Management of Working Capital - Introduction - ACCA Financial Management (FM)
54 Comments
M
Modou Lamin·
In the notes, it is said working capital does not earn profit directly, it is the non-current asset that do. what about the case pf the retailer, who buys an inventory, let says a bottle of water and sells it. Wont he/she be making profit on a non-current asset, an Inventory? or are they considered purchases and not non-current assets?
L
Lisa·
Notes, page 19, point 2: Working Capital is the name given to the NET CURRENT ASSETS = Inventories, Receivables, Cash and cash equivalents, less payables. The lecturer shouldn't have to answer questions like this.
Y
Yolandah·
Why did you use "Purchases of raw materials" for the payables days calculation and not Cost of goods sold?. Isn't this the assumed total cost for all inventory finished or not not just raw materials?
J
John MoffatTutor·
Payables days is the number of days they to pay suppliers for goods bought from them, regardless of whether or not the items they produce have been sold.
A
A-R·
Why do we refer to it as average receivables in the formula for calculating receivable day?
P
Persevere·
According to Efficiency ratios:
Receivables' turnover = Credit sales p.a./Average receivables which shows how quickly outstanding receivables are collected.
However, in Example 1: Receivables Days = Average receivables / Credit sales - WHY?? Please, can someone or the dear tutor shed some light on this confusion for me?
Thanks,
J
John MoffatTutor·
Receivables days is measuring how many days credit customers are taking (i.e. how many days it is before they pay).
J
JONE·
Hi, Receivable turnover and Receivable Days are two different measures that is why the way on how to compute them are also different. hope this helps thanks
Y
Yifei·
About the "Average", should we caculate Average receivable = (0+Receivable)/2 ?
because the annual account usually mean the number in year end, and the problem didn't give us the number of receivable in the beginning year... so i assume that there was 0 receivable in beginning.
V
Vincy·
The assumption of the opening balance being Zero is assumed only when the business is a new business.
Normally if no information is given regarding when the business has started and no opening balance is specified, the closing balance is taken as average balance.
Thank you.
O
Omer·
Concept of Working capital cycle well explained and illustrated , thank you
N
Nivay·
The equation for calculating receivables days from the question is Receivables days = Ave receivables / credit sales X 365.
To note the question assuming 365 days and there's no clear mention of credit sales hence we assume that sales in the question is credit sales since there is no additional information regarding credit sales. Hope that clarifies your question.
M
MALAVIKA·
The equation for calculating receivables days=Credit sales p. a. /Average inventory as per the note but it is not calculated as per the equation, why is receivables are divided by sales?( in example 1)
E
Emmanuel·
Hello sir,
please can you explain further to me this point in the lecture notes
"If a large sum of money is lent or borrowed, there are administrative savings; hence a
higher rate of interest can be paid to a lender and a lower rate of interest can be
charged to a borrower than would normally be the case.''
thank you.
R
reetusabreen·
Hi, in the example we have calculated the payable days considering the Purchase of Raw materials. We calculate on the basis of credit purchase. How are you sure the RM is not purchased on credit?
J
John MoffatTutor·
In the exam you have to make best use of the information you are provided with. There is no information given about whether purchases are on credit or not (as is likely in the exam) and therefore there is nothing else we can do.
K
Krystian·
Great lecture, thanks.
A
Asif·
Greetings sir,
Could you confirm the validity of the following logic that I understood from the operating cycle that you explained with example 1:
We purchased $518,400 of raw materials of which only $108,000 remains - the rest having moved onto the WIP stage. Therefore this would be equivalent to 76days wait time for the remaining raw material stock to become WIP if we took the whole amount of raw materials purchased as 365 days. Similarly we have 41 days wait time for the balance WIP valued at $75,600 which has not finished production to convert to finished products (valued at $675,000). Similarly we have 42 days wait time for the closing inventory finished goods ( valued at $86,400) to be sold and become COS (valued at $756,000). Similarly we have 73 days to wait for receivables not yet paid by customers from the credit sales made throughout the year (maybe due to late payments, allowables , etc). And 61 days of payables still pending after having taken care of the rest of credit purchases after having paid away the rest of the suppliers. So we add the receivable days and inventory days and deduct from payable days to find out how many days we remain cashless within the period after the balance payment is done of the payables and before the cash is received from the remaining receivables. We need to shorten this gap.
Please correct me elaborately and generously if I have made any wrong understanding in any of the steps. Please confirm to me if I have obtained the correct understanding.
Thankyou very much.
J
John MoffatTutor·
That is correct (although why have you typed out my lecture? :-) )
A
Asif·
:) Glad to know.
A
avishco·
Sir,
As per below question i agree we need to deduct 1 year's tax 30% of 20000, discount it and remove from the perpetuity value of tax. But why we did not remove 1-year discounted perpetuity value for the cash inflow also.
A company receives a perpetuity of $20,000 per annum in arrears, and pays 30% corporation tax 12 months after the end of the year to which the cash flows relate. At cost of capital of 10%, what is the after tax present value?
A. $140,000 B. $145,454 C. $144,000 D. $127,274
Thank you
Avinash
A
avishco·
Hello sir,
Please clarify regarding below question:
AW Co needs to have $100,000 working capital in place immediately for the start of a 2-year project. The amount will stay constant in real terms. Inflation is running at 10% per annum, and AW Co's money cost of capital is 12%. What is the present value of the cash flows relating to working capital?
A. $(21,060) B. $(20,300) C. $(108,730) D. $(4,090)
My question is how do we know that the Working capital in question will be need yearly?
It only mentioned need to have $100,000 working capital.
Thanks
Avinash.
J
John MoffatTutor·
Please post this sort of question in our Ask the Tutor Forum and not as a comment on a lecture.
Your questions have nothing to do with the management of working capital but are related to investment appraisal and are explained in the lectures on investment appraisal.
J
JojoBeat·
Hi Sir, I find this topic very contradictory. For example, we would want high working capital to reduce risk of liquidity problems. But then we don't want high receivables/inventory because there would be money "tied up" in them leading to less cash hence liquidity problems. Isn't receivables/inventory part of a current assets hence higher working capital and that reduces the risk of liquidity problems?
D
Dennis·
If you high receivables and high inventory then you do have high liquidity but the key thing here is is the receivables high due to higher receivables period or higher sales. what I mean here is when you have higher sales you are likely to have higher receivables but this doesn't mean you have liquidity problem on the other hand you make have similar amount of receivables but the collection period is bigger. than in this case you have higher receivables but the liquidity is low.
I
Irving·
Will the ratio formulas be given to us in the exam? Or will we have to memorize the Ratio?
J
John MoffatTutor·
They are not given in the exam :-)
A
Ayesha Ifthekar Ahmed·
Is FFM in ACCA same as FM on opentuition?
J
John MoffatTutor·
Paper FM is one of the exams for the ACCA Qualification. Paper FFM is one of the exams for the Foundation Level.
There are similarities between Paper FM and Paper FFM but they are not the same.
You can find free notes for Paper FFM here: https://opentuition.com/fia/ffm/
M
Mohsin·
Hello!
If Working capital is financed by short term liability then this mean it will increse current liability. Then why we deduct CL in formula to get Working capital. It is causing a confusion.
J
John MoffatTutor·
The definition of working capital is current assets minus current liabilities. I appreciate that it is confusing when examining how it is financed, but the finance has to come from borrowings and questions are testing your understanding of the difference between using short-term borrowings and long-term borrowings to finance the other current assets and current liabilities.
M
Melchizedek·
Hello Sir, you mentioned in your lecture that it is the non current liabilities that earn profit. In a pharmaceutical company that buys and sells pharmaceutical products, will this still hold true?
J
John MoffatTutor·
Although I did not mean that current assets do not contribute to making profits (for example cash balances may earn interest), it is the non-current assets that really generate the profit.
For your example, the company will need premises for offices and storage, computers etc., and if they want to expand they will need more premises, computers etc.. Without them they will not be in a position to sell the products and make profits.
D
Dhruv·
is FAU in acca actually AA on opentuition ? urgent hai bro
J
John MoffatTutor·
No it isn't. You can find free notes for FAU here:
https://opentuition.com/fia/fau/
M
MariaSuzanskaya·
Hello, sir!
I was wondering if you could help me to understand the following:
Why current ratio and quick ratio increase when company sells some inventory on credit at a profit?
I thought that current ratio would be the same because when we sell on credit inventory become receivables and we count both receivables and inventory as current assets when count current ration.
Also, I thought that quick ratio will increase because we sell some of our inventory and we we take away less inventory in the formula. As a result, the numerator becomes larger than if we had not sold inventory and the quotient, finally, is also larger.
Thank you.
Hope to hear from you soon.
K
Kok Yau·
1) when we are selling inventory on credit with a profit, we are selling it at a higher price and result in a higher amount of receivable, e.g. Selling inventory $50 at the price $75 gives raise a receivable of $75, therefore the current asset is increased by $25 overall and make the current ratio higher.
2) for quick ratio, same example applies. We get a $75 receivable and minus $50 less if we are going to sell the inventory, give us 75-(50)=125 more of current asset less inventory figure, hence higher quick ratio.
Hope this clarify the idea.
F
Fahad·
hello sir,
i am a little confused, what do you mean when you say Working capital is financed by long term ? Does this mean that the shares we issue and the loan that we get will result in cash with the company and thus increase in Working capital ? and if i got it right than the same logic goes for short term as well i.e. we get cash with us.
Thank you
J
John MoffatTutor·
All companies need working capital. It has to be financed somehow and as I discuss in the lectures it can be financed either by raising long-term capital or short-term (i.e. overdraft finance). However, as I also explain, although using overdraft finance may be cheaper it is more risky that using long-term finance.
L
liudi·
Dear sir, it’s not very common to see three parts when calculating inventory turnover , more commonly, ( Average inventory)*360 / COGS , am I right?
J
John MoffatTutor·
True, but you still have to be prepared for anything in the exam :-)
L
liudi·
thank you, sir. it is a pleasure to have your class online.
M
Muhammad Haris·
Hello Sir,
Why you have taken 518400 as credit purchases? Has not it been 842400 (756000+86400) which means Cost of goods sold + Closing Inventory.
J
John MoffatTutor·
The question specifically states the purchases during the period (and we have no choice but to assume that they were all purchased on credit).
The cost of goods sold will include other production costs (in addition to materials).
M
Muhammad Haris·
hmm YES Thank You Sir!
J
John MoffatTutor·
You are welcome :-)
A
Asher·
Thanks John. Indeed the business should manage its working capital properly. But is there an optimal level of working capital to be maintained by the business?
J
John MoffatTutor·
Not really, because it depends very much on the type of business.
A
Asher·
Okay sir. Thanks for the clarification.
A
akil·
Good day sir, I'm the notes there seems to be a mistake with the ratios, particularly with regards to the Receivable Turnover. I only came across it while learning the ratios before to attempt the questions with you only to realise we using the same figure just in reverse order... I'll go with the solutions just posting this here in case anyone else gets confused
M
mahoysam·
I qualified in Feb 2015, but I am here because I miss Mr John's lectures! I used to love and enjoy watching the F9 and P4 lectures!
Open tuition is the best!
J
John MoffatTutor·
Thank you for the comment :-)
A
Ansu Koroma·
Thanks John. I appreciate this video lecture. Working capital ratios are of little use unless they are compare to similar entities or industry average to that of competitors. It make sense to always look at the type of business the company is in when assessing the various ratios and the operating cycle itself.
J
John MoffatTutor·
Correct, and I do make this point in the lectures :-)
Receivables' turnover = Credit sales p.a./Average receivables which shows how quickly outstanding receivables are collected.
However, in Example 1: Receivables Days = Average receivables / Credit sales - WHY?? Please, can someone or the dear tutor shed some light on this confusion for me?
Thanks,
because the annual account usually mean the number in year end, and the problem didn't give us the number of receivable in the beginning year... so i assume that there was 0 receivable in beginning.
Normally if no information is given regarding when the business has started and no opening balance is specified, the closing balance is taken as average balance.
Thank you.
To note the question assuming 365 days and there's no clear mention of credit sales hence we assume that sales in the question is credit sales since there is no additional information regarding credit sales. Hope that clarifies your question.
please can you explain further to me this point in the lecture notes
"If a large sum of money is lent or borrowed, there are administrative savings; hence a
higher rate of interest can be paid to a lender and a lower rate of interest can be
charged to a borrower than would normally be the case.''
thank you.
Could you confirm the validity of the following logic that I understood from the operating cycle that you explained with example 1:
We purchased $518,400 of raw materials of which only $108,000 remains - the rest having moved onto the WIP stage. Therefore this would be equivalent to 76days wait time for the remaining raw material stock to become WIP if we took the whole amount of raw materials purchased as 365 days. Similarly we have 41 days wait time for the balance WIP valued at $75,600 which has not finished production to convert to finished products (valued at $675,000). Similarly we have 42 days wait time for the closing inventory finished goods ( valued at $86,400) to be sold and become COS (valued at $756,000). Similarly we have 73 days to wait for receivables not yet paid by customers from the credit sales made throughout the year (maybe due to late payments, allowables , etc). And 61 days of payables still pending after having taken care of the rest of credit purchases after having paid away the rest of the suppliers. So we add the receivable days and inventory days and deduct from payable days to find out how many days we remain cashless within the period after the balance payment is done of the payables and before the cash is received from the remaining receivables. We need to shorten this gap.
Please correct me elaborately and generously if I have made any wrong understanding in any of the steps. Please confirm to me if I have obtained the correct understanding.
Thankyou very much.
As per below question i agree we need to deduct 1 year's tax 30% of 20000, discount it and remove from the perpetuity value of tax. But why we did not remove 1-year discounted perpetuity value for the cash inflow also.
A company receives a perpetuity of $20,000 per annum in arrears, and pays 30% corporation tax 12 months after the end of the year to which the cash flows relate. At cost of capital of 10%, what is the after tax present value?
A. $140,000 B. $145,454 C. $144,000 D. $127,274
Thank you
Avinash
Please clarify regarding below question:
AW Co needs to have $100,000 working capital in place immediately for the start of a 2-year project. The amount will stay constant in real terms. Inflation is running at 10% per annum, and AW Co's money cost of capital is 12%. What is the present value of the cash flows relating to working capital?
A. $(21,060) B. $(20,300) C. $(108,730) D. $(4,090)
My question is how do we know that the Working capital in question will be need yearly?
It only mentioned need to have $100,000 working capital.
Thanks
Avinash.
Your questions have nothing to do with the management of working capital but are related to investment appraisal and are explained in the lectures on investment appraisal.
There are similarities between Paper FM and Paper FFM but they are not the same.
You can find free notes for Paper FFM here: https://opentuition.com/fia/ffm/
If Working capital is financed by short term liability then this mean it will increse current liability. Then why we deduct CL in formula to get Working capital. It is causing a confusion.
For your example, the company will need premises for offices and storage, computers etc., and if they want to expand they will need more premises, computers etc.. Without them they will not be in a position to sell the products and make profits.
https://opentuition.com/fia/fau/
I was wondering if you could help me to understand the following:
Why current ratio and quick ratio increase when company sells some inventory on credit at a profit?
I thought that current ratio would be the same because when we sell on credit inventory become receivables and we count both receivables and inventory as current assets when count current ration.
Also, I thought that quick ratio will increase because we sell some of our inventory and we we take away less inventory in the formula. As a result, the numerator becomes larger than if we had not sold inventory and the quotient, finally, is also larger.
Thank you.
Hope to hear from you soon.
2) for quick ratio, same example applies. We get a $75 receivable and minus $50 less if we are going to sell the inventory, give us 75-(50)=125 more of current asset less inventory figure, hence higher quick ratio.
Hope this clarify the idea.
i am a little confused, what do you mean when you say Working capital is financed by long term ? Does this mean that the shares we issue and the loan that we get will result in cash with the company and thus increase in Working capital ? and if i got it right than the same logic goes for short term as well i.e. we get cash with us.
Thank you
Why you have taken 518400 as credit purchases? Has not it been 842400 (756000+86400) which means Cost of goods sold + Closing Inventory.
The cost of goods sold will include other production costs (in addition to materials).
Open tuition is the best!