 The nature of working capital

 Objectives of working capital management

 The role of working capital management

Working Capital 

The cash operating cycle
Liquidity ratios
Overview – working capital

Maximisation of
shareholder wealth

Investment Financing
o n s
Dividend decision
decision decision

ol uti
ng S
a rn i
x L e
te
Working capital Working capital can

Ver
can boost cause liquidity
profits problems and costs
money to finance

A balance is
required
Question: Working capital calculation
What is the working capital of the following business?

Receivables = $100,000 Overdraft = $50,000

s
tio n
Work in progress = $24,000 Raw material
S olu = $30,000
in
Taxation due in nine months = $110,000
n g
e a r
x
Cash on three-month deposit
e L = $250,000
e r t
V
Suppliers = $120,000

A $100,000 B $124,000
C $224,000 C $528,000
Answer: Working capital calculation
B Description $
Current assets
Raw material 30,000
Work-in-progress 24,000
Receivables 100,000
Cash on short term deposit o n s
ol u ti 250,000
ng S
rn i
404,000
Current liabilities
L ea
Overdraft
tex 50,000
Taxation Ver 110,000
Suppliers
120,000
Working capital 280,000
124,000
Working capital management
 Sufficient working capital is essential to the survival of a
business, but too much is wasteful and unprofitable.

 The proper level of working capital should therefore be a

matter of management policy and control.ons
lu ti
i nSo
g
 e arn
L
Generally the finance xdirector or company treasurer will be
responsible for Verte
establishing a suitable policy.
The cash operating cycle
The cash operating cycle is the period of time between the point at
which cash begins to be spent on producing a product and the
collection of cash from a customer.

 o n s business equals:
The cash operating cycle in a manufacturing
lu ti
oremain in inventory
 i
The average time that raw materialsng S
e rn
a from suppliers
 x
Less the period of credit
t e L taken
Ve r
 Plus the time taken to produce the goods
 Plus the time the finished goods stay in inventory
 Plus the time taken by customers to pay for the goods
 The cash operating cycle
A typical operating cycle for a manufacturing company is:

Raw material purchased and stored

Customers pay
n s
Raw material issued
o
ol utiand used in

ng S manufacturing

a rn i
Finished goods
x L e
te
Ver
sold
Suppliers of raw material
paid
Finished goods stored
in inventory
Question: The cash operating cycle
A manufacturing company buys raw materials and stores them for 15
days in inventory. Products then take two days to make and finished
goods remain in stores for 20 days on average before sale. Customers
pay after 50 days and suppliers are paid after 35 days.
o n s
olu ti
What is the length of the cash operating
n g S cycle?
rn i
A 37 days
Le a
B 50 days r tex
C 52 days Ve
D 122 days
Answer: The cash operating cycle
A manufacturing company buys raw materials and stores them for 15 days in
inventory. Products then take two days to make and finished goods remain in stores
for 20 days on average before sale. Customers pay after 50 days and suppliers are
paid after 35 days.

C Working capital element Days

o ns
Raw material in inventory
ol u ti 15
ng S
Production/WIP
a r n i 2
Finished goods x Le 20
e r tecredit days
V
Less: supplier (35)
Receivables days
Working capital cycle length 50
52
Interpreting the cash operating cycle length

The longer the cycle, the more funding has to be dedicated

to funding working capital.

Cash is tied up in inventory then the companyshas to wait

ti o n because
S o u
until the goods are sold. This burden is llessened
cash is not needed immediately ito
rn ngpay suppliers.
Le a
rtex
Ve
Question to consider
Estimate the cash operating cycle length of a supermarket.

o n s
olu ti
n g S
rn i
Le a
r tex
Ve
The cash operating cycle – supermarket
Estimate the cash operating cycle length of a supermarket.

Receivables: cash sales;

receivable collection period = 0.
Inventory: fresh food sold in a few days.
o ns
Perhaps average inventory is five days.So l u ti
i ng
Suppliers paid after about 40 a
L rn perhaps.
days,
e
r tex
Ve
The cash operating cycle is therefore negative 35: supermarkets
are in a very fortunate position because they do not need to devote
capital to working capital management.
Liquidity ratios

Liquidity ratios may help to indicate if a company is

over-capitalised (excessive working capital) or if a business
has insufficient working capital and is likely to fail.

 o n s
The main ratios are:
o lu ti
 The current ratio i ng S
e arn
 The quick ratio tex L
V e r
 The accounts receivable period
 The inventory turnover period
 The accounts payable period
Current ratio
 Current ratio = Current assets/Current liabilities

 Current liabilities are paid from current assets: inventory is

sold, customers pay, cash is received and paid to suppliers.
 Usually a ratio > 1 is expected, but a safe o n s
S o luti ratio depends on:
n i ng
L e r
a ratio was last year
 x
What the company'stecurrent
r
Ve
 The nature of the business
 If too high this is less of an immediate issue but may be
detrimental to performance (overcapitalisation –see later)
Question – Current ratios
Company A is an engineering company making large steel
constructions.
Company B owns about 100 apartments which it rents out.
Some companies can operate safely on a low current
o n s ratio.
Are the following statements true or false? lu
o ti
1 Company A needs to keep ainhigh g S current ratio
a rn
2 Company B needs toLkeep
x e a high current ratio
te
Ver
A Statement 2 is true and statement 1 is false
B Statement 1 is true and statement 2 is false
C Both statements are false
D Both statements are true
Answer – Current ratios
Company A is an engineering company making large steel
constructions. Company B owns about 100 apartments which it rents
out.

Answer B
o ns
u ti
Company B will have predictable and stable income from many
ol
g S
sources. It can easily plan cash inflows and expenditure so it can safely
n
L ea rn i
exist with relatively low levels of cash and receivables.
tex
Ver
Company A's sales and income are likely to be erratic, yet cash has to
be paid regularly for rent and salaries. It needs to keep extra cash in
case of a period of poor sales.
Quick (acid test) ratio
Quick (acid test) ratio =
 (Current assets – inventories)/Current liabilities

 Inventory is omitted because in some businesses: s

ti o n
 Inventories can take a long time toSbe o lusold; customers are
n
all volunteers and can't be forced i ng to buy.
L e ar
rtex
 If inventory is slow-moving, it is safer to rely only on
e
receivables andVcash for the payment of current liabilities.
Accounts receivable days
Accounts receivable days =
(Trade receivables/Credit sales revenue) × 365 days

An increase in this ratio might indicate that o n s customers

some
lu ti
are having difficulty paying.
i nSo
g
e arn
tex L
Ve r
 Inventory turnover period
Inventory turnover period (finished goods) =
(Average inventory /Cost of sales (or purchases)) × 365

Inventory holding period (raw materials) =

lu ons × 365
(Average raw materials inventory /Annual purchases)
ti
i ngSo
e arn
te L
Average production periodx(work-in-progress) =
(Average WIP /Cost Ve r
of sales) × 365

Increases can mean that inventory is not selling well.

Eg slowdown in economy leading to overstocking.
Accounts payable days
Accounts payable period =
(Average trade payables /Purchases or cost of sales)× 365

An increase in this figure might mean that the scompany is

having difficulty paying its suppliers. olutio
n
i ng S
rn
tex Le a
Ve r
Question – Cash life cycle
Calculate the length of the cash life cycle from the following
figures.
$
Receivables 50,000
o n s
Inventory 60,000 olu ti
n g S
Payables 40,000 rn i
Sales 500,000 x Le
a
r te
Cost of sales Ve
300,000

A 31.6 days B 60.8 days

C 80.3 days D 158.2 days
Answer – Cash life cycle
Calculate the length of the cash life cycle from the following figures.
($) Receivables = 50,000 Inventory = 60,000 Payables = 40,000 Sales = 500,000
Cost of sales = 300,000

B
o ns
Receivables period = (50,000/500,000) ×lu
o ti
365 = 36.5
ng S
Inventory days = (60,000/300,000)×
a r n i 365 = 73
x Le
Payables days = (40,000/300,000)
r te × 365 = 48.7
Ve
Cash life cycle = 73 + 36.5 – 48.7 = 60.8 days
Sales revenue/net working capital
As sales increase, the need for working capital increases:
as, usually, more inventory, receivables and payables are
needed to keep up with the increase in sales.
The ratio
Sales revenue/(Current assets – current o n sliabilities)
o ti
lu
ing S
arn
ethat are supported by working
shows the amount of sales
tex L
e r
capital. If the ratioVincreases the business might be
overtrading – trying to do to much with too little working
capital.
Question – Overtrading
Look at this simple statement of
financial position:
Assume that turnover
$ $ doubles and that this will
Non-current assets
n s
10,000 cause receivables,
o
Current assets
olu ti
inventory and payables to
g S
Inventory 5,000
rn in double to keep pace.
Receivables
Le a
4,000
Cash
r tex 1,000 No capital is raised and no
Ve 10,000 non-current assets are
Current liabilities, payables (
2,000 ) bought.

8,000 Draft the new SOFP

18,000
 Answer – Overtrading
The company is forced to take out an overdraft to finance its working capital:

$ $ $ $
Non-current assets 10,000 10,000
o ns
Current assets
l u ti
o 10,000
Inventory 5,000
ng S
×2
Receivables
a r n
4,000 i ×2 8,000
x L e1,000
Cash
er te
V 10,000 18,000
Current liabilities payables ( 2,000) ×2 (4,000)
Overdraft (balancing figure) (6,000 )

8,000 8,000
18,000 18,000
Overtrading
 Overtrading happens when a business tries to do too
much, too quickly with too little long-term capital.
 Liquidity troubles arise because inventory and receivables
grow and the firm does not have enough capital to
o n sdue.
S o l uti
provide the cash to pay its debts as they fall
 Successful, rapidly growing,aing
rninexperienced companies
x L e
te
often have this problem.
Ver
 The problem is cured by injecting more long-term capital
and/or slowing growth to a more manageable pace.
Symptoms of overtrading (1)

 A rapid increase in sales revenue

 A rapid increase in current assets and possibly also non-
current assets
 Inventory turnover and accounts receivable sturnover
might slow down, making the problemluworse ti on
g S o
 There is only a small increasern i nin equity capital. The
L e a financed by:
rt x
increase in assets iselargely
 Slowing downVe payments to suppliers, and
 By bank overdrafts , which may exceed agreed limits
Symptoms of overtrading – (2)

 Some debt ratios and liquidity ratios alter dramatically.

 The proportion of total assets financed by proprietors'

capital falls, and the proportion financed by scredit rises
ti o n
 The current ratio and the quick ratio S o lu
fall
n i ng
 The business might haveeaarliquid deficit, that is, an
ex L
Ve rt
excess of current liabilities over current assets
Overcapitalisation
 Overcapitalisation means that the company has excessive
inventory, receivables and cash compared to its accounts
payable.
 Cash is not being used productively and this hurts profits.
 For example, a current ratio of 5 would indicateo n s a very large
amount of current assets compared o lu ti
i ng S to current liabilities.
 Perhaps some cash should e arn
be invested in new equipment to
te x L
r
increase productivity.
Ve
 Customers may be paying late, inventory may be excessive
and credit taken from suppliers too low – all are poor for
performance.
Exam question: Question 3 (c) , June 2008 (1)
Use the operating cycle information along with the sales and cost of sales information
to calculate an inventory figure and a receivables figure.

Operating cycle length = Inventory period + Receivables

period – Payables period
o n s
3 = Inventory periodo+lu2ti– 1
in g S
r
Inventory period = 3 – 2 + 1 =a2
e nmonths
t x L
e = $315,000
Inventory = $1.89m e×r2/12
V
Accounts receivable = $4.2m × 2/12 = $700,000
Current assets = 315,000 + 700,000 = $1,015,000
Exam question: Question 3 (c) , June 2008 (2)
Credit sales = $4.2 million; cost of sales = $1.89 million. Two months' credit is
given to customers and suppliers are paid after one month. Operating cycle =
three months. Current ratio = 1.4

Current assets = 315,000 + 700,000 = $1,015,000

Current assets/current liabilities = 1.4 lution
s
g S o
Current liabilities = 1,015,000/1.4rn in= 725,000
L ea
Accounts payable = 1.89 r tex× 1/12 = 157,500
Ve
Therefore the overdraft is: 725,000 – 157,500 = $567,500