W 6 WCM Review
W 6 WCM Review
W 6 WCM Review
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The nature of working capital
The amount tied up in working capital is equal to the value of raw materials, work in
progress, finished goods inventories and accounts receivable less accounts payable. The size
of this net figure has a direct effect on the liquidity of an organisation.
Net working capital of a business is its current assets less its current liabilities.
1. Holding inventory (from their purchase from external suppliers, through the
production and warehousing of finished goods, up to the time of sale)
3. Allowing customers (accounts receivable) time to pay Here are some examples.
(a) Supermarkets and other retailers receive much of their sales in cash or by credit card or
debit card. However, they typically buy from suppliers on credit. They may therefore have
the advantage of significant cash holdings, which they may choose to invest.
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Objectives of working capital management
The two main objectives of working capital management are to ensure that it has sufficient
liquid resources to continue in business and to increase its profitability.
Every business needs adequate liquid resources to maintain day to day cash flow. It needs
enough to pay wages, salaries and accounts payable if it is to keep its workforce and ensure
its supplies.
Maintaining adequate working capital is not just important in the short term. Adequate
liquidity is needed to ensure the survival of the business in the long term. Even a profitable
company may fail without adequate cash flow to meet its liabilities.
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If the turnover periods for inventories and accounts receivable lengthen (ie inventories and
receivables levels increase), or the payment period to accounts payable shortens (ie payables
level falls), then the cash operating cycle will lengthen and the investment in working capital
will increase.
The length of the cash operating cycle is often dictated by the industry. For example, a
construction business may have a long cash operating cycle because of the high level of work
in progress. Restaurant businesses usually have short cash operating cycles because they
have short inventory periods and customers pay by cash or debit or credit card.
Note also that it is possible to have a negative cash operating cycle. The bookseller and
retailer Amazon has a negative cash operating cycle because of short inventory periods and
fast payments from customers. When Amazon ships a book, for example, it charges the
customer's credit card and gets paid by the credit card company within a day.
1-2.5+2+1.5 = 2 months
Liquidity ratios
Working capital ratios may help to indicate whether a company is over-capitalised, with
excessive working capital, or if a business is likely to fail. A business which is trying to do
too much too quickly with too little long-term capital is overtrading.
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The current ratio is the standard test of liquidity.
Current ratio = Current assets
Current liabilities
A company should have enough current assets that give a promise of 'cash to come' to meet
its commitments to pay its current liabilities. Superficially, a ratio in excess of 1 implies that
the organization has enough cash and near-cash assets to satisfy its immediate liabilities.
However, interpretation needs to be conducted with care. Too high a ratio implies that too
much cash may be tied up in receivables and inventories. What is 'comfortable' varies
between different types of business.
Companies are unable to convert all their current assets into cash very quickly. In some
businesses where inventory turnover is slow, most inventories are not very liquid assets, and
the cash cycle is long. For these reasons, we calculate an additional liquidity ratio, known as
the quick ratio or acid test ratio.
This ratio should ideally be at least 1 for companies with a slow inventory turnover. For
companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting
that the company is in cash flow difficulties.
The trade accounts receivable are not the total figure for accounts receivable in the statement
of financial position, which includes prepayments and non-trade accounts receivable. The
trade accounts receivable figure will be itemised in an analysis of the total accounts
receivable, in a note to the accounts.
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(a) The statement of financial position value of accounts receivable might be abnormally
high or low compared with the 'normal' level the company usually has. This may apply
especially to smaller companies, where the size of year-end accounts receivable may largely
depend on whether a few or even a single large customer pay just before or just after the year
end.
(b) Revenue (turnover) in the statement of profit or loss excludes sales tax, but the accounts
receivable figure in the statement of financial position includes sales tax. We are not strictly
comparing like with like. In addition, accounts receivable from the statement of financial
position is at a point and may not be typical.
These indicate the average number of days that items of inventory are held for. As with the
average accounts receivable collection period, these are only approximate figures, but ones
which should be reliable enough for finding changes over time. Average inventory is often
calculated as (opening + closing balance) / 2 although other methods of estimating a typical
value may be used.
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A lengthening inventory turnover period indicates:
(a) A slowdown in trading, or
(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories
is becoming excessive
If we add together the inventory days and the accounts receivable days, this should give us
an indication of how soon inventory is convertible into cash, thereby giving a further
indication of the company's liquidity.
The accounts payable payment period often helps to assess a company's liquidity; an increase
in accounts payable days is often a sign of lack of long-term finance or poor management of
current assets, resulting in the use of extended credit from suppliers, increased bank
overdraft, and so on.
All the ratios calculated above will vary by industry; hence comparisons of ratios
calculated with other similar companies in the same industry are important.
You may need to use the following periods to calculate the operating cycle.
Days
Raw materials inventory holding period X
Accounts payable payment period (X)
Average production period X
Inventory turnover period (Finished goods) X
Accounts receivable payment period X
Operating cycle X
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shows the level of working capital supporting sales. Working capital must increase in line
with sales to avoid liquidity problems and this ratio can be used to forecast the level of
working capital needed for a projected level of sales.
Current liabilities are often a cheap method of finance (trade accounts payable do not usually
carry an interest cost). Companies may therefore consider that, in the interest of higher
profits, it is worth accepting some risk of insolvency by increasing current liabilities, taking
the maximum credit possible from suppliers.
Different industries have different optimum working capital profiles, reflecting their methods
of doing business and what they are selling.
(a) Businesses with a lot of cash sales and few credit sales should have minimal accounts
receivable.
(b) Businesses that exist solely to trade will only have finished goods in inventory, whereas
manufacturers will have raw materials and work in progress as well. In addition, some
finished goods, notably foodstuffs, have to be sold within a few days because of their
perishable nature.
(c) Large companies may be able to use their strength as customers to obtain extended
credit periods from their suppliers. By contrast small companies, particularly those that
have recently started trading, may be required to pay their suppliers immediately.
(d) Some businesses will be receiving most of their monies at certain times of the year,
while incurring expenses throughout the year. Examples include travel agents who will have
peaks reflecting demand for holidays during the summer and at Christmas.
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If there are excessive inventories, accounts receivable and cash, and very few accounts
payable, there will be an overinvestment by the company in current assets. Working capital
will be excessive and the company in this respect will be over-capitalised.
MCQ
QUESTION 1: When a UK High Street retailer sold one of its shops then paid for continued use
of the shop, how would you define this type of transaction?
a) Asset stripping
b) Sale and leaseback
c) Asset disposal
d) Borrowings
QUESTION 2: Which of the following is not correct while considering Working capital (WC)
1.Working capital is the difference between current assets and current liabilities
2 That is, inventories + receivables + cash − payables − bank overdrafts.
3 An investment in WC cannot be avoided in practice – typically large amounts are involved
4. Working Capital is calculated for medium to long term rather than short term
a. All of the above
b. Only 1
c. Only 4
d. Only 3
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c. Operating Cycle - Accounts Payable
d. Operating Cycle / Accounts Payable
QUESTION 8: A firm has an operating cycle of 120 days, an average collection period of 40
days, and an average payment period of 30 days. The firm’s average age of inventory is
_________ days.
(a) 80
(b) 50
(c) 90
(d) 70
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QUESTION 9: Apart from the trade payables (trade creditors), which one of the following is also
a major element of current liabilities?
A. Inventories
B. Long-term loans
C. Bank overdrafts
D. Cash
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