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P1 chapter 10

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P1 chapter 10

  1. 1. Chapter Working capital10 1
  2. 2. 10.1 Working capital Working capital is the capital available for conducting the day-to-day operations of the business and consists of current assets and current liabilities. Current assets Current liabilities Inventories Trade payables Trade receivables Bank overdrafts Cash Short term investmentsWorking capital can be viewed as a whole but interest is usually focussed on the individualcomponents such as inventories or trade receivables. Working capital is effectively the netcurrent assets of a business.Working capital can either be: Positive Current assets are greater than current liabilities Negative Current assets are less than current liabilitiesWorking capital management Working capital management is the administration of current assets and current liabilities. Effective management of working capital ensures that the organisation is maximising the benefits from net current assets by having an optimum level to meet working capital demands.It is difficult trying to achieve and maintain an optimum level of working capital for theorganisation. For example having a large volume of inventories will have two effects, firstlythere will never be stock outs, so therefore the customers are always satisfied, but secondly itmeans that money has been spent on acquiring the inventories, which is not generating anyreturns (i.e. inventories is a non productive asset), there are also additional costs of holdingthe inventories (i.e. warehouse space, insurance etc).The important aspect of working capital is to keep the levels of inventories, trade receivables,cash etc at a level which ensures customer goodwill but also keeps costs to the minimum.With trade payables, the longer the period of credit the better as this is a form of free credit,but again the goodwill with the supplier may suffer. 2
  3. 3. 10.2 Working capital cycle (operating/trading/cash cycle)The working capital cycle measures the time between paying for goods supplied to you andthe final receipt of cash to you from their sale. It is desirable to keep the cycle as short aspossible as it increases the effectiveness of working capital. The diagram below shows howthe cycle works. Cash Trade payables Trade receivables Money owing to Customer owing money, suppliers as stock as sales made on credit purchased on credit Inventories Sold on creditThe table below shows how the activities of a business have an impact on the cash flow. TRADE PROCESS EFFECTS ON CASHInventories are purchased on credit Inventories bought on credit temporarily help with which creates trade payables. cash flow as there is no immediate to pay for these inventories. The sale of inventories is made on This means that there is no cash inflow even credit which creates trade though inventory had been sold. The cash for the receivables. sold inventory will be received later.Trade payables need to be paid, and The cash has to be collected from the tradethe cash is collected from the trade receivables and then paid to the trade payables receivables. otherwise there is a cash flow problem. 3
  4. 4. The control of working capital is ensuring that the company has enough cash in its bank.This will save on bank interest and charges on overdrafts. The company also needs to ensurethat the levels of inventories and trade receivables is not too great, as this means funds aretied up in assets with no returns (known as the opportunity cost).The working capital cycle therefore should be kept to a minimum to ensure efficient and costeffective management.Working capital cycle for a trade Inventories days (time inventories are (Inventories / cost of sales) x 365 days held before being sold) + + Trade receivables days (how long the (Trade receivables / credit sales) x 365 days credit customers take to pay) - - Trade payables days (how long the (Trade payables / purchases) x 365 days company takes to pay its suppliers) = = Working capital cycle (in days) Working capital cycle (in days)Please note that for the trade payable days calculation, if information about creditpurchases is not known then cost of sales is used instead.Example 10.1 (CIMA P7 Nov 06)DX had the following balances in its trial balance at 30 September 2006:Trial balance extract at 30 September 2006 $000 $000Revenue 2,400Cost of sales 1,400Inventories 360Trade receivables 290Trade payables 190Cash and cash equivalents 95Calculate the length of DX s working capital cycle at 30 September 2006. 4
  5. 5. Working capital cycle in a manufacturing businessAverage time raw materials are in stock (Raw materials / purchases) x 365 days + + Time taken to produce goods (WIP & finished goods / cost of sales) x 365 days + +Time taken by customers to pay for goods (Trade receivables / credit sales) x 365 days - - Period of credit taken from suppliers (Trade payables / purchases) x 365 days = = Working capital cycle (in days) Working capital cycle (in days) Please note that for the trade payable days calculation, if information about credit purchases is not known then cost of sales is used instead. Example 10.2 (CIMA P7 May 05) AD, a manufacturing entity, has the following balances at 30 April 2005: Extract from financial statements: $000 Trade receivables 216 Trade payables 97 Revenue (all credit sales) 992 Cost of sales 898 Purchases in year 641 Inventories at 30 April 2005: Raw materials 111 Work in progress 63 Finished goods 102 Calculate AD s working capital cycle. 5
  6. 6. The shorter the cycle, the better it is for the company as it means: Inventories are moving though the organisation rapidly. Trade receivables are being collected quickly. The organisation is taking the maximum credit possible from suppliers.The shorter the cycle, the lower the company s reliance on external supplies of finance likebank overdrafts which is costly.Excessive working capital means too much money is invested in inventories and tradereceivables. This represents lost interest or excessive interest paid and lost opportunities (thefunds could be invested elsewhere and earn a higher return).The longer the working capital cycle, the more capital is required to finance it.Exam questions often ask how working capital can be managed effectively. To answer thequestion you need to discuss the overall working capital levels, and then the individualcomponents like stock, debtors and creditors.10.3 OvertradingWhen a company is trading large volumes of sales very quickly, it may also be generatinglarge amounts of credit sales, and as a result large volume of trade receivables. It will also bepurchasing large amounts of inventories on credit to maintain production at the same rate assales and therefore have large volumes of trade payables. This will extend the working capitalcycle which will have an adverse effect on cash flow. If the company doesn t have enoughworking capital, it will find it difficult to continue as there would be insufficient funds tomeet all costs as they fall due.Overtrading occurs when a company has inadequate finance for working capital to support itslevel of trading. The company is growing rapidly and is trying to take on more business thatits financial resources permit i.e. it is under-capitalised . Overtrading typically occurs inbusinesses which have just started to trade and where they may have suddenly begun toexperience rapid sales growth. In this situation it is quite easy to place high importance onsales growth whilst neglecting to manage the working capital. 6
  7. 7. Symptoms of overtrading Remedies for overtrading · Fast sales growth. Short-term solutions · Increasing trade payables. · Speeding up collection from customers. · Increasing trade receivables. · Slowing down payment to suppliers. · Fall in cash balances and · Maintaining lower inventory levels. increasing overdraft. Long term solutions · Increase the capital by equity or long- term debt.Overtrading may result in insolvency which means a company has severe cash flowproblems, and that a thriving company, which may look very profitable, is failing to meets itsliabilities due to cash shortages.Over-capitalisationThis is the opposite of over trading. It means a company has a large volume of inventories,trade receivables and cash balances but very few trade payables. The funds tied up could beinvested more profitably elsewhere and so this an effective use of working capital.Differences in working capital for different industries Manufacturing Retail Service High volume of WIP Goods for re-sale only None or very littleInventories and finished goods. and usually low inventories. volume. High levels of trade Very low levels as Usually low levels as Trade receivables, as they tend most goods are bought services are paid forreceivables be dependant on a few in cash. immediately. customers. Low to medium levels Very high levels of Low levels of Trade of trade payables. trade payables due to payables. payables huge purchases of inventory. 7
  8. 8. 10.4 Types of working capital policyWithin a business, funds are required to finance both non-current and current assets. Thelevel of current assets fluctuates, although there tends to be an underlying level required forcurrent assets. Assets £m 100 Temporary fluctuating current assets 80 Permanent current assets (Core level of inventories, trade receivables etc) 50 Non current assets 0 TimeA company must decide on a policy on how to finance its long and short-term assets. Thereare 3 types of policies that exist: Conservative policy Moderate policy Aggressive policyAll the non current assets, All the non current assets All the non current assetspermanent assets and some and permanent asset are and part of permanentof the temporary current financed by long-term assets financed by longassets are financed by long- finance. The temporary term. Remainingterm finance. fluctuating assets financed permanent assets all by short-term finance. temporary fluctuating assets by short term.£90m long term debt and £80m long term debt and £65m long term debt andequity. equity. equity.£10m short term overdrafts £20m short term overdrafts £35m short term overdraftsand bank loans. and bank loans. and bank loans. 8
  9. 9. Summary of the three policies: Conservative policy Moderate policy Aggressive policy Non current assets Non current assets Non current assetsLong term Permanent assets Permanent assets Permanent assets finance Temporary current assetsShort term Temporary current assets Temporary current assets Permanent assets finance Temporary current assets With an aggressive working capital policy, a company will hold minimal levels of inventories in order to minimise costs. With a conservative working capital policy the company will hold large levels of inventories. The moderate policy is somewhere in between the conservative and aggressive. Short-term debt can be cheap, but it is also riskier than long-term finance since it must be continually renewed. Therefore with an aggressive policy, the company may report higher profits due to lower level of inventories, trade receivables and cheaper finance, but there is greater risk. Example 10.3 (CIMA P7 May 06) A conservative policy for financing working capital is one where short-term finance is used to fund: A all of the fluctuating current assets, but no part of the permanent current assets. B all of the fluctuating current assets and part of the permanent current assets. C part of the fluctuating current assets and part of the permanent current assets. D part of the fluctuating current assets, but no part of the permanent current assets. Example 10.4 (CIMA P7 Nov 05) An entity s working capital financing policy is to finance working capital using short-term financing to fund all the fluctuating current assets as well as some of the permanent part of the current assets. What is this policy an example of? 9
  10. 10. 10.5 Working capital ratiosRatios are way of comparing financial values and quantities to improve our understanding. Inparticular they are used to asses the performance of a company.When analysing performance through the use of ratios it is important to use comparisons as asingle ratio is meaningless.The use of ratios · To compare results over a period of time · To measure performance against other organisations · To compare results with a target · To compare against industry averagesWe shall now look at some of the working ratios in detail and explain how they can beinterpreted.1 Current ratio (CA) or working capital ratio CA = Current assets (times) Current liabilitiesThe current ratio measures the short term solvency or liquidity; it shows the extent to whichthe claims of short-term creditors are covered by assets. The current ratio is essentiallylooking at the working capital of the company. Effective management of working capitalensures the organisation is running efficiently. This will eventually result in increasedprofitability and positive cash flows. Effective management of working capital involves lowinvestment in non productive assets like trade receivables, inventory and current accountbank balances. Also maximum use of free credit facilities like trade payables ensuresefficient management of working capital.The normal current ratio is around 2:1 but this varies within different industries. Low currentratio may indicate insolvency. High ratio may indicate not maximising return on workingcapital. Valuation of inventories will have an impact on the current ratio, as will year endbalances and seasonal fluctuations.2 Quick ratio or acid test Quick ratio = Current assets less inventories (times) Current liabilitiesThis ratio measures the immediate solvency of a business as it removes the inventories out ofthe equation, which is the item least representing cash, as it needs to be sold. Normal isaround 1: 1 but this varies within different industries. 10
  11. 11. 3 Trade payable days (turnover) Year end trade payables x 365 days Credit purchases (or cost of sales)This is the length of time taken to pay the suppliers. The ratio can also be calculated usingcost of sales, as credit purchases are not usually stated in the financial statements. High tradepayable day s is good as credit from suppliers represents free credit. If it s too high then thereis a risk of the suppliers not extending credit in the future and may lose goodwill. High tradepayable days may also indicate that the business has no cash to pay which indicatesinsolvency problems.4 Trade receivable days (turnover) Year end trade receivables x 365 days Credit sales (or turnover)This is the average length of time taken by customers to pay. A long average collectionmeans poor credit control and hence cash flow problems may occur. The normal stated creditperiod is 30 days for most industries. Changes in the ratio may be due to improving orworsening credit control. Major new customer pays fast or slow. Change in credit terms orearly settlement discounts are offered to customers for early payment of invoices.5 Inventory days Average inventory x 365 days Cost of salesAverage inventory can be arrived by taking this year s and last year s inventory values anddividing by 2 - (Opening inventories + closing inventories) / 2. This ratio shows how longthe inventory stays in the company before it is sold. The lower the ratio the more efficientthe company is trading, but this may result in low levels of inventories to meet demand. Alengthening inventory period may indicate a slow down in trade and an excessive build up ofinventories, resulting in additional costs.6 Inventory turnover is the reciprocal of inventory days. Cost of sales x number of times Average inventoryThis shows how quickly the inventory is being sold. It shows the liquidity of inventories, thehigher the ratio the quicker the inventory is sold. 11
  12. 12. Example 10.5 (CIMA P7 May 07)DR has the following balances under current assets and current liabilities: Current assets $ Current liabilities $ Inventory 50,000 Trade payables 88,000 Trade receivables 70,000 Interest payable 7,000 Bank 10,000Calculate DR s quick ratio.Example 10.6A companys current assets are less than its current liabilities. The company issues newshares at full market price.What will be the effect of this transaction upon the company s working capital and onits current ratio? Working capital Current ratioA Increase IncreaseB Constant IncreaseC Constant DecreaseD Decrease DecreaseExample 10.7If the current ratio for a company is equal to its acid test (that is, the quick ratio), then:A The current ratio must be less than one.B Working capital is negative.C Trade payables and overdraft are greater than trade payables plus inventories.D The company does not carry any inventories 12
  13. 13. Example 10.8The following are extracts of the Income Statement and Balance Sheet for Umar plc. Extract Balance Sheet at 30 June 20X2 20X1 £ 000 £ 000 £ 000 £ 000Current assetsInventories 84 74Trade receivables 58 46Bank 6 10 148 130Current liabilitiesTrade payables 72 82Taxation 20 20 92 102Net current assets 56 - Extract Income Statement for the year ended 30 June 20X2 20X1 £ 000 £ 000 £ 000 £ 000Turnover 418 392Opening inventory 74 58Purchases 324 318 398 376Closing inventory (84) (74) 314 302Gross profit 104 90Calculate and comment on the following ratios for Umar plc:1 Current ratio2 Quick ratio3 Inventory days4 Trade receivable days5 Trade payable days6 Working capital cycle in days 13
  14. 14. Example 10.9Controlling working capitalExplain how a manufacturing company could control its working capital levels, and theimpact of the suggested control measures.Example 10.10Working capital mini Q sDuring January 20X4, Gazza Ltd made credit sales of £30,000, which have a 25% mark up.It also purchased £20,000 of inventories on credit.Calculate by how much the working capital will increase or decrease as a result of theabove transactions?Tuffy Ltd has an annual turnover of £18m on which it earns a margin of 20%. All the salesand purchases are made on credit and it has a policy of maintaining the following levels ofinventories, trade receivables and payables throughout the year. Inventory £2 million Trade receivable £5 million Trade payable £2.5 millionCalculate Tuffy Ltd s cash cycle to the nearest day? 14
  15. 15. Key summary of chapter Working capital is the capital available for conducting the day-to-day operations of the business and consists of current assets and current liabilities.Working capital management is the administration of current assets and current liabilities. Effective management of working capital ensures that the organisation is maximising the benefits from net current assets by having an optimum level to meet working capital demands. TRADE PROCESS EFFECTS ON CASHInventories are purchased on credit Inventories bought on credit temporarily help with which creates trade payables. cash flow as there is no immediate to pay for these inventories. The sale of inventories is made on This means that there is no cash inflow even though credit which creates trade inventory had been sold. The cash for the sold receivables. inventory will be received later.Trade payables need to be paid, and The cash has to be collected from the tradethe cash is collected from the trade receivables and then paid to the trade payables receivables. otherwise there is a cash flow problem.Working capital cycle Inventories days (time inventories are (Inventories / cost of sales) x 365 days held before being sold) + + Trade receivables days (how long the (Trade receivables / credit sales) x 365 days credit customers take to pay) - - Trade payables days (how long the (Trade payables / purchases) x 365 days company takes to pay its suppliers) = = Working capital cycle (in days) Working capital cycle (in days) 15
  16. 16. Working capital cycle in a manufacturing business Average time raw materials are in stock (Raw materials / purchases) x 365 days + + Time taken to produce goods (WIP & finished goods / cost of sales) x 365 days + +Time taken by customers to pay for goods (Trade receivables / credit sales) x 365 days - - Period of credit taken from suppliers (Trade payables / purchases) x 365 days = = Working capital cycle (in days) Working capital cycle (in days) Overtrading occurs when a company has inadequate finance for working capital to support its level of trading. The company is growing rapidly and is trying to take on more business that its financial resources permit i.e. it is under-capitalised . Conservative policy Moderate policy Aggressive policy Non current assets Non current assets Non current assetsLong term Permanent assets Permanent assets Permanent assets finance Temporary current assetsShort term Temporary current assets Temporary current assets Permanent assets finance Temporary current assets 16
  17. 17. Working capital ratios Current assets_ (number of times) Current ratio Current liabilities Current assets inventory (number of times) Quick ratio Current liabilities Trade payables_____ x 365 days Trade payable days Cost of sales (or purchases) Inventory_ x 365 days Inventory days Cost of sales Trade receivable x 365 daysTrade receivable days Sales Cost of sales x number of times Inventory turnover Average inventory 17
  18. 18. Solutions to lecture examples 18
  19. 19. Chapter 10Example 10.1 (CIMA P7 Nov 06) Inventories days (Inventories / cost of sales) x 365 days 93.9 days (360 / 1,400) x 365 days Trade receivable days (Trade receivables / credit sales) x 365 days 44.1 days (290 / 2,400) x 365 days Trade payable days (Trade payables / cost of sales) x 365 days 49.5 days (190 / 1,400) x 365 days Working capital cycle 93.9 + 44.1 49.5 88.5 daysExample 10.2 (CIMA P7 May 05)1 Average time raw materials are in stock(Raw materials / purchases) x 365 days(111 / 641) x 365 = 63.2 days2 Time taken to produce goods(Work in progress & finished goods / cost of sales) x 365 days(63 + 102 / 898) x 365 = 67.1 days3 Time taken by customers to pay for goods(Trade receivables / credit sales) x 365 days(216 / 992) x 365 = 79.5 days4 Period of credit taken from suppliers(Trade payables / purchases) x 365 days(97 / 641) x 36 = 55.2 daysWorking capital cycle = 63.2 + 67.1 + 79.5 55.2 = 154.6 days 19
  20. 20. Example 10.3 (CIMA P7 May 06)The answer is D.Example 10.4 (CIMA P7 Nov 05)An aggressive policy.Example 10.5 (CIMA P7 May 07)Quick ratio = (current assets inventory) / current liabilities = (70,000 + 10,000) / (88,000 + 7,000) = 0.84Example 10.6The answer is A.The cash balance will increase, which means there is more working capital. The current ratiowill increase as there are more current assets than current liabilities.Example 10.7The answer is D. 20
  21. 21. Example 10.81 Current ratio = 148 / 92 = 1.61 for 20X2 =130 / 102 = 1.27 for 20X1The current ratio has increased, meaning that the organisation is more liquid. This is due tothe fact that inventory and trade receivables have increased (which are non productive assets),and trade payables have been reduced. Although this may be better for the current ratio, itmay not necessarily mean that the company is operating more efficiently. Has it increased itinventory piles because it anticipates higher sales and doesn t want to run out? Is it offeringit s credit customers longer time to pay to increase sales? Why are they paying their suppliersquicker? Surely it would be better to take as long as possible?2 Quick ratio = (148 84) / 92 = 0.70 for 20X2 = (130 74) / 102 = 0.55 for 20X1In 20X2 current liabilities are better covered than 20X1. Bad management of working capitalperhaps investigate further.3 Inventory days = (74 + 84) x 0.5 / 314 x 365 days = 91.8 days for 20X2 = (58 + 74) x 0.5 / 302 x 365 days = 79.8 days for 20X1Inventory is taking longer to sell; this could indicate poor inventory management. Why haveinventory levels risen? Maybe the company is taking a cautious approach and wants toensure enough is available to meet customer needs. But this is resulting in additional costs(unproductive asset)4 Trade receivable days = 58 / 418 x 365 days = 50.6 days for 20X2 = 46 / 392 x 365 days = 42.8 days for 20X1The collection of debts is worsening. Have the credit terms been extended to increase sales.Are there new customers who were not screened properly, resulting in delayed payments? Isthere a delay in issuing invoices, lack of screening new customers? Are the year end figuresrepresentatives of the year? Perhaps there are seasonal fluctuations that need to beconsidered. Further investigation required as yet again this is an unproductive asset.5 Trade payable days = 72 / 324 x 365 = 81.1 days for 20X2 = 82 / 318 x 365 = 94.1days for 20X1(Alternatively could have used cost of sales)The suppliers are being paid quicker, which is good for relationship with the suppliers, butbad for cash flow purposes. It is still quite high and might jeopardise supplier relationship,discounts foregone etc. Trade credit is a free source of finance, and the company must try tomaximise this. 21
  22. 22. 6 Working capital cycle 20X2 20X1Inventories days 91.8 79.8 PlusTrade receivables days 50.6 42.8 MinusTrade payables days (81.1) (94.1) EqualsWorking capital cycle (in days) 61.3 28.5In 20X2, the working capital cycle increased to 61.3 days from 28.5 days in 20X1. Thecompany is taking longer to covert its inventories into cash. The management of inventories,receivables and payables has deteriorated, and this needs to be investigated and corrected.Example 10.9Controlling working capitalSome of the practical aspects that could be taken to achieve this include:1 Reducing average raw material inventory holding period· Ordering in small quantities to meet immediate production requirements, but could lose quantity discounts.· Reducing the level of buffer stocks if these are held, but this will increase the risk of production being halted due to a stock out.· Reducing the lead time allowed to suppliers, but could also increase the risk of a stock out.2 Increase the period of credit taken from suppliers· If the credit period is extended then the company may lose discounts from prompt payment. The financial effect of this should be calculated and compared with the cost of funds from other sources.· If credit period is extended then goodwill may be lost, which is important in the event of goods being required urgently. 22
  23. 23. 3 Reducing the time taken to produce goods and inventory holding period or finished inventories· Efficiency leads to cost savings, therefore finding an efficient way to produce goods (i.e. in economic batch quantities), but the company must ensure than quality is not sacrificed.· The savings arising from inventory holding reduction must be evaluated against the cost of inventory out, together with the effect on customer service.4 Reducing the average debt collection period· The administrative costs of speeding up debt collection and the effect on sales of reducing credit period allowed must be evaluated.Example 10.10Working capital mini Q sFirstly note the difference between a mark up and a marginMark-up = 100% + 25% = 125% Profit = (25 / 125) Cost = 100 / 125Margin = 75% + 25% = 100% Profit = (25 / 100) Cost = 75 / 1001 Effect on WCIncrease in trade receivables £30,000Increase in trade payables (£20,000)Inventories increase due to purchases £20,000Inventories Decrease due to sales (i.e. COS) {30,000 x 100 / 125} (£24,000)Net effect on WC - increase £ 6,0002 Cash cycle = inventory days + trade receivable days trade payable daysInventory days = Average inventory x 365 Cost of salesCost of sales = £18 million x 0.8 = £14.4 million 23
  24. 24. Inventory days = £2 / £14.4 x 365 = 51 daysTrade receivable days = Trade receivable / sales x 365 = £5 / £18 x 365 = 101 daysTrade payable days = Trade payable / COS x 365 = £2.5m / £14.4 x 365 = (63) daysCash cycle = 89 days89 days is the average time from the payment of a supplier to the receipt from a customer. 24

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