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10. Which of the following statements concerning working capital management are correct?
1 Working capital should increase as sales increase
2 An increase in the cash operating cycle will decrease profitability
3 Overtrading is also known as under-capitalisation
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3The correct answer of this is D. My question is that an increase in cash operating cycle doesnt necessarily means decrease in profitability. A comapny can be very profitbale but have cash flow problems. These are two seprate issues in my understanding. I understand that increase in operating cycle can mean increase in overdraft costs. But it can also mean more sales and more focus on making profits. This is very ambiguish thing and in exam given it is a mcq its very hard to pick one correct answer. I dont think i am wrong if i am saying only 1 and 3 are correct. Because a company can have increased profits with increased opertaing cycle.
These type pf question we dont get any credit as its not even a written question 🙁 and the trouble is that its too common for examiner to sound like this. Technicaly i dont think i am wrong if i picked option b. and in middle of exam u cant wait and think that much. Dont u think its very unfair from examiners part? Please suggest what can we do as there seem to be no answer to this problem unfortunately
I obviously missed answering the original question in 2016 for some reason – sorry.
However an increase in the operating cycle will reduce profitability.
For example, one element in the calculation of the operating cycle is the number of days for which inventory is held. Certainly more sales will mean holding more inventory, but that does not mean that the inventory days has to increase. If the inventory days increases (and so the operating cycle increases) then they are holding more inventory than they need. It costs money to hold inventory and this will reduce the profitability from what it otherwise would have been.
Similar taking longer to collect receivables will mean that the operating cycle increases, and taking longer means more risk of irrecoverable debts and more lost interest and these will reduce the profitability from what it would otherwise have been,
Co is considering whether to factor its sales invoices. A factor has offered L Co a nonrecourse package at a cost of 1.5% of sales and an admin fee of $6,000 per year. Bad
debts are currently 2% of sales per year and sales are $1.5m per year.The cost of the package for L Co would be calculated as follows:
1. Cost of nonrecourse package: 1.5% of sales
Cost = 1.5% * $1.5m = $22,5002. Admin fee: $6,000 per year
3. Bad debts savings: 2% of sales
Savings = 2% * $1.5m = $30,000Therefore this means that L Co would actually save $1,500 by factoring its sales invoices with the nonrecourse package.
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