but invests in offering better credit terms to its customers, this would decrease liquidity but increase … ?

Answer 7

Profitability

Question 8

What is an aggressive approach to working capital management?

Answer 8

Low levels of working capital - low current assets - high current liabilities - high profitability = high risk

Question 9

What is a conservative approach to working capital management?

Answer 9

High levels of capital management - high CA’s - Low CL’s - lower profitability = lower risk

Question 10

What is over-capitalisation on working capital management?

Answer 10

Excessive CA’s and low CL’s

An over investment by the business in CA’s. Profitability will suffer

Question 11

What will healthy trading lead to?

Answer 11

Increased profitability

Need to increase investment in NCA’s and working capital

Question 12

What is over trading and it’s concequences?

Answer 12

When a business does not have sufficient capital to fund the increase
A business may not be able to pay it’s business payables

Question 13

What are the indicators of over trading?

Answer 13

rapid increase in revenue
rapid increase in volume of CA’s
Most of the increase n assets being financed by credit
Dramatic crop in liquidity ratios

Question 14

What is the current ratio?

Answer 14

Measure of how much of the total CA’s are financed by CL’s

A ratio of 2:1 means liabilities can be paid twice over out of the current assets

Question 15

What is the quick acid test ratio?

Answer 15

Measure how well CL’s are covered by liquid assets

1:1 means the entity is able to meet existing liabilities if they fall all at once

Question 16

When is the quick acid test ratio useful?

Answer 16

When inventory folding periods are long

Question 17

A company has $25m of current assets, of which $5m are inventory.
Its current liabilities stand at $15m.

What is the current ratio?

Answer 17

25m/15m=1.67

Question 18

A company has $25m of current assets, of which $5m are inventory.
Its current liabilities stand at $15m.

What is the quick ratio?

Answer 18

(25m-5m)/15m = 1.33

Question 19

What is the cash operating cycle?

Answer 19

Cash - payables
    |
purchases
     |
RAW MAERIALS
     |
production
    |
WORK IN PROGRESS
        |
production 
     |
FINISHED GOODS
    |
sales
   |
RECEIVABLES
    |
collections  (link back round to cash)

Question 20

A company has provided the following information:
Raw material inventory holding period 25 days
Payables payment period 40 days
Production period (WIP) 5 days
Finished goods holding period 15 days
Receivables collection period 66 days
Calculate the length of the cash operating cycle.

Answer 20

Cash cycle = 25 – 40 + 5 + 15 + 66 = 71 days

Question 21

How do you calculate the Current ratio?

Answer 21

current assets/ current liabilities

Question 22

How do you calculate the quick ratio (acid test)?

Answer 22

(Current assets - inventory) / current liabilities

Question 23

How do you calculate the receivables collection period in days?

Answer 23

Receivables / daily sales

OR

(Receivables x 365) / total sales

Question 24

How do you calculate the payables payment period in days?

Answer 24

Payables / daily purchases

OR

(payables x 365) / total purchases

Question 25

How do you calculate the inventory holding period?

Answer 25

Inventory / cost of sales x 365

Question 26

How do you calculate the raw materials ratio

Answer 26

Stock of raw material / raw material usage x365

if usage isn’t available use purchases

Question 27

How do you calculate the work in progress ratio?

Answer 27

work in progress / cost of production. x 365

Question 28

How do you calculate the finished goods ratio?

Answer 28

stock of finished gods / cost of sales. x 365

Question 29

How do you calculate the inventory turnover ratio?

Answer 29

total cost of sales / average inventory held

Question 30

What are some factors that affect the length of the cycle?

Answer 30

liquidity versus profitability decisions
terms of trade
management efficiency
industry norms e.g. retail versus construction.
The optimum level of working capital is the amount that results in no idle cash or unused inventory but that does not put a strain on liquid resources.

Question 31

A company has the following figures from its most recent accounts:
Receivables $13.7m
Trade payables $7.5m
Inventory (raw materials) $2.1m
Inventory (WIP) $1.1m
Inventory (finished goods) $5.9m
Sales (90% on credit) $105.9m
Materials purchases (100% on credit) $77.7m
Cost of sales $80.5m
Calculate the relevant working capital ratios. Assume 365 days in a year and round calculations to the nearest day.

Answer 31

Raw material inventory holding period: $2.1m/$77.7m × 365 = 10 days
WIP inventory holding period: $1.1m/$80.5m × 365 = 5 days
Finished goods inventory holding period: $5.9m/$80.5m × 365 = 27 days
Finished goods inventory turnover: $80.5m/$5.9m = 13.6 times
Receivables days: $13.7m/($105.9m × 90%) × 365 = 52 days
Payables days: $7.5m/$77.7m × 365 = 35 days

Question 32

How can working capital ratios formulae be changed to calculate the current level of investment (the SFP Figure)?

Answer 32

Trade receivables days/365 × credit sales

Question 33

A company has the following expectations for the forthcoming period:
Sales $30m
Materials costs $20m
Other costs $4m
Profit $6m
The following working capital ratios are expected to apply: Inventory days 45
Receivables days 65
Payables days 35
Calculate the working capital requirement.

Answer 33

Days = SFP figure/SPL figure × 365 
SFP figure = Days × SPL figure/365 
Inventory = 45 × $20m/365 = $2.47m 
Receivables = 65 × $30m/365 = $5.34m
Payables = 35 × $20m/365 = $1.92m 
Working capital required = $2.47m + $5.34m – $1.92m = $5.89m

Question 34

High inventory levels lead to?

Answer 34

The foregone interest that is lost (or borrowing interest that is paid) from tying up capital in inventory.
Holding costs: – storage – stores administration – risk of theft/damage/obsolescence.

Question 35

Low inventory levels lead to?

Answer 35

High re-order/set up costs.
Stock outs: – lost contribution – production stoppages – emergency orders.
Lost quantity discounts.

Question 36

What are the objectives of good inventory management?

Answer 36

optimum re-order level (ROL) how much should be left before re-ordering
optimum re-order quantity (EOQ) how many items should be ordered

Question 37

What is the aim of the EOQ model?

Answer 37

minimise total cost of holding and re-ordering inventory

Question 38

EOQ A company requires 2,000 units of material A per month.
The cost per order is $250 and the holding costs of inventory are $1.33 per unit per year.
Investigate the total cost of buying the material in quantities of 2,000, 3,000 and 4,000 units at a time.
Which is the cheapest option?
Use the EOQ formula to prove your answer is correct.

Answer 38

Ordering cost = D/Q × Co
Holding cost = Q/2 × Ch
For 2,000 units: D = 2,000 × 12 = 24,000
Ordering cost = 24,000/2,000 × $250 = $3,000
Holding cost = 2,000/2 × $1.33 = $1,330 Total cost = $4,330
For 3,000 units: Ordering cost = 24,000/3,000 × $250 = $2,000 Holding cost = 3,000/2 × $1.33 = $1,995
Total cost = $3,995
For 4,000 units: Ordering cost = 24,000/4,000 × $250 = $1,500 Holding cost = 4,000/2 × $1.33 = $2,660
Total cost = $4,160
EOQ = √(2 × $250 × 24,000/$1.33) = 3,004 units

Question 39

Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size needed for a discount, should the order size be increased above the EOQ?

Answer 39

Step 1: Calculate EOQ, ignoring discounts.
Step 2: If the EOQ is below the quantity qualifying for a discount, calculate the total annual inventory cost arising from using the EOQ.
Step 3: Recalculate total annual inventory costs using the order size required to just obtain each discount.
Step 4: Compare the cost of Steps 2 and 3 with the saving from the discount, and select the minimum cost alternative.
Step 5: Repeat for all discount levels.

Question 40

A company has annual demand for its product of 200,000 units. Assume that the company adopts an order level of 20,000 units and that the lead time from the supplier is four weeks. 
What is the reorder level?
How frequently (in weeks) will an order be made?

Answer 40

Demand in one week = 200,000/52 = 3,846 units.
Demand in the lead time = 3,846 × 4 = 15,384 units = re-order level.
Orders per year = 200,000/20,000 = 10
52/10 = 5.2
Orders will be made every 5.2 weeks

Question 41

What is the Just in time system?

Answer 41

JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory levels and improve customer service by manufacturing not only at the exact time customers require, but also in the exact quantities they need and at competitive prices.
In JIT systems the balancing act is dispensed with. Inventory is reduced to an absolute minimum or eliminated altogether.

Question 42

What is the periodic review system?

Answer 42

Inventory levels are reviewed at fixed intervals and then topped up to a predetermined level.

Question 43

What will a company’s credit policy be influenced by?

Answer 43

demand for products 
competitors’ terms 
risk of irrecoverable debts 
financing costs 
costs of credit control

Question 44

What are the four key aspects of a credit policy?

Answer 44

assess creditworthiness – new customers immediately – existing customers periodically
credit limits – amount of credit – length of time allowed before payment
invoice promptly and collect overdue debts – to reduce risk of default
monitor the credit system – aged receivable reports – ratios – statistical data

Question 45

How do you work out the finance cost?

Answer 45

Finance cost = Receivable balance x interest (overdraft) rate
[Receivable balance = Sales x Receivable days/365]

Question 46

ABC Co has sales of $50m for the previous year.
Receivables days are 57 and receivables are financed using an overdraft costing 6% per annum.
Calculate the receivables balance and the annual financing cost for receivables.

Answer 46

Receivables balance = $50m x 57/365 = $7,808,219

Financing cost = $7,808,219 × 6% = $468,493

Question 47

What are early settlement discounts?

Answer 47

Cash discounts may be offered by the company to encourage early payment by customers.
Cost = cash lost from receiving less money from customers (profitability sacrificed, lower liquidity)
Benefit = cash received earlier = lower receivables balance = lower working capital funding requirement (liquidity enhanced, lower funding cost)
Discounts may also reduce the number of irrecoverable debts.

If the cost of offering the discount exceeds the benefit of the saved funding cost, then the discount should not be offered.

Question 48

What is invoice discounting?

Answer 48

Invoice discounting is a method of raising finance against the security of receivables without using the receivables ledger administration services of a factor

Question 49

What is factoring?

Answer 49

Factoring is outsourcing of the credit control department to a third party.

Question 50

ABC Co has sales of $50m for the previous year.
Receivables at the yearend were $7,808,219 and receivables are financed using an overdraft costing 6% per annum.
Receivables days are 57.
The current receivables financing cost is $468,493.
ABC Co is now considering using a debt factor. It has been in negotiations with two factors who are offering different terms.
The first factor will operate on a service-only basis. ABC would be able to make administrative savings of $50,000 from this service. The factor also undertakes to pay all invoices within 30 days instead of the current 57. For its services the factor will charge a fee of 0.5% of ABC Co’s revenue.
The second factor will advance 85% of the book value of ABC Co’s invoices immediately at a cost of 7% in addition to administering the receivables ledger. The remaining 15% of sales will continue to be paid on average over 57 days. The factor promises administrative savings of $100,000 and will charge a fee of 0.25% of all sales.
Determine whether either of the factor offers is acceptable to ABC Co

Answer 50

First factor:
Savings = admin saving plus reduced receivables financing cost.
New receivables balance at 30 days = $50m × 30/365 = $4,109,589
Financing cost for these receivables at 6% = $246,575. Saving compared to old financing cost = $468,493 – $246,575 = $221,918
Plus admin saving of $50,000 = total saving of $271,918.
Factor fee = $50m × 0.5% = $250,000.
This is acceptable to ABC Co, leading to a net saving of $21,918.

Second factor:
On 85% of sales the factor will make immediate payment, removing the 6% overdraft cost for the receivables in relation to those sales.
Instead, however, the factor will charge a 7% cost. So that will represent an increase of 1% in terms of the financing cost for these receivables. $7,808,219 × 85% = $6,636,986.
Extra cost at 1% = $66,370.
Factor fee = $50m × 0.25% = $125,000
Total cost = $191,370
Admin saving: $100,000
This is not acceptable to ABC Co as they will be $91,370 worse off.

Question 51

What are the motives for holding cash?

Answer 51

transactions motive – to meet day-to-day expenses
precautionary motive – to meet unplanned expenditure
investment motive – to take advantage of investment opportunities
Failure to hold enough cash can lead to:
loss of settlement discounts – not enough cash available to pay suppliers early
loss of supplier goodwill – too many delayed payments can lead to issues
poor industrial relations – from delay in workers being paid
potential liquidation – if creditors bring company into administration for non-payment

Question 52

What is a cash budget and what is it used for?

Answer 52

A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the forecast into line with the overall business plan. 
Cash budgets are used to: 
assess and integrate operating budgets 
plan for cash shortages and surpluses 
compare with actual spending.

Question 53

What is a cash forecast and how can it be used?

Answer 53

A cash forecast is an estimate of cash receipts and payments for a future period under existing conditions.

Cash forecasts can be prepared based on:
A receipts and payments forecast.
A statement of financial position forecast.
Working capital ratios.

Question 54

Sales (before discounts) for a company are predicted to be as follows:
Month 1 2 3 4 5 6
($000) 50 55 58 63 70 74
20% of the sales will be for cash, with customers taking a 2% discount.
40% of sales will pay in the following month and 35% in two months.
The remaining 5% will be written off as bad debts.
Calculate the cash receipts for months 3 to 6.

Answer 54

Month		 	3 	4 	5 	6 
Cash (20% × 98%) 	11.4 	12.3 13.7 	14.5
1 month (40%) 	22 	23.2 25.2  28 
2 months (35%)	 17.5  19.3  20.3  22.1 
Total ($000)		 50.9  54.8  59.2 64.6

Question 55

What are cash management models and give two examples?

Answer 55

Cash management models are aimed at minimising the total costs associated with movements between:
a current account – very liquid but not earning interest (making profit)
short-term investments – less liquid but earning interest

Question 56

What is the Miller-Orr model?

Answer 56

Return point= lower limit + (1/3 X Spread)

Spread = 3[(3/4 X Transaction cost X variance of cash flows)/ interest rate] 1/3

Question 57

What must you do when weighing up a short-term cash investment?

Answer 57

These are used for temporary cash surpluses.
To weigh up an investment a company has to weigh up three potentially conflicting objectives and the factors surrounding them.
liquidity – the cash must be available for use when needed as the surplus is only short-term
safety – no risk of loss must be taken as once the surplus period is over the investment must be converted back into enough cash to meet the business needs
profitability – subject to the above, the aim is to earn the highest possible after-tax returns

Question 58

What is short-term borrowing and give the two main examples and their advantages and disadvantages?

Answer 58

bank overdraft
– flexible and cheap as only used when needed – but repayable on demand, may require security and interest rates can change
bank loans
– less flexible and more expensive as paying for a fixed period even if cash balances recover
– but more secure

Question 59

List the benefits and problems with short-term debt

Answer 59

Usually cheaper
More flexible

Renewal problem
Risk due to changing interest rates

Question 60

What are the strategies for funding working capital?

Answer 60

Current assets are made up of two elements:
permanent – the proportion of current assets that are effectively ‘fixed, e.g. buffer inventory levels, minimum receivables and minimum cash balances.
fluctuating – the proportion of current assets that changes, e.g. inventory above the buffer level, receivables above the minimum level.
The choice of funding working capital is either from:
short-term sources – cheaper due to lower risk for investor, but more risky as may not be renewed.
long-term sources – more expensive than short-term but less risky.

The strategy adopted depends on management’s attitude to risk
aggressive – finance most current assets, including permanent ones, with short-term finance. Risky but cheaper (more profitable).
conservative – finance most current assets, including a portion of fluctuating ones, with long-term finance. Safer but more expensive.
matching – fluctuating current assets financed with short-term sources, permanent current assets financed by long-term sources