Working Capital Management

Question 1

Gross Working Capital

Answer 1

The firm’s investment in current assets.

Question 2

The firm’s investment in current assets.

Answer 2

The administration of the firm’s current assets and the financing needed to support current assets.

Question 3

Significance of Working Capital Management 4

Answer 3

1. In a typical manufacturing firm, current assets exceed one-half of total assets.
2. Excessive levels can result in a substandard Return on Investment (ROI).
3. Current liabilities are the principal source of external financing for small firms.
4. Requires continuous, day-to-day managerial supervision.

Question 4

Working Capital Issues: Current Assets 2

Answer 4

• Working capital management affects the company’s risk, return, and share price.
• Working capital management affects:
  
  • Liquidity
  • Profitability
  • Risk

Question 5

Impact on Risk 3

Answer 5

1. Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk!
2. Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!
3. Lower inventory levels increase stockouts and lost sales. More risk

Question 6

Classifications of Working Capital: Components 5

Answer 6

1. Cash
2. marketable securities
3. receivables
4. inventory
5. Time (permanent/Temporary)

Question 7

Financing Needs and the Hedging Approach 2

Answer 7

• Fixed assets and the non-seasonal portion of current assets are financed with long-term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm).
• Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost).

Question 8

Risks vs. Costs Trade-Off (Conservative Approach) 3

Answer 8

Long-Term Financing Benefits

• Less worry in refinancing short-term obligations
• Less uncertainty regarding future interest costs

Short-Term Financing Risks

• Borrowing more than what is necessary
• Borrowing at a higher overall cost (usually)

Result

• Manager accepts less expected profits in exchange for taking less risk.

Question 9

Comparison with an Aggressive Approach 3

Answer 9

Short-Term Financing Benefits

• Financing long-term needs with a lower interest cost than short-term debt
• Borrowing only what is necessary

Short-Term Financing Risks

• Refinancing short-term obligations in the future
• Uncertain future interest costs

Result

• Manager accepts greater expected profits in exchange for taking greater risk.

Question 10

Inventory Management

Answer 10

• Seeks to minimise cost of holding inventory for production or resale.

Question 11

How does a firm determine the appropriate level of inventories?

Answer 11

Compare the benefits of economies of production, purchasing, and product marketing against the cost of the additional investment in inventories

Question 12

ABC Method of Inventory Control

Answer 12

Method which controls expensive inventory items more closely than less expensive items

• Review “A” items most frequently
• Review “B” and “C” items less rigorously and/or less frequently.

Question 13

When to Order? Issues to consider: 2

Answer 13

Lead Time – The length of time between the placement of an order for an inventory item and when the item is received in inventory.

Order Point – The quantity to which inventory must fall in order to signal that an order must be placed to replenish an item

Question 14

Safety Stock -

Answer 14

inventory stock held in reserve as a cushion against uncertain demand (or usage) and replenishment lead time.

Question 15

Just-in-Time Approach

Answer 15

An approach to inventory management and control in which inventories are acquired and inserted in production at the exact times they are needed

Question 16

Requirements of Just-in-Time Approach 4

Answer 16

1. A very accurate production and inventory information system
2. Highly efficient purchasing
3. Reliable suppliers
4. Efficient inventory-handling system

Question 17

Cash Management

Answer 17

Holding cash for short-term needs will incur opportunity cost of lost profit.

Question 18

Causes of cash flow problems: 6

Answer 18

1. making losses on a continuing basis
2. inflation
3. growth
4. seasonal factors
5. significant expenditure
6. Cash flow shortages can be eased by postponing expenditure, accelerating income and finding new cash resources.

Question 19

Choice of investment depends on: 4

Answer 19

1. size of the cash surplus
2. maturity of the short-term asset
3. yield required
4. any penalties for early encashment.

Question 20

Receivables Management 10

Answer 20

1. Receivables levels depend on terms of sale, ability of company to finance receivables, pricing policy and receivables collection procedures.
2. Administrative costs include recording, monitoring and collecting debts: bad debt collection costs; and credit insurance.
3. Finance costs include investment in receivables and losses due to bad debts.
4. Credit analysis should be based on company’s own experience, analysis of credit reports and analysis of published information.
5. Credit extended should reflect assessment of credit worthiness of prospective client.
6. Credit assessment should consider previous experience of similar firms, credit reports, analysis of published information.
7. Company can ensure agreed terms of sale are kept to thorough periodic review of credit limits, aged trade receivables analysis, efficient administration, agreed overdue account procedures.
8. Cash discounts may encourage early payment.
9. Cost of discount must be compared with benefit of lower financing charges and any decrease in risk of bad debts.
10. Benefits should exceed costs.