1 Working Capital: Lecture Example 1

4: WORKING CAPITAL
1 Working capital
1.1 Working capital is the value of current assets less the value of current liabilities.
Key terms Definition

Current assets Cash, inventory, receivables
Current liabilities Payables, loans falling due within one year, overdraft
2 Objectives of working capital management

2.1 The two main objectives of working capital management are:
(a) To increase the profits of a business
(b) To provide sufficient liquidity to meet short-term obligations as they fall due
Lecture example 1 Idea generation
Required
How can investment in higher levels of inventory or receivables affect:
(a) Profits?
(b) Liquidity?
Solution
2.2 There is often a conflict between the two main objectives of working capital management,
ie management need to carefully consider the level of investment in working capital and to
consider the impact that this is having on a company's liquidity position; an overview of this
is given by the cash operating cycle.
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4: WORKING CAPITAL
3 Overview – cash operating cycle

3.1 The cash operating cycle (also known as the working capital or the cash conversion cycle) is
the period of time between the outflow of cash to pay for raw materials and the inflow of
cash from customers.
Purchases Production In warehouse Sale Cash inflow
Raw materials WIP Finished goods Credit sales
Credit purchases Cash operating cycle (needs funding)
Cash outflow
3.2 The optimal length of the cycle depends on the industry.

Calculating the cash operating cycle
1. Inventory days
(a) Finished goods Finished goods  365 = days

Cost of sales
(b) WIP WIP  365 = days

Cost of production
(c) Raw material Raw material  365 = days

Raw material purchases
2. Av. collection period Re ceivables  365 = days

(credit) sales
3. Av. payables period Payables  365 = (days)

(credit) purchases
Cash operating cycle =
3.3 By comparing the cash operating cycle from one period to the next or one company to
another it should be possible to identify potential deficiencies.
46
4: WORKING CAPITAL
Lecture example 2 Technique demonstration
The table below gives information extracted from the annual accounts of Management plc for the
past year.
MANAGEMENT PLC – EXTRACTS FROM ANNUAL ACCOUNTS
Year 1
£
Inventory: Raw materials 108,000
Work in progress 75,600
Finished goods 86,400
Purchases of raw materials 518,400
Cost of production 675,000
Cost of goods sold 756,000
Sales 864,000
Receivables 172,800
Payables 96,400
Required
Calculate the length of the working capital cycle (assuming 365 days in the year).
Solution
1. Inventory days
(a) Finished goods £86,400  365 = days

Cost of sales
(b) WIP £75,600  365 = days

Cost of production
(c) Raw material £108,000  365 = days

Raw material purchases
2. Av. collection period £172,800  365 = days

(credit) sales
3. Av. payables period £96,400  365 = (days)

=
(credit) purchases
Cash operating cycle =
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4: WORKING CAPITAL
3.4 The working capital ratios can be used to work backwards to, for example, the amount of
sales or overdraft.
Lecture example 3 Exam Standard Section A 2 marks
A business has a current ratio of 2. Current assets consist of inventory of $10m and current
liabilities of $15m. The company gives on average 36.5 days' credit to its customers.
Required
Assuming that the business has a zero cash balance and that there are 365 days in a year, what is
the annual credit sales revenue?
A $150m
B $2m
C $20m
D $200m
Solution
4 Forecasting cash flow needs

4.1 The cash operating cycle can be used to determine the amount of cash needed at any sales
level, and to identify the possibility of a cash shortfall if sales rise too rapidly. Referring back
to the previous lecture example, we can identify a relationship between sales and cash
required by using the sales/net working capital ratio.
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4: WORKING CAPITAL
Lecture example 4 Technique demonstration
MANAGEMENT PLC – EXTRACTS FROM ANNUAL ACCOUNTS

Year 1
£
Sales 864,000
Inventory: Raw materials 108,000
Work in progress 75,600
Finished goods 86,400
Receivables 172,800
Payables (96,400)
Net working capital 346,400
Sales/net working capital ratio = 864,000/346,400 = 2.49
Required
What level of net working capital (ie cash) is needed to support sales, if sales rise by 30% over the
next year?
Solution
4.2 If a business fails to plan how to supply its forecast level of cash flow needs, it will be in
danger of overtrading. Overtrading is where a business has inadequate cash to support its
level of sales (it is also known as undercapitalisation). To deal with this risk a business
must either:
(a) Plan the introduction of new long-term capital
(b) Improve working capital management
(c) Reduce business activity
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4: WORKING CAPITAL
5 Chapter summary
Section Topic Summary
1 Working Working capital is the value of current assets less
capital the value of current liabilities.
2 Objectives The two main objectives of working capital
management are to increase the profits of a
business and to provide sufficient liquidity to meet
short-term obligations as they fall due. These two
objectives may sometimes conflict.
3 Overview This is given by the cash operating cycle.
4 Forecasting The cash operating cycle can be used to determine
the amount of cash needed at any sales level, and
to identify the possibility of a cash shortfall if sales
rise too rapidly.
END OF CHAPTER
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4: WORKING CAPITAL

Key terms Definition

2 Objectives of working capital management

Lecture example 1 Idea generation

3 Overview – cash operating cycle

Raw materials WIP Finished goods Credit sales

Credit purchases Cash operating cycle (needs funding)

3.2 The optimal length of the cycle depends on the industry.

(a) Finished goods Finished goods  365 = days

(b) WIP WIP  365 = days

(c) Raw material Raw material  365 = days

2. Av. collection period Re ceivables  365 = days

Cash operating cycle =

Lecture example 2 Technique demonstration

(a) Finished goods £86,400  365 = days

(b) WIP £75,600  365 = days

(c) Raw material £108,000  365 = days

2. Av. collection period £172,800  365 = days

3. Av. payables period £96,400  365 = (days)

Cash operating cycle =

Lecture example 3 Exam Standard Section A 2 marks

4 Forecasting cash flow needs

Lecture example 4 Technique demonstration

MANAGEMENT PLC – EXTRACTS FROM ANNUAL ACCOUNTS

Sales/net working capital ratio = 864,000/346,400 = 2.49

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