Chapter 10 Working capital - acornlive.com

1 1 Working capital Chapter 10 2 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 receivables Cash Short term investments Trade payables Bank overdrafts Working capital can be viewed as a whole but interest is usually focussed on the individual components such as inventories or trade receivables.

2 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.

3 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 ( inventories is a non productive asset), there are also additional costs of holding the inventories ( 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.

4 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. 3 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.

5 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. Inventories bought on credit temporarily help with cash flow as there is no immediate to pay for these inventories. The sale of inventories is made on credit which creates trade receivables. This means that there is no cash inflow even though inventory had been sold. The cash for the sold inventory will be received later. Trade payables need to be paid, and the cash is collected from the trade receivables.

6 The cash has to be collected from the trade receivables and then paid to the trade payables otherwise there is a cash flow problem. Cash Trade receivables Customer owing money, as sales made on credit Trade payables Money owing to suppliers as stock purchased on credit Inventories Sold on credit 4 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).

7 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 held before being sold) + Trade receivables days (how long the credit customers take to pay) - Trade payables days (how long the company takes to pay its suppliers) = Working capital cycle (in days) (Inventories / cost of sales) x 365 days + (Trade receivables / credit sales) x 365 days - (Trade payables / purchases) x 365 days = Working capital cycle (in days)

8 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 (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.

9 5 Working capital cycle in a manufacturing business Average time raw materials are in stock + Time taken to produce goods + Time taken by customers to pay for goods - Period of credit taken from suppliers = Working capital cycle (in days) (Raw materials / purchases) x 365 days + (WIP & finished goods / cost of sales) x 365 days + (Trade receivables / credit sales) x 365 days - (Trade payables / purchases) x 365 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.

10 Example (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. 6 The shorter the cycle, the better it is for the company as it means: Inventories are moving though the organisation rapidly.