ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 3: Working capital management
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Cash operating cycle and working capital requirements
The cash operating cycle is a key factor in deciding the minimum amount of
working capital required by a company. A longer cash operating cycle means a
larger investment in working capital.
The cash operating cycle, and each of the elements in the cycle, must be managed to
ensure that the investment in working capital is not excessive (i.e. the cash cycle is
not too long) nor too small (i.e. the cash cycle is too short, perhaps because the credit
period taken from suppliers is too long).
2.2 Elements in the the cash operating cycle
There are three main elements in the cash operating cycle:
The average length of time that inventory is held before it is used or sold
The average credit period taken from suppliers
The average length of credit period taken by (or given to) credit customers.
The cash operating cycle can be measured as:
days
Average inventory turnover period X
Plus: Average time for customers to pay
(‘debtor days’ or ‘average collection period’)
X
Minus: Average period of credit taken from suppliers.
(X)
= Cash operating cycle
X
Measuring the cash operating cycle: a manufacturing business
For a manufacturing business, it might be appropriate to calculate the inventory
turnover period as the sum of three separate elements:
the average time raw materials and purchased components are held in inventory
before they are issued to production (raw materials inventory turnover period),
plus
the production cycle (which relates to inventories of work-in-progress), plus
the average time that finished goods are held in inventory before they are sold
(finished goods inventory turnover).
2.3 Calculating the inventory turnover period
For a company in the retail sector or service sector of industry, the average
inventory turnover period is normally calculated as follows:
Inventory turnover period = Average inventory
× 365 days
Annual cost of sales
If possible, average inventory should be used to calculate the ratio because the year-
end inventory level might not be representative of the average inventory in the
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period. Average inventory is usually calculated as the average of the inventory
levels at the beginning and end of the period. However, the year-end inventory
should be used when opening inventory is not given and average inventory cannot
be calculated.
For companies in the retailing or service sector, the cost of sales is normally used
‘below the line’ in calculating inventory turnover. However, if the value for annual
purchases of materials is given, it might be more appropriate to use the figure for
purchases instead of cost of sales.
For a manufacturing company, the total inventory turnover period is the sum of the
raw materials turnover period, production cycle and finished goods turnover
period, calculated as follows.
Turnover period for:
Days
Raw material = (Average raw material inventory/
Annual raw material purchases)
× 365 days
A
Production cycle = (Average WIP/Annual cost of sales) × 365 days B
Finished inventory = (Average finished inventory/Annual cost of
sales)
× 365 days
C
Total A + B + C
Inventory turnover and the turnover period
Inventory turnover is the inverse of the inventory turnover period.
If the average inventory turnover period is 2 months, this means that inventory
is ‘turned over’ (used) on average six times each year (= 12 months/2 months).
If the inventory turnover is 8 times each year, we can calculate the average
inventory turnover period as 1.5months (= 12 months/8) or 46 days (= 365
days/8).
2.4 Calculating the average collection period
The average period for collection of receivables can be calculated as follows:
Average collection period = Average trade receivables
× 365 days
Annual sales
When normal credit terms offered to customers are 30 days (i.e. the customer is
required to pay within 30 days of the invoice date), the average collection period
should be about 30 days. If it exceeds 30 days, this would indicate that some
customers are taking longer to pay than they should, and this might indicate
inefficient collection procedures for receivables.
Chapter 3: Working capital management
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2.5 Calculating the average payables period
The average period of credit taken from suppliers before payment of trade payables
can be calculated as follows:
Average payment period = Average trade payables
× 365 days
Annual purchases
The average payment period should be close to the normal credit terms offered by
suppliers in the industry.
If the average payment period is much shorter than the industry average, this
might suggest that the company has not negotiated reasonable credit terms from
suppliers, or that invoices are being paid much sooner than necessary, which is
inefficient working capital management.
If the average payment period is much longer than the industry average, this
might indicate that the company has succeeded in obtaining very favourable
credit terms from its suppliers. Alternatively, it means that the company is
taking much longer credit than it should, and is failing to comply with its credit
terms. This might be an indication of either cash flow problems or (possibly)
unethical business practice.
Example
Extracts from the statement of financial position (balance sheet) and income
statement of a company are set out below.
$
Inventories:
Raw materials 864,000
Work in progress 448,128
Finished goods 1,567,893
Trade receivables 1,425,600
Trade payables 604,800
Annual purchases 1,745,000
Annual cost of sales 5,272,128
Annual sales 5,802,400
Required
Calculate the length of the cash operating cycle for the company.
Answer
Item Days
Rawmaterialturnover(864,000/1,745,000)×365days 181
Productioncycle(448,128/5,272,128)×365days 31
Finishedgoodsturnover(1,567,893/5,272,128)×365days 109
Creditperiodgiventocustomers(1,425,600/5,802,400)×365days 90
411
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Minus:
Creditperiodfromsupp liers(604,800/1,745,000)×365days (127)
Cashoperatingcycle 284
In this example, it takes the company 284 days on average from paying for the
goods and services that go into making its products, before it gets paid the cash
from the sales. If the cash cycle gets longer, this would mean having to find ever-
increasing amounts to finance the investment in inventory and trade receivables,
and it could result in serious cash flow and liquidity problems for the business.
2.6 Analysing the cash operating cycle
The cash operating cycle can be analysed to assess whether the total investment in
working capital is too large or possibly too small. The analysis can be made by
comparing each element of the cash operating cycle, and the cash operating cycle as
a whole, with:
the cash operating cycle of other companies in the same industry
the company’s own cash operating cycle in previous years, to establish whether
it is getting longer or shorter.
Comparisons with other companies in the industry
As a general rule, the inventory turnover period, average collection period and
average payment period should be about the same for all companies operating in
the same industry. If there are differences, there might be reasons. For example a
company with an unusually large proportion of sales to other countries might have
a longer average collection period because of the longer time that it takes to deliver
goods to customers.
If it is not possible to explain significant differences in any ratio between a
company’s own turnover periods and the industry average, the differences might be
due to inefficient working capital management (or possibly efficient management).
For example an unusually long inventory turnover period compared with the
industry average might indicate inefficiency due to excessive holding of inventory.
Slow-moving inventory might also indicate that a write off of obsolete inventory
might be necessary at some time in the near future.
Comparisons with previous years: trends
There might be a noticeable trend over time in a company’s turnover ratios from
one year to the next. A trend towards longer or shorter turnover and cycle times
should be investigated.
A particular cause for concern might be a trend towards longer inventory turnover
periods and longer average collection times, which might be an indication of
excessive inventories (inefficient inventory management) or inefficient collection
procedures for trade payables.
Chapter 3: Working capital management
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Example
In the financial year just ended, a retailing company had closing inventory costing
$425,000 and sales in the year were $4.5 million. In the previous year, closing
inventory was $320,000 and sales during that year were $4.3 million.
In this example, end-of-year inventory levels are used to calculate inventory
turnover periods, because average inventory for the previous year cannot be
calculated.
Average inventory turnover in the current year = $425,000/$4.5 million × 365 =
34 days.
Average inventory turnover in the previous year = $320,000/$4.3 million × 365 =
27 days.
The average turnover period has increased by 7 days. This might have implications
for profitability, as follows.
If the turnover period had remained 27 days in the current year, closing
inventory would be $333,000 (= 27/365 × $4.5 million). This is $95,000 less than
the actual inventory level, suggesting that with better inventory management,
working capital might have been lower by about $95,000.
If the higher inventory level at the end of the year indicates that it is taking
longer to sell inventory, this might suggest that the inventory will not be sold
unless the retail company has a sale and the goods are sold at a low gross profit
margin.
2.7 Changes in the cash cycle and implications for operating cash flow
When there are changes in the length of the cash operating cycle, this has
implications for cash flow as well as working capital investment.
A longer cash operating cycle, given no change in sales or the cost of sales,
increases the total investment in working capital. An increase in the inventory
turnover period means more inventory, and an increase in the average collection
period means more trade receivables. A reduction in the average payables
period means fewer trade payables, which also increases working capital.
An increase in working capital reduces operational cash flows in the period.
The reverse is also true. A shorter cash operating cycle results in less working
capital investment, and the fall in working capital increases operating cash flows in
the period.
The link between changes in the cash cycle and operating cash flows can be seen in
the statement of cash flows:
Extract from a statement of cash flows
$
Profit after adjustment for non-cash items such as depreciation X
Increase in inventory (X)
Increase in trade receivables (X)
Reduction in trade payables (X)
Operating cash flows (before interest and tax payments) X
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An increase in working capital has a direct effect on cash flows by reducing
operating cash flows below the level of operating profit by the amount of the
increase.
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Managing working capital: liquidity
Liquidity
Liquidity ratios
Sales revenue net working capital ratio
3 Other working capital ratios
The previous section explained the cash operating cycle and the relevance of
turnover periods for inventory, trade receivables and trade payables for cash flow
and the size of investment in working capital.
Other working capital ratios can also be used to analyse whether a company has too
much or too little working capital, and whether it has adequate liquidity.
3.1 Liquidity
Liquidity for an entity means having access to sufficient cash to meet all payment
obligations when they fall due. The main sources of liquidity for a business are:
cash flows from operations: a business expects to make its payments for
operating expenditures out of the cash that it receives from operations. Cash
comes in when customers eventually pay what they owe (and from cash sales)
holding ‘liquid assets’: these are assets that are either in the form of cash already
(money in a bank account) or are in the form of investments that can be sold
quickly and easily for their fair market value
access to a ‘committed’ borrowing facility from a bank (a ‘revolving credit
facility’). Large companies are often able to negotiate an arrangement with a
bank whereby they can obtain additional finance whenever they need it.
A key element of managing working capital is to make sure the organisation has
sufficient liquidity to meet its payment commitments as they fall due. Having
sufficient liquidity is a key to survival in business.
If there is insufficient liquidity, then even if the entity is making profits, it will go
out of business. If the entity cannot pay what it owes when the payment is due, legal
action will probably be taken to recover the unpaid money and the entity will be put
into liquidation. In practice, banks are usually the unpaid creditors who put illiquid
entities into liquidation.
The liquidity of a business entity can be assessed by analysing:
its liquidity ratios and
the length of its cash operating cycle (explained earlier).
3.2 Liquidity ratios
A liquidity ratio is used to assess the liquidity of a business. There are two liquidity
ratios:
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Current ratio = Current assets/ Current liabilities; and
Quick ratio (or acid test ratio) = (Current assets – Inventory)/Current liabilities
You should use the values in the closing balance sheet to calculate these two ratios.
The purpose of a liquidity ratio is to compare the amount of liquid assets held by a
company with its current liabilities. This is because the money to pay the current
liabilities should be expected to come from the cash flows generated by the liquid
assets.
Unlike the cash operating cycle ratios, the liquidity ratios include all current assets
(including cash and short-term investments) and all current liabilities (including any
bank overdraft and current tax payable).
Analysing the liquidity ratios
If the liquidity ratios are too high, this indicates that there is too much investment in
working capital. If the liquidity ratios are low, this indicates that the company might
not have enough liquidity, and might be at risk of being unable to settle its liabilities
when they fall due. So how do we assess whether the liquidity ratios are too high or
too low.
The liquidity ratios of a company may be compared with:
the liquidity ratios of other companies in the same industry, to assess whether
the company’s liquidity ratios are higher or lower than the industry average or
norm and
changes in the company’s liquidity ratios over time and whether its current
assets are rising or falling in proportion to its current liabilities.
It has sometimes been suggested that there ‘ideal liquidity ratios and that:
the ‘ideal’ current ratio might be 2:1.
the ‘ideal’ quick ratio might be 1:1.
When the ratios are below these ‘ideal’ levels, management might need to consider
how liquidity might be improved.
However, these ‘ideal’ ratios are only a very general guide.
The ‘normal’ or ‘acceptable’ liquidity ratios vary significantly between different
industries. The ideal liquidity ratios depend to a large extent on the ‘ideal’ or
‘normal’ turnover periods for inventory, collections and payments to suppliers.
A high ratio might be attributable to an unusually large holding of cash. When a
company has surplus cash or short-term investments, this might be temporary
and the company might have plans for how the cash will be used in the near
future.
The most appropriate way of using liquidity ratios is probably to monitor
changes in the ratio over time. When the ratios fall below a ‘safe‘ level, and
continue to fall, the entity might well have a serious liquidity problem.
Chapter 3: Working capital management
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Note
Which of the two liquidity ratios is more significant? The answer to this question is that
it depends on the normal speed of turnover for inventory. If inventory is held only for a
short time before it is used or sold, the current ratio is probably a more useful ratio,
because inventory is a liquid asset (convertible into cash within a short time).
On the other hand, if inventory is slow moving, and so fairly illiquid, the quick ratio
is probably a better guide to an entity’s liquidity position.
Example
20X7 20X8 20X9
$m $m $m
Inventory 130 240 225
Tradereceivables 245 312 400
Cash 100 54 23
–
–––––––
–
––––––– ––––––––
Currentassets 475 606 648
Currentliabilities (200) (300) (450)
–
–––––––
–
––––––– ––––––––
Netcurrentassets 275 306 198
–
–––––––
–
––––––– ––––––––
Inaddition,thefollowinginformationisavailable:
Creditsales1,500 1,530
Costofgoodssold1,120 1,200
Required
Assess the entity’s liquidity position, using:
inventory turnover time
the average collection time
liquidity ratios.
Answer
When the information is available, you should use average inventory and average
trade receivables for the year, rather than the year-end value. It is assumed that
average values for the year are the average of the beginning–of-year and end-of-
year values.
Inventory turnover
Average inventory:
20X9 = (240 + 225)/2 = 232.5
20X8 = (130 + 240)/2 = 185.0
Inventory turnover:
20X9 = (232.5/1,200) × 365 days = 71 days
20X8 = (185/1,120) × 365 days = 60 days.
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Inventory turnover was slower in 20X9 than in 20X8. This could be an indication of
problems with inventory management, as well as deteriorating liquidity.
The slower inventory turnover implies that we are not converting the stock to cash
as quickly as before. As a result more money is being tied up in working capital.
Average time for customers to pay
Average trade receivables:
20X9 = (312 + 400)/2 = 356.0
20X8 = (245 + 312)/2 = 278.5
Average time for credit customers to pay
20X9 = (356/1,530) × 365 days = 85 days
20X8 = (278.5/1,500) × 365 days = 68 days
As with inventory turnover, the payment time for trade receivables is worsening
and trade receivables are not converting to cash as quickly as before. This implies
that the liquidity position is deteriorating.
Liquidity ratios
Current ratio
20X7 20X8 20X9
Currentassets/currentliabilities 475/200
=2.38times
606/300
=2.02times
648/450
=1.44times
The liquidity position of the business, as measured by the current ratio, has become
much worse in 20X9 compared with 20X8 and 20X6. It could well be getting worse
continually. Creditor payments were covered by nearly 2.5 times in 20X7. By 20X9,
the cover had shrunk to around 1.5 times. This indicates a potential problem for the
business, possibly in the near future.
However, before making this judgement you should want to know the reasons for
the deterioration in inventory turnover time and the average time for customers to
pay, because these will be linked to the deterioration in the current ratio.
Quick ratio
20X7 20X8 20X9
(Currentassets‐Inventories)/Current
liabilities
345/200
=1.73times
366/300
=1.22times
423/450
=0.94times
This ratio confirms the analysis. The liquidity position is getting worse. However, a
ratio of 0.94 is only just below the ‘ideal’ quick ratio of 1.0 times; therefore further
analysis should be carried out to assess the problem, and what must be done to
resolve it. It might be appropriate to prepare a cash flow forecast for the next few
months, to assess the possible need for cash in the near future.