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35 Cards in this Set

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Working capital is made up of what?

Current assets (receivables + inventory + cash) less current liabilities (payables).

Working capital needs to balance profitability and liquidity. Describe this trade off for each aspect below:




1. Cash


2. Receivables


3. Inventory


4. Payables

Cash - cash means a business can get discounts and can pay debts but stops a business from earning a return on investment of this cash.




Receivables - not offering credit will improve the speed that you are paid but may reduce demand for the product you are offering.




Inventory - holding inventory means you can respond to customer demand but will mean cash is tied up that could be invested elsewhere.




Payables - not paying suppliers may forego discounts and may alienate suppliers, but having additional cash gives a business flexibility.

What are 3 types of assets?

Fluctuating current assets


Permanent current assets


Non current assets

How are these assets funded by short/long term finance when operating a defensive, average or aggressive risk strategy?

Defensive risk - long term finance fund all NCA and PCA, while also covering some of the FCA.




Average risk - long term finance funds all NCA and PCA. Short term finance covers all FCA.




Aggressive risk - long term finance only covers all NCA and some PCA. Short term finance covers the remaining PCA and all FCA.

As a general rule, short term finance is cheaper/more expensive (delete one) than long term finance because the risk taken by lenders is lower/higher (delete one).




What are two risks for the borrower specifically for short term finance?

As a general rule, short term finance is cheaper than long term finance because the risk taken by lenders is lower.




1. Renewal risk - short term finance continually expires and has to be renegotiated.


2. Interest rate risk - short term finance will be open to interest rate fluctuations in the market.

What are the two ways in which a business'


liquidity position can be assessed?




With what two things can these can this be


compared with?

1. Ratios (Payables days, receivables days,


inventory turnover, rate of inventory turnover).


2. The cash operating cycle.




1. The same company in previous periods


2. Other companies in the same industry

Would you typically expect an aggressive


company to have a high or low current ratio, and a high or low earnings per share ratio?

An aggressive company typically has high


profitability (earnings per share) and low


liquidity (current ratio).

What does the inventory turnover period show? How is it calculated?

Inventory turnover period shows the average length of time inventory is held for.




Inventory x 365


---------------


COS





What does the rate of inventory turnover show?


How is it calculated?

The rate of inventory turnover monitors how many times inventory turns over during the


trading period. It is the opposite calc to inventory turnover period.




Cost of sales


------------------- = X times


Average inventory

What does the receivables collection period show? How is it calculated?

Receivables collection period shows how long on average it takes to collect debts.




Average receivables


----------------------------- x 365


Annual sales revenue

What does the payables collection period show?


How is it calculated?

Payables collection period monitors how long on average the company waits before paying its suppliers.




Average payables


------------------------- x 365


Annual purchases

Broadly what does the cash operating cycle show?

The cash collection cycle shows the length of time between an organisation paying out cash for raw materials/other input costs and receiving the cash for goods.

What 5 figures are used to calculate the cash


operating cycle?

Raw materials holding period (av. RM inventory/annual RM usage)


+ Average production period ( av. WIP inventory/annual COS)


+ Average inventory holding period (av. FG inventory/annual COS)


+ Receivables days (av. receivables/annual sales)


- Payables days (av. payables/annual purchases)

Where averages are not calculable, what can be used instead?




Where cost of sales is not calculable, what can be used instead?



Where purchases is not calculable, what can be used instead?

If an average cannot be calculated, the closing balance should be used instead.




If cost of sales is not calculable, then production costs can be used instead.




If purchases is not calculable, then cost of sales can be used instead.

What two factors is the level of investment in working capital influenced by?

1. Growth




2. Inflation

What is overtrading?




What are the effects of overtrading on:


1. The cash collection cycle?


2. Sales and purchases?


3. Inventory?


4. Investment in short term/long term finance?


5. Non current assets?

Overtrading is where a company's sales grow too fast without sufficient investment in long term finance.




The cash collection cycle will increase


Sales and purchases will increase


Inventory could either decrease or increase


Short term finance will be used (payable days/


overdraft), but no long term finance will be used.


NCA will rise insufficiently, or decrease

What are two broad remedies to overtrading for a business?

1. An injection of cash (either equity or debt)




2. Working capital management (i.e. improving cash collection cycle)




- lower credit period offered/extend credit taken


- improve production techniques with machines


- reduce inventory levels (such as JIT)

What does the quick ratio remove from the


current ratio?




What is another name for the quick ratio?




What are two reasons for omitting this figure?

The quick ratio is the same as the current ratio but removes inventory.




The quick ratio is also called the acid test ratio.




Two reasons for omitting inventory are:


1. Inventory is the hardest CA to sell for cash


2. Sales proceeds likely to be lower than carrying value in the accounts so prudent to ignore.

What are 3 motives for holding inventory?

1. Transaction motive


2. Precautionary motive


3. Speculative motive

What are 3 costs associated with holding inventory?

1. Purchase price (of the inventory itself)




2. Holding costs (including opportunity cost)




3. Re-order costs (costs for each new order)

What are 3 methods for controlling inventory?

Re-order level system - e.g. two bins of inventory and reorder when one bin is empty.




ABC system - monitor the most important/


valuable inventory more closely.




EOQ model - see next cards

What is the formula for the EOQ model?





EOQ = Square root of (2cd/h)




c - cost of placing one order


d - estimated use of the inventory for period


h - cost of holding 1 unit of inventory for period



What two factors does the EOQ model ignore?




What is one assumption in terms of how


inventory is used throughout the year?

1. It ignores the £ amount of each oder


2. It ignores that bulk discounts can be gained




EOQ has to assume that inventory is used up in a uniform manner

What are 5 conditions that need to be present for a JIT system to work effectively?

1. Guaranteed quality of raw materials


2. Close relationship with just a few suppliers


3. Close geographic proximity


4. Efficient factory layout


5. Multi-skilled and flexible labour

What are perpetual inventory methods?

Perpetual inventory methods are when a


business keeps perpetual inventory records, so that orders can be based on data from an


inventory system.

Credit periods for a buyer are effectively a source of free short term finance for a business.




2 potential drawbacks of using a credit period are...?

1. Potentially losing credit status


2. Increased supplier prices or lost discounts

3 drivers behind taking an increased credit


period from suppliers are...?

1. Flexible




2. Useful for businesses unable to get


traditional credit sources




3. Useful for managing short-term cash


flow issues

Management of trade receivables involves the business trading off which two points?

A trade off between:




The costs of extending credit to the customer - irrecoverable debts, admin cost of credit control




The benefits of gaining credit - larger sales

What is a credit rating? Which customers get a high credit rating and which customers get a low credit rating?

A credit rating is the risk that a customer will not pay its debts. Customers that pay quickly, get a high rating. Customers that pay slowly, get a low credit rating.

Receivables can be sold like other assets, by two means. What are these two techniques?

Invoice discounting - selling the specific invoices to a discounting third party for a cash sum




Receivables factoring - the factorer takes a more holistic role over all receivables. This includes


accounting and collection, credit control and


finance against sales.

What are two other examples of good practice in receivables management?

1. Focus on key accounts




2. Manage time scales

Businesses can also take out insurance against the default of credit customers, and the political risk for exporters. To what 3 extents can a


business insure?

1. Insure all or part of its receivables ledger against default




2. Include a 'first loss'/excess so default above a certain level is covered




3. Insure up to a certain ceiling/credit limit

In terms of treasury management, what is the


basic trade-off?

The trade off is the costs of holding cash


(e.g. opportunity cost of what else could be done with money), and the costs of running out of cash.

What are 4 motives that determine how much cash a business would like to hold?




To recap how are these different to the 3 motives for holding inventory?

1. Transactions motive - to be able to buy and sell on a day by day basis


2. Finance motive - to be able to finance specific assets


3. Precautionary motive - in case something goes wrong


4. Investment motive - to take an opportunity if it arrises




The 3 motives for holding inventory are transaction motive,


precautionary motive and speculative motive.

The primary aim of good cash management is to have the right amount of cash available at the right time.




What 4 activities does this involve?

1. Accurate budgeting/forecasting


2. Planning short term finance when necessary


3. Planning investment of any cash surpluses


4. Cost-efficient cash transmission