Chapter 3 - Management Of Working Capital Flashcards
What is Working capital
Working capital is the name given to net current assets which are available for day-to-day operating activities
It normally includes inventory receivables cash/cash equivalents than less any payables
Working capital = receivables + Cash + inventory - payables
Why invest in working capital
It is the investments in non-current assets that earns profits for the company. Investments in working capital does not directly earn profits However companies need some working capital in order to run the business so no wise to put all resources in areas that earn profit as you need to;
- Allow customers to pay on credit and therefore have receivables otherwise they would lose business to competitors
- They need to carry inventory of finish goods in order to be able to fulfil demand
- They need to have a short-term cash balance in order to pay their bills
Therefore the company has a trade off between liquidity and profitability
Examples of long term and short term finance
Long term - loans, share issues
Short term - delayed payments to suppliers or overdraft
What is overtrading (or under capitalisation)
Is where the level of working capital is too low
What is overcapitalisation ?
Over capitalisation is where the overall level of working capital is too high
The solution is to reduce the level by better management of receivables cash and inventory
What is the operating cycle / cash operating cycle / working capital cycle ?
It’s the length of time between the payment of materials entering into inventory and the receipt of the proceeds of sales
Is essence it is the time without cash, difference between the cash in vs cash out using ratios like payable days and receivable days
What are the problems with the use of ratios ?
The statement of financial position is one point in time which is dangerous as won’t take into consideration seasonal factors
There may be window dressing
They only look at the present and not the future
They are of little value unless used in comparison
What are the efficiency ratios
Inventory turnover
Cost of goods sold per annum / average inventory
Receivables turnover
Credit sales per annum / average receivables
Payables turnover
Credit purchases per annum / average payables
How to work out operating cycle when given a extract of the SFP
Calculate the ratios for receivables/ payable days etc and you can work out the difference between cash in and cash out
