Chapter 13 The Management of Working Capital

Suggested Solutions

Discussion Questions
13.1 The working capital structure of different entities will vary in term of both account
types and relative significance of account balances.

Cabinet Cash & Carry Public

Maker Store Accountant

Current
Assets
: Cash Yes Yes Yes
: Prepayments Yes Yes Yes
: Accounts Receivable Yes* No Yes*
: Supplies Yes Yes Yes
: Raw Materials Yes* No No
: Work in Progress Yes No No
: Finished Goods Yes Yes* No
Current
Liabilities
: Bank Overdraft Yes Yes Yes
: Trade Creditors Yes* Yes* No
: Other Creditors Yes* Yes Yes
: S.T. Loans Yes Yes Yes
: Accruals Yes Yes Yes
: Provisions (eg Warranty) Yes Yes Yes

* Potentially major items

13.2 Working capital is the pool of trading assets and liabilities upon/with which a
business conducts its day-to-day operations. Technically, it is measured by the
difference between current assets (cash; debtors; inventory) and current liabilities
(bank overdraft; creditors).

13.3 (a) The period from payment for supplies/raw materials/inventory to the supplier
to the cash collection from sales of finished goods.

(b) It will vary as a result of:

(i) Business activity (eg manufacturer or retailer)
(ii) Credit policies (eg from supplier and to the customer)

(c) The cycle should be reviewed for several reasons.

(i) It is for this period that the firm is providing the credit, or having to
finance the working capital.
(ii) To check actual against budget, expectations or the past period results.
(iii) To review the components in terms of:
Obtaining early settlement discounts from suppliers
The existence of obsolete or slow moving inventory, or possibly
inventory shortages problems
The existence of slow paying debtors and possibly delinquent
debtors account balances
The limited provision of credit by suppliers
13.5 Holding excess inventory.

Possible benefits:
Avoid production delays
Avoid stock-out problems
Purchase discounts for bulk purchases
Defer the effect of price rises
Reduce order costs

Possible costs:
Finance costs to fund excess inventory
Storage, security and insurance costs
Potential obsolescence or product deterioration costs

13.13
An increase in production bottlenecks is likely to result in an increase in raw
materials and work-in-progress being processed within the plant. Therefore, stock
levels should rise.
A rise in interest rates will make the cost of holding inventory more expensive (if
they are financed by debt). This may, in turn, lead to a decision to reduce
inventory levels.
The decision to reduce the range of products should result in fewer inventory
being held. It would no longer be necessary to hold certain items in order to meet
customer demand.
Switching to a local supplier may reduce the lead time between ordering an item
and receiving it. This should, in turn, reduce the need to carry such high levels of
the particular item.
A deterioration in the quality of bought-in items may result in the purchase of
higher quantities of inventory in order to take account of the defective element in
inventory acquired and, perhaps, an increase in the inspection time for items
received. This would lead to a rise in inventory levels.
Application Exercises
Note: solutions to application exercises 13.4 and 13.8 are posted on BB as class exercises

13.2
Sales month Collected Month (percentage) Total
Current +1 +2 +3 +4 +5 %
January 30% 50% 15% 5% - - (100)
February 28% 48% 17% 7% - - (100)
March 26% 47% 19% 6% 2% - (100)
April 24% 46% 18% 7% 5% - (100)
May 22% 44% 17% 6% 6% 5% (100)
June 20% 42% 16% 8% 7% (NA) (93)

13.7
Year 1 Year 2 Year 3
Receivable turnover (days) 37 (100) 43 (116) 47 (127)
Inventory turnover (days) 48 (100) 54 (113) 65 (135)
Payables turnover (days) (8) (100) (9) (112) (31) (386)
Working Capital cycle (days) 77 (100) 88 (114) 81 (105)

(The second column in each year provides a trend percentage index)

Problems

(a) Dramatic decline in current ratio indicates a potential liquidity crisis

(b) Receivables turnover has slowed significantly (settlement period up 27% over the
period).
(c) Inventory turnover has slowed significantly (shelf life up 35% over the period).
(d) The creditors settlement period has increased but potentially at the high cost of early
settlement discount forgone (2/10 n/30 is equivalent to 36.5% p.a.).
(e) Non-current assets have increased by 41% while non-current liabilities have only risen
by 15%. The 26% difference being extracted largely from short term working capital.
Non-current assets should be funded from non-current liabilities or owners funds
(retained profits or contributions).
Case Studies

Case Study 13.1

1. A reduction in the speed with which bills are paid, especially by big business
The global credit crunch
Tightening of credit

2. Big business especially those with more than 500 employees

3. Insolvency and bankruptcy

Greater reliance on overdrafts (at a time when credit is tight)

4. Proposing a Late Payments Act, which would legally allow small businesses to
charge interest on money outstanding

5. Introduction of a late payments process along the lines suggested

Require customers to pay by cash or credit card

6. Construction possibly because of its own difficulty in getting cash based on work
in progress

7. Probably due to the fact that the NSW economy has in recent years not been
doing well

8. 36% related to business employing less than 5 staff and 42% related to
businesses employing 5-20 staff