Working capital management Flashcards
What does working capital management include?
Working capital management includes the following:
- Inventories
- Trade payables
- Trade receivables
- Cash
Efficiency ratios?
Efficiency ratios?
- Asset turnover (times) = Revenue ÷ capital employed
OR: Total asset turnover (times) = Revenue ÷ total assets
- Non-current asset turnover (times) = Revenue ÷ non-current assets
- Inventories turnover (times) = Cost of goods sold ÷ inventory
OR: Inventory holding period (days) = Inventory × 365 ÷ cost of goods sold
- ) Rate of collection of trade receivables (days) = Trade receivables × 365 ÷ credit sales (or revenue)
- Rate of payment of trade payables (days) = Trade payables × 365 ÷ credit purchases (or cost of goods sold)
- Working capital cycle (days) = Inventory holding (or storage) period + trade receivables collection period – trade payables payment period
- Current ratio (X:1) = Current assets ÷ current liabilities
- Quick ratio (X:1) = (Current assets – inventory) ÷ current liabilities
The nature and purpose of working capital?
The nature and purpose of working capital?
Working capital is the difference between current assets and current liabilities. An asset expected to be realised, consumed or sold within the normal operating cycle of the business is referred to as a current asset. In the same manner, a liability is treated as a current liability if it is due to be settled within the normal operating cycle of the business.
Working capital is the total amount of capital tied up in current assets and current liabilities.
This normally includes:
- inventories,
- trade receivables,
- cash and cash equivalents
- less trade payables
All of which are available for day-to-day operating activities.
Working capital = inventory + trade receivables + cash and cash equivalents – trade payables
working capital is the lifeblood of an organisation and a company cannot survive without working capital funds.
Finance can be
- long term (Loans or issue of shares)
- or short term (overdrafts or delay of payment to suppliers)
What is ‘permanent and temporary working capital’?
What is ‘permanent working capital’?
- Permanent working capital
Permanent working capital is fixed is fixed and should be financed by long term sources of finance.
permanent working capital is the minimum level of working
capital required to continue uninterrupted day-to-day business activities.
- Temporary working capital
Fluctuates day to day above this level of permanent working capital and should be financed by short erm sources of finance.
Temporary working capital is the additional financial requirement that arises out of events such as seasonal demand for products or business activity.
Working capital cycle (WCC) of a product provider versus a service provider?
Product provider or manufacturer WCC:
- Cash
- Purchase inventory
- Supplier payment
- Work in progress
- Finished goods
- Sales
- Receivables
Then the cycle starts again from 1.
Service provider WCC:
- Cash
- Revenue
- Trade recievables
What factors determine working capital cycle?
What factors determine working capital cycle?
Working capital requirements change from time to time as per the size and nature of industries as well as other internal and external factors.
In general, the following factors affect requirement of working capital :
- Nature of business
- Size of business
- Production policy
- Seasonal fluctuations
- Credit policies
In general, the following factors affect requirement of working capital :
- Nature of business
- Size of business
- Production policy
- Seasonal fluctuations
- Credit policies
Describe the above?
- Nature of business
The investment in working capital depends on the nature of the business, product type and production techniques. For example, retail companies have a low cash cycle with few credit customers, high supplies on credit terms and a large inventory to cater to the demands of customers.
Manufacturing companies have a long cycle with significant current assets. The service sector does not hold any finished goods and has an insignificant amount of liabilities.
- Size of business
The larger the size of business, the greater the working capital requirements to support its scale of operation. However, a small business may also need a large amount of working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of a smaller business.
- Production policy
Some companies manufacture their products when orders are received while others manufacture products in anticipation
of future demands.
- Seasonal fluctuations
If the demand for the product is seasonal, the working capital required in that season will be higher. For example, there is
greater demand for air conditioners in summer.
- Credit policies
A liberal sales credit policy demands a higher level of working capital as it prolongs the debtors’ collection period and vice versa.
However, a liberal credit policy without consideration of the creditworthiness of the customers will land the business in trouble and the requirements of working capital will also unnecessarily increase.
Similarly, a tight credit policy from suppliers shortens the creditors’ settlement period and lengthens the WCC, requiring the need for alternative finance.
How do you calculate the WCC?
How do you calculate the WCC?
WCC = inventory holding (or storage) period + trade receivables collection period – trade payables payment period
Inventory holding period is the average number of days taken to process or sell inventory. it can be further broken down by the following…?
- Inventory holding (days)
(a) Finished goods = [FG ÷ cost of goods sold] × 365
(b) Work in progress = [WIP ÷ cost of production*] × 365
(c) Raw materials = [RM ÷ RM consumed] × 365
- Rate of collection of trade receivables (days) =
a ) Trade receivables × 365
b) Credit sales (or revenue)
- Less: Rate of payment of trade payables (days) =
a) Trade payables × 365
b)Credit purchases (or cost of goods sold
What is overcapitalisation?
Every company should have adequate or optimum working capital to run its operations efficiently and effectively, but
without holding too much working capital.
Holding high levels of working capital means the entity has idle funds with unnecessary cost implications – a phenomenon known as overcapitalisation.
A low level of working capital can result in a situation where the company is not able to meet its day-to-day demands
(such as paying bills – including salaries and wages – when they arise) and may lead to insolvency.
What is Overtrading associated with?
Overtrading is associated with…
A rapid increase in revenue that is not supported by sufficient working capital. The signs of overtrading are:
- a rapid increase in revenue and the volume of current assets
- most of the increase in assets being financed by credit
- a dramatic drop in liquidity ratios
A conservative approach to working capital vs aggressive approach ?
A conservative approach to working capital consist of:
- Higher level of working capital
- Higher liquidity
- Cash tied up
- Lower profitability
- Lower risk
Aggressive approach includes:
- Lower level working capital
- Lower liquidity
- Cash savings
- Higher profitability
- Higher risk
Management decides on the optimal level and proper management of working capital that results in no idle cash or unused inventory, but also does not put a strain on liquid resources needed for the daily running of the business. The
company faces a trade-off between profitability and liquidity.
Why is working capital needed in a business? What is the optimal level of working capital?
Working capital is the total amount of cash tied up in current assets and current liabilities which normally includes
inventories, receivables, cash and cash equivalents, less payables.
All of these are available for day-to-day operating activities. Businesses need working capital in order to keep the business running. It enables businesses:
- to allow customers/trade receivables to buy on credit – offering credit provides a competitive advantage in the
market; - to carry inventories of finished goods to meet customer demand; and
to have cash to pay the bills. A company needs working capital to pay salaries, wages and other day-to-day
obligations.
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 needed for the daily running of the business.
The company faces a trade-off between profitability and liquidity. Management decides on the optimal level of working capital to ensure that it is managed properly.
Holding high levels of working capital implies holding idle funds with unnecessary cost implications, a phenomenon known as ‘overcapitalisation’.
Low working capital can result in a situation where the firm is not able to meet its demands.
Liquid Ratios?
Financial managers use liquidity or working capital (WC) ratios to control and monitor working capital. Two main ratios are employed.
The first is the current ratio or the WC ratio, calculated as:
Current assets ÷ current liabilities
A current ratio of less than one could indicate liquidity problems. While there is a general target current ratio of 2:1, the acceptability of the ratio will depend on the nature of the business and how it compares with those of a similar type.
The second ratio is the quick ratio (also referred to as the liquidity or acid test ratio)
(Current assets – inventory) ÷ current liabilities
The quick ratio excludes inventory which cannot easily and quickly be converted into cash. Although the general target
is 1:1, an ideal ratio depends on industry practice
