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Working Capital Management - Coggle Diagram
Working Capital Management
Working capital
comprises of cash and other current assets less overdrafts and current liabilities
Income and cashflow are not necessarily closely related
long term profit is far more important than working capital balances, however in the short term it is vital to have working capital well under control
Liquidity
refers to the amount of cash in hand or readily obtainable to meet payment obligations
Liquidity ratios
indicate the ability to meet liabilities from available assets and are calculated from the SoFP figures.
Current ratio
ratio of current assets divided by current liabilities
provides a broad measure of liquidity; higher ratio would suggest that the business would have little difficulty meeting current liabilities from current assets
If current assets have a large proportion of inventory however, this may be misleading since inventory is less liquid than other current assets
Quick ratio
indicates the ability to pay payables in the short term, recognising that inventory may take some time to convert into cash and so focuses on those current assets that are relatively liquid
rations of (current assets less inventory) divided by current liabilities
Liquidity ratio analysis
Low current ratio
if this is low but similar to last year the company can probably continue to operate at that level
Declining current ratio
might be a reason for concern, indicating that the company is running into difficulties
Overtrading
improving rate of profit accompanied by falling current ratio may indicate the entity has expanded too quickly and is unable to generate sufficient cash from trading to meet growing working capital requirements
Figures from SoFP
actual figures from SoFP should always be considered; e.g. large bank overdraft is often a sign of liquidity problems regardless of the liquidity ratio
Increase in current ratio
increases here should prompt investigation into policies; there may be deliberate attempt to secure working capital or issues with a growing/unneeded working capital
When analysing liquidity ratios, the actual figure is less important than the trend over time
Ideal levels
if a norm is required, the best guide will usually be the industry average given the different types of business in the world
Industry average should indicate whether current/quick ratios need to be higher or lower for the market in question
Efficiency ratios
these give as insight into the effectiveness of the entity's management of the components of working captial
Inventory turnover
average number of days taken to sell an item of inventory
(inventory/CoS)*365
Shorter the period the quicker inventory can be turned into cash
Can also divide by 52 or 12 for weekly/monthly basis.
Formula can be inverted to show how often inventory has turned over during the year
CoS/Closing inventory
Receivables turnover
measure of the average length of time taken for customers to settle their balance
(recievables/Sales)*365
Only trade receivables should be used not total receivables
the shorter the ratio the quicker the entity's customers are paying
If goods are sold on cash and credit, only credit receivables should be used in the ratio
Receivables/credit sales)*365
Payables turnover
average time taken to pay suppliers
(payables/purchases)*365
Only trade payables should be used, taxation/interest/other payables should be excluded
Longer ratio is preferable for cash flow, as trade payables are effectively interest free loans
Balance must be struck between slow payment but adhering to payment terms to maintain credit ratings
Working capital cycle
gives an indication of the length of time cash remains tied up in current assets
It is the length of time between the entity's outlay on raw materials, wages and other expenses and the inflow of cash from sales of goods
Working capital in non-manufacturing = inventory turnover- payable turnover + receivable turnover
working capital in manufacturing = average time raw materials remain in inventory - credit period from suppliers + time taken to produce goods+ time goods remain in finished inventory + time taken by customers to pay
average time raw materials remain in inventory
(average raw materials in inventory/purchases) x 365
credit period from suppliers (payables turnover)
(trade payables/purchases) x 365
time taken to produce goods (WIP turnover)
(average WIP/manufacturing costs) x 365
time goods remain in finished inventory (finished goods turnover)
(average finished goods inventory/CoS) x 365
time taken by customers to pay (receivables turnover)
(average finished goods inventory/credit sales) x 365
Logic is that inventory cannot be converted into cash until it is sold and customer pays for the goods, which is offset against the fact that o cash is invested until the entity has paid the supplier for goods
Working capital and corporate strategy
management must identify ideal balance between current and quick ratio to ensure working capital requirements can be met
Shortening the working capital cycle
Reduce raw material inventory holding
done by reviewing slow moving items and reorder levels, implementing inventory control models, and maintaining efficient links with suppliers
reducing inventory may result in loss of bulk purchase discounts, loss of cost savings from price rises, or production delays due to inventory shortage
Obtain more finance from suppliers by delaying payments
could be detrimental to commercial relationships, loss of early payment discount or even loss of reliable source of supplies
Reduce work in progress
reducing production volume (resulting in loss of business/reduction in workforce), or improving production techniques/efficiency
Reducing finished goods inventory
reorganise the production schedule and distribution, which may affect ability to meet customer demand and reduce sales
Reduce credit given to customers
invoice and follow customers up more frequently, discount incentives, however could lead to loss of customers/revenue
Working capital is a static SoFP concept referring to the excess of current assets over current liabilities
If working capital exceeds current net operating assets (inventory plus receivables less payables) there is a cash surplus (usually represented by bank deposits and investments)
If working capital is less than current net operating assets there is a cash deficit (represented by bank load/overdraft)
Working capital control can be divided into areas dealing with inventory, receivables, payables and cash
Unprofitable entities can survive for some time if they have access to liquid assets/cash, proving that working capital is essential to long term success and development (greater the surplus the more solvent an entity is)
Working capital policy is a function of two decisions; investment decisions and financing decisions
Investment decisions
constitute the appropriate level of investment and a suitable mix of current assets for a set level of activity
Aggressive working capital policy
minimal inventory is held, minimising cost but therefore adversely affecting revenue since entity may not be able to respond to rapid increases in demand
Conservative working capital policy
large inventory is held, resulting in a lower expected return but also lowering the risks associated with aggressive policy also
Moderate working capital policy
a mixture of both policies in terms of risks and returns
Financing decisions
involve determining the mix of long term versus short term debt; when yield is increasing short term debt costs less then long term debt
Aggressive working capital policy
part of permanent asset base is financed by short term debt, which provides the highest expected yield (as short term debt costs less) but also carries an inherently higher risk
Conservative working capital policy
permanent financing (long term debt plus equity) which exceeds the permanent asset base. Provides the least risk but also lowers the expected yield.
Cash and inventories at higher levels results in a conservative working capital policy, providing a safety buffer
Receivables at a higher level results in more risk due to e.g. lengthening credit terms, which is an aggressive working capital policy and provides no buffer of cash
Overtrading
where an entity enters into commitments in excess of its available short term resources (can happen even in profitable companies)
Particular risk is attached to entities when they grow rapidly and do not raise enough long term finance
additional inventories and trade receivables are funded by increases in payables
additional non current assets may be required for the expansion and will be paid out of current funds, reducing working capital
Ultimately, cash shortages will occur resulting in a non ability to meet its liabilities, and despite any profitability may be forced into liquidation
Symptoms of overtrading
increasing revenue
increasing inventory and receivables
increasing current and non current assets
increasing assets funded by credit
current liabilities exceed current assets and there is a decrease in both current and quick ratio