Working Capital and Operating cycle Flashcards
Define Working capital
Short-term assets and liabilities
- capital available to fund the day-to-day operations of an entity
- excess of your current assets over current liabilities
What does working capital management involve
The balance between the requirement to minimise the risk of insolvency (due to insufficient cash)
and the requirement to maximise profits (through minimising costs and maximising returns)
What is the working capital cycle?
Period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a purchaser
also known as the cash cycle/ operating cycle
How is the working capital cycle calculated?
Inventory days + Receivables days - Payable days
=Number of days of ‘cash’ we need
What does the inventory days ratio show
How long on average goods are held in inventory before they are sold
Generally the lower the better
When an entity is manufacturing business what elements are in the inventory days ratio
Raw material days, Work-in-progress days, Finished good days
Inventory Days Ratio Formula
(Average Inventory/ Cost of Sales) x 365 Days
How to work out average Inventory
Opening Balance - Closing balance / 2
How to find inventory ratio in days
Average inventory/ cost of sales x 12
What does an increasing trend in inventory days show
Increasing ratio: slowdown in trading - business should take action
Or due to an active decision to build up inventory by management
Need to compare to an industry average to identify potential issue
Define Receivable days
Shows how long on average customers take to pay for goods bought on credit
Receivable days ratio formula
Average Receivables/ Credit sales x 365 days
What are the risks of receivables
-Cash tied up in inventory
- Risk of Debt
- Slow Payment risks
What considerations are there for the receivables ratio?
Receivables days raito should compared with an entity’s credit terms to determine effectiveness
An increasing ratio could indicate that customers are having financial difficulty
What is the payable day ratio formula?
Average Payable days/ Credit purchases x 365 days
What does the payables days ratio show
On average how long does the business take to pay for goods they have bought on credit
How to work out Raw material days
Average raw materials/ Raw materials purchased or used x 365
How to work out WIP days
Average WIP/ Cost of production (factory costs) x 365
How to work out working capital
Raw materials period + WIP period + Finished good periods + Receivables period - Payables period = working capital
How to work out Finished good days
Average finished goods/ cost of sales x 365
What are actions that could be taken to decrease working capital?
- Reduce Raw materials ordered or just in time order (risk of not having enough stock)
- Reduce WIP days by speeding production (costs involved to speed up)
- Reduce FG days- extra marketing, reduce prices (costs incurred decrease in profits)
- Reduce receivable days - offer discounts and chase for payments (upsetting customers, costs incurred)
- Increase time to pay suppliers to increase payables (discounts lost, risk of losing suppliers)
What does liquidity measure
An entity’s ability to meet its debts as they fall due
Current Ratio
How many times an entity’s current assets cover its current liabilities
Current Assets/ Current Liabilities
What current ratio is ideal for most businesses
At least 1 and ideally 2
