A good working capital management system is very important to any business entity as it comprises the core issues that affect the operations and financial health of business. To be able to manage effectively a good business, one must be able to manage working capital. This enables the company to maintain profitability, liquidity, and effectually growth.
One great advantage of a good working capital management is that a firm is easily able to access lending facilities from financial institutions. A business can get short-term loans which include invoice discounting, bank lines of credit, accounts receivable-backed loans within a short period. This enables a business to meet its obligations whenever it has constraints. These facilities are flexible and have varying interest rates and repayment periods. A business needs to maintain good records and review its working capital ratios from time to time to ensure that they are within the accounting provisions.
Through a good working capital management, a business`s profitability is increased. This is because wastage is reduced and that goods are taken to the market at the right time. Storage costs are also reduced leading to more profits. Creditors are paid on time leading to good credit ratings while debtors funds are collected in time.
A good working capital management system ensures that a business`s production is not interrupted. This leads to more goods to be sold. The capital (plant and Equipment) are also fully utilized. This ensures that plant and equipment are not idle and that their cost is fully used. A business with an efficient chain of production is often able to sell its products at a discount as it enjoys economies of scale, unlike the others. This leads to a competitive advantage against the competitors.
- Calculate the following ratios for each year and comment on your findings.
- Inventory Days = [Cost of goods sold / Average inventory] *365
COGS 9300 6600
Average inventory (3000+1300)/2 1300/1
Inventory Days = (9300/3650)365 (6600/1300)365
= 146 days = 71 days
The inventory days have increased in the two years. The business is also keeping inventory for more days than its competitors in the industry.
- Receivables days = (Average receivables/Net Credit sales)*365
Average Receivables = (3800+1850)/2 1850/1
Net Credit Sales = 15,600 11,100
Receivable days = (4725/15,600)365 (1850/11,100)365
= 110 days 60 days
The company is taking more days in 2016 to collect payments than it did in 2015. This is not good for the business. It is also taking more days to collect than the industry average.
- Payable days = 365/Annual Purchases * Average Trade payables
Annual Purchases = (9300+3000-1300) (6600+1300-0)
Average payables = (2870+1600)/2 1600/1
Payable Days = (365/11000)* 2235 (365/7900)*1600
= 74 days 73 days
The business is taking almost same days in the two years to pay its creditors. The business is also taking lesser days when compared to average industry. This is good as it reduces its operating cycle.
- Calculate the length of the cash operating cycle (working capital cycle) for each year and explain its significance.
Cash operating cycle = Inventory days + Receivable days – payable days
= 182 Days 58 days
It is important to note that through cash operating cycle a business is able to know the amount of time each dollar invested is held up in the production to the sales process. In this it knows how long it takes to convert the invested dollar back to cash. This is critical as the business is able to know how long it taking to convert the invested cash back to cash again. It also looks at the amount that the business needs to collect receivables and also the amount of time that it can afford to pay its bills with being charged penalties or hurting its credit ratings.
- Discuss the relationship between working capital management and business solvency, and explain the factors that influence the optimum cash level for a business.
Working capital management is the technique of monitoring and managing cash and other inputs from production all the way to sales. Working capital management monitors how long it’s taking to convert invested cash back to cash again. This period is critical as it determines the solvency of a business. The longer a business takes to convert Cash to cash again the more its liquidity is rigid. This therefore means that working capital management is directly proportional to the solvency of a business.
Factor cost = 0.5/100* 15,600
80% of debtors = 80/100*3800
= 3040 * 9/100
Reduce debtors by 30% = 0.3*3800
Reduce administration expenses = 2/100*1000
The offer is acceptable as the business will be assisted to reduce its debtors by 80 percent. This will come at an additional cost however; this will be countered by the reduction in administration expenses and the comfort of quick conversion of debtors to cash.
- Fees 3/100*37400 = 1112
Interest 7/100*4600 = 322
Savings $ 100,000 per year in administration costs and 350,000 in bad debts
In case of an interest rate hike the business will be affected in that the interest rate costs will increase. There is also a chance that the value of the bond will decrease making it not financially viable to redeem it but rather to hold it to maturity. To insure itself against interest rate risk the business can either take the agreement with the factor company as this will enable it reduce costs of administration and also bad debts. The business can also reduce the number of days it takes to collect receivables and try to increase the number of days it takes to pay its suppliers legally. This will enable it to use less of its overdraft facility.
- The business is overtrading. The business has an overdraft of 3225 in 2017 and 1600 in 2016. This increase in overdraft usage has also led to an increase in interest costs. This is however; not reflecting in profits before taxation. The cost of goods sold in 2017 increased by 10,627 (34408-23781).This should then reflect in profits which does not.
- The average cost of financing short term lending is 5% while the factor company is proposing 7%. The difference being 2 % . This is financially acceptable after putting into consideration that the business will also reduce in administration expenses which reduce company`s profits and also significantly reduce the company`s bad debts.