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Hi,
Point 1:
If a company has too much working capital, then it will have high liquidity and low profitability.Point 2:
If a company has too little working capital, then it will have low liquidity and high profitability.I don’t understand why a company with too much working capital will have high liquidity. I thought high working capital means more money is tied up in the working capital. Thus, this would result in lower liquidity.
And also if a company has high investment in its receivables and inventories, shouldn’t this lead to higher profitability? Since, the company would be able win more customers with its longer credit period and also prevent stock out.
If so, then this will contradict point 1?
Point 1:
High liquidity means that they have more short-term cash available to pay their short term liabilities. So although there is more long-term finance being used for the working capital, they will not have any short-term problems in paying their liabilities.Point 2:
It is the fact that the statement says ‘too much’ working capital. That means they have more than they really need for the size and type of the business. In that case, as I explain in my lectures, it would make more sense to manage the working capital more efficiently and as a result either be able to reduce their long term borrowings (and so save interest, which increases profits) or use some of the cash released to expand the company (and so increase profits).Thanks
I understand that a business has to manage the working capital more efficiently in order to maintain a balance between liquidity and profitability.
If a company has high working capital, does it mean to conclude whether the company has high liquidity or low liquidity depends on the level of inventories, receivables or cash?
If the working capital is high due to higher cash balances, then can we say it has HIGH liquidity?
If the working capital is high because of higher amount of inventories and receivables, then does it mean it has LOW liquidity due to higher money is tied up?
I am confused if a company with high working capital will have
Option A: high liquidity and low profitability
Option B: low liquidity and high profitabilityI can’t reach a conclusion
Liquidity measures how easily the company is able to pay short term liabilities out of short term assets. It is not just cash – receivables and inventories will turn into cash in the short term. The current ratio and the quick(acid-test) ratios are good measures of the level of liquidity.
As far as your final question is concerned, I can’t really add much to what I have already replied to you. Higher levels of working capital means higher levels of liquidity. However higher levels of working capital mean more money is tied up in working capital, which means there will be more long term borrowing needed and as a result more interest payable and therefore lower profits. So it is option A.
Have you watched my lectures on the management of working capital?
Yes, I always watched your lectures 🙂
In ACCA FFM December 2019 Q22(c), the answer says
“increasing the order size will mean that Fleet Co stock levels will increase and this will lengthen the inventory days. This will increase its working capital cycle. Everything else being equal, this will increase the amount of money tied up in inventory and reduce the amount of cash held, thus REDUCING company’s LIQUIDITY”I thought if stock level increase, working capital will increase and liquidity will increase? But the answer says liquidity will reduce?
I cannot find a question called Fleet in either the Paper FM or Paper FFM exams for December 2019, and much depends on the information in the question and on the precise requirements.
However, as I wrote before, the current ratio and the quick ratio are better measures of liquidity and if liquidity appears to be a potential problem the quick ratio is more useful (because cash is readily available, cash from receivables should be received in time to pay the payables, but inventory take longer to turn into cash because it needs to be sold first and then it takes time to collect the cash from customers.
Thanks for the reply
The question link:
https://www.accaglobal.com/my/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-cbe-past-exams.html#The answer link:
https://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/d19-ffm-cbe-sample-a.pdfI have found the question at last (it was question 28, not 22 🙂 )
It will reduce the liquidity for the reason that I wrote before. An increase in inventory also means an increase in the payables. It takes longer to receive the money from selling the inventory and so this will reduce the liquidity. Whether this is actually a problem or not for this company is impossible to say (because there is not enough information) and you are not asked to comment on this.
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