L5 FINANCIAL MANAGEMENT

WORKING CAPITAL MANAGEMENT I

Question 1.
Long term capital, business funding or simply 'capital' refers to sources of finance
that are called upon or issued to support the long-term development of the business.
Net working capital is the balance of current assets and current liabilities. The term
'current' means these assets and liabilities have durations of less than 1 year.

The level of current assets is a key factor in the firm's liquidity position. The firm
must be able to generate enough cash to meet its short-term needs and so to
continue trading. Working capital, then, is a key factor in the firm's long-term
success. The greater the extent to which current assets exceed current liabilities,
the more solvent is the firm.

Question 2.
Working capital management has 2 overarching objectives: liquidity and profitability.

A company must have sufficient liquidity to enable it to meet its liabilities as they fall
due and to allow production capacity to fulfil the current level of demand.

This means that a company must have access to enough cash or highly liquid assets
to pay its bills. Businesses have a cash cycle that sees cash tied up (in production)
before it grows (hopefully!) and is then released from customers. The timing of cash
inflows (receipts) and outflows (payments) therefore often doesn't match so a
balance of working capital is needed to keep the business afloat.

As well as cash, current assets comprise inventory (stock) and receivables (debtors).
Stock and debtor levels are often proportional to demand/revenue. This means as
the business grows then so does the amount of investment tied up in working capital.
In this respect if working capital cannot keep up with the demand requirements, the
business will struggle.

However, investment in working capital is expensive and therefore working capital

must be managed efficiently so as to not compromise the overall objective of a
commercial company which should be shareholder wealth maximisation. Holding too
much working capital (i.e. investing too heavily) is costly. This is money that could be
used to develop the business or returned to shareholders, so a balance needs to be
struck between liquidity (risk) and profitability (return).

If a company gets working capital management wrong, the consequences can be

fatal. Overtrading occurs when the working capital base of a company is too small to
support its trading volume. In these cases, liquidity is insufficient and despite a
company growing profitable business, short term cashflow problems can cause it to
fail.

Question 3.

(a) The Cash conversion cycle quantifies the time between paying for inputs and
receiving cash from sales. The length of the cash conversion cycle is a factor in
determining the level of working capital.

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The cash conversion cycle (CCC) is given by the formula:

ICP + RCP - PDP (days)

ICP= Inventory conversion period

RCP= Receivables collection period
PDP= Payables deferral period

(b) Stocks:
Raw materials (250/1,070) x 365 = 85 days
Work in progress (115/1,458) x 365 = 29 days
Finished goods (186/1,458) x 365 = 47 days

Debtors (345/1,636) x 365 = 77 days

Creditors (162/1,070) x 365 = (55) days

Cash Conversion Cycle: = 183 days

Question 4.
Overtrading: occurs when the volume of trade is not supported by an adequate
supply of capital.

Signs of Overtrading:

1. Rapid increase in turnover:

Forecast financial statements for 2020 show that our turnover is expected to
increase by:
100 x (8,300 – 6,638)/6,638 = 25%

2. Rapid increase in current assets:

Current assets are expected to rise by 100 x (5,950 – 4,700)/4,700 = 27%, slightly
above the increase in turnover.

3. Increase in stock days and debtor days:

Debtor days are expected to increase from 110 to 121 days, with a 38% increase in
total debtors:

2020: 365 x 2,750/8,300 = 121 days

2019: 365 x 2,000/6,638 = 110 days

Stock days are not expected to increase, but to fall from 265 days to 238 days.
Nevertheless, a 19% increase in stocks is anticipated.

2020: 365 x 3,200/4,900 = 238 days

2019: 365 x 2,700/3,720 = 265 days

4. Increased reliance on short term finance:

Reserves are expected to increase by £100,000.

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Total assets are expected to increase by £1,400,000.

Hence expansion based primarily on an expansion of short-term finance:

5. Increase in trade creditors:

= 100 x (2,550 –1,800)/1,800 = 42%
Increase in overdraft:
= 100 x (2,750 – 2,300)/2,300 = 20%

Creditor days will increase from 177 to 190 days, i.e. in relative terms an increase of
42% – more than increase in turnover (25%) and increase overdraft (20%).

2020: 365 x 2,550/4,900 = 190 days

2019: 365 x 1,800/3,720 = 177 days

6. Decrease in current ratio and quick ratio

The current ratio expected to fall slightly from 1·04 to 1.03
2020: 5,950/5,800 = 1·03
2019: 4,700/4,500 = 1·04

The Quick ratio expected to increase from 0·44 to 0·47.

2020: 2,750/5,800 = 0·47
2019: 2,000/4,500 = 0·44

Comparison with Sector Averages

 an increasing trend of debtor days away from the sector average of 100 days is
clearly a cause for concern. If Doe's level is to be brought into line with the sector
average financing must fall by: (£2·75m x 21/121) = £477,000 - equivalent to
17% of our forecast overdraft.
 a decrease in stock days is encouraging, although forecast stock days remain
13% higher than the sector average.
 there is clear evidence of an increased reliance on short-term finance.
 the trend of creditor days is increasing away from the sector average of 120
days. The forecast of 190 days is a very worrying (58% more than the average)
representing £940,000 (£2·55m x 70/190) more in trade finance that Doe Ltd is
carrying.
 it is likely suppliers will begin to press for earlier settlement in the near future.
 the quick ratio is expected to increase - it is still 15% below the sector average.
The current ratio is expected to be 25% lower than the average.
 both reflect an increased reliance of Doe Ltd on short-term finance.

Conclusion on Overtrading
 Evidence suggests Doe Ltd is moving into an overtrading situation, although the
evidence is not conclusive.
 Pressure from the bank to reduce our overdraft serves to highlight the fact.
 Doe needs to reduce its reliance on short-term finance
 Improved working capital management could reduce debtors and (to a lesser
extent) stocks.
 More drastic measures than this will be needed to deal with the reliance on short-
term finance.

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 Reducing trade credit to an average level would need £1m of additional finance.
 The company has no long-term debt; hence this source of finance deserves
serious consideration.

Question 5.
F = £5 per order
S = 200,000 bars per year
H = £0.50 per 1,000 bars

Using the EOQ: Q= √((2 × S × F)/H)

EOQ = (2 x 5 x 200,000/(0.5/1,000))½ = 63,245 bars (63 boxes)

Re-order level = (8 x 200,000)/48 = 33,333 bars (34 boxes)
Average stock level = EOQ/2 = 63,000/2 = 31,500 bars

Question 6.

(a)(1) Average no. of orders per year = 200,000/ 50,000 = 4 orders

Annual ordering cost = 4 x £200 = £800

Buffer stock held = 200,000 x 30/365 = 16,438 units

Average inventory held = 16,438 + (50,000/2) = 41,438 units

Total annual holding cost = 41,438 x 0·2 = £8,288

Annual cost of current ordering policy = 8,288 + 800 = £9,088

(a)(2) EOQ = ((2 x 200,000 x 200)/0·2)0·5 = 20,000 units

Average no. of orders per year = 200,000/20,000 = 10 orders

Annual ordering cost = 10 x £200 = £2,000

Average inventory held = 16,438 + (20,000/2) = 26,438 units

Annual holding cost = 26,438 x 0·2 = £5,288
Annual cost of EOQ ordering policy = 2,000 + 5,288 = £7,288

Saving compared to current policy = 9,088 – 7,288 = £1,800

(b) Students should discuss the following points:

 demand for inventory, holding cost per unit and order cost are assumed by
the EOQ to be constant over the period the model is applied to
 it ignores the cost of running out of inventory (stock-outs)
 the model was initially based on zero lead time and no buffer stock, but
these issues can be accommodated by the model

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Phase Test Preparation:

Q1. E An increase in the credit period allowed by suppliers

This will allow a company to retain cash longer before paying suppliers and hence
help its liquidity position. All the other options will lead to a deterioration in a
company’s working capital management situation.

Q2. E Increase in the number of days to turn-over stock

This will worsen a company’s working capital management situation as it will take
longer for the company to get money back into the company. All the other options
will lead to an improvement in a company’s working capital management situation.

Q3. D Decreasing debtor period

This is likely to indicate that a company is in control of its debtor collection and
hence not overtrading. All the other indicators point toward a firm that could be in an
overtrading position.

Q4. C Conservative
A company with high levels of current assets indicates one that is following a low
risk, lower profit ‘conservative’ working capital policy.

Q5. B (1) and (2) are correct

Statement (3) is the only incorrect one of the three. Re-order costs are an integral
part of the EOQ model.

Q6. B 1,000
F = £200 per order
S = 20,000 components per year
H = £8 per unit

Using the EOQ: Q= √((2 × S × F)/H)

EOQ = (2 x 20,000 x £200/(£8))½ = 1,000

Q7. B An aged receivables analysis will highlight slow-paying customers

This is the only true statement of the five. The cash conversion cycle can and often
is negative for cash-based industries. Aggressive working capital policies relate to
either the level of working capital or how it is financed so statement C is ambiguous.
Having a current ration less than 2 doesn’t automatically mean a company has
liquidity issue – it is just and average figure that is often quoted. Finally, cash
surpluses should not be invested in convertibles as there is an element of risk with
them.

Q8. D 12,600
F = £150 per order
S = 799,100 Product Q’s per year
H = £1.51 per unit

Using the EOQ: Q= √((2 × S × F)/H)

EOQ = (2 x 799,100 x £150/(£1.51))½ = 12,600

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