Chapter- Working Capital

Dec
Premium Course Notes [Session 5 and 6
Dec 2015
ACCA F9
Financial Management
Premium Class
Session 5 and 6
Patrick Lui
ACCA
hklui2007@yahoo.com.hk
Prepared by Patrick Lui P. 191 Copyright @ Kaplan Financial 2015

Chapter 8 Working Capital Management
SYLLABUS
1. Describe the nature of working capital and identify its elements.

2. Identify the objectives of working capital management in terms of liquidity and
profitability, and discuss the conflict between them.
3. Discuss the central role of working capital management in financial management.
3. Explain the cash operating cycle and the role of accounts payable and accounts
receivable.
4. Explain and apply relevant accounting ratios.
(a) current ratio and quick ratio
(b) inventory turnover ratio, average collection period and average payable period
(c) sales revenue/net working capital ratio
5. Explain the concept of overtrading and its application.

1. The Elements of Working Capital
1.1 Working capital is the capital available for conducting the day-to-day operations of
an organization; normally the excess of current assets over current liabilities.
1.2 Working Capital Management

Working capital management is the management of all aspects of both current
assets and current liabilities, to minimize the risk of insolvency while
maximizing the return on assets.
1.3 Investing in working capital has a cost, which can be expressed either as:
(a) the cost of funding it, or
(b) the opportunity cost of lost investment opportunities because cash is tied up
and unavailable for other uses.
1.4 Working capital is an investment which affects cash flows.
(a) When inventory is purchased, cash is paid to acquire it.
(b) Receivables represent the cost of selling goods or services to customers,
including the costs of the materials and the labour incurred.
(c) The cash tied up in working capital is reduced to the extent that inventory is
financed by trade payables. If suppliers give a firm time to pay, the firm’s
cash flows are improved and working capital is reduced.

2. The Objectives of Working Capital Management
2.1 Objectives of working capital management
2.1.1 Current assets are a major balance sheet item and especially significant to smaller
firms.
2.1.2 Mismanagement of working capital is a common cause of business failure, e.g.:
(a) inability to meet bills as they fall due
(b) overtrading during periods of growth
(c) overstocking.
2.1.3 Objectives of Working Capital Management (Dec 07, Jun 10, Dec 13)
(a) The two main objectives of working capital management are to ensure:
(i) it has sufficient liquid resources to continue in business and to
increase its profitability.
(ii) the objective of profitability supports the primary financial
management objective, which is shareholder wealth maximization.
(iii) the objective of liquidity ensures that liabilities can be met as they
fall due.
(b) Conflict between two objectives:
(i) liquid assets such as bank accounts earn very little return or no
return, so liquid assets decrease profitability.
(ii) profitability is met by investing over the longer term in order to
achieve higher returns.
(c) Trade-off between two objectives:
(i) it depends on the particular circumstances of an organization.
(ii) liquidity may be more important objective when short-term
finance is hard to find.
(iii) profitability may become a more important objective when cash
management has become too conservative.
(iv) both objectives are important and neither can be neglected.

Multiple Choice Questions
1. The key trade-off that lies at the heart of the working capital management is that
between:
A Business stability and solvency

B Debtors and creditors
C Current assets and current liabilities
D Liquidity and profitability
Question 1
Identify the objectives of working capital management and discuss the conflict that may
arise between them. (3 marks)
(ACCA F9 Financial Management December 2007 Q4(a))
Question 2
Discuss whether profitability or liquidity is the primary objective of working capital
management. (4 marks)
(ACCA F9 Financial Management June 2010 Q1(c))

2.1.4 Example 1
What differences would there be in working capital policies for a manufacturing
company and a food retailer?
Solution:
The manufacturing company will need to invest heavily in spare parts and may be
owed large amounts of money by its customers. The food retailer will have a large
inventory of goods for resale but will have low accounts receivable.
The manufacturing company will therefore need a carefully considered policy on

the management of accounts receivable which will need to reflect the credit policies
of its close competitors.
The food retailer will be more concerned with inventory management.
2.2 Central role of working capital management
2.2.1 Central role of working capital management (Dec 13)
Working capital management is central to financial management for several

reasons:
(a) Cash is the life-blood of a company’s business activities and without
enough cash to meet short-term liabilities, a company would fail.
(b) Current asset can account for more than half of a company’s assets and
so must be carefully managed. Poor management of current assets can lead
to loss of profitability and decreased returns to shareholders.
(c) For SMEs current liabilities are a major source of finance and must be
carefully managed in order to ensure continuing availability of such finance.
Question 3
Identify the objectives of working capital management and discuss the central role of
working capital management in financial management. (7 marks)
(ACCA F9 Financial Management December 2013 Q3(d))

2.2.2 Liquidity in the context of working capital management means having enough cash or
ready access to cash to meet all payment obligations when these fall due. The main
sources of liquidity are usually:
(a) cash in the bank
(b) short-term investments that can be cashed in easily and quickly
(c) cash inflows from normal trading operations (cash sales and payments by
receivables for credit sales)
(d) an overdraft facility or other ready source of extra borrowing.
2.2.3 A firm choosing to have a lower level of working capital than rivals is said to have
an ‘aggressive’ approach, whereas a firm with a higher level of working capital has a
‘defensive’ approach.
2.2.4 There is a trade-off under which trading growth and increased profitability squeeze
cash. Ultimately, if not properly managed, increased trading can carry with it the
spectre of overtrading and inability to pay the business creditors.
2.2.5 It is worth while stressing the difference between cash flow and profits. Cash flow is
as important as profit. Unprofitable companies can survive if they have liquidity.
Profitable companies can fail if they run out of cash to pay their liabilities (wages,
amounts due to suppliers, overdraft interest, etc.).
2.2.6 Some examples of transactions that have this ‘trade-off’ effect on cash flows and on
profits are as follows:
(a) Purchase of non-current assets for cash. The cash will be paid in full to the
supplier when the asset is delivered; however profits will be charged
gradually over the life of the asset in the form of depreciation.
(b) Sale of goods on credit. Profits will be credited in full once the sale has been
confirmed; however the cash may not be received for some considerable
period afterwards.
(c) With some payments such as tax there may be a significant timing difference
between the impact on reported profit and the cash flow.
2.2.7 Clearly, cash balances and cash flows need to be monitored just as closely as trading
profits. The need for adequate cash flow information is vital to enable management to
fulfil this responsibility.

Question 4
Fill in the blanks in the table to identify the advantages of having more or less working
capital.
2.3 Advantages to take steps to improve working capital management
2.3.1 Advantages to take steps to improve working capital management
(a) Credit management effect:

(i) The fundamental objective of the company is to maximise the wealth of
its shareholders and good working capital management helps to achieve
this by minimising the cost of investing in current assets.
(ii) Good credit management, for example, aims to minimise the risk of
bad debts and expedite the prompt payment of money due from
debtors in accordance with agreed terms of trade.
(iii) Taking steps to optimise the level and age of debtors will minimise
the cost of financing them, leading to an increase in the returns

available to shareholders.
(b) Inventory management effect:
(i) Good inventory management, for example using techniques such as
the economic order quantity model, ABC analysis, inventory rotation
and buffer inventory management can minimise the costs of holding
and ordering inventory.
(ii) The application of just-in-time methods of inventory procurement and
manufacture can reduce the cost of investing in inventory. Taking
steps to improve inventory management can therefore reduce costs
and increase shareholder wealth.
(c) Other example:
(i) Cash budgets can help to determine the transactions need for cash
in each budget control period, although the optimum cash position will
also depend on the precautionary and speculative need for cash.
(ii) Cash management models such as the Baumol model and the Miller-
Orr model can help to maintain cash balances close to optimum
levels.
The different elements of good working capital management therefore combine to
help the company to achieve its primary financial objective.
Question 5
Outline the advantages to a company of taking steps to improve its working capital
management, giving examples of steps that might be taken. (7 marks)
(ACCA 2.4 Financial Management and Control June 2003 Q3(d))

3. The Cash Operating Cycle

(Dec 11, Jun 13, Jun 14)
3.1 Meaning of cash operating cycle
3.1.1 The Cash Operating Cycle

The cash operating cycle (working capital cycle or trading cycle) is the length of
time between the company’s outlay on raw materials, wages and other expenditures
and the inflow of cash from the sale of goods.

3.2 Calculation of the cash operating cycle
3.2.1 For a manufacturing business, the cash operating cycle is calculated as:
Raw materials holding period x

Less: Payables’ payment period (x)
WIP holding period x
Finished goods holding period x
Receivables’ collection period x
x
3.2.2 For a wholesale or retail business, there will be raw materials or WIP holding periods,
and the cycle simplifies to:
Inventory holding period x

Less: Payables’ payment period (x)
Receivables’ collection period x
x
The cycle may be measured in days, weeks or months.
3.2.3 Example 2
A company generally pays its suppliers six weeks after receiving an invoice, whilst
receivables usually pay within four weeks of invoicing. Raw materials inventory is
held for a week before processing begins. Processing itself takes three weeks.
Finished goods stay in inventory for an average of two weeks.
How long is the company’s cash operating cycle?
Solution:
Cash operating cycle = 1 – 6 + 3 + 2 + 4 = 4 weeks

Question 6
A company has provided the following information:
Receivables collection period 56 days

Raw material inventory holding period 21 days
Production period (WIP) 14 days
Suppliers’ payment period 42 days
Finished goods holding period 28 days
Calculate the length of the operating cycle.
3.3 Significance of the cash operating cycle
3.3.1 The significance of the cash operating cycle in determining the level of investment in
working capital is that the longer the cash operating cycle, the higher the
investment in working capital.
3.3.2 The length of the cash operating cycle varies between industries: for example, a
service organization may have no stock holding period, a retail organization will have
a stock holding period based almost entirely on finished goods and a very low level of
debtors, and a manufacturing organization will have a stock holding period based on
raw materials, work-in-progress and finished goods. The level of investment in
working capital will therefore depend on the nature of business operations.
3.3.3 The cash operating cycle and the resulting level of investment in working capital does
not depend only on the nature of the business, however. Companies within the
same business sector may have different levels of investment in working capital,
measured for example by the accounting ratio of sales/net working capital, as a result
of adopting different working capital policies.
(a) A relatively aggressive policy on the level of investment in working capital is
characterized by lower levels of stock and debtors: this lower level of
investment increases profitability but also increases the risk of running out
of stock, or of losing potential customers due to better credit terms being
offered by competitors.
(b) A relatively conservative policy on the level of investment in working capital
has higher levels of investment in stock and debtors: profitability is
therefore reduced, but the risk of stock-outs is lower and new credit
customers may be attracted by more generous terms.

3.3.4 It is also possible to reduce the level of investment in working capital by:
(a) reducing the length of the cash operating cycle. This is achieved by reducing
the stock holding period (for example by using JIT methods),
(b) reducing the debtor deferral period (for example by improving debtor
management), or
(c) increasing the creditor deferral period (for example by settling invoices as
late as possible).
In this way an understanding of the cash operating cycle can assist in taking steps to
improve working capital management and profitability.
3.3.5 On the other hand, if there are excessive levels of working capital, the firm has
unnecessary additional costs: the cost of tying up funds, plus the storage, ordering
and handling costs of being overburdened with stock. Running throughout is the risk
of being temporarily short of that vital lifeblood of a business – cash (that is, suffering
a liquidity risk).
Question 7
Explain the meaning of the term ‘cash operating cycle’ and discuss its significance in
determining the level of investment in working capital. Your answer should refer to the
working capital needs of different business sectors. (7 marks)
(ACCA 2.4 Financial Management and Control June 2004 Q2(c))
3.4 Working capital management and business solvency
3.4.1 The main reason that companies fail, though, is because they run out of cash and so
good cash management is an essential part of good working capital management.
Business solvency cannot be maintained if working capital management in the form

of cash management is of a poor standard.
3.5 Factors that influence the optimum cash level for a business
3.5.1 First, it is important to note that cash management is a forward-looking activity, in that
the optimum cash balance must reflect the expected need for cash in the next
budget period, for example in the next month. The cash budget will indicate expected
cash receipts over the next period, expected payments that need to be made, and any
shortfall that is expected to arise due to the difference between receipts and payments.
This is the transactions need for cash, since it is based on the amount of cash needed
to meet future business transactions.
3.5.2 However, there may be a degree of uncertainty as to the timing of expected
receipts. Debtors, for example, may not all pay on time and some may take extended
credit, whether authorised or not. In order to guard against a possible shortfall of
cash to meet future transactions, companies may keep a ‘buffer stock’ of cash by
holding a cash reserve greater than called for by the transactions demand. This is the
precautionary demand for cash and the optimum cash balance will reflect
management’s assessment of this demand.
3.5.3 Beyond this, a company may decide to hold additional cash in order to take
advantage of any business opportunities that may arise, for example the possibility
of taking over a rival company that has fallen on hard times. This is the speculative
demand for cash and it may contribute to the optimum cash level for a given
company, depending on that company’s strategic plan.
2. Which of the above will increase the length of the cash operating cycle?
1 An increase in the period of credit given by suppliers

2 A decrease in the period of credit given by suppliers
3 An increase in the period of credit given to customers
4 A decrease in the period of credit given to customers
A 1 & 3 only
B 2 & 4 only
C 2 & 3 only

D 1 & 4 only
3. Which of the following will shorten the cash operating cycle?
A An increase in the raw materials inventory holding period

B An increase in the trade payables days
C An increase in the trade receivables days
D An increase in the production period
4. Which one of the following would lengthen the working capital cycle?
A Delaying payments made to suppliers

B Reducing raw material inventory
C Increasing the turnover of finished goods inventory
D Increasing credit given to customers
5. Sanderling Ltd buys raw materials from suppliers on six weeks’ credit, which are
delivered immediately. The raw materials are held in stock for four weeks before being
issued to production. The production process takes three weeks and the finished goods
are held in stock for two weeks before being sold on credit. Customers are allowed
eight weeks’ credit and pay promptly at the end of the period.
What is the length of the operating cash cycle of the business?
A 19 weeks
B 11 weeks
C 17 weeks
D 23 weeks
6. Which one of the following equations describes the operating cash cycle?
A Average stock turnover period + average creditor payment period – average debt
collection period
B Average stock turnover period + average debt collection period – average
creditor payment period

C Average cash balance + average debt collection period – average creditor

payment period
D Average cash balance – average debt collection period + average creditor
payment period
7. Dunelm (Engineering) Co buys raw materials from suppliers on four weeks’ credit and
they are delivered immediately. When the raw materials are received, they are held in
the warehouse for five weeks before being used in production. The production process
takes one week and the completed goods are held for two weeks before finally being
sold to credit customers. These customers are allowed a maximum credit period of six
weeks but pay after three weeks in order to obtain a discount for prompt settlement.
What is the opening cash cycle of the business?
A 7 weeks
B 10 weeks
C 11 weeks
D 12 weeks
8. The following information has been calculated for A Co:
Trade receivables collection period 52 days

Raw material inventory turnover period 42 days
Work in progress inventory turnover period 30 days
Trade payables payment period 66 days
Finished goods inventory turnover period 45 days
What is the length of the working capital cycle?
A 103 days
B 131 days
C 235 days
D 31 days
(ACCA F9 Financial Management Pilot Paper 2014)
9. The following amounts are taken from a company’s latest financial statements:

Sales revenue $3,074,000

Cost of sales $1,884,000
Inventories $160,000
Trade receivables $514,000
Trade payables $325,000
Based on the above amounts, what is the cash cycle of the company? (Assume one
year is 365 days)
A 21 days
B 29 days
C 41 days
D 68 days
10. D Co decides to offer a 2% early settlement discount that half of all customers take up.
They pay in 1 month instead of the usual 2. D Co pays 10% per annum for its
overdraft facility.
What impact will this have?
Cash operating cycle Reported profits

A Reduce Increase
B Unaffected Increase
C Reduce Reduce
D Unaffected Reduce
Question 8
Extracts from the recent financial statements of Anjo plc are as follows:
Income statements 2006 2005

$000 $000
Turnover 15,600 11,100
Cost of sales 9,300 6,600
Gross profit 6,300 4,500
Administration expenses 1,000 750
Profit before interest and tax 5,300 3,750

Interest 100 15
Profit before tax 5,200 3,735
Statement of financial position 2006 2005

$000 $000 $000 $000
Non-current assets 5,750 5,400
Current assets
Inventory 3,000 1,300
Receivables 3,800 1,850
Cash 120 900
6,920 4,050
Current liabilities
Trade payables 2,870 1,600
Overdraft 1,000 150
(3,870) (1,750)
Total assets less current liabilities 8,800 7,700
All sales were on credit. Anjo plc has no long-term debt. Credit purchases in each year were
95% of cost of sales. Anjo plc pays interest on its overdraft at an annual rate of 8%. Current
sector averages are as follows:
Inventory days: 90 days
Receivable days: 60 days
Payables days: 80 days
Required:
(a) Calculate the following ratios for each year and comment on your findings.
(i) Inventory days
(ii) Receivables days
(iii) Payables days
(6 marks)
(b) Calculate the length of the cash operating cycle (working capital cycle) for each year

and explain its significance. (4 marks)

(c) Discuss the relationship between working capital management and business solvency,
and explain the factors that influence the optimum cash level for a business. (7 marks)
(d) A factor has offered to take over sales ledger administration and debt collection for an
annual fee of 0.5% of credit sales. A condition of the offer is that the factor will
advance Anjo plc 80% of the face value of its debtors at an interest rate 1% above the
current overdraft rate. The factor claims that it would reduce outstanding debtors by
30% and reduce administration expenses by 2% per year if its offer were accepted.
Required:
Evaluate whether the factor’s offer is financially acceptable, basing your answer on the
financial information relating to 2006. (8 marks)
(Total 25 marks)
(ACCA 2.4 Financial Management and Control December 2006 Q3)
4. Working Capital Ratios
4.1 The periods used to determine the cash operating cycle are calculated by using a series
of working capital ratios.
4.2 The ratios for the individual components (inventory, receivables and payables) are
normally expressed as the number of days/weeks/months of the relevant income
statement figure they represent.
4.3 Working Capital Ratios

(a) Working capital ratios may help to indicate whether a company is over-
capitalised, with excessive working capital, or if a business is likely to
fail.
(b) A business is trying to do too much too quickly with too little long-term
capital is overtrading (or undercapitalisation).
4.4 Types of Working Capital Ratios

(Dec 08, Dec 09, Jun 12, Jun 13, Jun 14, Dec 14)
(1) Current ratio =
(2) Quick ratio =

(3) Accounts receivable payment period =
(4) Finished goods turnover period =
(5) Raw materials holding period =
(6) WIP holding period / average production period =
OR
(7) Accounts payable payment period =
(8) Working capital turnover =
4.5 These liquidity ratios are a guide to the risk of cash flow problems and insolvency.
If a company suddenly finds that it is unable to renew its short-term liabilities (for
instance if the bank suspends its overdraft facilities) there will be a danger of
insolvency unless the company is able to turn enough of its current assets into cash
quickly.
4.6 In general, high current and quick ratios are considered ‘good’ in that they mean
that an organisation has the resources to meet its commitments as they fall due.
However, it may indicate that working capital is not being used efficiently, for
example that there is too much idle cash that should be invested to earn a return.
4.7 Conventional wisdom has it that an ideal current ratio is 2 and an ideal quick ratio is 1.
It is very tempting to draw definite conclusions from limited information or to say that
the current ratio should be 2, or that the quick ratio should be 1.
4.8 However, this is not very meaningful without taking into account the type of ratio
expected in a similar business or within a business sector. Any assessment of working
capital ratios must take into account the nature of the business involved.
4.9 For example a supermarket business operating a JIT system will have little inventory
and since most of sales are for cash they will have few receivables. In addition the
ability to negotiate long credit periods with suppliers can result in a large payables
figure. This can result in net current liabilities and a current ratio below 1 – but does

not mean the business has a liquidity problem.

4.10 Some companies use an overdraft as part of their long-term finance, in which case the
current and quick ratios may appear worryingly low. In such questions you could
suggest that the firm reschedule the overdraft as a loan. Not only would this be
cheaper but it would also improve liquidity ratios.
4.11 Example 3
Calculate liquidity and working capital ratios from the following accounts of a
manufacturer of products for the construction industry, and comment on the ratios.
2014 2013
$m $m
Sales revenue 2,065.0 1,788.7
Cost of sales 1,478.6 1,304.0
Gross profit 586.4 484.7
Current assets
Inventories 119.0 109.0
Accounts receivable (note 1) 400.9 347.4
Short-term investments 4.2 18.8
Cash at bank and in hand 48.2 48.0
572.3 523.2
Current liabilities
Loans and overdrafts 49.1 35.3
Corporation taxes 62.0 46.7
Dividend 19.2 14.3
Accounts payable (note 2) 370.7 324.0
501.0 420.3
Net current assets 71.3 102.9
Notes 2014 2013

$m $m
1 Trade accounts receivable 329.8 285.4
2 Trade accounts payable 236.2 210.8
Solution:
2014 2013
Current ratio
Quick ratio
Accounts receivable payment

period
Inventory turnover period
Accounts payable turnover

period
Sales revenue/ net working
capital
(a) The company is a manufacturing group serving the construction industry, and
so would be expected to have a comparatively lengthy accounts receivable
turnover period, because of the relatively poor cash flow in the construction
industry.
(b) The company compensates for this by ensuring that they do not pay for raw
materials and other costs before they have sold their inventories of finished
goods (hence the similarity of accounts receivable and accounts payable
turnover periods.)
(c) The company’s current and quick ratio have fallen but are still reasonable,
and the quick ratio is not much less than the current ratio. This suggests that
inventory levels are strictly controlled, which is reinforced by the low
inventory turnover period.
(d) The ratio of sales revenue/net working capital indicates that working capital
has not increased in line with sales. This may forecast future liquidity
problems.
It would seem that working capital is tightly managed, to avoid the poor liquidity
which could be caused by a high accounts receivable turnover period and

comparatively high accounts payable. However, turnover has increased but net
working capital has declined due in part to the fall in short term investments and
the increase in loans and overdrafts.
Question 9 – Working capital requirement

The following data relate to ABC Co, a manufacturing company.
Sales revenue for year: $1,500,000

Costs as percentage of sales:
Direct materials 30%
Direct labour 25%
Variable overheads 10%
Fixed overheads 15%
Selling and distribution 5%
Average statistics relating to working capital are as follows:

(1) Receivables take 2.5 months to pay
(2) Raw materials are in inventory for three months
(3) WIP represents two months’ worth of half-produced goods
(4) Finished goods represent one month’s production
(5) Credit it taken:
- Materials 2 months
- Direct labour 1 week
- Variable overheads 1 month
- Fixed overheads 1 month
- Selling and distribution 1/2 month
WIP and finished goods are valued at the cost of material, labour and variable expenses.
Required:

Compute the working capital requirement of ABC Co assuming that the labour force is paid
for 50 working weeks in each year.
11. Sourton Ltd wishes to forecast its financial performance and position for the
forthcoming year. The forecast model used by the company incorporates the following
relationships:
Sales: non-current assets 2·4:1

Non-current assets: current assets 0·8:1
Current ratio 1·0:1
Acid-test ratio 0·6:1
The sales for the forthcoming year are expected to be $50 million
What is the forecast level of inventory to be held at the end of the year?
A $60·0m
B $38·4m
C $10·4m
D $6·0m
12. Extracts from a company’s accounts show the following balances:
$000
Inventories 114
Receivables 216
Cash 42

Payables 180
Loans 60
Which of the following is the company’s quick ratio, calculated to the nearest two
decimal places?
A 1.55
B 1.08
C 2.07
D 1.43
The following information relates to questions 13 and 14

Annual sales $2,500,000
Costs as a percentages of sales:
Raw materials 10%
Direct labour 15%
Production overhead 5%
Working capital statistics:

Average raw materials holding period 4 weeks
Average finished goods holding period 2 weeks
Average receivables collection period 6 weeks
Average payables collection period 8 weeks
All finished goods values include raw materials, direct labour and production overheads.
Assume there are 52 weeks in the year.
13. How much working capital is required to finance goods inventory, to the nearest $?
A $28,846
B $9,615
C $57,962
D $24,038
14. How much working capital is required to finance receivables?
A $384,615
B $86,538

C $115,385
D $288,462
15. The following data relates to a manufacturing company:
Average finished goods inventory $25,000

Average raw materials inventory $15,000
Average WIP $30,000
Sales for the period $400,000
Gross profit margin 25%
WIP is 50% complete as regards materials and conversion costs.
What is the average production period (work-in-progress) to the nearest whole day?
A 37 days
B 73 days
C 30 days
D 18 days
16. The forecast balance sheet of Charon plc for the forthcoming year is based on the
following relationships:
Current ratio 2:1

Sales: current assets 5:1
Acid-test ratio 1·5:1
If sales for the coming year are expected to be $30 million, what is the value of stocks
that will appear in the forecast balance sheet?
A $1·5m
B $3·0m
C $4·5m
D $10·5m
17. Akkadia Co expects sales revenue of $20 million for the coming year. It also aims to

achieve the following ratios: current ratio of 2.5:1; sales revenue to current assets of
4:1; and acid test ratio of 2:1.
Based on this, what will be the forecast inventory?
A $1 million
B $3 million
C $4 million
D $6 million
18. MM Co sells some inventory on credit for a profit.
All else being equal, what will happen to the quick and current ratio after this sale?
Quick ratio Current ratio

A Increase Decrease
B No change Increase
C Increase No change
D Increase Increase
19. A company sells inventory for cash to a customer, at a selling price which is below the
cost of the inventory items.
How will this transaction affect the current ratio and the quick ratio immediately after
the transaction?
Current ratio Quick ratio

A Increase Increase
B Increase Decrease
C Decrease Increase
D Decrease No change
20. A company has a liquidity ratio equal to 0.5. The directors believe that the company
has to reduce its bank overdraft and have agreed to alter the company's credit terms to

customers from two months to one month.
What would be the effects on the company's cash operating cycle and liquidity ratio if
this change were to be achieved?
Cash operating cycle Liquidity ratio

A Decrease Decrease
B Decrease No change
C Decrease Increase
D Increase Increase
21. A company has annual credit sales of $27 million and related cost of sales of $15
million. The company has the following targets for the next year:
Trade receivables days 50 days

Inventory days 60 days
Trade payables days 45 days
Assume there are 360 days in the year.
What is the net investment in working capital required for the next year?
A $8,125,000
B $4,375,000
C $2,875,000
D $6,375,000
(ACCA F9 Financial Management December 2014)
5. Overtrading
(Dec 08, Jun 12)
5.1 Overtrading (or under-capitalisation)
Overtrading occurs when a business has insufficient finance for working capital
to sustain its level of trading.

5.2 A business is said to be overtrading when it tries to engage in more business than its
working capital will allow. It could be that too much money is tied up in stocks and
trade debtors, and cash is not coming in quickly enough to meet debts as they fall
due.
5.3 It could be that the firm failed to obtain sufficient equity finance when it was
established to support its trading level, or it could be that the managers are particularly
bad at managing the working capital resources that they have.
5.4 Even if an overtrading business operates at a profit, it could easily run into serious
trouble because it is short of money. Such liquidity troubles stem from the fact that it
does not have enough capital to provide the cash to pay its debts as they fall due.
5.5 Symptoms of overtrading
Symptoms of overtrading are as follows.

(a) There is a rapid increase in turnover.
(b) There is a rapid increase in the volume of current assets and possibly also
fixed assets. Inventory turnover and accounts receivable turnover might
slow down, in which case the rate of increase in inventories and accounts
receivable would be even greater than the rate of increase in sales.
(c) There is only a small increase in proprietors’ capital (perhaps through
retained profits). Most of the increase in assets is financed by credit,
especially:
(i) Trade accounts payable – the payment period to accounts payable
is likely to lengthen
(ii) A bank overdraft, which often reaches or even exceeds the limit of
the facilities agreed by the bank
(d) Some debt ratios and liquidity ratios alter dramatically
(i) The proportion of total assets financed by proprietors’ capital falls,
and the proportion financed by credit rises.
(ii) The current ratio and the quick ratio fall.
(iii) The business might have a liquid deficit, that is, an excess of
current liabilities over current assets.

5.6 Example 4
ABC Co appoints a new managing director who has great plans to expand the
company. He wants to increase turnover by 100% within two years, and to do this
he employs extra sales staff. He recognizes that customers do not want to have to
wait for deliveries, and so he decides that the company must build up its inventory
levels. There is a substantial increase in the company’s inventories. These are held
in additional warehouse space which is now rented. The company also buys new
cars for its extra sales representatives.
The managing director’s policies are immediately successful in boosting sales,

which double in just over one year. Inventory levels are now much higher, but the
company takes longer credit from its suppliers, even though some suppliers have
expressed their annoyance at the length of time they must wait for payment. Credit
terms for accounts receivable are unchanged, and so the volume of accounts
receivable, like the volume of sales, rises by 100%.
In spite of taking longer credit, the company still needs to increase its overdraft
facilities with the bank, which are raised from a limit of $40,000 to one of $80,000.
The company is profitable, and retains some profits in the business, but profit
margins have fallen. Gross profit margins are lower because some prices have been
reduced to obtain extra sales. Net profit margins are lower because overhead costs
are higher. These include sales representatives’ wages, car expenses and
depreciation on cars, warehouse rent and additional losses from having to write off
out-of-date and slow-moving inventory items.
The statement of financial position of the company might change over time from
(A) to (B).
Situation A Situation B
$ $ $ $ $ $
Current assets
Inventory 60,000 150,000
Accounts receivable 64,000 135,000
Cash 1,000 -
125,000 285,000
Current liabilities

Bank 25,000 80,000

Accounts payable 50,000 200,000
75,000 280,000
50,000 5,000
210,000 215,000
Share capital 10,000 10,000

Income statement 200,000 205,000
210,000 215,000
Sales $1,000,000 $2,000,000

Gross profit $200,000 $300,000
Net profit $50,000 $20,000
In situation (B), the company has reached its overdraft limit and has four times as
many accounts payable as in situation (A) but with only twice the sales turnover.
Inventory levels are much higher, and inventory turnover is lower.
The company is overtrading. If it had to pay its next trade account, or salaries and
wages, before it received any income, it could not do so without the bank allowing
it to exceed its overdraft limit. The company is profitable, although profit margins
have fallen, and it ought to expect a prosperous future. But if it does not sort out its
cash flow and liquidity, it will not survive to enjoy future profits.
Suitable solutions to the problem would be measures to reduce the degree of

overtrading.
(a) New capital from the shareholders could be injected.
(b) Better control could be applied to inventories and accounts receivable. The
company could abandon ambitious plans for increased sales and more fixed
asset purchases until the business has had time to consolidate its position, and
build up its capital base with retained profits.
A business seeking to increase its turnover too rapidly without an adequate capital
base is not the only cause of overtrading. Other causes are as follows.
(a) When a business repays a loan, it often replaces the old loan with a new one
(refinancing). However a business might repay a loan without replacing it,
with the consequence that it has less long-term capital to finance its current
level of operations.

(b) A business might be profitable, but in a period of inflation, its retained

profits might be insufficient to pay for replacement of fixed assets and
inventories, which now cost more because of inflation.
22. Which of the following best describes overtrading?
A Selling more than you can manufacture and/or you hold in inventory.
B Having too much working capital thus reducing profitability.
C Selling stocks and shares outside the stock exchange opening hours.
D Suffering liquidity issues as a result of growing too quickly.
23. Which of the following is NOT a typical symptom of overtrading?
A A rapid increase in sales revenue

B A bank overdraft which may reach the limit of the facilities agreed by the bank
C An decrease in the current ratio and the quick ratio
D An decrease in trade payables days.
24. An investor undertook a ratio analysis of the most recent financial statements of
Calcaria Co and concluded that the company was over-capitalised.
Which one of the following ratios would be consistent with this condition?
A A short average settlement period for receivables

B A long inventory-holding period
C A long average settlement period for payables
D A high sales to working capital ratio
25. Which one of the following may indicate that a business is over-capitalised?
A A higher-than-average debt to equity ratio

B A lower-than-average acid-test ratio

C A lower-than-average sales to working capital ratio
D A higher-than-average net profit margin
26. An analysis of the financial statements of a business reveals the following financial
ratios:
1. A higher than average inventory holding period

2. A higher than average payment period for trade payables
3. A lower than average current ratio
4. A lower than average sales to working capital ratio
Which TWO of the above is consistent with a business being over-capitalised?
A 1 and 2
B 1 and 4
C 2 and 3
D 3 and 4
27. The management of Uruk Co feels that the company is over-capitalised and have cited
the following statements to support their view.
1. Over-capitalisation is indicated by lower-than-average sales revenue to working

capital ratio.
2. Over-capitalisation is indicated by higher-than-average debt to equity ratio.
Which of the following combinations (true/false) concerning the above statements is

correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False
28. Which of the following statements concerning working capital management are
correct?

1 Working capital should increase as sales increase

2 An increase in the cash operating cycle will decrease profitability
3 Overtrading is also known as under-capitalisation
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(ACCA F9 Financial Management December 2014)
Question 10 – Interest Rate Risk, Overtrading and Factoring

The following financial information related to Gorwa Co:
Income statements 2007 2006
$000 $000
Sales (all on credit) 37,400 26,720
Cost of sales 34,408 23,781
Operating profit 2,992 2,939
Finance costs (interest payments) 355 274
Profit before taxation 2,637 2,665
Statement of financial position 2007 2006

$000 $000 $000 $000
Current assets
Inventory 4,600 2,400
Trade receivables 4,600 2,200
9,200 4,600
Current liabilities

Trade payables 4,750 2,000

Overdraft 3,225 1,600
7,975 3,600
Net current assets 1,225 1,000
14,857 13,750
8% Bonds 2,425 2,425
12,432 11,325
Capital and reserves
Share capital 6,000 6,000
Reserves 6,432 5,325
12,432 11,325
The average variable overdraft interest rate in each year was 5%. The 8% bonds are
redeemable in ten years’ time.
A factor has offered to take over the administration of trade receivables on a non-recourse
basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables
collection period of 30 days and Gorwa Co will save $100,000 per year in administration
costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the
factor would advance 80% of the face value of receivables at an annual interest rate of 7%.
Required:
(a) Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase
in interest rates and advise the company of steps it can take to protect itself against
interest rate risk. (7 marks)
(b) Use the above financial information to discuss, with supporting calculations, whether
or not Gorwa Co is overtrading. (10 marks)
(c) Evaluate whether the proposal to factor trade receivables is financially acceptable.
Assume an average cost of short-term finance in this part of the question only.
(8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2008 Q2)

Chapter- Working Capital

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Dec

Premium Course Notes [Session 5 and 6

Prepared by Patrick Lui P. 191 Copyright @ Kaplan Financial 2015

Chapter 8 Working Capital Management

1. Describe the nature of working capital and identify its elements.

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1. The Elements of Working Capital

1.2 Working Capital Management

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2. The Objectives of Working Capital Management

2.1 Objectives of working capital management

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Multiple Choice Questions

A Business stability and solvency

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The manufacturing company will therefore need a carefully considered policy on

The food retailer will be more concerned with inventory management.

2.2 Central role of working capital management

2.2.1 Central role of working capital management (Dec 13)

Working capital management is central to financial management for several

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2.3 Advantages to take steps to improve working capital management

2.3.1 Advantages to take steps to improve working capital management

(a) Credit management effect:

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3. The Cash Operating Cycle

3.1.1 The Cash Operating Cycle

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3.2 Calculation of the cash operating cycle

Raw materials holding period x

Inventory holding period x

The cycle may be measured in days, weeks or months.

How long is the company’s cash operating cycle?

Cash operating cycle = 1 – 6 + 3 + 2 + 4 = 4 weeks

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Receivables collection period 56 days

Calculate the length of the operating cycle.

3.3 Significance of the cash operating cycle

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3.4 Working capital management and business solvency

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of cash management is of a poor standard.

Multiple Choice Questions

1 An increase in the period of credit given by suppliers

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3. Which of the following will shorten the cash operating cycle?

A An increase in the raw materials inventory holding period

A Delaying payments made to suppliers

What is the length of the operating cash cycle of the business?

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C Average cash balance + average debt collection period – average creditor

What is the opening cash cycle of the business?

8. The following information has been calculated for A Co:

Trade receivables collection period 52 days

What is the length of the working capital cycle?

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Sales revenue $3,074,000

What impact will this have?

Cash operating cycle Reported profits

Income statements 2006 2005

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Statement of financial position 2006 2005