Chapter8-WCMgt-working Capital
Chapter8-WCMgt-working Capital
Chapter8-WCMgt-working Capital
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
W o rk in g
C a p ita l
M anagem ent
E l e m e n ts
of
W C
O b je c tiv e s
of
W C
M anagem ent
C ash
O p e ra tin g
C y c le
W o rk in g
C a p ita l
R a tio s
T ra d e -o ff b e tw e e n
L i q u id i t y &
P r o fita b ility
M e a n in g
8 R a tio s
C e n tra l R o le o f
W o rk in g C a p ita l
M anagem ent
C a lc u la tio n
C a lc u la tio n o f
W o rk in g C a p ita l
R e q u ire m e n t
A d v a n ta g e s to
Im p ro v e W C
M anagem ent
S ig n ific a n c e o f
C a sh O p e ra tin g
C y c le
W C M anagem ent
a n d B u sin e ss
S o lv e n c y
F a c to rs In flu e n c e
O p tim u m C a sh
L evel
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O v e rtra d in g
S y m p to m s
1.
1.1
Working capital is the capital available for conducting the day-to-day operations of
an organization; normally the excess of current assets over current liabilities.
1.2
1.3
1.4
Investing in working capital has a cost, which can be expressed either as:
(a)
the cost of funding it, or
(b)
the opportunity cost of lost investment opportunities because cash is tied up
and unavailable for other uses.
Working capital is an investment which affects cash flows.
(a)
When inventory is purchased, cash is paid to acquire it.
(b)
Receivables represent the cost of selling goods or services to customers,
including the costs of the materials and the labour incurred.
(c)
The cash tied up in working capital is reduced to the extent that inventory is
financed by trade payables. If suppliers give a firm time to pay, the firms
cash flows are improved and working capital is reduced.
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2.
2.1
2.1.1 Current assets are a major balance sheet item and especially significant to smaller
firms.
2.1.2 Mismanagement of working capital is a common cause of business failure, e.g.:
(a)
inability to meet bills as they fall due
(b)
overtrading during periods of growth
(c)
overstocking.
2.1.3
(b)
(c)
Question 1
Identify the objectives of working capital management and discuss the conflict that may
arise between them.
(3 marks)
(ACCA F9 Financial Management December 2007 Q4(a))
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Question 2
Discuss whether profitability or liquidity is the primary objective of working capital
management.
(4 marks)
(ACCA F9 Financial Management June 2010 Q1(c))
2.1.4
Example 1
What differences would there be in working capital policies for a manufacturing
company and a food retailer?
Solution:
The manufacturing company will need to invest heavily in spare parts and may be
owed large amounts of money by its customers. The food retailer will have a large
inventory of goods for resale but will have low accounts receivable.
The manufacturing company will therefore need a carefully considered policy on
the management of accounts receivable which will need to reflect the credit policies
of its close competitors.
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(Dec 13)
2.2.3
2.2.4
2.2.5
Liquidity in the context of working capital management means having enough cash or
ready access to cash to meet all payment obligations when these fall due. The main
sources of liquidity are usually:
(a)
cash in the bank
(b)
short-term investments that can be cashed in easily and quickly
(c)
cash inflows from normal trading operations (cash sales and payments by
receivables for credit sales)
(d)
an overdraft facility or other ready source of extra borrowing.
A firm choosing to have a lower level of working capital than rivals is said to have
an aggressive approach, whereas a firm with a higher level of working capital has a
defensive approach.
There is a trade-off under which trading growth and increased profitability squeeze
cash. Ultimately, if not properly managed, increased trading can carry with it the
spectre of overtrading and inability to pay the business creditors.
It is worth while stressing the difference between cash flow and profits. Cash flow is
as important as profit. Unprofitable companies can survive if they have liquidity.
Profitable companies can fail if they run out of cash to pay their liabilities (wages,
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2.2.7
2.2.8
Some examples of transactions that have this trade-off effect on cash flows and on
profits are as follows:
(a)
Purchase of non-current assets for cash. The cash will be paid in full to the
supplier when the asset is delivered; however profits will be charged
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.
Clearly, cash balances and cash flows need to be monitored just as closely as trading
profits. The need for adequate cash flow information is vital to enable management to
fulfil this responsibility.
Test your understanding 1
Fill in the blanks in the table to identify the advantages of having more or less
working capital.
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2.3
2.3.1
(b)
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3.
3.1
3.1.1
124
125
3.2
3.2.1
x
(x)
x
x
x
x
3.2.2
For a wholesale or retail business, there will be raw materials or WIP holding periods,
and the cycle simplifies to:
Inventory holding period
Less: Payables payment period
Receivables collection period
x
(x)
x
x
Example 2
A company generally pays its suppliers six weeks after receiving an invoice, whilst
receivables usually pay within four weeks of invoicing. Raw materials inventory is
held for a week before processing begins. Processing itself takes three weeks.
Finished goods stay in inventory for an average of two weeks.
How long is the companys cash operating cycle?
Solution:
Cash operating cycle = 1 6 + 3 + 2 + 4 = 4 weeks
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3.2.4
56 days
21 days
14 days
42 days
28 days
3.3
3.3.1
The significance of the cash operating cycle in determining the level of investment in
working capital is that the longer the cash operating cycle, the higher the
investment in working capital.
3.3.2 The length of the cash operating cycle varies between industries: for example, a
service organization may have no stock holding period, a retail organization will have
a stock holding period based almost entirely on finished goods and a very low level of
debtors, and a manufacturing organization will have a stock holding period based on
raw materials, work-in-progress and finished goods. The level of investment in
working capital will therefore depend on the nature of business operations.
3.3.3 The cash operating cycle and the resulting level of investment in working capital does
not depend only on the nature of the business, however. Companies within the
same business sector may have different levels of investment in working capital,
measured for example by the accounting ratio of sales/net working capital, as a result
of adopting different working capital policies.
(a)
A relatively aggressive policy on the level of investment in working capital is
characterized by lower levels of stock and debtors: this lower level of
investment increases profitability but also increases the risk of running out
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Question 5
Explain the meaning of the term cash operating cycle and discuss its significance in
determining the level of investment in working capital. Your answer should refer to the
working capital needs of different business sectors.
(7 marks)
(ACCA 2.4 Financial Management and Control June 2004 Q2(c))
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3.4
3.4.1
The main reason that companies fail, though, is because they run out of cash and so
good cash management is an essential part of good working capital management.
Business solvency cannot be maintained if working capital management in the form
of cash management is of a poor standard.
3.5
3.5.1
3.5.2
3.5.3
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Question 6
Extracts from the recent financial statements of Anjo plc are as follows:
Income statements
Turnover
Cost of sales
2006
$000
15,600
9,300
2005
$000
11,100
6,600
Gross profit
Administration expenses
6,300
1,000
4,500
750
5,300
100
3,750
15
5,200
3,735
2006
$000
Non-current assets
Current assets
Inventory
Receivables
Cash
2005
$000
5,750
3,000
3,800
120
$000
1,300
1,850
900
6,920
Current liabilities
Trade payables
Overdraft
2,870
1,000
$000
5,400
4,050
1,600
150
(3,870)
(1,750)
8,800
7,700
All sales were on credit. Anjo plc has no long-term debt. Credit purchases in each year were
95% of cost of sales. Anjo plc pays interest on its overdraft at an annual rate of 8%. Current
sector averages are as follows:
Inventory days: 90 days
Receivable days: 60 days
Payables days: 80 days
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Required:
(a)
(b)
(c)
(d)
Calculate the following ratios for each year and comment on your findings.
(i) Inventory days
(ii) Receivables days
(iii) Payables days
(6 marks)
Calculate the length of the cash operating cycle (working capital cycle) for each year
and explain its significance.
(4 marks)
Discuss the relationship between working capital management and business solvency,
and explain the factors that influence the optimum cash level for a business. (7 marks)
A factor has offered to take over sales ledger administration and debt collection for an
annual fee of 0.5% of credit sales. A condition of the offer is that the factor will
advance Anjo plc 80% of the face value of its debtors at an interest rate 1% above the
current overdraft rate. The factor claims that it would reduce outstanding debtors by
30% and reduce administration expenses by 2% per year if its offer were accepted.
Required:
Evaluate whether the factors offer is financially acceptable, basing your answer on the
financial information relating to 2006.
(8 marks)
(Total 25 marks)
(ACCA 2.4 Financial Management and Control December 2006 Q3)
4.
4.1
The periods used to determine the cash operating cycle are calculated by using a series
of working capital ratios.
The ratios for the individual components (inventory, receivables and payables) are
normally expressed as the number of days/weeks/months of the relevant income
statement figure they represent.
4.2
4.3
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trying to do too much too quickly with too little long-term capital is overtrading.
4.4
(Dec 08, Dec 09, Jun 12, Jun 13, Jun 14)
Current assets
(1)
(2)
Quick ratio =
(3)
(4)
(5)
(6)
OR
Average WIP
365 days
Cost of sales
(7)
(8)
4.5
4.6
Sales revenue
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.
In general, high current and quick ratios are considered good in that they mean
that an organisation has the resources to meet its commitments as they fall due.
However, it may indicate that working capital is not being used efficiently, for
example that there is too much idle cash that should be invested to earn a return.
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4.7
4.8
4.9
4.10
4.11
Conventional wisdom has it that an ideal current ratio is 2 and an ideal quick ratio is 1.
It is very tempting to draw definite conclusions from limited information or to say that
the current ratio should be 2, or that the quick ratio should be 1.
However, this is 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.
For example a supermarket business operating a JIT 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 reschedule the overdraft as a loan. Not only would this be
cheaper but it would also improve liquidity ratios.
Example 3
Calculate liquidity and working capital ratios from the following accounts of a
manufacturer of products for the construction industry, and comment on the ratios.
2010
2009
$m
$m
Sales revenue
2,065.0
1,788.7
Cost of sales
1,478.6
1,304.0
Gross profit
586.4
484.7
Current assets
Inventories
Accounts receivable (note 1)
Short-term investments
Cash at bank and in hand
119.0
400.9
4.2
48.2
109.0
347.4
18.8
48.0
572.3
523.2
49.1
62.0
19.2
370.7
35.3
46.7
14.3
324.0
501.0
420.3
Current liabilities
Loans and overdrafts
Corporation taxes
Dividend
Accounts payable (note 2)
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71.3
102.9
Notes
2010
$m
329.8
236.2
2009
$m
285.4
210.8
2009
Current ratio
572.3
1.14
501.0
523.2
1.24
420.3
Quick ratio
453.3
0.90
501.0
414.2
0.99
420.3
329.8
285.4
365 58 days
365 58 days
2,065
1,788.7
119 .0
109.0
365 29 days
365 31 days
1,478.6
1,304
236.2
210.8
365 58 days
365 59 days
1,478.6
1,304.0
2,065
1,788.7
28.96
17.38
572.3 501.0
523.2 420.3
(a)
(b)
(c)
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$1,500,000
30%
25%
10%
15%
5%
135
Required:
Compute the working capital requirement of ABC Co assuming that the labour
force is paid for 50 working weeks in each year.
Solution:
136
137
5.
Overtrading
(Dec 08, Jun 12)
5.1
5.2
5.3
5.4
5.5
A business is said to be overtrading when it tries to engage in more business than its
working capital will allow. It could be that too much money is tied up in stocks and
trade debtors, and cash is not coming in quickly enough to meet debts as they fall
due.
It could be that the firm failed to obtain sufficient equity finance when it was
established to support its trading level, or it could be that the managers are particularly
bad at managing the working capital resources that they have.
Even if an overtrading business operates at a profit, it could easily run into serious
trouble because it is short of money. Such liquidity troubles stem from the fact that it
does not have enough capital to provide the cash to pay its debts as they fall due.
Symptoms of overtrading
Symptoms of overtrading are as follows.
(a)
There is a rapid increase in turnover.
(b)
There is a rapid increase in the volume of current assets and possibly also
fixed assets. Inventory turnover and accounts receivable turnover might
slow down, in which case the rate of increase in inventories and accounts
receivable would be even greater than the rate of increase in sales.
(c)
There is only a small increase in proprietors capital (perhaps through
retained profits). Most of the increase in assets is financed by credit,
especially:
(i)
Trade accounts payable the payment period to accounts payable
is likely to lengthen
(ii)
A bank overdraft, which often reaches or even exceeds the limit of
the facilities agreed by the bank
(d)
Some debt ratios and liquidity ratios alter dramatically
(i)
The proportion of total assets financed by proprietors capital falls,
and the proportion financed by credit rises.
(ii)
The current ratio and the quick ratio fall.
(iii)
The business might have a liquid deficit, that is, an excess of
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Example 4
ABC Co appoints a new managing director who has great plans to expand the
company. He wants to increase turnover by 100% within two years, and to do this
he employs extra sales staff. He recognizes that customers do not want to have to
wait for deliveries, and so he decides that the company must build up its inventory
levels. There is a substantial increase in the companys inventories. These are held
in additional warehouse space which is now rented. The company also buys new
cars for its extra sales representatives.
The managing directors policies are immediately successful in boosting sales,
which double in just over one year. Inventory levels are now much higher, but the
company takes longer credit from its suppliers, even though some suppliers have
expressed their annoyance at the length of time they must wait for payment. Credit
terms for accounts receivable are unchanged, and so the volume of accounts
receivable, like the volume of sales, rises by 100%.
In spite of taking longer credit, the company still needs to increase its overdraft
facilities with the bank, which are raised from a limit of $40,000 to one of $80,000.
The company is profitable, and retains some profits in the business, but profit
margins have fallen. Gross profit margins are lower because some prices have been
reduced to obtain extra sales. Net profit margins are lower because overhead costs
are higher. These include sales representatives wages, car expenses and
depreciation on cars, warehouse rent and additional losses from having to write off
out-of-date and slow-moving inventory items.
The statement of financial position of the company might change over time from
(A) to (B).
Situation A
$
Situation B
$
Non-current assets
160,000
210,000
Current assets
Inventory
60,000
150,000
Accounts receivable
64,000
135,000
Cash
1,000
139
125,000
285,000
Current liabilities
Bank
25,000
80,000
Accounts payable
50,000
200,000
75,000
280,000
50,000
5,000
210,000
215,000
Share capital
10,000
10,000
Income statement
200,000
205,000
210,000
215,000
$1,000,000
$2,000,000
Gross profit
$200,000
$300,000
Net profit
$50,000
$20,000
Sales
In situation (B), the company has reached its overdraft limit and has four times as
many accounts payable as in situation (A) but with only twice the sales turnover.
Inventory levels are much higher, and inventory turnover is lower.
The company is overtrading. If it had to pay its next trade account, or salaries and
wages, before it received any income, it could not do so without the bank allowing
it to exceed its overdraft limit. The company is profitable, although profit margins
have fallen, and it ought to expect a prosperous future. But if it does not sort out its
cash flow and liquidity, it will not survive to enjoy future profits.
Suitable solutions to the problem would be measures to reduce the degree of
overtrading.
(a) New capital from the shareholders could be injected.
(b) Better control could be applied to inventories and accounts receivable. The
company could abandon ambitious plans for increased sales and more fixed
asset purchases until the business has had time to consolidate its position, and
build up its capital base with retained profits.
A business seeking to increase its turnover too rapidly without an adequate capital
base is not the only cause of overtrading. Other causes are as follows.
(a) When a business repays a loan, it often replaces the old loan with a new one
(refinancing). However a business might repay a loan without replacing it,
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(b)
with the consequence that it has less long-term capital to finance its current
level of operations.
A business might be profitable, but in a period of inflation, its retained
profits might be insufficient to pay for replacement of fixed assets and
inventories, which now cost more because of inflation.
2006
$000
26,720
23,781
Operating profit
Finance costs (interest payments)
2,992
355
2,939
274
2,637
2,665
2007
$000
Non-current assets
Current assets
Inventory
Trade receivables
Current liabilities
Trade payables
Overdraft
2006
$000
13,632
$000
4,600
4,600
2,400
2,200
9,200
4,600
4,750
3,225
2,000
1,600
7,975
3,600
$000
12,750
1,225
1,000
8% Bonds
14,857
2,425
13,750
2,425
12,432
11,325
6,000
6,432
6,000
5,325
12,432
11,325
The average variable overdraft interest rate in each year was 5%. The 8% bonds are
141
A factor has offered to take over the administration of trade receivables on a non-recourse
basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables
collection period of 30 days and Gorwa Co will save $100,000 per year in administration
costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the
factor would advance 80% of the face value of receivables at an annual interest rate of 7%.
Required:
(a)
(b)
(c)
142
A company has a liquidity ratio equal to 0.5. The directors believe that the company has
to reduce its bank overdraft and have agreed to alter the company's credit terms to
customers from two months to one month.
What would be the effects on the company's cash operating cycle and liquidity ratio if
this change were to be achieved?
A
B
C
D
2.
Liquidity ratio
Decrease
No change
Increase
Increase
The key trade-off that lies at the heart of the working capital management is that
between:
A
B
C
D
3.
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4.
Archie plc manufactures plastic cutlery. The company buys raw materials from suppliers
that allow the company 2.5 months credit. The raw materials remain in inventory for 2
months and it takes Archie plc 2 months to produce the goods, which are sold
immediately production is completed. Customers take an average of 1.5 months to pay.
What is Archie plcs cash operating cycle?
A
B
C
D
5.
6.
2 months
2.5 months
3 months
7 months
Which one of the following would lengthen the working capital cycle?
A
B
C
D
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