Working Capital Management

Assets

$

Non-current assets

100

Current assets

200

Non-current liabilities

50

Current liabilities

30

Equity

220

Liquidity

Profitability

Inventories:

Increase

Reduce liquidity –consume more cash to buy stocks

Increase profits – more stocks are available for sale and more revenue

Too many inventories – further reduce profits, ie inventory losses due to purchase, ordering and holding costs

Decrease

Improve liquidity – save cash not to buy stocks

Decrease profits – fewer stocks available and less revenue

Managing inventory level well – reduce management costs and increase profits, ie Just-in-Time (JIT) system

Receivables:

Increase

Reduce liquidity – we are owed too much money

Increase profitability – more credits are offered to credit customers, increasing revenue

Too much receivables – increase bad debt expenses and collection costs (the use of factoring service), reducing profitability

Decrease

Improve liquidity – we are paid on time

Decrease profitability – more difficult to attract new customers as fewer credits are offered

Managing receivables well – increase profitability as there will be less bad debt expenses

Payables:

Increase

Improve liquidity – as a free source of finance

Reduce profitability – suppliers may not wish to offer the best price, loss of cash discount

Decrease

Reduce liquidity – lose a free source of finance

Increase profitability – suppliers may wish to offer the best price, enjoy cash discount

Cash:

Increase

Improve liquidity – have cash ready to pay the bill due

Reduce profitability – loss of opportunity to invest in profitable projects

However, cash discount income could be earned by using surplus cash, increasing profitability

Decrease

Decrease liquidity – do not have cash ready to pay the bill due

Increase profitability – more opportunities to invest in profitable projects

However, investment decisions may fail, therefore, reducing profitability

Exam rehearsal question:

Which of the following statements concerning working capital management are correct?

• The twin objectives of working capital management are profitability and liquidity
• A conservative approach to working capital investment will increase profitability
• Working capital management is a key factor in a company's long-term success
• 1 and 2 only
• 1 and 3 only
• 2 and 3 only
• 1, 2 and 3

Comment: B

Exam rehearsal question:

Andrew Co is a large listed company financed by both equity and debt.

In which of the following areas of financial management will the impact of working capital management be smallest?

1. Liquidity management
2. Interest rate management
3. Management of relationship with the bank
4. Dividend policy

Comment: D. Working capital management may have an impact on dividend policy, but the other areas will be more significant.

Exam rehearsal question:

Which of the following statements concerning working capital management are correct?

• 1 Working capital should increase as sales increase
• 2 An increase in the cash operating cycle will decrease profitability
• 3 Overtrading is also known as under-capitalisation
• 1 and 2 only
• 1 and 3 only
• 2 and 3 only
• 1, 2 and 3

Comment: D

Exam rehearsal question:

Which TWO of the following are correct descriptions of net working capital?

1. Current assets — current liabilities
2. Inventory days + accounts receivable days — accounts payable days
3. Current assets / current liabilities
4. The long-term capital invested in net current assets

Comment: A and D. B is operating cycle. C is current ratio.

Calculation:

Liquidity ratios:

Current ratio = Current assets/Current liabilities

• Ideally should be at least 2:1

Quick or acid test ratio = (Current assets – Inventories)/Current liabilities

• Ideally should be at least 1:1

Efficiency ratios:

Trade receivables collection period = Trade receivables/Credit sales x 365 days

• This is the period before businesses collect cash from credit customers.
• Rationale – if credit sales are $1,000 during the year with $100 not yet collected from credit customers, ie 10% not collected. This is then converted into days by timing 365, ie business still needs 36.5 days before credit customers are paid.
• In the UK, 365 days are used whereas in the US, 360 days are used. Usually in the exam, 360 days are used.
• Ideally, average trade receivables (opening and closing trade receivables divided into two) should be used if available.
• Total sales figure could be used if credit sales are not given.
• Weeks or months could be used if the period is not required in days.

Trade payables payment period = Trade payables/Credit purchases x 365 days

• This is the period before credit suppliers are paid.
• Rationale – if credit purchases are $2,000 during the year with $400 still owed to suppliers, ie 20% not paid yet. This is then converted into days by timing 365, ie business still needs another 73 days to settle the invoice.
• Ideally, average trade payables (opening and closing trade payables divided into two) should be used if available.
• Costs of sales or total purchases figure could be used if credit purchases are not given.
• Weeks or months could be used if the period is not required in days.

Inventory turnover period = Inventory/Cost of sales x 365 days

• This is the period before inventories are sold.
• Rationale – if costs of sales are $3,000 with $1,000 inventories still unsold, ie 1/3 not yet sold, and this is then converted into days by timing 365 days. Business still needs 122 days to sell stocks.
• Ideally, average inventories (opening and closing inventories divided into two) should be used if available.
• Total purchases figure could be used if costs of sales are not given.
• Weeks or months could be used if the period is not required in days.

Raw materials days = Raw materials inventory/Purchases x 365 days

• This is the period before raw materials are transferred to the production line
• Costs of sales figure could be used if purchases are not given

Work-in-progress (WIP) period = (WIP inventory/cost of sales) x 365 days

• This is the period before work-in-progress are transferred to finished items

Finished goods turnover period = Finished goods/costs of sales x 365 days

• This is the period before finished goods are finally sold to customers.

Working capital cycle in a manufacturing business:

• Working capital cycle = inventory turnover period (includes raw materials turnover period, work-in-progress turnover period and finished goods turnover period) + trade receivables collection period – trade payable payment period

Tutorial note: Period could be days, weeks and months

Inventory turnover ratio = Cost of sales/Average inventories

• If average inventories are not available, closing inventory balance could be used
• The higher the ratio, the quicker inventories could be sold

Sales revenue/net working capital ratio = Sales/(Current assets – Current liabilities)

• This shows the efficiency that net working capital is turned into sales.
• The higher the ratio, the greater the efficiency.

Trade receivables balance = Trade receivables collection period x Credit sales / 365

Trade payables balance = Trade payables payment period x Credit purchases / 365

Inventory balance = Inventory period x Costs of sales / 365

Exam rehearsal question:

The following information has been calculated for A Co:

Trade receivables collection period: 52 days

Raw material inventory turnover period: 42 days

Work in progress inventory turnover period: 30 days

Trade payables payment period: 66 days

Finished goods inventory turnover period: 45 days

What is the length of the working capital cycle?

1. 103 days
2. 131 days
3. 235 days
4. 31 days

Comment: A. The length of the operating cycle is 52 + 42 + 30 – 66 + 45 = 103 days.

Exam rehearsal question:

A company has annual credit sales of $27 million and related cost of sales of $15 million. The company has the following targets for the next year:

Trade receivables days 50 days

Inventory days 60 days

Trade payables 45 days

Assume there are 360 days in the year.

What is the net investment in working capital required for the next year?

1. $8,125,000
2. $4,375,000
3. $2,875,000
4. $6,375,000

Comment: B

Inventory = 15,000,000 x 60/360 = $2,500,000

Trade receivables = 27,000,000 x 50/360 = $3,750,000

Trade payables = 15,000,000 x 45/360 = $1,875,000

Net investment required = 2,500,000 + 3,750,000 — 1,875,000 = $4,375,000

Exam rehearsal question:

For the coming year, a company has budgeted sales of $2m per month, 80% of which will be on credit. It expects its accounts receivable payment period to be three months. Forecast average inventory and average accounts payable for the coming year are $10m and $4m respectively.

What is the company's working capital requirement for the coming year (to one decimal place)?

Comment: $10.8m. Accounts receivable = ($2m x 12 x 80% x 3/12) = $4.8m;

Working capital requirement = $4.8m + $10m - $4m = $10.8m.

Exam rehearsal question:

A company's typical inventory holding period at any time is as follows:

Annual cost of goods sold as per the financial statements is $100m of which the raw material purchases account for 50% of the total. The company has implemented plans to reduce the level of inventory held, the effects of which are expected to be as follows:

• Raw material holding time to be reduced by 5 days
• Production time to be reduced by 4 days
• Finished goods holding time to be reduced by 5 days.

Assuming a 365-day year, what will be the reduction in inventory held?

1. $2.603m
2. $3.836m
3. $1.918m
4. $3.151m

Comment: D

Raw material effect using raw material purchases = (100m x 50%) x (5/365) = $684,932

Work in progress effect using cost of goods sold = 100m x (4/365) = $1,095,890

Finished goods effect using cost of goods sold = 100m x (5/365) =$1,369,863

Reduction in inventory = 684,932 + 1,095,890 + 1,369,863 = $3,150,685 or $3.151m

Exam rehearsal question:

Which TWO of the following statements about overcapitalisation and overtrading are correct?

1. Overtrading often arises from a rapid increase in sales revenue
2. Overcapitalisation results in a relatively low current ratio
3. Overtrading may result in a relatively high accounts payable turnover period
4. Overcapitalisation is the result of too much short-term capital

Comment: A and C.

Statement B is incorrect as overcapitalisation results in a relatively high current ratio. Statement D is incorrect as overcapitalisation is the result of an organisation having too much long-term capital

Exam rehearsal question:

Which of the following statements concerning working capital are correct?

• 1 Working capital should increase as sales increase
• 2 An increase in the cash operating cycle will decrease profitability
• 3 Overtrading is also known as under-capitalisation
• 1 and 2 only
• 1 and 3 only
• 2 and 3 only
• 1, 2 and 3

Comment: D, that all three statements are correct. Many candidates chose answers B or C rather than answer D.

Exam rehearsal question:

Crago Co is concerned that it may be overtrading. Financial information relating to the company is as follows.

Companies which are similar to Crago Co have the following average values for 20X5:

Assume there are 360 days in each year.

Required:

Evaluate whether Crago can be considered to be overtrading and discuss how overtrading can be overcome.

Note: Up to 4 marks are available for calculations. (10 marks)

Comment:

Overtrading arises when a company does not have enough long-term finance to support its operation. Symptoms are as follows:

Rapid increase in sales revenue:

Overtrading can arise as a result of a rapid increase in sales revenue which is not matched by a corresponding increase in working capital investment.

The sales revenue of Crago Co has rapidly increased by 42·5% over the year, while the ratio of sales income/net working capital has increased from 12 times to 86 times, showing that working capital investment has not matched the increase in sales revenue.

Long term debts:

Overtrading can also arise due to the business repaid long term debt but not replace it back, ie decreased long term funding. However, the long term debt of Crago Co has not changed.

Increased reliance on short-term finance:

There is evidence of an increased reliance by Crago Co on short-term finance, since the overdraft has increased by 182% from $850,000 to $2,400,000, while trade payables have increased by 52% from $1,250,000 to $1,900,000.

In addition, the proportion of current assets financed from short-term sources has increased from 68% to 96%. As noted earlier, there has been no increase in long-term debt.

Decline in gearing and liquidity ratios:

The current ratio of Crago Co has declined from 1.5 times to 1.05 times, while its quick ratio has remained unchanged at 0·5 times. Both ratios are below their sector average values of 1·7 times and 0·8 times respectively.

Overcoming overtrading:

Overtrading can be overcome by increasing the long-term capital of a company. This could be achieved by Crago Co raising either new debt finance or new equity finance.

Financial analysis:

Sales income growth: 17,100/12,000 = 42·5%

Inventory growth: 2,500/2,100 = 19%

Trade receivables growth: 2,000/1,000 = 100%

Trade payables growth: 1,900/1,250 = 52%

Overdraft growth: 2,400/850 = 182%

Exam rehearsal question:

The following financial information relates to Wobnig Co.

Income statement extracts:

Average ratios for the last two years for companies with similar business operations to Wobnig Co are as follows:

Current ratio 1·7 times

Quick ratio 1·1 times

Inventory days 55 days

Trade receivables days 60 days

Trade payables days 85 days

Sales revenue/net working capital 10 times

Required:

Using suitable working capital ratios and analysis of the financial information provided, evaluate whether Wobnig Co can be described as overtrading (undercapitalised). (12 marks)

Comment:

Overtrading arises when a company does not have enough long-term finance to support its operation. Symptoms are as follows:

Rapid increase in revenue compared to long-term finance:

Revenue has increased by 40%, from $10,375,000 to $14,525,000, while long-term finance has increased by only 4·7% ($16,268,000/$15,541,000).

Increase in trade receivables days:

A rapid increase in revenue may be due to offering more generous credit terms to customers, ie increased receivables days by 31% from 61 days to 80 days which are much higher than industry average of 60 days.

There is a risk that Wobnig Co would suffer significant cash flows risks if receivables are turned into bad debts.

Increase in inventory days:

Inventory days also increased from 60 days in 2010 to 75 days in 2011 which are well above the average value for similar companies of 55 days.

There is a risk that Wobnig Co would suffer significant cash flows risks if inventories become obsolesce or damaged.

Decrease in profitability:

A rapid increase in revenue may also be due to offering lower prices on products sold, affecting gross profit margin or net profit margin.

The net profit margin of Wobnig Co has decreased from 36% in 2010 to 28% in 2011. While revenue increased by 40%, profit before interest and tax increased by only 8·9% ($4,067,000/$3,735,000).

While this decrease in profitability supports the possibility that Wobnig Co has decreased selling prices in order to increase sales volume, such a decrease in profitability may also be caused by an increase in cost of sales or other operating costs.

An increased dependence on short-term finance:

The sales revenue/net working capital ratio has increased from 11 times in 2010 to 15 times in 2011, compared to the average value for similar companies of 10 times. There has been a 500% increase in the company’s overdraft ($1,500,000/$250,000) and a 75% increase in trade payables ($2,865,000/$1,637,000).

Furthermore, trade payables days rose from 90 days in 2010 to 100 days in 2011, higher than the average value for similar companies of 85 days. Short-term debt as a proportion of total debt increased from 6% in 2010 ($250,000/$4,250,000) to 27% in 2011 ($1,500,000/$5,500,000). This analysis supports the view that Wobnig Co is more dependent on short-term finance in 2011 than in 2010.

A decrease in liquidity:

The current ratio of Wobnig Co has fallen from 1·5 times in 2010 to 1·2 times in 2011, compared to an average value for similar companies of 1·7 times.

The quick ratio or acid test ratio, which is a more sensitive measure of liquidity, has fallen from 0·9 times in 2010 to 0·7 times in 2011, compared to an average value for similar companies of 1·1 times.

There are clear indications that liquidity has fallen over the period and that Wobnig Co has a weaker liquidity position than similar companies on an average basis.

However, the current assets of the company do still exceed its current liabilities, so it does not yet have a liquid deficit.

Conclusion:

Overall, it can be concluded that there are several indications that Wobnig Co is moving, or has moved, into an overtrading (under capitalisation) position.

Workings:

Increase in revenue = 100 x (14,525 – 10,375)/10,375 = 40%

Increase in long-term finance = 100 x (16,268 – 15,541)/15,541 = 4·7%

Exam rehearsal question:

The following information about working capital levels over the last year is as follows:

Required:

Calculate the fluctuating and permanent working capital.

Comment:

Minimum (permanent) working capital

= Inventories + Receivables -Payables = $3.9m + $1.6m - $1.3m = $4.2m

Fluctuating working capital = Maximum working capital – Minimum working capital = $5.6m + $4.2m - $3.4m - $4.2m = $2.2m

Exam rehearsal question:

Crag Co has sales of $200m per year and the gross profit margin is 40%. Finished goods inventory days vary throughout the year within the following range:

Maximum Minimum

Inventory (days) 120 90

All purchases and sales are made on a cash basis and no inventory of raw materials or work in progress is carried. Crag Co intends to finance permanent current assets with equity and fluctuating current assets with its overdraft.

In relation to finished goods inventory and assuming a 360-day year, how much finance will be needed from the overdraft?

1. $10m
2. $17m
3. $30m
4. $40m

Comment: A. $200m x 30/360 x 0·6 = $10m

Exam rehearsal question:

Pop Co is switching from using mainly long-term fixed rate finance to fund its working capital to using mainly short-term variable rate finance.

Which of the following statements about the change in Pop Co's working capital financing policy is true?

1. Finance costs will increase
2. Re-financing risk will increase
3. Interest rate risk will decrease
4. Overcapitalisation risk will decrease

Comment: B. Pop Co is moving to an aggressive funding strategy which will increase refinancing risk.

Exam rehearsal question:

Discuss briefly the factors which influence the formulation of working capital policy. (6 marks)

Comment:

Working capital policies cover investment and funding policies, factors are as follows:

Business nature:

Working capital elements size is affected by the business nature. For example, a manufacturing company may have much higher levels of inventories such as work in progress inventories than service companies.

Another example is when a business operating using a Business to Business (B2B) model, it tends to have higher receivables levels than Business to Consumer (B2C) model.

Operating cycle:

Working capital investments are affected by the operating cycle length and the desired level of investment in current assets.

For example, businesses which need to pay suppliers in a short period of time may finance its working capital using long term financing options to ensure funds are available anytime it wants.

Terms of trade:

Businesses tend to follow terms of trade offered by competitors to remain competitive in the market.

For example, if a competitor offers very generous credit to its customers, the business may decide to offer similar credits and hence the investment in receivables increases.

Risk attitudes:

Risk aggressive businesses tend to adopt aggressive approach when they are managing working capital, ie to reduce the working capital needs to minimise its costs.

Risk averse businesses tend to adopt conservative approach when they are managing working capital, ie to increase the working capital needs to minimise its liquidity risks.

Exam rehearsal question:

Required:

Discuss THREE factors which determine the level of a company’s investment in working capital. (6 marks)

Comment:

Nature of the industry:

For companies such as housebuilding industries with a long production process may have a large investment in working capital such as high work in progress.

For companies in the service industry such as education companies, they usually have lower working capitals than other companies since the value of inventories is usually low with low credit offered to customers.

Investment policy:

The aggressive working capital investment policy means the current assets level in the business is low and the current liabilities level is high. It usually increases risks to the business such as increased stockout risks but at the same time, the costs to the business are low such as low storage cost is required.

The conservative working capital investment policy means the current assets level in the business is high and the current liabilities level is low. It usually decreases risks to the business such as decreased stockout risks but at the same time, the costs to the business are high such as high storage cost is required.

Terms of trade:

If a business trades with an existing customer, a generous credit may be offered to that customer and therefore, the investment in working capital is high such as the increase in receivables.

Management efficiency:

A failure to apply credit control procedures such as sending statements to credit customers promptly may increase the level of bad debts and working capital investment.

Exam rehearsal question:

The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:

For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers.

For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the company’s overdraft.

CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015:

Required:

Analyse and compare the current asset and current liability positions for March 2014 and March 2015, and discuss how the working capital financing policy of CSZ Co would have changed. (8 marks)

Comment:

Inventory = 60/365 x (60% x $40m) = $3,945 (in thousands)

Receivables = 75/365 x $40m = $8,219

Payables = 55/365 x (60% x $40m) = $3,616

Current ratio = 1.4 = current assets/current liabilities

Therefore, current liabilities = (3,945,205 + 8,219,178) / 1.4 = 8,688 Therefore bank overdraft = 8,688 – 3,616= $5,072

Comparing current assets and current liabilities:

The overdraft as a percentage of current liabilities will fall from 69% (4,682/6,819) to 58% (5,072/8,688).

Even though the overdraft is expected to increase by 8.3%, current liabilities are expected to increase by 27.4% (8,688/6,819).

Most of this increase is expected to be carried by trade payables, which will rise by 69.2% (3,616/2,137), with trade payables days increasing from 30 days to 55 days.

At the end of March 2014, current liabilities were 56% of current assets (100 x 6,819/12,275), suggesting that 44% of current assets were financed from a long-term source.

At the end of March 2015, current liabilities are expected to be 71% of current assets (100 x 8,688/12,164), suggesting that 29% of current assets are financed from a long-term source which is less than that in the previous year.

This increasing reliance on short-term finance implies an aggressive change in the working capital financing policy of CSZ Co.

Exam rehearsal question:

Critically discuss the similarities and differences between working capital policies in the following areas:

• Working capital investment;
• Working capital financing. (9 marks)

Comment:

Working capital investment:

This determines how much working capital should be invested in a business and it can be compared with another business using operating cycle.

It does not need to separate current assets into permanent and fluctuating.

Investment policies do not have matching approach. However, aggressive policy requires lower investment levels in working capital whilst conservative policy requires higher investment levels in working capital.

Liquidity risks are higher in aggressive approach than in conservative approach whilst management costs are lower in aggressive approach than in conservative approach.

Working capital financing:

This determines how working capital should be financed using short or long term financing options and it can not be compared with another business.

It usually separates current assets into permanent and fluctuating so that moderate, aggressive and conservative policies could be used depending on different risk attitudes.

Permanent current assets are the minimum current assets in a business whilst the fluctuating current assets are current assets to meet its unpredictability needs, ie using maximum current assets to minus permanent current ones.

This requires matching approaches, ie non-current assets and permanent current assets should ideally be financed by long term financing options whilst fluctuating current assets should ideally financed by short term financing options.

Risk aggressive businesses tend to finance permanent working capital using partly short and long term finance to reduce financing costs whilst risk averse businesses tend to finance fluctuating working capital using partly short and long term finance to reduce liquidity risks.

Exam rehearsal question:

Required:

Discuss the key factors in determining working capital funding strategies. (10 marks)

Comment:

Costs and risks:

Funding working capital using short term loans are less expensive than long term loans in terms of the total interest payments to be paid to the creditors.

However, there is an increased risk when using short term loans to fund working capital since the loan may be repayable on demand by creditors such as using overdraft.

Funding for different current assets:

Current assets can either be fluctuating or permanent. Receivables and inventories to meet the daily demand are examples of fluctuating current assets, whereas if these are needed for the core level of the business, these are permanent current assets.

For fluctuating current assets, short term funds should be used. For some businesses, they may also use part of the long term funds to fund part of the fluctuating current assets for security reasons. This is known as the conservative approach.

For permanent current assets, long term funds should be used. For some businesses, they may also use part of the short term funds to fund part of the permanent current assets to avoid the high interest costs. This is known as the aggressive approach.

Approaches:

The risk of the conservative approach is lower than the aggressive approach, however, the cost is higher than the aggressive approach.

It really depends on the management’s risks attitude before deciding which approach to be adopted. For businesses with very good liquidity position, they might adopt the conservative approach.

The matching approach could also be used to fund working capitals where all fluctuating current assets are financed using short term funds such as short term loans and all permanent current assets are financed using long term funds such as long term loans and equity. This requires business to have an accurate forecast about the working capital needs.

Previous funding decisions:

Working capital funding strategies may also be affected by the business previous funding decisions, ie if the business used the aggressive approach to manage its working capital, it is very likely that this approach is going to continue.

Organisation size:

If the business size is small, it is highly unlikely that the business could rely on long term funds such as using equity finance, and therefore, for small businesses, they tend to use the short term funds to finance its working capital.

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