Working Capital Management Flashcards
With regard to the BASE LEVEL for working capital, can you explain the 2 elements of investment?
Working Capital Investment is split into 2 elements based on seasonality:-
PERMANENT - The base level of working capital required during the year
FLUCTUATING - the portion ABOVE the base level that allows for seasonality and other short-term changes.
The BASE LEVEL required for an entity will be typically governed by the entities approach to managing the level of working capital (an aggressive approach means a LOWER base level than a conservative approach.
What are the benefits of the following policies for WCM?
Aggressive?
Conservative?
AGGRESSIVE the benefits:-
* lower levels of current assets therefore lower financing costs;
* lower financing costs result in better PROFITABILITY
* QUICKER cash turnover may allow more reinvestment and hence allow the business to expand more quickly.
CONSERVATIVE the benefits:-
* lower liquidity risk - less risk of the Co. running out of cash or going into liquidity
* greater ability to meet a sudden surge in sales demand.
* more relaxed CREDIT policy for receivables may improve sales.
Can you explain the 3 possible policies that exist to manage working capital?
- Aggressive Policy - this approach attempts to reduce costs by holding the lowest levels of cash, inventory and receivables as possible. This produces a SHORT operating cycle. This policy carries the greatest risk of liquidity, as well as the greatest RETURN.
- Conservative Policy - This approach attempts to reduce risks by holding higher levels of cash, inventories and receivables. This produces a long operating cycle. RISKS such as stock-outs or liquidity problems are LOW but resulting in increased costs.
- Moderate Policy - this adopts a middle ground between aggressive and conversative.
Why is it essential to BUDGET an appropriate amount of working capital?
It is essential to budget an appropriate amount of working capital to MEET ANTICIPATED FUTURE NEEDS.
Can you explain the LENGTH OF CYCLE of a construction company & the nature?
NATURE OF THE BUSINESS
* projects tend to be long term
* whilst progress payments could be made by customer
* the bulk of cash will be received at the end of the project;
LENGTH OF CYCLE
* long cycle
Can you explain the LENGTH OF CYCLE of a supermarket & the nature?
NATURE OF THE BUSINESS
* few if any credit customers
* higher inventory turnover
* can negotiate quite long credit terms with suppliers
LENGTH OF CYCLE
* short
*low & negative
Can you explain some detrimental effects if you try shorten the cash cycle?
Trying to shorten the cash cycle may have detrimental effects else where, with the organisation lacking CASH to meet its commitments and losing sales, since CUSTOMERS will generally prefer to :-
- BUY from suppliers who are prepared to extend trade credit
and - WHO have items available when required.
What are the FACTORS affecting the length of the working capital cycle?
- Liquidity VS profitability decisions
- management efficiency
- industry norms eg retail VS construction
What is the outcome if a firm PUSHES FASTER items around the working capital cycle?
The FASTER a firm pushes items around the cycle the LOWER ITS INVESTMENT in working capital will be.
What is and summarise the WORKING CAPITAL CYCLE?
The length of time between the entities OUTLAY & INFLOW.
This is also known as the “cash operating cycle”.
OUTLAY - on raw materials, wages and other expenditures
INFLOW - of cash from the sale of goods
Inventory days + trade receivable days - trade payable days = WORKING CAPITAL CYCLE
Calculate inventory days?
Inventory / Cost of Sales x 365
What is a limitation of the EOQ?
- It cannot be used if demand is unknown.
- It cannot be used if the cost of placing orders fluctuates
- It does not take account of discounts
What is NOT a limitation of the EOQ?
- It does not consider storage costs of the inventory.
The economic order quantity model calculates the most efficient number of items for an entity to order each time. The model relies on a number of assumptions, such as the fact that demand is know, order costs are fixed and storage costs are fixed.
Give examples of the “trade off” between profitability vs liquidity?
a) receiving a bulk purchase discount (improved profitability) for buying more inventory than is currently required (reducing liquidity)
b) offering credit to customers attracts more customers (so improves profitability but reduces liquidity)
Sometimes the opposite situation can be seen where an entity can IMPROVE LIQUIDITY but at the expense of PROFITABILITY for example - offering an early settlement discount to customers.
Give examples of the “trade off” of cash flow vs profit?
a) purchase of non-current assets for cash. The cash is often paid in full to the supplier when the asset is delivered, however PROFITS will be reduced over the life of the asset as a result of the depreciation charged.
b) Sale of goods on credit, PROFITS will be credited in full once the sale has been confirmed, however the cash may not be received for some considerable period afterwards.
c) with some payments such as TAX there may be a significant timing difference between impact on reported profit and cash flow.
Clearly, CASH BALANCES and CASH FLOWS need to be monitored just as closely as profit.
