Working capital management

Question 1

Working capital is

Answer 1

the cash invested in current assets less current liabilities. Current assets will consist
of inventories (raw materials, work in progress and finished goods), receivables and cash. Current
liabilities will consist of trade and other payables, short term loans and overdrafts

Question 2

The liquidity objective of working capital management is

Answer 2

to ensure that the organisation
always has sufficient cash to pay its liabilities as they become due.

Question 3

The profitability objective of working capital management is to

Answer 3

ensure that the organisation is
as efficient as possible by, amongst other things, ensuring all capital is invested to earn the
maximum return.

Question 4

The level of working capital held will

Answer 4

impact the liquidity and profitability of the business. The policy
used may be aggressive (maintain a low level) or conservative (maintain a high level).

Question 5

Aggressive WC Policy

Answer 5

Maintain a low level of working capital

Higher profit (due to greater investment of
cash), but lower liquidity and higher risk due to
lower cash and inventory balances (hence more
chance of running out of cash / inventory).

Question 6

Maintain a high level of working capital

Answer 6

Lower profit (due to more cash being tied up
in working capital, earning no return), but
higher liquidity and lower risk due to higher
cash and inventory balances.

Question 7

The cash operating cycle is the time difference between cash being paid out for production costs and
cash being received for goods sold. This can be calculated as follows:

Answer 7

Average time raw materials are in stock X
Average time work in progress is in production X
Average time finished goods are in stock X
Average collection period X
Less: (Average payable period) (X)
Cash operating cycle X

Question 8

Quick ratio (acid test) =

Answer 8

Current assets − inventory / Current liabilities

Question 9

Inventory turnover ratio =

Answer 9

Cost of sales / Average inventory x 365

Question 10

Average inventory period =

Answer 10

Average inventory / Cost of sales × 365 days

Question 11

Average collection period =

Answer 11

Average trade receivables / Credit sales turnover × 365 days

Question 12

Average payable period =

Answer 12

Average trade payables / Credit purchases or cost of sales
× 365 days

Question 13

Sales revenue/net working capital ratio

Answer 13

Sales revenue / Net working capital

Question 14

Overtrading / undercapitalisation could thus be indicated by:

Answer 14

– A rapid increase in turnover
– An increase in inventory days
– An increase in receivables days
– An over reliance on short-term sources of finance, including overdraft, trade payables
and leasing
– A decrease in the current ratio
– A decrease in the quick ratio
– A decrease in profit caused by selling more at low prices

Question 15

Techniques for managing accounts receivable

Answer 15

Credit analysis
Credit control
Debt collection
Offering early settlement discounts
Factoring and invoice discounting

Question 16

Credit analysis

Answer 16

Before credit is offered to a new customer their creditworthiness needs to be assessed to give
confidence that they will meet their debts as and when they fall due

Question 17

There is no single correct way of
assessing credit worthiness, but common elements include obtaining:

Answer 17

A bank reference
 At least one trade references
 A credit rating agency report
 Financial statements
 Any media coverage
 Views of a member of staff who has visited the potential customer

Question 18

Credit control

Answer 18

Accounts receivable need to be managed by ensuring:
 Invoices and statements are issued on time
 The credit limit is not exceeded and is reviewed regularly
 The on-going financial performance is kept under review

Question 19

Debt collection

Answer 19

It is essential to ensure that amounts owing are collected when due. This will include the following:
 Ensuring any queries are investigated promptly
 The account is put on hold if any amounts are overdue
 Legal action is taken (when necessary) to recover the funds

Question 20

Cost/Benefit analysis of accounts receivable policies

You may be asked to evaluate a change to an accounts receivable policy for example:

Answer 20

A change in the credit period offered
 An early settlement discount
 Debt factoring
 Invoice discounting

Question 21

Factoring is

Answer 21

an arrangement to have debts collected by a factor company, which may advance a
proportion of the money it is due to collect

Question 22

The client of the factor can chose some or all of the
following three services offered:

Answer 22

Debt collection and administration – Factoring usually involves administration of the client’s
invoicing, sales accounting and debt collection service and credit protection for the client’s
debts.
 Financing – The factor will advance usually up to 80% of the face value of the debt – the finance
is repaid once the invoices have been settled and the balance is passed to the issuing company
after deduction of a fee. This fee is equivalent to an interest charge on the cash advanced.
 Credit insurance – If a non-recourse service is provided the factor the factor provides protection
for the client against irrecoverable debts. If the customer of the client fails to pay, the factor
bears the loss and the client receives the money from the debt. However, with non-recourse,
the factor (not the firm) will decide what action to take against non-payers.

Question 23

Invoice discounting is

Answer 23

a source of finance and involves the purchase of trade debts at a discount
(effectively a loan to the company secured on specific receivables).

Question 24

Describe invoice discounting

Answer 24

 Invoice discounting enables the company from which the debts are purchased to raise finance.
 Unlike with debt factoring, the invoice discounter does not take over the administration of the
client’s sales ledger. A client should only want to have some invoices discounted when he has a
temporary cash shortage, and so invoice discounting tends to consist of one-off deals.

Question 25

Managing foreign accounts receivable is the same as managing home accounts receivable but three
points in particular need to be borne in mind:

Answer 25

(1) Credit periods tend to be longer due to the extra time taken for goods to be physically
transported and the extra associated paperwork. These delays in foreign trade mean that
exporters often build up large investments in inventories and accounts receivable. These
working capital investments have to be financed somehow.
(2) The bad debt risk is generally higher and so the credit worthiness checks become even more
important. If a foreign customer refuses to pay a debt, the exporter must pursue the debt in the
debtor’s own country, where procedures will be subject to the laws of that country.
(3) If the debts are denoted in a foreign currency, their value will vary as the exchange rates vary.
Potential solutions to this problem are covered in Chapter 7.

Question 26

Managing foreign accounts receivable - The first two issues above can be managed and reduced as follows:

Answer 26

Reduced credit terms
Advances on / discounting of Bills of Exchange
Export factoring
Documentary credits / Letters of credit
Countertrade
Export credit insurance

Question 27

Documentary credits / Letters of credit

Answer 27

 A method of payment in international trade, which gives the exporter a secure risk-free method
of obtaining payment.
 The buyer (importer) and the seller (exporter) first of all agree a contract for the sale of the
goods, which provides for payment through a letter of credit (a guarantee of payment).
 The buyer then requests a bank in his country to issue a letter of credit in favour of the exporter
(through the letter, the bank guarantees payment to the beneficiary).

Question 28

Countertrade

Answer 28

A means of financing trade in which goods are exchanged for other goods.

Question 29

Export credit insurance

Answer 29

Insurance against the risk of non-payment by foreign customers for export debts.
 Premiums for export credit insurance are however very high and the benefits are sometimes
not fully appreciated.

Question 30

Using trade credit effectively

Answer 30

Trade credit helps to reduce the cash operating cycle and so the amount should be maximised,
however care must be taken not to abuse suppliers as this can result in future credit being stopped.
As relationships with suppliers develop, the amount of credit should be extended

Question 31

Cash is a critical resource for all businesses and the most common reason for business failure is
running out of cash. Most businesses will be able to

Answer 31

raise more cash as long as they have sufficient
time to do so. It is thus essential to plan ahead by preparing cash flow forecasts to determine future
cash flows and cash balances.

Question 32

Techniques for managing cash balances

Answer 32

The transactions motive
The precautionary motive
The speculative motive

Question 33

The speculative motive

Answer 33

to enable the organisation to benefit from one off opportunities e.g.
taking advantage of an unexpected early settlement discount offer

Question 34

Centralised treasury management and cash control

Answer 34

Cash can be managed and controlled either at a local level or it can be centralised. Most organisations
follow a centralised treasury management and cash control approach due to the benefits this brings:
 Allows the internal netting off of local surpluses and deficits which is cheaper
 Lower bank charges due to increased volumes through a single point
 Better interest rates on borrowing and lending due to increased volumes
 Reduced external foreign exchange due to internal netting off
 Allows the employment of experts due to the volume of work required

Question 35

Cash management models

Answer 35

Baumol model
Miller-Orr model

Question 36

Baumol model

Answer 36

This model is based on the same principles as the inventory EOQ model and identifies the optimal cash
holding level. When obtaining cash there are two relevant costs which need to be minimised:
(1) The cost of obtaining new funds (F)
(2) The cost of holding cash for a year (I)

Question 37

The amount of cash to be raised (Q) can be calculated by using the following formula:

Answer 37

Q = SR 2FS
I
F = Cost of obtaining funds
S = Amount of cash required per annum
I = Cost of holding $1 for one year

The Baumol model assumes a constant use of cash which is unlikely in the real world.

Question 38

Miller-Orr model

Answer 38

The Miller-Orr model is more realistic and allows for a varying cash balance and sets lower and
upper limits between which the amount of cash should be kept.
 If the upper limit is breached, then cash is invested (in e.g. T-Bills) to reduce the amount of cash
held and if the lower limit is breached, then cash is raised (by liquidating investments) to
increase the amount of cash held, to take the cash balance to the return point:

Question 39

the varience of cashflows is

Answer 39

The standard deviation squared

Question 40

The distinction between permanent and fluctuating current assets

Answer 40

The overall level of current assets is likely to vary over time; this is particularly obvious if we
think of a seasonal business. The level of current assets will fluctuate between a minimum and
maximum level.
 The minimum level represents a permanent long-term requirement from a funding point of
view; whereas the range between the minimum and maximum represent a temporary shortterm requirement.

Question 41

The relative cost and risk of short-term and long-term finance and the matching
principle

Answer 41

 Long term funding is relatively expensive but is lower risk, as once it is raised, assuming there is
no breach of any terms, it may be kept for the long term whether or not it is required.
 Short-term funding is relatively cheap (due to liquidity preference theory, see Chapter 7) but is
higher risk, as once it is repaid there is no guarantee that it will be replaced even if it is required.
 The matching principle states that long term investments should be financed with long term
finance e.g. people buy their homes with 25-year mortgages; and short term investments
should be financed with short term finance e.g. if you don’t have enough money to last until
your next pay day, you use an overdraft.

Question 42

The aggressive approach

Answer 42

As short-term funding is the cheapest source of finance, the most cost effective approach is to finance
all of your current assets with short term finance. This will result in lower finance costs and higher
profits compared to the other strategies. However, as there is no guarantee that this finance will be
available when required, this is a very high risk strategy which should only be used if the organisation
is confident of always being able to raise the required short-term finance. This strategy is called the
aggressive funding policy

Question 43

The conservative approach

Answer 43

Alternatively, long-term finance could be used to fund all of your current assets, this would be more
expensive, but the organisation will know that it will not run out of funding and so is safe. This will lead
to higher finance costs and lower profits compared to the aggressive policy. Consequently, this is
referred to as the conservative funding policy.

Question 44

The matching approach

Answer 44

The matching funding policy uses long term funding for the minimum permanent current assets and
uses short term finance for the range between the minimum and maximum. The finance costs and
profits will probably be somewhere between those of the conservative and aggressive strategies.
However there is still a risk that the required short term finance cannot be found.

Question 45

Management attitudes to risk, previous funding decisions and organisation size

Answer 45

If management are high risk takers they are likely to adopt the aggressive funding policy and if
they are risk averse they are likely to adopt the conservative funding policy. In practice most
managers will be somewhere in between these two extremes and so the matching funding
policy is very popular.
 Previous funding decisions for current assets will also influence the current decision as if these
are seen as having been successful they are more likely to be repeated.
 Finally, larger organisations are able to raise funds relatively easily and so the risks of the
aggressive funding policy may not in fact be that high.
 Smaller organisations find fund raising significantly harder and find raising long-term finance
even harder than short term-finance and so, ironically, may be forced into the aggressive
funding policy despite the high risks involved.