OBJECTIVES
• Describe the risk-return tradeoff involved in managing working capital.
• Describe the determinants of net working capital.
• Compute the firm’s cash conversion cycle.
• Identify the primary sources of short-term credit
• Relevant accounting ratios.
10.1 Objective of Working Capital Management (WCM)
Two key objectives
WCM:
i) Liquidity: A business with insufficient working capital will be unable to meet obligations
as
they fall due, leading to late payments to employees, suppliers and other providers of
credit.
Late payments can result in lost employee loyalty, lost supplier discounts and a
damaged
credit rating. Non-payment (default) can lead to the compulsory liquidation of assets to
repay creditors.
ii) Profitability: Funds tied up in working capital tend to earn little, or no, return.
Hence, a company with a high level of working capital may fail to achieve the return on
capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by
its investors. Therefore, there is a trade-off between liquidity and profitability in WCM.
Working capital represents the net current assets available for day-to-day operating
activities.
Current assets less current
liabilities
A firm’s current assets are assets that are expected to be converted to cash within 1 year, such as cash
and marketable securities, accounts receivable, inventories.
10.2 Impact of WCM on the company
Poor WCM leads to an inability to meet short-term obligations may force businesses to cease
trading. It requires interactions between its components. For example, extending the credit period
offered to customers can lead to additional sales. However, the company’s cash position will fall due
to the longer wait for customers to pay, potentially leading to the need for a bank overdraft and
increase interest on the overdraft impacting the profit. Slow /poor collection from debtors and quick
payments to creditors (Acc. payables) will is another example of poor WCM.
Working capital management is central to the effective management of a business
because:
i) Current assets comprise the majority of the total assets of some companies
ii) Shareholder wealth is more closely related to cash generation than accounting profits
iii) Failure to control working capital, and hence to manage liquidity, is a major cause of
corporate collapse.
Holding more current assets will reduce the risk of
illiquidity.
However, liquid assets like cash and marketable securities earn relatively less compared to other
assets. Thus, larger amounts of liquid investments will reduce overall rate of return.
The trade-off: Increased liquidity must be traded off against the firm’s reduction in return on
investment.
Flexibility of current
liabilities
Current liabilities can be used to match the timing of a firm’s needs for short-term financing.
Example: Obtaining seasonal financing versus long-term financing for short-term needs.
Interest Cost
Interest rates on short-term debt are lower than on long-term debt
Other things remaining the same, the greater the firm’s reliance on short-term debt or current
liabilities in financing its assets, the greater the risk of illiquidity.
The trade-off: A firm can reduce its risk of illiquidity through the use of long-term debt at the
expense of a reduction in its return on invested funds. This trade-off involves an increased risk of
illiquidity versus increased profitability
10.3 The Hedging Principle
The hedging principle involves matching the cash-flow-generating characteristics of an asset with
the maturity of the source of financing used to finance its acquisition. Thus, a seasonal need for
inventories should be financed with a short-term loan or current liability.
On the other hand, investment in equipment that is expected to last for a long time should be financed
with long-term debt.
Overtrading – insufficient working capital to support the level of business activities. This can also
be described as under-capitalisation and is characterised by a high and rising proportion of short-term
finance to long-term finance
Over-capitalisation – an excessive level of working capital, leading to
inefficiency.
10.4 Liquidity ratios
Current ratio = Current assets / Current
liabilities
If the current ratio falls below 1 this may indicate problems in meeting obligations as they fall due.
Even if the current ratio is above 1 this does not guarantee liquidity, particularly if inventory is slow
moving. On the other hand a very high current ratio is not to be encouraged as it may indicate
inefficient use of resources (for example, excessive cash balances).
The level of a firm’s current ratio is heavily influenced by the nature if its business for example:
Traditional manufacturing industries require significant working capital investment in
inventory
(comprising raw materials, work in progress and finished goods); trade receivables (as their
business
customers expect to be offered generous credit
terms).
Modern manufacturing companies may use just-in-time management techniques to reduce the level of
buffer inventory.
In some industries, a current ratio of less than 1 might be considered acceptable. Retailers are able to
negotiate long credit periods with suppliers while offering little credit to customers leading to higher
trade payables as compared with trade receivables. These retailers are also able to keep their
inventory levels to a minimum through efficient supply chain management.
Quick (acid test) ratio = (Quick assets / Current liabilities) = (Current assets – inventory /
Current liabilities)
The quick ratio is particularly relevant where inventory is slow
moving.
10.5 Efficiency ratios
Inventory turnover = Cost of sales / Average
inventory
This shows how quickly inventory is sold; higher turnover reflects faster-moving inventory.
However, working capital ratios are often easier to interpret if they are expressed in ‘days’ as opposed
to
‘turnover’:
Inventory days = (Average inventory / Annual cost of sales) ×
365
Inventory days estimates the time taken for inventory to be sold. Everything else being equal a
business would prefer lower inventory days.
Trade receivable days = (Average trade receivables / Annual credit sales) ×
365
Can assume that:
i) Year-end receivables are representative of the average figure;
and ii) All sales are made on credit.
Receivables days estimates the time taken for customers to pay. Everything else being equal a
business would prefer lower receivables days.
Trade payable days = (Average trade payables / Annual credit purchases) ×
365
Can assume that:
i) Year-end payables are representative of the average
figure ii) Cost of sales approximates annual credit
purchases
iii) All purchases are made on credit.
Payables days estimates the time taken to pay suppliers. A business would prefer to increase its
payables days, unless this proves expensive in terms of lost settlement discounts or leads to other
problems such as a damaged reputation.
Sales to working capital = Annual sales / Average working
capital
In this ratio working capital is defined as the level of investment in inventory and receivables less
payables. Can assume that year-end working capital is representative of the average figure over the
year.
The sales to working capital ratio indicates how efficiently working capital is being used to generate
sales. Everything else being equal the business would prefer this ratio to rise.
10.6 Cash operating cycle
The cash operating cycle (also known as the working capital cycle or the cash conversion cycle), is
the number of days between paying suppliers and receiving cash from sales.
Cash operating cycle = Inventory days + Receivables days – Payables days.
Table 10.6: The determinants of Dell Computer Corporation’s cash conversion cycle for
1995-2012
The longer the operating cycle the greater the level of resources ‘tied up’ in working capital. Although
it is desirable to have as short a cycle as possible, there may be external factors which restrict
management’s ability to achieve this:
Nature of the business – a supermarket chain may have low inventory days (fresh food), low
receivables days and significant payables days.
Industry norms – if key competitors offer long periods of credit to their customers it may be difficult
to reduce receivables days without losing business.
Power of suppliers – the supplier demanding ‘cash on delivery’ in future i.e. causing payables days to
actually fall.
For a meaningful evaluation to be made of a firm’s working capital management it is necessary to
identify:
Trends – the change in a ratio over
time.
External benchmarks – industry average (sector) ratios are commonly published by business schools
or consultancies.
10.7 Example
The following table is provided for reference purposes:
Example: Topple Co has the following forecast figures for its first year of trading:
Sales $3,600,000
Purchases expense $3,000,000
Average receivables $306,000
Average inventory $495,000
Average payables $230,000
Average overdraft $500,000
Gross profit margin 25%
Industry average data:
Inventory days 53
Receivables days 23
Payables days 47
Current ratio 1.43
Assume there are 365 days in the year.
Required:
Calculate and comment on Sunshine Co.’s cash operating cycle, current ratio, quick ratio and sales
to working capital ratio.
The length of the cash operating cycle indicates that there will be 70 days between Sunshine Co.
receiving cash from sales and paying cash to suppliers. This is significantly longer than the industry
average of 29 days (53 + 23 – 47) and likely to lead to liquidity problems, as evidenced by the size of
the overdraft.
Sunshine Co. expects to take approximately the same credit period from its suppliers as is taken by
its own customers, whereas the industry norm is to take a significantly longer credit period from
suppliers (47 days) than is taken by customers (23 days). Therefore, slow inventory turnover is the
main cause of Sunshine Co.’s long working capital cycle.
Sunshine Co.’s receivables days is also above the industry average as the firm may have been forced
to offer very favourable terms of trade in order to attract customers.
Sunshine Co. is paying its own suppliers much more quickly than the industry norm. Although this
puts pressure on liquidity, it may be taking advantage of settlement discounts offered by suppliers.
The current ratio shows $1.10 of current assets per $1 of current liabilities, which does not
compare favourably with the industry average of 1.43 and may not be sufficient as Sunshine Co.’s
inventory appears to be slow moving. More relevant, therefore, is the quick ratio which indicates only
$0.42 of liquid assets per $1 of current liabilities.
The first year’s trading may not be representative. Once Sunshine Co. becomes more established it
should benchmark its sales to working capital ratio against sector data if available.
ACCA ON THE WEB
10.8 Financing
Total assets will be equal to sum of temporary, permanent and spontaneous sources of
financing.
i) Temporary sources of financing consist of current liabilities such as short-term secured
and
unsecured notes payable.
ii) Permanent sources of financing include intermediate-term loans, long-term debt,
preferred stock, and common equity.
iii) Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations.
Trade credit from the firm’s suppliers when the firm orders it. Trade credit appears on balance sheet
as accounts payable.
Wages and salaries payable, accrued interest, and accrued taxes also provide valuable sources of
spontaneous financing.
10.9 Cost of short-term
Interest = principal x rate x time (15-5)
APR = Interest / (principal x time) (15-6)
APR = (Interest / principal) x (1 / time) (15-7)
A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000
principal amount plus $30 interest. What is the APR (annual percentage rate)?
APR = ($30 / $1000) x (1 / (90/360))
= 00.3 x 360 / 90 = 0.12 =
12%
10.10 Short-term credit sources
It can be classified into two basic groups:
i) Unsecured sources Unsecured loans include all of those sources that have as their
security only the lender’s faith in the ability of the borrower to repay the funds when due:
accrued wages and taxes, trade credit, unsecured bank loans, and commercial paper
For trade credit: the terms “2/10 net 30” means a 2% discount is offered for payment
within
10 days, or the full amount is due in 30 days.
Commercial banks: provide Lines of credit and Transaction loans (notes payable)
ii) Secured sources: Involve the pledge of specific assets as collateral in the event the
borrower defaults in payment of principal or interest: Commercial banks, finance
companies, factoring, inventory loans.
