PM – Tutorial notes on Working Capital Mgt.

- Introduction(EU – 08032758426)

WORKING CAPITAL MANAGEMENT

Definition of working capital – this refers to as an amount an entity needs to support its daily
operations. There are basically two concepts of working capital namely;
 Gross working capital – refers to as current assets (those assets that can easily be converted
into cash within a short period of time (say one year) and include: cash, short-term securities or
marketable securities, account receivable and inventory- raw materials, work in progress &
finished goods.
 Net working capital - refers to the difference current assets and current liabilities (those claims
of outsiders which are payable within a short period of time (say one year) and include; trade
accounts payable, bills payable, taxation payable, dividend payment due, short term loans,

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long-term loans maturing within one year, lease rentals due within one year).
The net working capital indicates the liquidity position of the firm and as such currents assets should
be sufficiently in excess of current liabilities preferably 2:1 ratio. There must be proper management

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of working capital at all times to guide against a weak liquidity position which could pose a threat to
the solvency of a company. Investment in working capital should just be adequate because excessive
investment impairs profitability while inadequate investment can threaten solvency. However, there is

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no precise way to determine the exact amount of working capital for firms since the data and problem
of each company are different.
Objectives of working capital management
The objectives of working capital management are:
 To ensure that it has sufficient liquid resources to continue operation – liquidity can be
maintained by ensuring that the amounts of cash tied up in inventory and receivable is not
excessive
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 To increase its profitability – to be able to earn steady amount of profit, a firm would have to
invest enough funds in working capital to generate sales. Current assets are needed because
sales do not convert into cash immediately thus there is an operating cycle involves in the
conversion of sales into cash.

Operating cycle or working capital cycle or cash operating cycle

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The cash operating cycle is the period of time which elapses between the point at which cash begins to
be expended on the production of a product and the collection of cash from a customer. The cash
operating cycle is the period between the suppliers being paid and the cash being received from the
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customers.
The cash operating cycle in a manufacturing business equals:
Months
The average time that raw materials remain in inventory X
Plus the time taken to produce the goods X
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Plus the time taken by customers to pay for the goods X

Less the time taken to pay suppliers (X)
Cash operating cycle X
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If the turnover periods for inventories and accounts receivable lengthen (ie inventories and
receivables levels increase), or the payment period to accounts payable shortens (ie payables level
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falls), then the cash operating cycle will lengthen and the investment in working capital will increase

Working capital ratios

Working capital ratios help to show whether a company is over-capitalised with excessive working
capital or if a business is likely to fail.
1. The current ratio – this is the standard test of liquidity. The business should have enough
current assets (cash) to meets its commitments to pay its current liabilities. A ratio in excess of
one (1) implies that the business has enough cash and near cash assets to meet it current
liabilities.
Current Ratio = Current Assets
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2. The quick ratio or acid test ratio – this ratio ideally should be at least 1 for companies with a
slow inventory turnover. For a fast inventory turnover company, a quick ratio can be less than 1
without suggesting that the company is in cash flow difficulties.
Quick Ratio = Current Assets - Inventory
Current Liabilities

3. The accounts receivable payment period – this is a rough measure of the average length of

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time it takes for a company’s accounts receivable to pay what they owe.

ARPP = Trade Receivable X 365days

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Credit sales

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4. The inventory turnover period – this indicates the average number of days that items of
inventory are held. A lengthening inventory turnover period indicates:
 A slowdown in trading
 A build up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive
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Inventory days (finished goods) = Average Inventory X 365days
Cost of sales

Inventory days (Raw materials) = Average RM Inventory X 365days

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Annual purchases
Inventory days (work-in-progress) = Average Inventory X 365days
Cost of sales
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Inventory turnover = Cost of Sales

Average inventory
Note- Inventory turnover measure how fast inventory is converted to sales
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5. The accounts payable payment period – it helps to assess a company liquidity, an increase in
accounts payable days is often a sign of lack of long-term finance or poor management of
currents assets, resulting in the use of extended credit from suppliers, increased bank overdraft,
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and so on.

APPP = Average trade payables X 365days

Purchases or Cost of sales

6. The sales revenue/net working capital ratio – this shows the level of working capital
(excluding cash) required to support sales. This means that if this ratio was 5, then for every N5
increase in sales an extra N1 is required to finance the required increase in net working capital.

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SR/NWCR = Sales
Receivable + Inventory - Payables

Determinant of Working Capital

There are no specific set of rules or formulae to determine the working capital requirements of firms.
In an attempt to decide on the optimum capital needs of firms several factors should be consider
reflecting the peculiarity of the industries and their methods of doing business and what they are
selling. Generally the following factors influence the working capital requirement of businesses:
1. Nature of Business: some companies require little investment in fixed assets and more in

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working capital. The trading or manufacturing concerns will required more amount of working
capital along- with their investment of stock, raw materials and finished products while public
utilities and railway will require less working capital and more investment in non current assets.

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2. Volume of business – the size of the company has a direct relation with the working capital
needs. Big business has to keep higher working capital for investment in current assets and for
paying current liabilities.

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3. Terms of credit: the length of the period of credit has a direct bearing on working capital. A
company buying goods for cash and selling on credit will be requiring more amount of working
capital and vice versa.
4. Seasonal variations: there are some businesses that produce and make sales only in a
particular period. Thus, their working capital needs will be very large during few months
(season) and will gradually decrease as and when the sales are made.
5. Technology and Manufacturing policy: an extended manufacturing time span means a larger
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tie-up of funds in inventories.
6. Operating efficiency: this relates to the optimum utilization of resources at minimum costs. The
working capital investment will be lower if a firm can effectively controlled its operating costs
and utilizing current assets.
7. Price level changes: in the period of rising price level firm will be require to maintained higher
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amount of working capital. Same level of current assets will need increased investment when
prices are increasing.
Financing working capital (Current Assets)
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Working capital can be funded by a mixture of short and long-term financing. There basically three
major types of financing working capital:
1. Long-term financing: these include the use of ordinary share capital, preference share capital,
debentures, long term borrowing, retained earnings, etc.
2. Short-term financing: it is obtained for a period of less than one year mostly from banks and
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other financial institution in the money market. These include public deposits, commercial paper,
factoring of receivables, etc,
3. Spontaneous financing: this arises in the course of business it’s include trade credit and
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outstanding expenses.
Approaches to Working Capital financing
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1. Matching or hedging approach: company uses long term sources to finance fixed and
permanent current assets and short term financing to finance temporary current assets.
2. Conservative approach: the firm depends more on long term funds for its financing needs by
financing its permanent assets and also a part of temporary current assets with long-term
financing. Here, the firm has less risk of facing the problem of shortage of funds but would be
less profitable in term of financing costs and flexibility in payment.
3. Aggressive approach: the firm uses short term funds to finance permanent current assets and
even fixed assets which make the firm more risky.
Note
 Permanent current assets - are the amount required to meet long-term minimum needs
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and sustain normal trading activity for example, inventory and the average levels of
accounts receivable.
 Temporary or fluctuating current assets – these are the current assets which vary
according to normal business activity (due to changes in working capital that arise in
normal course of business operations). Example when some accounts receivable are
settled later than expected, or when inventory moves more slowly than planned.
Over capitalization of working capital or under trading
This is a situation where there are excessive inventories, account receivable and cash, and very few
accounts payable, this result to an over investment in current assets.
Symptoms of under trading are:

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 A very high current ratios
 Lowers turnover ratio
 Low or falling sales/working capital ratio compare with previous periods

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Overtrading: this is when a business tries to do too much too quickly with too little long- term capital
such that it is trying to support too large a volume of trade with the capital resources at its disposal.
In other words, it is an expansion of its operations too quickly (aggressively) without adequate support

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from capital.
Symptoms of overtrading are:
 Rapid increase in sales revenue
 Rapid increase in the volume of current assets. Inventory and accounts receivable turnover
might slow down
 Increase in liabilities (credit financing )
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 Poor debt ratios
 Falling current and quick ratios
 Liquid deficit that is excess of current liabilities over current assets.
MANAGEMENT OF WORKING CAPITAL
Working capital management refers to a company's managerial accounting strategy designed to
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monitor and utilize the two components of working capital, current assets and current liabilities, to
ensure the most financially efficient operation of the company. The primary purpose of working
capital management is to make sure the company always maintains sufficient cash flow to meet its
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short-term operating costs and short-term debt obligations.

Liquidity and profitability are the two main aims of working capital management which means that
firm should maintain balance between the two. Liquidity means the firm’s continuous ability to meet
maturing obligations while profitability means the firm’s ability to increase the shareholders’ wealth.
Liquidity ensure solvency however there is a cost associated with maintaining a sound liquidity
position as considerable amount of the firms current assets will be tied up which will affect the firm’s
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profitability. On the other hand, to have higher profitability the firm may sacrifice solvency and
maintain a relatively low level of current assets. This will leads to increase in the firm’s profitability
as lesser funds is tied up in idle currents assets, but the solvency of the firm will be threaten thereby
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exposing the firm to greater risk of cash shortage and stock out.
Dangers of excessive working capital:
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 Unnecessary accumulation of inventories

 Management inefficiency
 Loss of profitability
 Increase in bad debt
 Loss of income from investment of surplus cash
Dangers of inadequate working capital:
 It stagnates growth due to non availability of working capital
 It results to operating inefficiency when the firm cannot meet its day to day commitment.
 Under utilization of fixed assets

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 Loss of reputation

QUESTION 1 (NOV. 2015, Q.3)

The working capital cycle of a business is the length of time between payment for inventory entering
into inventory and receipt of the proceeds of sales.
The table below gives information extracted from the statement of Comprehensive Income and the
Statement of Financial position of Bright sum plc. For the years 2012 to 2014

2012 2013 2014

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Inventory: N’000 N’000 N’000
Raw materials 1,080 1,458 1,800
Work-in-progress 756 972 933

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Finished goods 864 1,296 1,428
Purchases 5,184 7,020 7,200
Cost of goods sold 7,560 9,720 10,983

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Revenue 8,640 10,800 11,880
Trade receivables 1,728 2,592 2,970
Trade payables 864 1,053 1,260

You are required to:

a. Calculate the working capital cycle for each of the 3 years (9 marks)
b. Explained THREE possible actions that might be taken to reduce the length of the cycle and
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TWO possible disadvantages of each. (6
marks)
(Total 15
marks)
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QUESTION 2 (MAY. 2012, Q.4)

The Managing Director of Soulex Limited, a small-scale business enterprise, is worried about the short
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-term solvency/liquidity of his company. The Management Accountant, based on the instruction of the
managing Director came up with the following estimated figures for the coming trading year:
Sales/Turnover N8,400,000
Average Accounts Receivable N759,000
Gross Profit Margin 25%
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Average Inventories N
Finished Goods 525,000
Work in progress (80% complete) 825,000
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Raw Materials 330,000

Average Accounts payable 315,000
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Materials’ costs represent 50% of the total cost of sales

Required: calculate the cash operating cycle of the company to the nearest day.

QUESTION 3 (ACCA)

The following data relate to Corn Co, a manufacturing company.

Revenue for the year $1,500,000
Cost as percentage of sales %
Direct materials 30
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Direct labour 25
Variable overheads 10
Fixed overheads 15
Selling and distribution 5

On average:
a. Accounts receivable take 2.5 months before payment
b. Raw materials are in inventory for three months
c. Work in progress represents two months’ worth of half produced goods.
d. Finished goods represents one month’s production
e. Credit is taken as follows:

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i. Direct materials 2 months
ii. Direct labour 1 week
iii. Variable overheads 1 month

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iv. Fixed overheads 1 month
v. Selling and distribution 0.5 months
Work in progress and finished goods are valued at material, labour and variable expense cost.

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Compute the working capital requirement of Corn Co assuming the labour force is paid for 50
working weeks a year.
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N
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