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Summary ManAcc 379 Working Capital & Capital Budgeting notes
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MANACC TERM 2Alexandra Shtein
2021
, WORKING CAPITAL
What is working capital
• The capital of a business which is used in its day-to-day trading operations
• Current assets LESS current liabilities
• Invest in working capital (inventory, debtors and cash) as we would invest in property, plant and equipment
• Investment must be financed through creditors, banks, overdrafts and interest bearing debt
• Working capital policy ð basic policy decisions in optimising current asset investments and its financing
Net working capital (NWC)
• An indicator of:
- a company's liquidity
- its operational effectiveness
- its short-term financial well-being.
• A significant positive NWC creates the potential to grow by making additional investments.
• If current assets do not exceed current liabilities, a company will not be able to grow ð paying creditors is going to be difficult, and the
company may even go bankrupt.
Net working capital Current assets – current liabilities
Current assets Convert into cash in less than 1 year
Current liabilities Repay within 1 year
Working capital
• The composition of working capital will differ between industries, nature of the firm etc.
• The compositions impacts cash flows, liquidity and risk areas
◦ Invest in more inventory ð cash decreases, increase admin and other expenses
◦ Are existing cash flows stable or volatile? ð Increase or decrease in net working capital
• By effectively managing and optimizing working capital levels, cash flow can be generated
Working Capital Cycle
Materials /
Creditors purchases
Production
Payment
Collection Inventory Store
Debtors / Sales
,Working capital ratios
Working capital ratio Current Assets: Current Liabilities
Quick ratio (Current Assets – Inventory): Current Liabilities
Debtors collection period Trade Debtors x 365 * If credit sales are not
Credit Sales available, use sales
Creditors payment period (days) Trade Creditors x 365 * If credit purchases are not
Credit Purchases available, use cost of sales
Inventory turnover Cost of sales or 365 Av. inv = OB + CB inv.
Number of times p.a. that inventory is Average Inventory inventory days 2
replaced
Inventory days Inventory or 365
Number of days’ inventory on hand Cost of Sales inventory turnover
Raw material days on hand Raw material inventory x 365 Use total purchases if
Raw material purchases inventory categories’
individual purchases are not
given
Work in progress days on hand Work in Progress inventory x 365
Cost of Sales
Finished good days on hand Finished Goods Inventory x 365
Cost of Sales
Net investment in working capital (days) Net working capital x 365
Sales
Cost of Discount foregone [(1 + D/(100 – D))(365/t) – 1]
Cash Procurement Production Sales
Impact on SFP: Impact on SFP: Impact on SFP: Impact on SFP:
•∆ Debtors •∆ Creditors •∆ Raw materials •∆ Debtors
•∆ Creditors •∆ Raw materials •∆ WIP •∆ Finished goods
•∆ Bank •∆ Finished goods
Example:
Raw Materials Manufacture Pay Creditors Sell Finished Receive
Ordered products R1 000 Products R1 500 from
debtor
T0 T30 T60 T105
Inventory days = 60 days Debtors days = 45
Creditors days = 30 days Working Capital Cycle = 75 days (105 – 30)
Management goal is shortening of the working capital cycle (cash cycle)
How:
Eg:
Inventory days ð 55
Debtor days ð 50
Creditor days ð 50
Working capital cycle ð45
, • Lower levels of raw materials
• Faster production
• Faster sales (marketing)
• Quicker collection of debtors
• Postpone creditor payments
Ratio calculations:
Use closing balance if no information is given for opening balance
Opening Closing Average
Inventory 2 000 3 000 2 500 Purchases Cost of sales + closing inventory – opening
Account 1 600 2 000 1 800 inventory
receivable 8 200 + 3 000 – 2 000 = 9 200
Accounts payable 750 1 000 875
Sales 11 500
Cost of sales 8 200
Raw materials days Inventory days = 2 500/8 200 x 365 Operating cycle = 168.4
= RM/Purchases x 365 = Inventory/COS x 365 = 111.3 days = 111.3 + 57.1 days
Work in progress days Debtors’ days = 1 800/11 500 x 365
= WIP/COS x 365 = Debtors/credit sales x 365 = 57.1 days
Finished goods days LESS
= FG/COS x 365
Creditors’ days = 875/9 200 x 365
= Creditors/Purchases x 365 = 34.7 days
EQUALS
Working capital cycle = 111.3 + 57.1 - 34.7
(or Cash cycle) = 133,7 days
INVENTORY DAYS = Raw Materials Days + Work-in-Progress Days + Finished Goods Days
WORKING CAPITAL CYCLE = Inventory Days + Debtors Days – Creditors Days
OPERATING CYCLE = Inventory Days + Debtors Days
WORKING CAPITAL CYCLE Inventory Days + Debtors Days – Creditors Days
Inventory days Debtors days Creditors days
Increase WCC: increase increase decrease
Decrease WCC: decrease decrease Increase
Optimal WC policy = balance risk & return
Effect on cash flow
Objective
Risks
Working capital too high cash flow under pressure
Working capital too low risk of stockouts, loss of profits, less debtors, cannot pay creditors
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