Chapter III
Working capital
Topic List
1. The Nature of Working Capital
2. Objectives of Working Capital Mgt.
3. Roles of Working Capital Mgt.
4. The Cash Operating Cycle
5. Liquidity Ratios
The nature of working capital
• Net working capital of a business is its current assets
less its current liabilities.
Current assets Current liabilities
Cash Trade accounts payable
Inventory of raw materials Taxation payable
Inventory of work in progress Dividend payments due
Inventory of finished goods Short-term loans
Amounts receivable from A/R Long-term loans maturing
within one year
Marketable securities Lease rentals due within one
Slide 2
year
The nature of working capital
The total investment in working capital is calculated as:
Current assets:
• Inventory X
• Trade receivable X
• Short-term investments X
• Cash X
XX
Minus current liabilities:
• Bank overdraft X
• Trade payables X
• Other current liabilities X
XX
Investment in working capital XXX
Slide 3
Objectives of working capital
• The two main objective of working capital
management are to ensure it has sufficient
liquid resources to continue in business and
to increase its profitability.
• Every business needs adequate liquid resources
to maintain day to day cash flow. It needs
enough to pay wage, salaries and accounts
payable if it is to keep its workforce and ensure
its supplies.
Slide 4
Role of working capital management
• Working capital management is a key factor in
an organization's long-term success.
• A business must therefore have clear policies
for the management of each component of
working capital.
• The management of cash, marketable securities,
account receivable, accounts payable, accruals
and other means of short-term financing is the
direct responsibility of the financial manager and
it requires continuous day to day supervision.
Slide 5
The cash operation cycle
Slide 6
Example: Cash operating cycle
Wines Co buys raw materials from suppliers that
allow Wines 2.5 months credit. The raw materials
remain in inventory for one month, and it takes Wines
2 months to produce the goods. The goods are sold
within a couple of days of production being completed
and customers take on average 1.5 months to pay.
Required
Calculate Wines's cash operating cycle.
Slide 7
Example: Cash operating cycle
Solution
We can ignore the time that finished goods are in inventory
Months
• The average time that raw materials remain in inventory 1.0
• Less the time taken to pay suppliers (2.5)
• The time taken to produce the goods 2.0
• The time taken by customers to pay for the goods 1.5
Cash operating cycle 2.0
Slide 8
Example: Cash operating cycle
Slide 9
Calculating the inventory turnover period
• For a company in the retail sector or
service sector of industry, the average
inventory turnover period in normally
calculated as follows:
Average inventory
Inventory turnover period 365days
Annual cos t of sales
Slide 10
Calculating the inventory turnover period
• For a manufacturing company, the total inventory
turnover period is the sum of the raw material
turnover period, production cycle and finished goods
turnover period,
Average raw material inventory
Raw material 365days
Annual raw purchase
Average WIP
Pr oduction cycle 365days
Annual cos t of sale
Average finished inventory
Finished inventory 365days
Annual cos t of sale
Slide 11
Cash Operating Cycle
Slide 12
Liquidity ratio
Slide 13
Liquidity ratio
• All the ratios calculated above will vary by industry;
hence comparisons of ratios calculated with
other similar companies in the same industry are
important.
• These liquidity ratios are a guide to the risk of cash
flow problems and insolvency. If a company suddenly
finds that it is unable to renew its short-term
liabilities (for example, if the bank suspends its
overdraft facilities, there will be a danger of
insolvency unless the company is able to turn
enough of its current assets into cash quickly.
Slide 14
Example: Working capital ratios
Slide 15
Example: Working capital ratios
Slide 16