Quiz, Paper Exam & CBE - Lecture notes 1 PDF

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WORKING CAPITAL MANAGEMENTQ U I Z What are 3 reasons for keeping hold of cash? Precaution, Speculation & ___________?  TRANSACTION Is offering a long credit policy to your customers a sign that you favour profitability or liquidity in your working capital management?  PROFITABILITY P A P E...

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WORKING CAPITAL MANAGEMENT QUIZ 1) What are 3 reasons for keeping hold of cash? Precaution, Speculation & ___________?  TRANSACTION 2) Is offering a long credit policy to your customers a sign that you favour profitability or liquidity in your working capital management?  PROFITABILITY PAP E R

A. Liquidity management B. Interest rate management C. Management of relationship with the bank D. Dividend policy 2. Which of the following statements concerning working capital management are correct? (1) The twin objectives of working capital management are profitability and liquidity (2) A conservative approach to working capital investment will increase profitability (3) Working capital management is a key factor in a company’s long-term success B. 1 and 3 only D. 1, 2 and 3

3. 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 C. 2 and 3 only

B. 1 and 3 only D. 1, 2 and 3

4. Which of the following statements concerning working capital management are correct? 1. The twin objectives of working capital management are profitability and liquidity 2. A conservative approach to working capital investment will increase profitability 3. Working capital management is a key factor in a company’s long-term success A. 1 and 2 only C. 2 and 3 only

Other information - Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each year. Required: Identify the objectives of working capital management and discuss the central role of working capital management in financial management.

E XAM

1. Andrew Co is a large listed company financed by both equity and debt. In which of the following areas of financial management will the impact of working capital management be smallest?

A. 1 and 2 only C. 2 and 3 only

inventory equal to 40% of one month’s sales is maintained. Product Q - The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days.

B. 1 and 3 only D. 1, 2 and 3

5. PROBLEM: Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the year. Product P - The annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each order costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year. Buffer

ANSWER: 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. 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. 6. Critically discuss the similarities and differences between working capital policies in the following areas: (i) Working capital investment; (ii) Working capital financing. ANSWER: Working capital investment policy is concerned with the level of investment in current assets, with one company being compared with another. Working capital financing policy is concerned with the relative proportions of short-term and long-term finance used by a company. While working capital investment policy is therefore assessed on an inter-company comparative basis, assessment of working capital financing policy involves analysis of financial information for one company alone. Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets. Working capital investment policy does not require this analysis. Permanent current assets represent the core level of investment in current assets that supports a given level of business activity. Fluctuating current assets represent the changes in the level of current assets that arise through, for example, the unpredictability of business operations, such as the level of

trade receivables increasing due to some customers paying late or the level of inventory increasing due to demand being less than predicted. Working capital financing policy relies on the matching principle, which is not used by working capital investment policy. The matching principle holds that long-term assets should be financed from a long-term source of finance. Noncurrent assets and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance, while fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan. Both working capital investment policy and working capital financing policy use the terms conservative, moderate and aggressive. In investment policy, the terms are used to indicate the comparative level of investment in current assets on an inter-company basis. One company has a more aggressive approach compared to another company if it has a lower level of investment in current assets, and vice versa for a conservative approach to working capital investment policy. In working capital financing policy, the terms are used to indicate the way in which fluctuating current assets and permanent current assets are matched to short-term and longterm finance sources. An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source. A conservative financing policy means that permanent current assets and a portion of fluctuating current assets are financed from a long-term source. An aggressive financing policy will be more profitable than a conservative financing policy because short-term finance is cheaper than long-term finance, as indicated for debt finance by the normal yield curve (term structure of interest rates). However, an aggressive financing policy will be riskier than a conservative financing policy because short-term finance is riskier than long-term finance. For example, an overdraft is repayable on demand, while a short-term loan may be renewed on less favourable terms than an existing loan. Provided interest payments are made, however, long-term debt will not lead to any pressure on a company and equity finance is permanent capital. Overall, therefore, it can be said that while working capital investment policy and working capital financing policy use similar terminology, the two policies are very different in terms of their meaning and application. It is even possible, for example, for a company to have a conservative working capital investment policy while following an aggressive working capital financing policy.

CBE 1.



Which TWO of the following statements concerning working capital management are correct? The twin objectives of working capital management are profitability and liquidity

  

A conservative approach to working capital investment will increase profitability Working capital management is a key factor in a company's long-term success The current ratio is a measure of profitability The true statements are:  The current ratio is a measure of liquidity.  Adopting a conservative approach to working capital management will decrease profitability.

2. PROBLEM: Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack business administration skills. The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large multinational car manufacturing companies and are often late in paying their invoices. Oscar Co is a rapidly growing company and revenue has doubled in the last four years. Oscar Co has focused in this time on product development and customer service, and managing trade receivables has been neglected. Oscar Co’s average trade receivables are currently $5.37m, and bad debts are 2% of credit sales revenue. Partly as a result of poor credit control, the company has suffered a shortage of cash and has recently reached its overdraft limit. The four founders have spent large amounts of time chasing customers for payment. In an attempt to improve trade receivables management, Oscar Co has approached a factoring company who offered two possible options: Option 1  Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a full recourse basis. The factor would charge a service fee of 0.5% of credit sales revenue per year. Oscar Co estimates that this would result in savings of $30,000 per year in administration costs. Under this arrangement the average trade receivables collection period would be 30 days. Option 2  Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a non-recourse basis. The factor would charge a service fee of 1.5% of credit sales revenue per year. Administration cost savings and average trade receivables collection period would be as Option 1. Oscar Co would be required to accept an advance of 80% of credit sales when invoices are raised at an interest rate of 9% per year. Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per year . (c) Discuss THREE factors that determine the level of a company's investment in working capital. ANSWER: A company’s working capital investment is equal to the sum of its inventories and its accounts receivable, less its accounts payable. The following factors will determine the level of a company’s investment in working capital: 1. The nature of the industry and the length of the working capital cycle. Some businesses have long production processes which inevitably lead to long working capital cycles and large investments in working capital. Housebuilding, for example, requires the building company to acquire land, gain government permission to build, build houses and when complete, sell them to customers. This process can often take more than a year and require large

investment in work-in-progress and therefore in working capital. Other industries, such as supermarkets, buy goods on long credit terms, have rapid inventory turnover and sell to customers for cash. They often receive payment from customers before they need to pay suppliers and therefore have little (or negative) investment in working capital. 2. Working capital investment policy. Some companies take a conservative approach to working capital investment, offering long periods of credit to customers (to promote sales), carrying high levels of inventory (to protect against stock-outs), and paying suppliers promptly (to maintain good relationships). This approach offers many benefits, but it necessitates a large investment in working capital. Others take a more aggressive approach offering minimal credit, carrying low levels of inventory and delaying payments to suppliers. This will result in a low level of working capital investment. 3. Efficiency of management and terms of trade. If management of the components of working capital is neglected, then investment in working capital can increase. For example, a failure to apply credit control procedures such as warning letters or stop lists can result in high levels of accounts receivable. Failure to control inventory by using the EOQ model, or JIT inventory management principles, can lead to high levels of inventory.

PROBLEM: It is the middle of December 20X6 and Pangli Co is looking at working capital management for January 20X7. Forecast financial information at the start of January 20X7 is as follows: Inventory $455,000 Trade receivables $408,350 Trade payables $186,700 Overdraft $240,250 All sales are on credit and they are expected to be $3.5M for 20X6. Monthly sales are as follows: November 20X6 (actual) December 20X6 (forecast) January 20X7 (forecast)

$270,875 $300,000 $350,000

Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit, only 60% of customers pay in the month following purchase, while the remaining customers take an additional month of credit. Inventory is expected to increase by $52,250 during January 20X7. Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the remaining 30% until the end of February 20X7. All suppliers of the company require payment within 30 days. Credit purchases from suppliers during January 20X7 are expected to be $250,000. Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating cash outflows are expected to be $146,500 in January 20X7. Pangli Co has no cash and relies on its overdraft to finance daily operations. The company has no plans to raise long-term finance during January 20X7.

CASH OPERATING CYCLE A. WORKING CAPITAL CYCLE QUIZ 1. Your working capital management policies are as follows:  Use a Just-in-time stock system meaning a stock holding time of 2 days only  Credit offered to customers 60 days  Credit received from suppliers 45 days How long is your working capital / cash operating cycle? 17 DAYS  2+60-45 = 17 2. Is a negative operating cycle possible?  YES 3. Revenue Cost of sales Gross profit

25,400 Receivables (21,300) Inventory 4,100 Payables

3,500 4,300 1,200

What is the cash operating cycle (to the nearest day)? 103 DAYS  50 + 74 - 21 = 103 3,500 / 25,400) * 365 = 50 ( 4,300 / 21,300) * 365 = 74 (- 1,200 / 21,300) * 365 = -21 PAPER EXAM

Assume that each year has 360 days. Required: 1. Calculate the cash operating cycle of Pangli Co at the start of January 20X7. 2. Calculate the overdraft expected at the end of Jan. 20X7. ANSWER: 1) The cash operating cycle can be calculated by adding inventory days and receivables days, and subtracting payables days. Cost of sales = 3,500,000 x (1 – 0·4) = $2,100,000 Inventory days = 360 x 455,000/2,100,000 = 78 days Trade receivables days = 360 x 408,350/3,500,000 = 42 days Trade payables days = 360 x 186,700/2,100,000 = 32 days Cash operating cycle of Pangli Co = 78 + 42 – 32 = 88 days 2. Inventory at end of Jan. 20X7 = $507,250

455,000 + 52,250 =

At the start of January 20X7, 100% of December 20X6 receivables will be outstanding ($300,000), together with 40% of November 20X6 receivables ($108,350 = 40% x 270,875), a total of $408,350 as given. Trade receivables at start of January 20X7 Outstanding November 20X6 receivables paid December 20X6 receivables, 60% paid January 20X7 credit sales Trade receivables at end of January 20X7

408,350 (108,350) (180,000) 350,000 470,000

Trade payables at start of January 20X7 Payment of 70% of trade payables

186,700 (130,690)

January 20X7 credit purchases Trade payables at end of January 20X7 Overdraft at start of January 20X7 Cash received from customers Cash paid to suppliers Interest payment Operating cash outflows Overdraft expected at end of January 20X7

250,000 306,010 240,250 (288,350) 130,690 70,000 146,500 299,090

3.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

If the working capital cycle had been negative, CSZ Co would have been receiving cash from its customers before it needed to pay its trade suppliers. A company which does not give credit to its customers, such as a supermarket chain, can have a negative working capital cycle. Even if companies might generally prefer to be paid by customers before they have to pay their suppliers, the question of whether the working capital cycle should be positive or negative implies that companies are able to make such a choice, but this is not usually the case. This is because the length of the working capital cycle depends on its elements, which are inventory days, trade receivables days and trade payables, and these elements usually depend on the nature of the business undertaken by a company and the way that business is conducted by its competitors. The length of the working capital cycle is usually therefore similar between companies in the same business sector, but can differ between business sectors.

What is the length of the working capital cycle? A. 103 days C. 235 days

far as CSZ Co is concerned, which could be funded from a short-term or long-term source.

B. 131 days D. 31 days

 52 + 42 + 30 – 66 + 45 = 103 days. 4. The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:

5. Extracts from the recent financial statements of Bold Co are given below.

Inventory Trade receivables Trade payables Overdraft Net current asstes

Turnover 21300 Cost of Sales (16400) Gross Profit 4900

5,700 6,575 2,137 4,682

12,275 (6,819) 5,456

For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers. For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the company’s overdraft. CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015: Inventory days: Trade receivables: Trade payables: Current ratio:

60 days 75 days 55 days 1.4 days

Required: (a) Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 2014 and discuss whether a working capital cycle should be positive or negative. ANSWER: Inventory days = 365 x (5,700/26,000) = 80 days Trade receivables days = 365 x (6,575/40,000) = 60 days Trade payables days = 365 x (2,137/26,000) = 30 days Working capital cycle of CSZ Co = 80 + 60 – 30 = 110 days The working cycle of CSZ Co is positive and the company pays its trade suppliers 110 days (on average) before it receives cash from its customers. This represents a financing need as

Non-Current Assets Current assets Inventory Trade Receivables Total Assets

3000 4500 3500

8000 11000

Current Liabilities Trade Payables Overdraft

3000 3000

6000

Equity Ordinary Shares Reserves

1000 1000

2000

Non-Current Liabilities Bonds

3000 11000

A factor has offered to manage the trade receivables of Bold Co in a servicin...