Week 22 - The Appraisal of Working Capital Flashcards
(97 cards)
1
Q
What is working capital?
A
Working capital refers to net current assets, calculated as current assets minus current liabilities.
2
Q
What does working capital indicate?
A
It indicates the financial resources available for a company’s daily operational needs.
3
Q
How do you calculate working capital?
A
Working Capital = Current Assets – Current Liabilities
4
Q
What are examples of current assets?
A
Cash, inventory, accounts receivable, and short-term investments.
5
Q
What are examples of current liabilities?
A
Accounts payable, short-term debt, and accrued expenses.
6
Q
What does the measure of working capital indicate about a company?
A
It shows the company’s ability to manage elements of working capital effectively.
7
Q
What is the working capital cycle?
A
The working capital cycle is the process of converting current assets and liabilities into cash through business operations.
8
Q
What is the first stage of the working capital cycle?
A
Raw materials are purchased to begin production.
9
Q
What follows raw materials in the working capital cycle?
A
Work in progress — the raw materials are used in production.
10
Q
What comes after work in progress in the cycle?
A
Finished goods are completed and ready for sale.
11
Q
What are the two types of sales in the cycle?
A
Cash sales and credit sales.
12
Q
What happens after credit sales?
A
Trade receivables are created — the business waits to receive payment.
13
Q
What does the business receive after collecting trade receivables?
A
Cash in bank or hand, completing the cash conversion.
14
Q
What role do trade payables play in the cycle?
A
They represent amounts owed to suppliers, which can delay outflows and help manage cash.
15
Q
What is the relationship between working capital and cash?
A
Working capital occupies cash by tying it up in current assets like inventory and receivables.
16
Q
What are the consequences of poor working capital management?
A
It increases working capital needs, requiring more cash and short-term financing, which pressures company liquidity.
17
Q
How can a company reduce pressure on its cash and liquidity?
A
By minimising its working capital needs, it reduces reliance on short-term financing.
18
Q
Do all industries have the same working capital needs?
A
No, working capital size and composition vary by industry.
19
Q
What are working capital characteristics of a service industry (e.g., consulting)?
A
Low or no inventories, mostly receivables and payables
Short business cycles, low working capital needs
20
Q
What are working capital characteristics of a manufacturing industry?
A
High inventories (raw materials, WIP, finished goods), high receivables and payables
Long production cycles, high working capital needs
21
Q
What are the three key components of working capital?
A
Trade receivables, inventories, and trade payables.
22
Q
How do trade receivables affect cash?
A
More trade receivables mean less cash at hand.
23
Q
How do inventories affect cash?
A
More inventories mean less cash at hand.
24
Q
How do trade payables affect cash?
A
More trade payables mean more cash at hand.
25
What are the two forms of working capital ratios?
"In periods" (measured in days) and "in times" (measured as a turnover ratio).
26
What does a shorter settlement period for trade receivables indicate?
Faster collection of receivables and improved cash flow.
27
What does a longer payment period for trade payables indicate?
Delayed cash outflows, helping preserve cash.
28
What does a shorter inventory holding period indicate?
Faster inventory turnover and improved efficiency.
29
What is the effect of reducing all three periods on the operating cash cycle?
It decreases the operating cash cycle, improving liquidity.
30
What does a higher trade receivable turnover ratio indicate?
Receivables are collected more quickly.
31
What does a lower trade payable turnover ratio indicate?
The company is taking longer to pay suppliers.
32
What does a higher inventory turnover ratio indicate?
Inventory is sold and replaced more quickly.
33
How are "in periods" and "in times" related?
They are inverses of each other.
34
What is the formula to convert turnover to days?
Days = 365 ÷ Turnover
35
If something happens once per year, how many days does it take?
365 ÷ 1 = 365 days
36
If something happens twice per year, how many days does it take?
365 ÷ 2 = 182.5 days
37
If something happens three times per year, how many days does it take?
365 ÷ 3 ≈ 122 days
38
What does a higher turnover (in times/year) imply about the number of days?
A higher turnover means fewer days — faster activity.
39
What are trade (or account) receivables?
Amounts owed to a company by customers from credit sales.
40
What is the Accounts Receivable Turnover ratio?
It measures how many times accounts receivable are collected (turned over) during a year.
41
What is the formula for A/R Turnover?
A/R Turnover = Credit Sales ÷ Average Accounts Receivable
42
What does a higher A/R turnover indicate?
Customers are paying faster — better cash collection efficiency.
43
What is Days A/R Outstanding?
The average number of days it takes to collect receivables from customers.
44
What is the formula for Days A/R Outstanding?
Days A/R = 365 ÷ A/R Turnover
45
What does a lower Days A/R figure indicate?
Faster collection of payments and improved liquidity.
46
What does Trade Receivables Turnover measure?
It measures how many times a company collects its trade receivables during a year.
47
What is the formula for Trade Receivables Turnover?
Trade Receivables Turnover = Credit Sales ÷ Average Trade Receivables
48
What does a higher trade receivables turnover indicate?
Faster collection of receivables — shorter time between sales and cash collection.
49
Is a higher trade receivables turnover generally good or bad?
Generally good — it indicates better cash flow and efficient credit management.
50
What could a high trade receivables turnover indicate?
Efficient collection of receivables
Customers have low bargaining power
Sales are mostly in cash rather than on credit
51
What could a low trade receivables turnover indicate?
Inefficient collection of receivables
Customers have high bargaining power
The company is offering favourable credit terms to boost sales
52
Trade receivables turnover Example: J Sainsbury plc 2020
Trade Receivables (current only): £811m
Credit Sales £28,993m (assume all sales on credit basis)
Trade receivables turnover = 28,993/ 811
= 35.75 times
Interpretation:
On average, Sainsbury collects its trade receivables 36 times a
year
53
What is the settlement period for trade receivables?
It is the average number of days it takes for a company to collect cash from its credit customers.
54
What is the formula for the settlement period for A/R?
Settlement Period = (Average Accounts Receivable ÷ Credit Sales) × 365 days
55
What does a longer settlement period mean for a business?
Cash is tied up longer in receivables
Slower cash inflow
Potential liquidity issues
56
What does a shorter settlement period suggest?
Faster collection from customers
Improved cash flow and liquidity
57
Settlement period for A/R Example: J Sainsbury plc 2020
– A/R (current only): £811m
– Credit Sales £28,993m (assume all sales on credit basis)
Settlement period for
trade receivables = 811/ 28993 x 365 = 10.21
Interpretation:
– Sainsbury needs to wait on average around 10 days before it can receive
cash from credit customers.
58
Why might we use average trade receivables instead of year-end trade receivables?
The average trade receivables over the year provide a more representative view of the trade receivable level throughout the year, instead of just at year-end.
59
How do you calculate average trade receivables?
Average Trade Receivables = (Trade Receivables at Year End + Trade Receivables at Previous Year End)/ 2
60
What should be considered when calculating ratios with different sources (e.g., balance sheet and income statement)?
All ratios should be computed on a consistent basis (e.g., using either average or year-end values) to ensure accurate comparisons.
61
What should you use as a proxy for credit sales if they are not disclosed separately?
Use total sales as a proxy for credit sales. For exams, if credit sales are unknown, use revenue instead.
62
What factors may influence the collection period for trade receivables?
Seasonal business (depending on the timing of the accounting year-end)
A few slow payers who delay payments
63
How does the average period of credit vary?
It varies between industries and according to the economic situation.
64
What could an abnormally high period of credit indicate?
It may indicate poor credit control procedures.
65
What is the formula for the Settlement Period for Trade Receivables?
Settlement Period = Trade Receivables/ Credit Sales x365
66
What does the Settlement Period for Trade Receivables tell us?
It tells us how long the company typically waits before collecting cash from its customers.
67
What does a lower settlement period for trade receivables indicate?
A lower settlement period is generally better, as it means the company is collecting payments more quickly and improving cash flow.
68
What does A/P Turnover measure?
It measures how many times a company pays off its trade payables during a year.
69
What is the formula for A/P Turnover?
A/P Turnover = Credit Purchases/ Average Accounts Payable
70
What is the formula for Days A/P Outstanding?
Days A/P Outstanding = 365/ A/P Turnover
71
What does Days A/P Outstanding tell us?
It tells us the average number of days a payable sits on the books before being paid.
72
What does a higher A/P turnover indicate?
A higher A/P turnover indicates that the company is paying its payables more quickly.
73
What does a lower Days A/P Outstanding indicate?
A lower Days A/P Outstanding indicates that the company is paying its payables faster, improving relationships with suppliers.
74
What does Trade Payables Turnover measure?
It measures how many times a company pays off its trade payables during a year.
75
What is the formula for Trade Payables Turnover?
Trade Payables Turnover = Credit Purchases/ Average Trade Payable
76
What should you do if credit purchase information is not directly available?
Use total purchases as a proxy for credit purchases.
77
How can you calculate total purchases if you only have information about inventory and cost of goods sold (COGS)?
Purchase = Closing Inventory - Opening Inventory + COGS
78
What does a lower Trade Payables Turnover indicate?
A lower turnover means the company is taking longer to pay off its trade payables.
79
What could a high trade payables turnover indicate?
Could either indicate
Suppliers have more bargaining power and demand faster payment terms.
The company may be taking advantage of early payment discounts.
80
What could a low trade payables turnover indicate?
Could either indicate
The company has more bargaining power than its suppliers, allowing it to pay off payables late.
The company might be in bad financial condition, struggling to pay off trade payables quickly.
81
Trade payables turnover
Example: J Sainsbury plc 2020
– Trade Payables in 2020: £4,275m
– COGS in 2020: £26,977m
– Inventory at the year end 2020: £1,732
– Inventory at the year end 2019: £1,929
Purchase = Closing inventory – Opening inventory + COGS
= Inventory 2020 – Inventory 2019 + COGS 2020
= 1732 – 1929 + 26977
= 26780
Trade payables turnover = 26780/ 4275 = 6.26 times
Interpretation:
– Sainsbury pays off its trade payables to suppliers, on average, 6 times in a year
82
What does the payment period for trade payables indicate?
It indicates the average length of time it takes for a company to pay its trade payables.
83
How is the payment period for trade payables calculated?
Payment Period for Trade Payables = Trade Payables/ Credit Purchases x 365
84
What does a longer payment period for trade payables mean for a company?
A longer payment period means that the company is taking more time to pay its payables, which keeps cash tied up for a shorter time and helps with liquidity.
85
What does a shorter payment period for trade payables imply?
A shorter payment period means the company is paying off its payables more quickly, potentially improving relationships with suppliers but using cash more quickly.
86
Payment period for trade payables
Example: J Sainsbury plc 2020
– Trade Payables in 2020: £4,275m
– COGS in 2020: £26,977m
– Inventory at the year end 2020: £1,732
– Inventory at the year end 2019: £1,929
Purchase = Closing inventory – Opening inventory + COGS
= Inventory 2020 – Inventory 2019 + COGS 2020
= 1732 – 1929 + 26977
= 26780
Payment period for trade payables = 4275/ 26780 × 365 = 58.27days
Interpretation:
– Sainsburys spent on average around 58 days to pay cash to its
suppliers, when making purchases on credit
87
Why might you use average trade payables instead of year-end trade payables?
The average trade payables over the year provide a more representative figure of the "normal" level of trade payables.
88
How do you calculate average trade payables?
Average Trade Payables = (Trade Payables at Year End + Trade Payables at Previous Year End)/ 2
89
What does using average trade payables help to reflect?
It helps reflect the typical or normal level of trade payables, smoothing out any fluctuations at year-end.
90
What is a common issue when calculating trade payables ratios?
Purchases are not usually disclosed separately and often need to be estimated.
91
How can you calculate purchases if inventory and COGS data are available?
Purchases = Closing Inventory - Opening Inventory + COGS
92
What should you do on an exam if the prior year inventory is not given?
Use Cost of Sales (COGS) as a proxy for purchases and follow the exam formula sheet.
93
Why might a company delay paying its suppliers?
Delaying payments can be beneficial for cash flow, but may affect the company’s credit rating or supplier relationships.
94
What can a high payment period relative to other firms suggest?
It may indicate financial distress or poor liquidity.
95
What does the Payment Period for Trade Payables tell us?
It tells us how long a company typically waits before paying its suppliers.
96
Is a higher payment period for trade payables generally better?
Yes, because it means the company can hold on to cash longer, improving liquidity.
97
What is a potential risk of a very high payment period?
It could damage supplier relationships or indicate financial trouble if it’s abnormally high.
