Chapter
10
Working capital
1
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
Inventories
Trade receivables
Cash
Short term investments
Current liabilities
Trade payables
Bank overdrafts
Working capital can be viewed as a whole but interest is usually focussed on the individual
components such as inventories or trade receivables. Working capital is effectively the net
current assets of a business.
Working capital can either be:
Positive
Negative
Current assets are greater than current liabilities
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 capital
demands.
It is difficult trying to achieve and maintain an optimum level of working capital for the
organisation. For example having a large volume of inventories will have two effects, firstly
there will never be stock outs, so therefore the customers are always satisfied, but secondly it
means that money has been spent on acquiring the inventories, which is not generating any
returns (i.e. inventories is a non productive asset), there are also additional costs of holding
the 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.
2
10.2
Working capital cycle (operating/trading/cash cycle)
The working capital cycle measures the time between paying for goods supplied to you and
the final receipt of cash to you from their sale. It is desirable to keep the cycle as short as
possible as it increases the effectiveness of working capital. The diagram below shows how
the cycle works.
Cash
Trade receivables
Customer owing money,
as sales made on credit
Trade payables
Money owing to
suppliers as stock
purchased on credit
Inventories
Sold on credit
The table below shows how the activities of a business have an impact on the cash flow.
TRADE PROCESS
Inventories are purchased on credit
which creates trade payables.
The sale of inventories is made on
credit which creates trade
receivables.
Trade payables need to be paid, and
the cash is collected from the trade
receivables.
EFFECTS ON CASH
Inventories bought on credit temporarily help with
cash flow as there is no immediate to pay for these
inventories.
This means that there is no cash inflow even
though inventory had been sold. The cash for the
sold inventory will be received later.
The cash has to be collected from the trade
receivables and then paid to the trade payables
otherwise there is a cash flow problem.
3
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 ensure
that the levels of inventories and trade receivables is not too great, as this means funds are
tied 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 cost
effective management.
Working capital cycle for a trade
Inventories days (time inventories are
held before being sold)
+
(Inventories / cost of sales) x 365 days
Trade receivables days (how long the
credit customers take to pay)
-
(Trade receivables / credit sales) x 365 days
Trade payables days (how long the
company takes to pay its suppliers)
=
(Trade payables / purchases) x 365 days
Working capital cycle (in days)
Working capital cycle (in 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
Revenue
Cost of sales
Inventories
Trade receivables
Trade payables
Cash and cash equivalents
$000
2,400
1,400
360
290
190
95
Calculate the length of DX’s working capital cycle at 30 September 2006.
4
Working capital cycle in a manufacturing business
Average time raw materials are in stock
+
(Raw materials / purchases) x 365 days
+
Time taken to produce goods
+
(WIP & finished goods / cost of sales) x 365 days
+
Time taken by customers to pay for goods
-
(Trade receivables / credit sales) x 365 days
-
Period of credit taken from suppliers
=
(Trade payables / purchases) x 365 days
=
Working capital cycle (in days)
Working capital cycle (in 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
Trade payables
216
97
Revenue (all credit sales)
Cost of sales
Purchases in year
992
898
641
Inventories at 30 April 2005:
Raw materials
Work in progress
Finished goods
111
63
102
Calculate AD’s working capital cycle.
5
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 (the
funds 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 the
question you need to discuss the overall working capital levels, and then the individual
components like stock, debtors and creditors.
10.3
Overtrading
When a company is trading large volumes of sales very quickly, it may also be generating
large 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 as
sales and therefore have large volumes of trade payables. This will extend the working capital
cycle which will have an adverse effect on cash flow. If the company doesn’t have enough
working capital, it will find it difficult to continue as there would be insufficient funds to
meet all costs as they fall due.
Overtrading occurs when a company has inadequate finance for working capital to support its
level of trading. The company is growing rapidly and is trying to take on more business that
its 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 to
experience rapid sales growth. In this situation it is quite easy to place high importance on
sales growth whilst neglecting to manage the working capital.
6
Symptoms of overtrading
·
·
·
·
Fast sales growth.
Increasing trade payables.
Increasing trade receivables.
Fall in cash balances and
increasing overdraft.
Remedies for overtrading
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 longterm 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 its
liabilities 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 be
invested more profitably elsewhere and so this an effective use of working capital.
Differences in working capital for different industries
Manufacturing
Inventories
Trade
receivables
Trade
payables
High volume of WIP
and finished goods.
High levels of trade
receivables, as they tend
be dependant on a few
customers.
Low to medium levels
of trade payables.
Retail
Service
Goods for re-sale only
and usually low
volume.
Very low levels as
most goods are bought
in cash.
None or very little
inventories.
Very high levels of
trade payables due to
huge purchases of
inventory.
Low levels of
payables.
7
Usually low levels as
services are paid for
immediately.
10.4
Types of working capital policy
Within a business, funds are required to finance both non-current and current assets. The
level of current assets fluctuates, although there tends to be an underlying level required for
current assets.
Assets
£m
100
Temporary fluctuating current assets
80
Permanent current assets
(Core level of inventories, trade receivables etc)
50
Non current assets
0
Time
A company must decide on a policy on how to finance its long and short-term assets. There
are 3 types of policies that exist:
Conservative policy
Moderate policy
Aggressive policy
All the non current assets,
permanent assets and some
of the temporary current
assets are financed by longterm finance.
All the non current assets
and permanent asset are
financed by long-term
finance. The temporary
fluctuating assets financed
by short-term finance.
£90m long term debt and
equity.
£80m long term debt and
equity.
All the non current assets
and part of permanent
assets financed by long
term. Remaining
permanent assets all
temporary fluctuating assets
by short term.
£65m long term debt and
equity.
£10m short term overdrafts
and bank loans.
£20m short term overdrafts
and bank loans.
£35m short term overdrafts
and bank loans.
8
Summary of the three policies:
Conservative policy
Moderate policy
Aggressive policy
Long term
finance
Non current assets
Permanent assets
Temporary current assets
Non current assets
Permanent assets
Non current assets
Permanent assets
Short term
finance
Temporary current assets
Temporary current assets
Permanent assets
Temporary current assets
With an aggressive working capital policy, a company will hold minimal levels of inventories
in order to minimise costs. With a conservative working capital policy the company will hold
large levels of inventories. The moderate policy is somewhere in between the conservative
and aggressive.
Short-term debt can be cheap, but it is also riskier than long-term finance since it must be
continually 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 is
greater risk.
Example 10.3 – (CIMA P7 May 06)
A conservative policy for financing working capital is one where short-term finance is used
to fund:
A
B
C
D
all of the fluctuating current assets, but no part of the permanent current assets.
all of the fluctuating current assets and part of the permanent current assets.
part of the fluctuating current assets and part of the permanent current assets.
part of the fluctuating current assets, but no part of the permanent current assets.
Example 10.4 – (CIMA P7 Nov 05)
An entity’s working capital financing policy is to finance working capital using short-term
financing to fund all the fluctuating current assets as well as some of the permanent part
of the current assets.
What is this policy an example of?
9
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 a
single 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 be
interpreted.
1
Current ratio (CA) or working capital ratio
CA
=
Current assets
Current liabilities
(times)
The current ratio measures the short term solvency or liquidity; it shows the extent to which
the claims of short-term creditors are covered by assets. The current ratio is essentially
looking 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 low
investment in non productive assets like trade receivables, inventory and current account
bank balances. Also maximum use of free credit facilities like trade payables ensures
efficient management of working capital.
The normal current ratio is around 2:1 but this varies within different industries. Low current
ratio may indicate insolvency. High ratio may indicate not maximising return on working
capital. 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
Current liabilities
(times)
This ratio measures the immediate solvency of a business as it removes the inventories out of
the equation, which is the item least representing cash, as it needs to be sold. Normal is
around 1: 1 but this varies within different industries.
10
3
Trade payable days (turnover)
Year end trade payables
Credit purchases (or cost of sales)
x
365 days
This is the length of time taken to pay the suppliers. The ratio can also be calculated using
cost 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 there
is 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 indicates
insolvency problems.
4
Trade receivable days (turnover)
Year end trade receivables
Credit sales (or turnover)
x
365 days
This is the average length of time taken by customers to pay. A long average collection
means 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 or
worsening credit control. Major new customer pays fast or slow. Change in credit terms or
early settlement discounts are offered to customers for early payment of invoices.
5
Inventory days
Average inventory
Cost of sales
x
365 days
Average inventory can be arrived by taking this year’s and last year’s inventory values and
dividing by 2 - (Opening inventories + closing inventories) / 2. This ratio shows how long
the inventory stays in the company before it is sold. The lower the ratio the more efficient
the company is trading, but this may result in low levels of inventories to meet demand. A
lengthening inventory period may indicate a slow down in trade and an excessive build up of
inventories, resulting in additional costs.
6
Inventory turnover is the reciprocal of inventory days.
Cost of sales
Average inventory
x
number of times
This shows how quickly the inventory is being sold. It shows the liquidity of inventories, the
higher the ratio the quicker the inventory is sold.
11
Example 10.5 – (CIMA P7 May 07)
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 new
shares at full market price.
What will be the effect of this transaction upon the company’s working capital and on
its current ratio?
Working capital
A
B
C
D
Increase
Constant
Constant
Decrease
Current ratio
Increase
Increase
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
B
C
D
The current ratio must be less than one.
Working capital is negative.
Trade payables and overdraft are greater than trade payables plus inventories.
The company does not carry any inventories
12
Example 10.8
The following are extracts of the Income Statement and Balance Sheet for Umar plc.
Extract Balance Sheet at 30 June
20X2
£’000
£’000
Current assets
Inventories
Trade receivables
Bank
Current liabilities
Trade payables
Taxation
20X1
£’000
84
58
6
148
74
46
10
130
72
20
92
82
20
102
Net current assets
56
Extract Income Statement for the year ended 30 June
20X2
20X1
£’000
£’000
£’000
Turnover
418
Opening inventory
74
58
Purchases
324
318
398
376
Closing inventory
(84)
(74)
314
Gross profit
104
Calculate and comment on the following ratios for Umar plc:
1
2
3
4
5
6
Current ratio
Quick ratio
Inventory days
Trade receivable days
Trade payable days
Working capital cycle in days
13
£’000
-
£’000
392
302
90
Example 10.9
Controlling working capital
Explain how a manufacturing company could control its working capital levels, and the
impact of the suggested control measures.
Example 10.10
Working capital mini Q’s
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 sales
and purchases are made on credit and it has a policy of maintaining the following levels of
inventories, trade receivables and payables throughout the year.
Inventory
Trade receivable
Trade payable
£2 million
£5 million
£2.5 million
Calculate Tuffy Ltd’s cash cycle to the nearest day?
14
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 capital
demands.
TRADE PROCESS
Inventories are purchased on credit
which creates trade payables.
The sale of inventories is made on
credit which creates trade
receivables.
Trade payables need to be paid, and
the cash is collected from the trade
receivables.
EFFECTS ON CASH
Inventories bought on credit temporarily help with
cash flow as there is no immediate to pay for these
inventories.
This means that there is no cash inflow even though
inventory had been sold. The cash for the sold
inventory will be received later.
The cash has to be collected from the trade
receivables 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)
+
(Inventories / cost of sales) x 365 days
Trade receivables days (how long the
credit customers take to pay)
-
(Trade receivables / credit sales) x 365 days
Trade payables days (how long the
company takes to pay its suppliers)
=
(Trade payables / purchases) x 365 days
Working capital cycle (in days)
Working capital cycle (in days)
+
-
=
15
Working capital cycle in a manufacturing business
Average time raw materials are in stock
+
(Raw materials / purchases) x 365 days
+
Time taken to produce goods
+
(WIP & finished goods / cost of sales) x 365 days
+
Time taken by customers to pay for goods
-
(Trade receivables / credit sales) x 365 days
-
Period of credit taken from suppliers
=
(Trade payables / purchases) x 365 days
=
Working capital cycle (in days)
Working capital cycle (in days)
Overtrading occurs when a company has inadequate finance for working capital to support
its level of trading. The company is growing rapidly and is trying to take on more business
that its financial resources permit i.e. it is “under-capitalised”.
Conservative policy
Moderate policy
Aggressive policy
Long term
finance
Non current assets
Permanent assets
Temporary current assets
Non current assets
Permanent assets
Non current assets
Permanent assets
Short term
finance
Temporary current assets
Temporary current assets
Permanent assets
Temporary current assets
16
Working capital ratios
Current assets_ (number of times)
Current liabilities
Current ratio
Quick ratio
Current assets – inventory
Current liabilities
(number of times)
Trade payables_____
Cost of sales (or purchases)
Trade payable days
Inventory_
Cost of sales
Inventory days
Trade receivable days
Trade receivable
Sales
Inventory turnover
Cost of sales
Average inventory
17
x 365 days
x 365 days
x 365 days
x
number of times
Solutions to lecture examples
18
Chapter 10
Example 10.1 – (CIMA P7 Nov 06)
Inventories days
Trade receivable days
Trade payable days
Working capital cycle
(Inventories / cost of sales) x 365 days
(360 / 1,400) x 365 days
(Trade receivables / credit sales) x 365 days
(290 / 2,400) x 365 days
(Trade payables / cost of sales) x 365 days
(190 / 1,400) x 365 days
93.9 + 44.1 – 49.5
Example 10.2 – (CIMA P7 May 05)
1
Average time raw materials are in stock
(Raw materials / purchases) x 365 days
(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
(Trade receivables / credit sales) x 365 days
(216 / 992) x 365 = 79.5 days
4
Period of credit taken from suppliers
(Trade payables / purchases) x 365 days
(97 / 641) x 36 = 55.2 days
Working capital cycle = 63.2 + 67.1 + 79.5 – 55.2 = 154.6 days
19
93.9 days
44.1 days
49.5 days
88.5 days
Example 10.3 – (CIMA P7 May 06)
The answer is D.
Example 10.4 – (CIMA P7 Nov 05)
An aggressive policy.
Example 10.5 – (CIMA P7 May 07)
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 ratio
will increase as there are more current assets than current liabilities.
Example 10.7
The answer is D.
20
Example 10.8
1
Current ratio
= 148 / 92
=130 / 102
=
=
1.61
1.27
for 20X2
for 20X1
The current ratio has increased, meaning that the organisation is more liquid. This is due to
the 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, it
may not necessarily mean that the company is operating more efficiently. Has it increased it
inventory piles because it anticipates higher sales and doesn’t want to run out? Is it offering
it’s credit customers longer time to pay to increase sales? Why are they paying their suppliers
quicker? Surely it would be better to take as long as possible?
2
Quick ratio
=
=
(148 – 84) / 92 =
(130 – 74) / 102 =
0.70
0.55
for 20X2
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 =
(58 + 74) x 0.5 / 302 x 365 days =
91.8 days for 20X2
79.8 days for 20X1
Inventory is taking longer to sell; this could indicate poor inventory management. Why have
inventory levels risen? Maybe the company is taking a cautious approach and wants to
ensure 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
46 / 392 x 365 days
=
=
50.6 days for 20X2
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? Is
there a delay in issuing invoices, lack of screening new customers? Are the year end figures
representatives of the year? Perhaps there are seasonal fluctuations that need to be
considered. Further investigation required as yet again this is an unproductive asset.
5
Trade payable days =
=
72 / 324 x 365 =
82 / 318 x 365 =
81.1 days for 20X2
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 to
maximise this.
21
6
Working capital cycle
Inventories days
Plus
Trade receivables days
Minus
Trade payables days
Equals
Working capital cycle (in days)
20X2
91.8
20X1
79.8
50.6
42.8
(81.1)
(94.1)
61.3
28.5
In 20X2, the working capital cycle increased to 61.3 days from 28.5 days in 20X1. The
company 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 could
lose 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 a
stock 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 cost
of funds from other sources.
·
If credit period is extended then goodwill may be lost, which is important in the event
of goods being required urgently.
22
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 not
sacrificed.
·
The savings arising from inventory holding reduction must be evaluated against the
cost 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 of
reducing credit period allowed must be evaluated.
Example 10.10
Working capital mini Q’s
Firstly note the difference between a mark up and a margin
Mark-up = 100% + 25% = 125%
Margin = 75% + 25% = 100%
Profit = (25 / 125)
Profit = (25 / 100)
1
Cost = 100 / 125
Cost = 75 / 100
Effect on WC
Increase in trade receivables
Increase in trade payables
Inventories – increase due to purchases
Inventories – Decrease due to sales (i.e. COS)
{30,000 x 100 / 125}
Net effect on WC - increase
£30,000
(£20,000)
£20,000
(£24,000)
£ 6,000
2
Cash cycle = inventory days + trade receivable days – trade payable days
Inventory days
=
Average inventory
x
365
Cost of sales
Cost of sales = £18 million x 0.8 = £14.4 million
23
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 / COS x 365
= £2.5m / £14.4 x 365
=
(63) days
=
89 days
Trade payable days
Cash cycle
89 days is the average time from the payment of a supplier to the receipt from a customer.
24