Chapter

Working capital
10

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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 Current liabilities

Inventories Trade payables
Trade receivables Bank overdrafts
Cash
Short term investments

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 Current assets are greater than current liabilities

Negative 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.

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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 payables Trade receivables

Money owing to Customer owing money,
suppliers as stock as sales made on credit
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 EFFECTS ON CASH

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.
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.

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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 (Inventories / cost of sales) x 365 days
held before being sold)
+ +

Trade receivables days (how long the (Trade receivables / credit sales) x 365 days
credit customers take to pay)
- -

Trade payables days (how long the (Trade payables / purchases) x 365 days
company takes to pay its suppliers)
= =

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 $000
Revenue 2,400
Cost of sales 1,400
Inventories 360
Trade receivables 290
Trade payables 190
Cash and cash equivalents 95

Calculate the length of DX’s working capital cycle at 30 September 2006.

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 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 216

Trade payables 97

Revenue (all credit sales) 992

Cost of sales 898
Purchases in year 641

Inventories at 30 April 2005:

Raw materials 111
Work in progress 63
Finished goods 102

Calculate AD’s working capital cycle.

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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.

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 Symptoms of overtrading Remedies for overtrading

· Fast sales growth. Short-term solutions

· Increasing trade payables. · Speeding up collection from customers.
· Increasing trade receivables. · Slowing down payment to suppliers.
· Fall in cash balances and · Maintaining lower inventory levels.
increasing overdraft.
Long term solutions
· Increase the capital by equity or long-
term 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 Retail Service

High volume of WIP Goods for re-sale only None or very little
Inventories and finished goods. and usually low inventories.
volume.
High levels of trade Very low levels as Usually low levels as
Trade receivables, as they tend most goods are bought services are paid for
receivables be dependant on a few in cash. immediately.
customers.
Low to medium levels Very high levels of Low levels of
Trade of trade payables. trade payables due to payables.
payables huge purchases of
inventory.

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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 long-
term finance.
£90m long term debt and
equity.
All the non current assets
and permanent asset are
financed by long-term
finance. The temporary
fluctuating assets financed
by short-term finance.
£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 £20m short term overdrafts £35m short term overdrafts
and bank loans. and bank loans. and bank loans.

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 Summary of the three policies:

Conservative policy Moderate policy Aggressive policy

Non current assets Non current assets Non current assets

Long term
Permanent assets Permanent assets Permanent assets
finance
Temporary current assets

Short term Temporary current assets Temporary current assets Permanent assets
finance 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 all of the fluctuating current assets, but no part of the permanent current assets.
B all of the fluctuating current assets and part of the permanent current assets.
C part of the fluctuating current assets and part of the permanent current assets.
D 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?

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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 (times)

Current liabilities

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 (times)

Current liabilities

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.

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3 Trade payable days (turnover)

Year end trade payables x 365 days

Credit purchases (or cost of sales)

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 x 365 days

Credit sales (or turnover)

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 x 365 days

Cost of sales

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 x number of times

Average inventory

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.

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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 Current ratio

A Increase Increase
B Constant Increase
C Constant Decrease
D 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 The current ratio must be less than one.

B Working capital is negative.
C Trade payables and overdraft are greater than trade payables plus inventories.
D The company does not carry any inventories

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Example 10.8

The following are extracts of the Income Statement and Balance Sheet for Umar plc.

Extract Balance Sheet at 30 June

20X2 20X1
£’000 £’000 £’000 £’000
Current assets
Inventories 84 74
Trade receivables 58 46
Bank 6 10
148 130
Current liabilities
Trade payables 72 82
Taxation 20 20
92 102
Net current assets 56 -

Extract Income Statement for the year ended 30 June

20X2 20X1
£’000 £’000 £’000 £’000
Turnover 418 392
Opening inventory 74 58
Purchases 324 318
398 376
Closing inventory (84) (74)
314 302
Gross profit 104 90

Calculate and comment on the following ratios for Umar plc:

1 Current ratio
2 Quick ratio
3 Inventory days
4 Trade receivable days
5 Trade payable days
6 Working capital cycle in days

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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 £2 million
Trade receivable £5 million
Trade payable £2.5 million

Calculate Tuffy Ltd’s cash cycle to the nearest day?

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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 EFFECTS ON CASH

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.
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 (Inventories / cost of sales) x 365 days
held before being sold)
+ +

Trade receivables days (how long the (Trade receivables / credit sales) x 365 days
credit customers take to pay)
- -

Trade payables days (how long the (Trade payables / purchases) x 365 days
company takes to pay its suppliers)
= =

Working capital cycle (in days) Working capital cycle (in days)

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 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

Non current assets Non current assets Non current assets

Long term
Permanent assets Permanent assets Permanent assets
finance
Temporary current assets

Short term Temporary current assets Temporary current assets Permanent assets
finance Temporary current assets

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 Working capital ratios

Current assets_ (number of times)

Current ratio
Current liabilities

Current assets – inventory (number of times)

Quick ratio
Current liabilities

Trade payables_____ x 365 days

Trade payable days
Cost of sales (or purchases)

Inventory_ x 365 days

Inventory days
Cost of sales

Trade receivable x 365 days

Trade receivable days
Sales

Cost of sales x number of times

Inventory turnover
Average inventory

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Solutions to lecture examples

18
Chapter 10

Example 10.1 – (CIMA P7 Nov 06)

Inventories days (Inventories / cost of sales) x 365 days 93.9 days

(360 / 1,400) x 365 days
Trade receivable days (Trade receivables / credit sales) x 365 days 44.1 days
(290 / 2,400) x 365 days
Trade payable days (Trade payables / cost of sales) x 365 days 49.5 days
(190 / 1,400) x 365 days
Working capital cycle 93.9 + 44.1 – 49.5 88.5 days

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

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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.

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Example 10.8

1 Current ratio = 148 / 92 = 1.61 for 20X2

=130 / 102 = 1.27 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 = 0.70 for 20X2

= (130 – 74) / 102 = 0.55 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 = 91.8 days for 20X2
= (58 + 74) x 0.5 / 302 x 365 days = 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 = 50.6 days for 20X2
= 46 / 392 x 365 days = 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 = 81.1 days for 20X2

= 82 / 318 x 365 = 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.

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6 Working capital cycle
20X2 20X1
Inventories days 91.8 79.8
Plus
Trade receivables days 50.6 42.8
Minus
Trade payables days (81.1) (94.1)
Equals
Working capital cycle (in days) 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.

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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% Profit = (25 / 125) Cost = 100 / 125
Margin = 75% + 25% = 100% Profit = (25 / 100) Cost = 75 / 100

1 Effect on WC

Increase in trade receivables £30,000

Increase in trade payables (£20,000)
Inventories – increase due to purchases £20,000
Inventories – Decrease due to sales (i.e. COS)
{30,000 x 100 / 125} (£24,000)

Net effect on WC - increase £ 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

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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 days = Trade payable / COS x 365

= £2.5m / £14.4 x 365 = (63) days

Cash cycle = 89 days

89 days is the average time from the payment of a supplier to the receipt from a customer.

24