Management of Working capital

1
Management of Working capital

• Elements of working capital
• Working capital and cash flow
• Liquidity ratios
• Overtrading
• Predicting business failure
• Strategic fund management

2
Elements of working capital

• Current assets less current liabilities
• Liquidity is important in both short term and
  long term
• Lack of liquidity is a major reason for company
  failure
• Too much liquidity may lead to opportunities
  being missed

3
Working capital cycle

• Also known as cash cycle, operating cycle,
  trading cycle
• Calculated as stock period (RM WIP)
• debtors period
• - creditors period
• Shorter period means cash is generated more
  quickly

4
Liquidity ratios

• Current ratio
• ignore the more than x nonsense!
• depends on type of business
• Quick (or acid test) ratio
• Debtors period
• note that year end date may influence result
• Stock period
• Creditors period

5
Overtrading

• growing faster than sources of finance can
  support
• Thus cannot pay debts as they fall due
• May be signalled by
• rapid growth in turnover
• reduced stock and debtors turnover
• longer creditors period
• pressure from creditors
• overdraft limit reached/breached
• fall in current / quick ratios
• current assets less than current liabilities

6
Overtrading - responses

• Inject new capital
• Improve control / turnover of stock / debtors
• Delay investment in fixed assets
• NB WC requirement may be calculated as
• current assets current liabilities

7
Over-capitalisation

• excessive investment in working capital
• Indicators include
• high current ratio
• acid test ratio
• long stock turnover period
• debtors collection period
• short creditors payment period
• low working capital turnover ratio
• However note that company may be planning
  expansion, and has obtained resources for that
  purpose.
• In exam
• use words such as tends possible may
  indicate
• draw conclusions based on trends / overall
  picture
• try to avoid simplistic conclusion
• however keep analysis logical and
• state the obvious

8
Predicting business failure

• Liquidity ratios may assist
• Notoriously difficult!
• See separate notes Predicting Business Failure

9
Cash Flow Planning

• Cash Budgeting
• Strategic fund management
• (an extension of cash flow planning)

10
Cash budgeting

• Short term
• Includes revenue and capital flows
• Early warning device
• Timing/amount/term of borrowing/investment
• Need to build in contingencies
• e.g. Scottish Parliament
• Wembley Stadium

11
Strategic fund management

• Separate assets into
• core activities
• those which could be sold if necessary
• Problems can be met by
• working capital management
• changing dividend policy
• selling non-essential assets