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1

What is working capital?

Working capital is the CAPITAL available for conducting the day-to-day operations of an organisation; normally the excess of (current assets -current liabilities).

Working capital management is the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets.

2

Working capital has a cost which can be expressed as?

the cost of funding it, or
the opportunity cost of lost investment opportunities because cash is tied up and unavailable for other uses.

3

What is the objective of working capital management?

Balancing of the current assets and liabilites right. This can also be seen as trade off between cash flow vs profits. or liquidity vs profitability

Liquidity: Ensuring current are sufficiently liquid to minimise the risk of insolvency

Profitability: Investing in less liquid assets in order to maximise return

4

What is an example of a trade off between liquidity and profitability?

Receiving a bulk purchase discount (improved profitability) for buying more inventory than is currently required (reduced liquidity)

Offering credit to customers (attracts more customers so improves profitability but reduces liquidity)

5

What is an example of a trade off between cash flow and profits?

(a) Purchase of non-current assets for cash. The cash will be paid in full to the supplier when the asset is delivered; however the cost will be charged to profits gradually over the life of the asset in the form of depreciation.

(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 the impact on reported profit and the cash flow.

6

What is an aggressive working capital management approach?

Keeping working capital levels to a minimum (Including cash) in order to improve profitability is termed an aggressive approach to working capital management.

An aggressive approach will result in lower working capital funding costs and higher risk,

7

What is a conservative working capital management approach?

Maintaining a high level of net working capital (including cash) in order to avoid liquidity problems is termed a conservative approach to working capital management.

Conservative approach will result in higher working capital funding costs and lower risk.

8

What does over capitalisation mean?

If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be an over-investment by the company in current assets. Working capital will be excessive and the company will be over-capitalised.

9

What does over trading mean?

For example, healthy trading growth typically produces:
 increased profitability
 the need to increase investment in non-current assets and working capital.

If the business does not have access to sufficient capital to fund the increase, it is said to be ‘overtrading’.

10

What are the symptoms of an overtrading company?

A rapid increase in revenue
An increase in the values of the working capital days, particularly receivables and payables
Most of the increase in assets being financed by credit
A dramatic drop in the liquidity ratios

11

What are the types of working capital ratios?

Liquidity and efficiency (forming the operating cycle)

12

What are liquidity ratios and the types?

Two key measures, the current ratio and the quick ratio, are used to assess SHORT-term liquidity. Generally, a higher ratio indicates better liquidity.

13

What is the current ratio and the formula

The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations.

The current ratio measures a company's ability to pay current, or short-term, liabilities (debt and payables) with its current, or short-term, assets (cash, inventory, and receivables).


The higher the ratio, the better as it is more liquid

Current ratio= Current Assets ÷ Current Liabilities

A measure of 2:1 means that current liabilities can be paid twice over out of existing current assets.

14

What is the quick ratio/ Acid test and the formula

The quick or acid test ratio:
measures how well current liabilities are covered by liquid assets
 is particularly useful where inventory holding periods are long and therefore distort the current ratio. e.g. car manufacturing companies

Acid test = (CA- Inventory)÷ CL

A measure of 1:1 means that the company is able to meet existing liabilities if they all fall due at once.

15

How are liquidity ratios used/taken for?

These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds that it is unable to renew its short-term liabilities (for instance if the bank suspends its overdraft facilities) there will be a danger of insolvency unless the company is able to turn enough of its current assets into cash quickly.

However, the numbers are not very meaningful without taking into account the type of ratio expected in a similar business or within a business sector. Any assessment of working capital ratios must take into account the nature of the business involved.

16

.What kind of business may have a low current ratio?

supermarket business operating a just in time system will have little inventory and since most of sales are for cash they will have few receivables. In addition, the ability to negotiate long credit periods with suppliers can result in a large payables figure. This can result in net current liabilities and a current ratio below 1 – but does not mean the business has a liquidity problem.

Some companies use an overdraft as part of their long-term finance, in which case the current and quick ratios may appear worryingly low. In such questions, you could suggest that the firm replace the overdraft with a loan. Not only would this be cheaper but it would also improve liquidity ratios.

17

What is the cash operating cycle?

The cash operating cycle is the length of time between the company’s outlay/expenditure on raw materials, wages and other expenditures and the inflow of cash from the sale of goods.

It also reflects a firm’s investment in working capital as it moves through the production process towards sales. The investment in working capital gradually increases, first being only in raw materials, but then in labor and overheads as production progresses.

This investment must be maintained throughout the production process, the holding period for finished goods and up to the final collection of cash from trade receivables.

(Note: The net investment can be reduced by taking trade credit from suppliers.)

The faster a firm can ‘push’ items around the cycle the lower its investment in working capital will be.

18

What is the calculation of the cash operating cycle for manufacturing businesses?

Raw materials holding period
Work in progress holding period
Finished goods holding period
Trade receivable days
( Payables payment period )

19

What is the calculation of the cash operating cycle for wholesale or retail businesses?

There will be no raw materials or WIP holding period so the cycel simplifies to

Inventory holding period
( Payables payment period )

20

What is the calculation of the cash operating cycle for wholesale or retail businesses?

There will be no raw materials or WIP holding period so the cycel simplifies to

Inventory holding period
( Payables payment period )

21

What is the optimum level of working capital?

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.

22

What are the factors affecting the length of the operating cycle?

 liquidity versus profitability decisions
 terms of trade
 management efficiency
 industry norms, e.g. retail versus construction.

23

..

..

24

The amount of cash required to fund the operating cycle will increase due to what?

The amount of cash required to fund the operating cycle (and therefore the funding cost for working capital) will increase as either:

the cycle gets longer
the level of activity/sales increases.

25

What is the inventory holding period?

The length of time inventory is held between purchase and sale.

Inventory days= (Inventory ÷ Cost of Sales) x 365

26

What is the raw material holding period?

The length of raw materials are held between purchase and being used in production.

Material days= (Material ÷ Purchases) x 365

27

What is the WIP holding period?

The length of time it takes to get from raw material to finished goods (average production time)

WIP = (WIP ÷ Cost of sales/ Production cost ) x 365

28

What is the finished goods holding period?

The length of time finished goods are held between completion or purchase and sale.

FGD = (Finished Goods÷ Cost of sales/ Production cost ) x 365

29

For these ratios, is high or low value prefered?

a low ratio is usually seen as a sign of good working capital management. It is very expensive to hold inventory and thus minimum inventory holding usually points to good practice.

30

For these ratios, is high or low value prefered?

a low ratio is usually seen as a sign of good working capital management. It is very expensive to hold inventory and thus minimum inventory holding usually points to good practice.