Chapter 18 Working Capital Management: Answer - Test Your Understanding 1

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Chapter 18 Working Capital Management

Answer – Test Your Understanding 1

Raw materials inventory holding period 21


WIP holding period 14
Finished goods holding period 28
Receivables’ collection period 56
Operating cycle 119
Less: Suppliers’ payment period (42)
Cash cycle 77

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Answers to Examination Style Questions

Answer 1
Objectives of working capital management:
1. The objectives of working capital management are profitability and liquidity.
2. The objective of profitability supports the primary financial management
objective, which is shareholder wealth maximisation.
3. The objective of liquidity ensures that companies are able to meet their liabilities as
they fall due, and thus remain in business.
[1 mark]
Discussion of conflict between objectives:
4. However, funds held in the form of cash do not earn a return, while near-liquid
assets such as short-term investments earn only a small return.
5. Meeting the objective of liquidity will therefore conflict with the objective of
profitability, which is met by investing over the longer term in order to achieve
higher returns.
[2 marks]
Good working capital management therefore needs to achieve a balance between the
objectives of profitability and liquidity if shareholder wealth is to be maximised.

Answer 2
Objectives of working capital management:
1. Profitability and liquidity are usually cited as the twin objectives of working capital
management.
2. The profitability objective reflects the primary financial management objective of
maximising shareholder wealth, while liquidity is needed in order to ensure that
financial claims on an organisation can be settled as they become liable for payment.
[1 – 2 marks]
Conflict between two objectives:
3. The two objectives are in conflict because liquid assets such as bank accounts earn
very little return or no return, so liquid assets decrease profitability. Liquid assets
in fact incur an opportunity cost equivalent either to the cost of short-term finance or to
the profit lost by not investing in profitable projects.
[1 – 2 marks]
Trade-off between two objectives:
4. Whether profitability is a more important objective than liquidity depends in part on
the particular circumstances of an organisation. Liquidity may be the more
important objective when short-term finance is hard to find, while profitability

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may become a more important objective when cash management has become too
conservative. In short, both objectives are important and neither can be neglected.
[1 mark]

Answer 3
 The objectives of working capital management are usually taken to be profitability and
liquidity.
 Profitability is allied to the financial objective of maximising shareholder wealth, while
liquidity is needed in order to settle liabilities as they fall due.
 A company must have sufficient cash to meet its liabilities, since otherwise it may fail.
 However, these two objectives are in conflict, since liquid resources have no return or
low levels of return and hence decrease profitability.
 A conservative approach to working capital management will decrease the risk of
running out of cash, favouring liquidity over profitability and decreasing risk.
 Conversely, an aggressive approach to working capital management will emphasise
profitability over liquidity, increasing the risk of running out of cash while increasing
profitability.
[3 – 4 marks]
Working capital management is central to financial management for several reasons.
 First, cash is the life-blood of a company’s business activities and without enough cash
to meet short-term liabilities, a company would fail.
 Second, current assets 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.
 Third, for SMEs current liabilities are a major source of finance and must be carefully
managed in order to ensure continuing availability of such finance.
[3 – 4 marks]

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Answer 4

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Answer 5
Objectives and advantages of working capital management:
1. The objectives of working capital management are often stated to be profitability and
liquidity. These objectives are often in conflict, since liquid assets earn the lowest
return and so liquidity is achieved at the expense of profitability. However, liquidity is
needed in the sense that a company must meet its liabilities as they fall due if it is to
remain in business. For this reason cash is often called the lifeblood of the company,
since without cash a company would quickly fail. Good working capital management
is therefore necessary if the company is to survive and remain profitable.
[2 marks]
Credit management effect:
2. 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. 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. 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.
[2 marks]
Stock management effect:
3. A similar case can be made for the management of stock. It is likely that Velm plc will
need to have a good range of stationery and office supplies on its premises if customers’
needs are to be quickly met and their custom retained. Good stock management, for
example using techniques such as the economic order quantity model, ABC analysis,
stock rotation and buffer stock management can minimise the costs of holding and
ordering stock. The application of just-in-time methods of stock procurement and
manufacture can reduce the cost of investing in stock. Taking steps to improve stock
management can therefore reduce costs and increase shareholder wealth.
[2 marks]

Other example:
4. 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. Cash management models such as the
Baumol model and the Miller-Orr model can help to maintain cash balances close
to optimum levels.
[1 mark]

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The different elements of good working capital management therefore combine to help the
company to achieve its primary financial objective.

Answer 6
Meaning of cash operating cycle:
The cash operating cycle is the length of time between paying trade creditors and
receiving cash from debtors. It can be calculated by adding together the average stock
holding period and the average debtors’ deferral period, and then subtracting the average
creditors’ deferral period. The stock holding period may be subdivided into the holding
periods for raw materials, work-in-progress and finished goods. In terms of accounting ratios,
the cash operating cycle can be approximated by adding together stock days and debtor
days (debtors’ ratio) and subtracting creditor days (creditors’ ratio). If creditors are paid
before cash is received from debtors, the cash operating cycle is positive; if debtors pay
before trade creditors are paid, the cycle is negative.
[2 marks]
Significant level of working capital management:
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.
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. 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 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. 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.

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4. It is also possible to reduce the level of investment in working capital by reducing
the length of the cash operating cycle. This is achieved by reducing the stock holding
period (for example by using JIT methods), by reducing the debtor deferral period (for
example by improving debtor management), or by 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.

Answer 7
(a)
Companies may get short-term financing by maintaining and using lines of credit from banks.
Listed companies may get additional finance through a rights issue.

(b)
A B
Inventory turnover 5.73 4.72
Inventory turnover period (days) 63.69 77.27
Trade receivables turnover 9.39 11.49
Trade receivables turnover period (days) 38.88 31.75
Operating cycle (days) 102.57 109.03

Company B has a relatively longer operating cycle than Company A. Its inventory turnover
period is longer but its trade receivable turnover period is shorter as compared to Company A.
(Note: average figures in calculating inventory turnover and trade receivables turnover are
acceptable.)

(c)
A B
Trade payables turnover 4.14 3.66
Trade payables turnover period (days) 88.24 99.6
Cash cycle (days) 14.33 9.43

Company B has a shorter cash cycle than A. It takes on average 9.43 days between the time it
pays for inventory and the time it collects cash on the sales. It succeeded in having a longer
trade payables turnover period.
(Note: average figures in calculating trade payables turnover is acceptable.)

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(d)
Having a long operating cycle indicates that it takes a long time buying inventory to actual
collection of cash. That is, a long time in converting inventory to trade receivables and finally
cash.

(e)
From Du Pont identity, ROE = net profit margin × asset turnover × equity multiplier

The shorter the operating cycle, the shorter the cash cycle, and the lower the investment in
inventories and receivables. Total assets are lower, the asset turnover is higher and ROE is
higher.

Answer 8
(a)
Calculation of ratios:
Stock days 2006: (3,000/9,300) x 365 = 118 days
2005: (1,300/6,600) x 365 = 72 days
Sector average: 90 days

Debtor days 2006: (3,800/15,600) x 365 = 89 days


2005: (1,850/11,100) x 365 days = 61 days
Sector average: 60 days

Creditor days 2006: (2,870/9,300) x 365 = 119 days


2005: (1,600/6,600) x 365 = 93 days
Sector average: 80 days
[3 marks]

Comment:
In each case, the ratio in 2006 is higher than the ratio in 2005, indicating that deterioration
has occurred in the management of stock, debtors and creditors in 2006.

Stock days have increased by 46 days or 64%, moving from below the sector average to
28 days – one month – more than it. Given the rapid increase in turnover (40%) in 2006,
Anjo plc may be expecting a continuing increase in the future and may have built up
stocks in preparation for this, i.e. stock levels reflect future sales rather than past sales.
Accounting statements from several previous years and sales forecasts for the next period
would help to clarify this point.

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Debtor days have increased by 28 days or 46% in 2006 and are now 29 days above the
sector average. It is possible that more generous credit terms have been offered in order to
stimulate sales. The increased turnover does not appear to be due to offering lower prices,
since both gross profit margin (40%) and net profit margin (34%) are unchanged.

In 2005, only management of creditors was a cause for concern, with Anjo plc taking 13
more days on average to settle liabilities with trade creditors than the sector. This has
increased to 39 days more than the sector in 2006. This could lead to difficulties between
the company and its suppliers if it is exceeding the credit periods they have specified. Anjo
plc has no long-term debt and the statement of financial position indicates an increased
reliance on short-term finance, since cash has reduced by $780,000 or 87% and the
overdraft has increased by $850,000 to $1 million.

Perhaps the company should investigate whether it is undercapitalised (overtrading). It is


unusual for a company of this size to have no long-term debt.
[3 marks]
(b)
Cash operating cycle (2005) = 72 + 61 – 93 = 40 days [1 mark]
Cash operating cycle (2006) = 118 + 89 – 119 = 88 days [1 mark]

The cash operating cycle or working capital cycle gives the average time it takes for the
company to receive payment from debtors after it has paid its trade creditors. This represents
the period of time for which debtors require financing. The cash operating cycle of Anjo
plc has lengthened by 48 days in 2006 compared with 2005. This represents an increase in
working capital requirement of approximately $15,600,000 x 48/365 = $2.05 million.
[2 mark]
(c)
Working capital and business solvency:
1. The objectives of working capital management are liquidity and profitability, but
there is a tension between these two objectives. Liquid funds, for example cash, earn
no return and so will not increase profitability. Near-liquid funds, with short
investment periods, earn a lower return than funds invested for a long period.
Profitability is therefore decreased to the extent that liquid funds are needed.

2. 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

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cash management is of a poor standard.
[3 – 4 marks]
Factors influencing optimum cash level:
In order to balance the twin objectives of liquidity and profitability in terms of cash
management, a company needs to decide on the optimum amount of cash to hold at any given
time. There are several factors that can aid in determining the optimum cash balance.

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.

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. 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.
[4 – 5 marks]
(d)
$000 Marks
Current debtors = 3,800
Debtors under factor = 3,800 x 0.7 = 2,660
Reduction in debtors = 1,140 [1]

Finance cost saving = 1,140 x 0.08 = 91.2 [1]


Administration cost saving = 1,000 x 0.02 = 20.0 [1]
Interest on advance = 2,660 x 0.8 x 0.01 (21.3) [2]

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Factor’s annual fee = 15,600 x 0.005 = (78.0) [1]
Net benefit of accepting factor’s offer 11.9 [1]

Conclusion and discussion:


Although the terms of the factor’s offer are financially acceptable, suggesting a net
financial benefit of $11,900, this benefit is small compared with annual turnover of $15.6
million. Other benefits, such as the application of the factor’s expertise to the debtor
management of Anjo plc, might also be influential in the decision on whether to accept the
offer. [1 mark]

Answer 9
1. Costs incurred $
Direct materials 30% of $1,500,000 450,000
Direct labour 25% of $1,500,000 375,000
Variable overheads 10% of $1,500,000 150,000
Fixed overheads 15% of $1,500,000 225,000
Selling and distribution 5% of $1,500,000 75,000

2. Average value of current assets $ $


Finished goods 1/12 x $975,000 81,250
Raw materials 3/12 x $450,000 112,500
WIP (2 months @ half produced – 1 month
equivalent cost)
Materials 1/12 x $450,000 37,500
Labour 1/12 x $375,000 31,250
Variable overheads 1/12 x $150,000 12,500
81,250
Receivables 2.5 x $1,500,000 312,500
587,500
3. Average value of current liabilities
Materials 2/12 x $450,000 75,000
Labour 1/50 x $375,000 7,500
Variable overheads 1/12 x $150,000 12,500
Fixed overheads 1/12 x $225,000 18,750
Selling and distribution 1/24 x $75,000 3,125
(116,875)
Working capital required 470,625

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Answer 10
(a)
The Miller Orr Model assumes that many companies do not use cash flows uniformly and the
model allows them to have daily cash flow variations. The cash balance is allowed to
fluctuate between the upper limit and the lower limit. The purchase and sales of marketable
securities can only be made when one of these limits is reached.

(b)
In Miller Orr Model, target cash balance Z

(1) Return point (Z) = Lower limit + (1/3 × spread)


1/ 3
 3 transactio n cos t  var iance of cash flows 
(2) Spread = 3    
4 int erest rate 
Variance and interest rates should be expressed in daily terms.

1/ 3
50,000  1,000,000 
Spread = 3   
3
  194,792.68
4 5% / 365 
Return point (Z) = 1,000,000 + 194,792.68 / 3 = $1,064,930.9

(c)
Upper limit for cash balance H = 1,000,000 + 194,792.68 =1,194,792.68

(d)

Z is the target cash balance. L is the lower limit and H is the upper limit. When cash level

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reaches the upper limit, it indicates purchase of securities to reduce cash. When cash level
reaches the lower limit, it indicates sales of securities to get cash.

(e)
To improve cash cycle, management may consider the following methods:
1. Offer discount to customers to encourage early collection.
2. Factor accounts receivable at banks and get immediate cash.
3. Implement cash sales instead of credit sales.
4. Get credit line from banks.
5. Diversify to cash business like retail.

Answer 11
(a)

From the graph, the rationale behind the Miller-Orr Model is that when the cash level of a
company reaches the upper limit (H), the company buys securities for short term investment.
When the cash level reaches the lower limit (L), it sells securities to provide more cash.

(b)(i)
1/ 3
 3  50,000  1,000,000 
Z    1,000,000  $1,064,930.89
 4  5% / 365 

(b)(ii)
H  3  1,064,930.89  2  1,000,000  $1,194,792.68

(b)(iii)
A company may consider using a line of credit offered by a bank to solve its short-term cash

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flow problem.

(c)
When a company pays earlier, it can maintain good relationships with its creditors and avoid
the surcharges of making late payments. This may facilitate better purchase terms in the
future.

The cost of making early payments includes opportunity cost as money paid earlier,
especially large amounts, may be used for better investments. In addition, early payment may
create a cash flow shortage. When this happens, a company may have to ask for short-term
borrowing and incur interest expenses.

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