Controlling working capital

Question 1

What are the components of working capital?

Answer 1

Working capital has the following components:

1. current assets: inventory, trade receivables and cash
2. current liabilities: trade payables and bank overdraft

A reduction in working capital can be achieved either by speeding up the cycle of inventory and trade receivables, or by lengthening the cycle of trade payables.

In essence either approach, or a combination of both, will reduce the level of funds invested in working capital

Question 2

How do you reduce inventory levels?

Answer 2

• The cost of holding inventory includes purchasing goods, storing, insuring and managing them once they are in inventory.
• For most businesses, carrying inventory involves a major working capital investment and uses large amounts of finance that could be used elsewhere in the business.
• We should note that some companies, such as service companies, may hold little or no inventory. Inventory levels need to be tightly controlled while retaining the capacity to meet future demand.
• Inventory management is balancing those two opposing factors for optimum profitability and cash savings.

Question 3

What are the advantages of reducing inventory levels?

Answer 3

Advantages of reducing inventory levels:

1. Carrying low inventory reduces carrying costs of storage (rent, insurance and interest charges).
2. It frees up money tied up in inventories.
3. It reduces the risk of deterioration, obsolescence and theft.

Question 4

What are the dis-advantages of reducing inventory levels?

Answer 4

1. Reducing inventories risk the possibility of stock outs and dissatisfied customers
2. A higher risk of loss production time
3. Bulk purchase discounts may not be available

Question 5

What is tighter credit control?

Answer 5

Tighter credit control is a strategy employed by businesses, particularly in manufacturing and retailing, to ensure
customers pay promptly, so that cash is received by businesses as quickly as possible.

This control will increase cash sales and decrease bad debts written off, improving a company’s cash flow and profit.

This will involve management of trade receivables more efficiently and thus reduce the level of working capital.

efficient collection of income from credit customers releases fund which can be reinvested in the business as a source of short term finance. Settlement discounts may be offered to encourage prompt payment.

The higher the level of trade receivables, the larger the commitment of finance – and the more cost for the company in terms of opportunity cost in interest and the greater risk of losses through bad debts.

Businesses with too much credit could experience cash flow problems. Those not offering enough credit would risk losing customers with detrimental consequences on sales and profitability. The key is to choose the right mix of credit and cashflow for the business.

Question 6

Advantages of tighter credit controls?

Answer 6

Advantages of tighter credit controls:

1. Tighter credit control frees up cash.
2. It creates savings in opportunity cost in interest.
3. It reduces the cost of credit control and the risk of losses through bad debts.

Question 7

Dis-advantages of tighter credit controls?

Answer 7

Dis-advantages of tighter credit controls:

1. Tighter credit control risks losing the competitive edge over businesses providing credit, thus resulting in a potential loss of customers.
2. Loss of customers could result in reduced sales and reduced profit

Question 8

How is delaying payments to trade payables used as short term finance?

Answer 8

Companies often use trade payables as a cheap form of short-term finance by using the full credit period before payment. However, delaying payment beyond the agreed credit period would be dangerous.

This is because a company risks losing its credit status with its suppliers and this could result in supplies being stopped.

Additionally, the company could risk the possibility of not being able to buy on credit in the future and/or lose the benefit of any settlement discount offered by the supplier for early payment.

Question 9

Advantages of delaying payments to trade payables?

Answer 9

Advantages of delaying payments to trade payables:

1. Delaying payment to trade payables helps cash retention that can be used for other purposes.
2. Trade payables are often viewed as a source of ‘free credit’ and a cheap form of short-term finance
3. *‘Buy now, pay later’: if the business can sell the goods first and pay for them later, there are savings on opportunity costs if trade payables are paid within the agreed time

Question 10

Dis-advantages of delaying payments to trade payables?

Answer 10

Dis-advantages of delaying payments to trade payables:

1. There may be a reputational cost from loss of goodwill that could damage the company’s credit status.
2. Potential loss of suppliers due to breach of the terms of credit and default if their suppliers aren’t paid on time.
3. Suppliers may increase prices in future.
4. Loss of benefits from suppliers who provide incentives such as settlement discounts on early payments

Question 11

How is sale of redundant assets used as a source of short and long term finance?

Answer 11

sale of redundant assets is used as a source of short and long term finance is dependent on a companies assets.

Selling equipment or motor vehicles, for example, can cater to short-term and small finance needs. Selling land, buildings or machinery can cater to long-term, larger finance needs. This method can be used as a ‘one off’ source of finance to free up cash for other business needs.

The future operating capability of the business
should always be a consideration if this option is being undertaken as the assets can only be sold once.

Routine replacement of non-current assets should always happen as part of day-to-day operations.

Question 12

Advantages to the sale of redundant assets?

Answer 12

Advantages to the sale of redundant assets:

1. It raises finance from assets that are no longer needed – as long as this is clearly identified as being the case.
2. No interest charges or dilution of control are associated with this, unlike debt or equity financing.

Question 13

Dis-advantages to the sale of redundant assets?

Answer 13

Dis-advantages to the sale of redundant assets:

1. Businesses do not always have surplus assets available for sale.
2. Selling off redundant assets is a ‘one off’ source of finance.
3. It may not be easy to find potential buyers and can be a slow method of raising finance

Question 14

How is retained earnings used as a long term finance?

Answer 14

retained earnings is used as a long term finance:

Most business investments come from reinvested profit. Though it is normally considered long-term finance, it can also be used for financing working capital.

Retained earnings can be re-invested into the company to make improvements, fund projects, etc.