1. U3.3 Working Capital

2. About Cash
Current asset
In hand or At bank
Liquidity

3. Cash Problems
Lack of cash or working capital more often than lack of profit lead to:
Insolvency
Liquidation

4. Working Capital = Current Assets – Current Liabilities
Money available for daily business operation
Also known as Net Current Assets
Shows available funds to pay immediate expenses
Working Capital = Current Assets – Current Liabilities

5. Current Assets
Cash
Debtors
Stocks

6. Current Liabilities
Overdrafts
Creditors
Tax

7. Working Capital Cycle
Production Costs
Sales
Cash

8. Working Capital Cycle
Hold enough cash to cover production costs i.e. stock, wages, debt collection
Without being wasteful by holding too much i.e. cash could be more profitably invested elsewhere

9. Current Ratio Desired ratio is 1:1
CA significantly higher indicates wastefulness
CA significantly lower indicates liquidity problem

10. Question 3.3.1
Page 364

11. Cash vs. Profit Simply put Profit = Revenues – Costs
Revenues are not always cash!
There are sources of cash outside of revenues.
Profitable companies can be cash poor.
Unprofitable companies can be cash rich.

12. Question 3.3.2
Page 365

13. Cash Flow Forecasts
Expected movement of cash in and out of a business:
Cash Inflows receipts
Cash Outflows payments, expenses, outgoings
Net Cash Flow cash inflows – cash outflows

14. Cash Flow Statements
Depicts the actual flow of cash in and out of a business over a given period of time.

15. Reasons for Cash Flow Forecasts
Persuade banks and other lenders when seeking external finance.
Aid in the anticipation and preparation for periods of time where cash flow shortages or surpluses may occur.
Assists in business and strategic planning.

16. Constructing Cash Flow Forecasts
Jul
Aug
Sept
Oct
Nov
Dec
Opening Balance
5,000
3,000
300
(1,400)
(2,600)
600
Inflows
Cash sales revenue
6,000
6,500
6,800
7,500
9,500
Other income
4,000
Total cash inflows
11,500
Outflows
Stocks
2,500
2,200
2,700
3,300
Labor costs
3,500
Other costs
2,000
1,800
Total cash outflows
8,000
7,700
8,200
8,00
8,300
9,000
Net cash flow
(2,000)
(2,700)
(1,700)
(1,200)
3,200
500
Closing balance
1,100

17. Cash Flow Forecast Practice
Jan ($)
Feb ($)
Mar ($)
Apr ($)
Cash sales
2,000
4,000
Stock purchases
600
900
1,200
Rent
1,000
Other costs
800
Opening cash balance
1,600
1,900
Net cash flow
300
1,800
Closing balance

18. Question 3.3.3
Page 368

19. Causes of Cash Flow Problems
Overtrading: quick expansion
Overborrowing: high geared
Overstocking: poor inventory control
Poor credit control: lenient credit policies
Unforeseen changes: demand shifts

20. Question 3.3.4
Page 369

21. Managing Working Capital
Dealing with liquidity problems:
Seek alternative sources of finance
Improve cash inflows
Reduce cash outflows

22. Seeking Alternative Sources of Finance
Overdrafts
Sale and leaseback
Selling off fixed assets
Debt factoring
Government assistance
Growth strategies

23. Improving Cash Inflows
Tighter credit control
Cash payments only
Change pricing policy
Improved product portfolio
Improved marketing planning

24. Reducing Cash Outflows
Seek preferential credit terms
Seek alternative suppliers
Better stock control
Reduce expenses

25. Combining Strategies Pareto principle Contingency fund 80/20 rule
80% time and resources boosting cash inflow
20% on cost cutting
Contingency fund
Cash set aside for unexpected, emergency use

26. Alternatives to Dealing with Cash Flow Problems
Spread risks with wider customer base
Require partial payments over time from customers of large or lengthy projects/services
Establish systems to pay bills in regular installments
Establish quality management systems

27. Question 3.3.5
Page 373

28. Limitations of Cash Flow Forecasting
Marketing
Human resources
Operations management
Competitors
Changing fashion and tastes
Economic changes
External shocks

29. Working Capital and Business Strategy
“More often than not, businesses fail because of cash flow problems rather than profitability problems.”
Cash flow “forecasts and calculations are static, i.e. they only represent the cash flow situation of a firm at one point in time”.
“Managers face a dilemma in balancing the conflict between the desire for sufficient working capital and the desire for profits.”
“Working capital is regarded as being more important than profit in the short run.”

31. 3.3.1 Answer Key
Working capital (or net current assets) refers to the money available for the daily running of a business, i.e. it is used to pay for everyday costs such as wages, utility bills, and payment so suppliers. Working capital is mainly generated from the sale of goods and services.

32. Improved cash flow management is needed during a long working capital cycle, such as when Le Royal Meridien are building new hotels because:
There is a prolonged delay between payments for production costs (to construct new hotels) and proceeds from customers paying to stay at the new hotels. Poor cash flow management could therefore cause the construction work to halt due to a lack of working capital.

33. Current liabilities (such as overdrafts, creditors and tax demands) will further drain cash flow. Again it is vital to manage cash flow in order to keep the Le Royal Meridien afloat.
Poor cash flow management can make the organization go further into debt as it seeks to borrow more finance to fund the construction of the new hotels. This may cause gearing problems for the hotel chain.

34. 3.3.2 Answer Key
The working capital cycle refers to the interval between cash paid by a business for the costs of production and receiving the cash from customers. For example, if the customers pay by credit then payment is not received until a later date, although costs are incurred for the transaction. Due to its revamped menu, McDonald’s was able to entice more customers thereby helping to boost its sales by 6 per cent. However, cash is not the same as profit. The costs of product research and development for its new menu, for example, would contribute to higher operation costs and hence lower profits. It is likely that there is a significant time lag between investment expenditure (R&D and marketing costs for its revamped menu) and receiving sufficient sales revenue to recoup the costs. Hence, it is probably that overall profits declined despite sales revenue being slightly higher.

35. Credit cards allow customers to ‘buy now and pay later’ through a third party, i.e. a financial lender. The finance company pays the retailer (and charges the retailer a small fee for the service) and charges the customer at a later date. Since credit improves flexibility (customers do not need to carry so much cash with them) and allows customers to buy now but to postpone payment, it can attract a large number of customers to businesses, including McDonald’s. Hence, sales revenues may increase since customers have a greater choice of payment systems. However, retailers and restaurants such as McDonald’s will not receive their payment instantaneously, i.e. there is a (relatively short) delay in payment from the credit card company. This therefore extends the working capital cycle of the business that offers credit to its customers. In addition, the amount received from the finance company will be slightly lower since a fee will be charged by the creditor.

36. 3.3.3 Answer Key

37. Definition of liquidity problem, i. e
Definition of liquidity problem, i.e. the extent to which the Cottam Stationers can meet its short term debts. The firm seems to be suffering from worsening liquidity as seen by the closing balance figures. The net cash flow for the first four months of trading is also negative suggesting the firm has insufficient working capital.

38. 3.3.4 Answer Key

39. The cash flow forecast suggests several things likely to be faced by Charlotte Davies:
The business is expected to have a negative closing balance in September and October, and hence short term external finance is likely to be sought. Furthermore, the net cash flow between Aug and Oct are negative, i.e. the liquidity position is rather unfavorable although the liquidity position is significantly better by the end of Nov:

40. The closing balance in November is favorable, although the cash flow position is still significantly lower than the opening balance at the start of trading in August. This position highlights the difference between profit and cash for the business.
Given that the organization is a new establishment, the cash flow forecast suggests that the firm might well succeed since negative cash flow only occurs temporarily.
However, it is difficult to conclude whether the organization will have a positive net cash flow and closing balance after December (the most profitable time of year for perfume retailers).

41. Total receipts have continually increased by (200%) whilst payments have only increased by 30.3%, i.e. the liquidity position is improving over time.
Overall, the cash flow position faced by Charlotte Davies seems healthy so long as it can secure finance to overcome the short term liquidity problem in September and October (a $500 deficit in these two months is rather insignificant).

42. 3.3.5 Answer Key
Profitable firms can experience cash flow problems for a number of reasons, such as:
Overtrading
Long working capital cycle
Poor credit control
Long credit periods

43. Cash flow forecast for Ducie’s Dance Studios Ltd
Cash flow forecast for Ducie’s Dance Studios Ltd. For the period April to June:

44. The options available to Marj Ducie in dealing with her liquidity problems include:
Applying for a pre-approved overdraft for May (and perhaps June) in case actual cash outflows are higher than those forecast, in which case the closing balance would be negative; but this option would incur high interest charges
Offering incentives to customers to pay earlier (or by cash) since half of the sales are paid for on credit; whilst this might improve liquidity, incentives might reduce the profits of the business

45. Better credit control by offering less credit (since 50% of customers pay by credit) or a shorter credit period (currently one month’s credit); but this might lead to fewer customers thereby diminishing the attractiveness and profitability of the business
Investigate the reason for the increase in direct costs (as a percentage of the sales revenue) from 30% in May to 33.33% in June

46. Negotiate paying the indirect costs in installments to ease the cash flow
Reviewing marketing planning to help Ducie’s Dance Studios Ltd. To better meet the needs and wants of its customers, thereby helping to improve the firm’s cash inflows
Reviewing pricing strategy in order to raise sales revenues