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Managing Working Capital
Learning Outcomes
• What is Working Capital?
• Why is it important for business operations?
• What is Liquidity?
• How do we measure Liquidity?
• Defining Operating Working Capital
• Case Study Companies
What is Working Capital?
Working capital management is the management of the short-term investment and financing of a company.
What is Working Capital?
Working Capital = Current Assets - Current Liabilities
Working Capital Formula
Why is Working Capital Important?
Working capital is the cash available for daily operations, to cover short term expenses and also any unplanned expenses.
Working Capital is important for young companies that cannot access capital on the financial markets.
Why is Working Capital Important?
Liquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted into cash.
Liquidity management is the ability of the company to generate cash when and where needed.
Sources of Liquidity
•Existing cash
•Short-term funds
•Converting customers invoices quickly into cash
•Sale of assets
Current Assets
Current Assets Definition
Cash & Cash Equivalents Cash, money market securities, short-term government bonds
Short-term investments Investments in stocks and bonds that will be redeemed within 12 months
Accounts Receivable Money owed to a business, usually in the form of invoices
Prepaid Expenses Future expenses that have been paid in advance. eg. insurance
Inventories Stock of goods for eventual sale
Question
Which of the follow is not a current asset?
A. Cash
B. Accounts Payable
C. Accounts Receivable
Question
Which of the follow is not a source of liquidity?
A. Sale of assets
B. Capital Expenditure
C. Converting customers’ invoices
Current Liabilities
Current Liabilities Definition
Short term loans Money owed to the bank within 12 months.
Accounts Payable Total amount owed to suppliers (creditors) for goods and services received but not paid
Accrued Income Taxes Income tax payable to the Government within 12 months
Accrued Liabilities Includes salaries, dividends payable. Typically booked on balance sheet before payment takes place
London Coffee Company
View of the Balance Sheet
Question
Which of the following is not a current liability:
A. Accrued Income Taxes
B. Prepaid Expenses
C. Short-term Loans
Current Liabilities
If accounts receivable is: money owed to a business, usually in the form of invoices
What are some strategies can we use to manage accounts receivable?
Question for you
Hit and have a go at answering before we continue
Accounts Receivable
• Strategies to manage accounts receivable:
- Effective processing and tracking of invoices
- Invoice clients sooner
- Establish credit policies
- Extend payment methods
- Review accounts receivable regularly and prepare performance measurement reports
Current Liabilities
If accounts payable is the: Total amount owed to suppliers (creditors) for goods and services received but not paid What are some strategies can we use to manage accounts payable?
Question for you
Hit and have a go at answering before we continue
Accounts Payables
• Effective strategies for accounts payable management include:
- Use technology to centralise the accounts payable process
- Negotiate vendor terms (30days, 90 days etc.)
- Trade credit and the cost of alternative forms of short-term financing
Inventories
Inventory (stock) is the goods that a business holds for the eventual purpose of selling.
Inventory management involves preserving a balanced level of inventory that meets market demand.
Why hold inventory? • For regular sales operations • Incase of excess demand / To guarantee stock
Current Liabilities
If inventories are the goods that a business holds for the eventual purpose of selling. What are some strategies can we use to manage inventories?
Question for you
Hit and have a go at answering before we continue
Inventory Management
What might be different ways to manage inventory?
•A system where actual orders indicate when a unit should be produced (‘demand-pull’) - Just in Time
•Determining the number of units produced with each order to minimise holding/order/storage costs - Economic order quantity
Measuring Liquidity: Ratios
By measuring liquidity, we can tell how easy it will be for the company to raise cash or convert assets into cash.
In the below formulas, we include current assets such as accounts payable, short term investments and receivables as they can be ‘liquidated’ converted into cash quickly.
Measuring Liquidity: Ratios
1. Current Ratio
2. Quick Ratio
3. Cash Ratio
4. Accounts Payable Days
5. Accounts Receivable Days
6. Inventory Days
7. Cash Conversion Cycle
Liquidity Ratios - Current Ratio
Current Ratio
Indicates if a company has sufficient resources to cover its short term obligations.
Current AssetsCurrent Liabilities
Current Ratio =
Liquidity Ratios - Current Ratio
Quick Ratio
Indicates if a company has sufficient resources to cover its short term obligations using its assets which are as near to cash.
Quick Ratio = Current Assets− Inventories
Current Liabilities
Liquidity Ratios - Current Ratio
Cash Ratio
A more specific measure of a company’s liquid assets relative to its short term obligations.
Cash Ratio = Cash& Cash Equivalents
Current Liabilities
Question
Current assets DIVIDED BY current liabilities is:
A. Quick Ratio
B. Cash Ratio
C. Current Ratio
Question
The quick ratio EXCLUDES which of the following?
A. Accounts receivable
B. Inventories
C. Cash
Liquidity Ratios - Inventory Days
Inventory days
Tells us how many days inventories eg. products stored in a factory take to be sold.
InventoriesCost of Goods Sold
x 365 days
Liquidity Ratios - Receivables Days
Accounts ReceivableTotal Sales
x 365 days
Receivables days
Calculates how many days it takes for debtors (someone who owes us money) eg. client invoices to pay us.
Liquidity Ratios - Payables Days
Accounts PayableCost of Goods Sold
x 365 days
Payables days
How many days we need to make payments to creditors.
Question
To improve our cash flow position, should we aim to:
1. Decrease Payables Days?
2. Decrease Receivables Days?
3. Increase Inventory Days?
Liquidity Ratios: Cash Conversion Cycle
Cash Conversion Cycle
How long does it take for these assets and liabilities to convert into cash overall?
Inventory Days + Receivables Days - Payables Days =
Cash Conversion Cycle
Case Study: Working Capital Reporting
Case Study: Working Capital Reporting
• Working capital is a measure of a company’s short term financial
health.
• The objective of working capital management is to ensure a smooth
operating cycle.
• Companies can use a number of operational strategies to improve
their working capital positions.
• Financial analysts measure liquidity by calculating ratios from a
company’s financial statements.
Recap
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