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Working capital

Chapter

10

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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

InventoriesTrade receivables

CashShort term investments

Trade payablesBank overdrafts

Working 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 liabilities

Working 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 capitaldemands.

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.

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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

held before being sold)

+

Trade receivables days (how long thecredit customers take to pay)

-

Trade payables days (how long the

company takes to pay its suppliers)

=

Working capital cycle (in days)

(Inventories / cost of sales) x 365 days

+

(Trade receivables / credit sales) x 365 days

-

(Trade payables / purchases) x 365 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 10.1 (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 95

Calculate the length of DXs working capital cycle at 30 September 2006.

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Working capital cycle in a manufacturing business

Average time raw materials are in stock

+

Time taken to produce goods

+

Time taken by customers to pay for goods

-

Period of credit taken from suppliers

=


(Raw materials / purchases) x 365 days

+

(WIP & finished goods / cost of sales) x 365 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 216Trade payables 97

Revenue (all credit sales) 992Cost of sales 898Purchases in year 641

Inventories at 30 April 2005:

Raw materials 111Work in progress 63Finished goods 102

Calculate ADs working capital cycle.

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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 like bank overdrafts which is costly.

Excessive working capital means too much money is invested in inventories and trade

receivables. 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 Overtrading

When 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 be

purchasing 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 in

businesses 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.

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Symptoms of overtrading Remedies for overtrading

·

Fast sales growth.· Increasing trade payables.

· Increasing trade receivables.

· Fall in cash balances andincreasing overdraft.

Short-term solutions· Speeding up collection from customers.

· Slowing down payment to suppliers.

· Maintaining lower inventory levels.

Long term solutions

· Increase the capital by equity or long-term debt.

Overtrading may result in insolvency which means a company has severe cash flow problems, and that a thriving company, which may look very profitable, is failing to meets itsliabilities due to cash shortages.

Over-capitalisation This 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

Inventories

High volume of WIPand finished goods.

Goods for re-sale onlyand usually lowvolume.

None or very littleinventories.

Trade

receivables

High levels of tradereceivables, as they tend

be dependant on a fewcustomers.

Very low levels asmost goods are boughtin cash.

Usually low levels asservices are paid forimmediately.

Trade

payables

Low to medium levelsof trade payables.

Very high levels oftrade payables due tohuge purchases ofinventory.

Low levels of payables.

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10.4 Types of working capital policy

Within 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 for

current assets.Assets £m

100

80

50

0Time

A 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 policy

All the non current assets, permanent assets and someof the temporary currentassets are financed by long-term finance.

All the non current assetsand permanent asset arefinanced by long-termfinance. The temporaryfluctuating assets financed

by short-term finance.

All the non current assetsand part of permanentassets financed by longterm. Remaining

permanent assets alltemporary fluctuating assets

by short term.

£90m long term debt andequity.

£10m short term overdraftsand bank loans.





Permanent current assets

(Core level of inventories, trade receivables etc)

Non current assets

Temporary fluctuating current assets

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Summary of the three policies:


Long term

finance

Non current assetsPermanent assets

Temporary current assets



Short term

finance

Temporary current assets Temporary current assets Permanent assetsTemporary current assets

With an aggressive working capital policy, a company will hold minimal levels of inventoriesin order to minimise costs. With a conservative working capital policy the company will holdlarge levels of inventories. The moderate policy is somewhere in between the conservativeand aggressive.

Short-term debt can be cheap, but it is also riskier than long-term finance since it must becontinually 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 isgreater risk.


A conservative policy for financing working capital is one where short-term finance is usedto 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.


An entity s working capital financing policy is to finance working capital using short-termfinancing to fund all the fluctuating current assets as well as some of the permanent partof the current assets.

What is this policy an example of?

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10.5 Working capital ratios

Ratios are way of comparing financial values and quantities to improve our understanding. In particular 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 averages

We 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 liabilities

The 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 capital

ensures the organisation is running efficiently. This will eventually result in increased profitability and positive cash flows. Effective management of working capital involves lowinvestment in non productive assets like trade receivables, inventory and current account

bank 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 end

balances and seasonal fluctuations.

2 Quick ratio or acid test

Quick ratio = Current assets less inventories (times)Current liabilities

This 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.

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3 Trade payable days (turnover)

Year end trade payables x 365 daysCredit 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 trade

payable 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 trade

payable 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 daysCredit 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 credit

period 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 daysCost of sales

Average 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 timesAverage inventory

This shows how quickly the inventory is being sold. It shows the liquidity of inventories, thehigher the ratio the quicker the inventory is sold.

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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 10,000

Calculate DR s quick ratio.

Example 10.6

A company's 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 companys working capital and on

its current ratio?

Working capital Current ratio

A Increase IncreaseB Constant IncreaseC Constant DecreaseD Decrease Decrease

Example 10.7

If 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

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Example 10.8

The following are extracts of the Income Statement and Balance Sheet for Umar plc.

Extract Balance Sheet at 30 June20X2 20X1

£ 000 £ 000 £ 000 £ 000

Current assetsInventories 84 74

Trade receivables 58 46Bank 6 10

148 130

Current liabilitiesTrade payables 72 82

Taxation 20 20

92 102 Net current assets 56 -

Extract Income Statement for the year ended 30 June

20X2 20X1£ 000 £ 000 £ 000 £ 000

Turnover 418 392

Opening inventory 74 58Purchases 324 318

398 376Closing inventory (84) (74)314 302

Gross profit 104 90

Calculate and comment on the following ratios for Umar plc:

1 Current ratio2 Quick ratio

3 Inventory days4 Trade receivable days5 Trade payable days6 Working capital cycle in days

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Example 10.9

Controlling working capital

Explain how a manufacturing company could control its working capital levels, and theimpact of the suggested control measures.

Example 10.10

Working capital mini Qs

During 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 the

above 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 millionTrade payable £2.5 million

Calculate Tuffy Ltds cash cycle to the nearest day?

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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 capitaldemands.

TRADE PROCESS EFFECTS ON CASH

Inventories are purchased on creditwhich creates trade payables.

Inventories bought on credit temporarily help withcash flow as there is no immediate to pay for these

inventories.

The sale of inventories is made oncredit which creates trade

receivables.

This means that there is no cash inflow even thoughinventory had been sold. The cash for the sold

inventory will be received later.

Trade payables need to be paid, andthe cash is collected from the trade

receivables.

The cash has to be collected from the tradereceivables and then paid to the trade payables

otherwise there is a cash flow problem.

Working capital cycle

Inventories days (time inventories are

held before being sold)

+

Trade receivables days (how long the

credit customers take to pay)

-

Trade payables days (how long the

company takes to pay its suppliers)

=


(Inventories / cost of sales) x 365 days

+


-


=


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Working capital cycle in a manufacturing business

Average time raw materials are in stock

+

Time taken to produce goods

+

Time taken by customers to pay for goods

-

Period of credit taken from suppliers

=



+

(WIP & finished goods / cost of sales) x 365 days

+


-


=


Overtrading occurs when a company has inadequate finance for working capital to supportits level of trading. The company is growing rapidly and is trying to take on more businessthat its financial resources permit i.e. it is

under-capitalised .


Long term

finance


Temporary current assets



Short term

finance

Temporary current assets Temporary current assets Permanent assetsTemporary current assets

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Working capital ratios

Current ratioCurrent assets_ (number of times)

Current liabilities

Quick ratioCurrent assets inventory (number of times)

Current liabilities

Trade payable daysTrade payables_____ x 365 days

Cost of sales (or purchases)

Inventory daysInventory_ x 365 days

Cost of sales

Trade receivable daysTrade receivable x 365 days

Sales

Inventory turnoverCost of sales x number of times

Average inventory

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Solutions to lecture examples

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Chapter 10


Inventories days (Inventories / cost of sales) x 365 days(360 / 1,400) x 365 days

93.9 days

Trade receivable days (Trade receivables / credit sales) x 365 days(290 / 2,400) x 365 days

44.1 days

Trade payable days (Trade payables / cost of sales) x 365 days(190 / 1,400) x 365 days

49.5 days

Working capital cycle 93.9 + 44.1 49.5 88.5 days


1 Average time raw materials are in stock


(111 / 641) x 365 = 63.2 days

2 Time taken to produce goods

(Work in progress & finished goods / cost of sales) x 365 days

(63 + 102 / 898) x 365 = 67.1 days

3 Time taken by customers to pay for goods


(216 / 992) x 365 = 79.5 days

4 Period of credit taken from suppliers


(97 / 641) x 36 = 55.2 days

Working capital cycle = 63.2 + 67.1 + 79.5 55.2 = 154.6 days

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The answer is D.


An aggressive policy.


Quick ratio = (current assets inventory) / current liabilities

= (70,000 + 10,000) / (88,000 + 7,000)

= 0.84

Example 10.6

The 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 10.7

The answer is D.

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Example 10.8

1 Current ratio = 148 / 92 = 1.61 for 20X2=130 / 102 = 1.27 for 20X1

The 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 20X1

In 20X2 current liabilities are better covered than 20X1. Bad management of working capital perhaps 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 20X1

Inventory 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 20X1

The 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, but bad 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.

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6 Working capital cycle

20X2 20X1

Inventories 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 28.5

In 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 10.9

Controlling working capital

Some 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 couldlose 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 astock 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 costof funds from other sources.

· If credit period is extended then goodwill may be lost, which is important in the eventof goods being required urgently.

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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 notsacrificed.

· The savings arising from inventory holding reduction must be evaluated against thecost 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 ofreducing credit period allowed must be evaluated.

Example 10.10

Working capital mini Qs

Firstly note the difference between a mark up and a margin

Mark-up = 100% + 25% = 125% Profit = (25 / 125) Cost = 100 / 125

Margin = 75% + 25% = 100% Profit = (25 / 100) Cost = 75 / 100

1 Effect on WC

Increase 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 £ 6,000

2 Cash cycle = inventory days + trade receivable days trade payable daysInventory days = Average inventory x 365

Cost of sales

Cost of sales = £18 million x 0.8 = £14.4 million

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Inventory days = £2 / £14.4 x 365 = 51 days

Trade receivable days = Trade receivable / sales x 365

= £5 / £18 x 365 = 101 days

Trade payable days = Trade payable / COS x 365= £2.5m / £14.4 x 365 = (63) days

Cash cycle = 89 days

89 days is the average time from the payment of a supplier to the receipt from a customer.

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