W2 Working Capital & Cash Flow Management

What is the basic formula to reconcile Net Income to Operating Cash Flow?

Net Income + Depreciation/Amortisation - Increase in Working Capital.

Why is depreciation "added back" in the cash flow statement?

It is a non-cash expense (a "paper booking") that reduced profit but did not involve an actual cash outflow.

What are the three main sections of a Consolidated Statement of Cash Flow?

1. Operating Activities (day-to-day),

2. Investing Activities (CAPEX/Securities),

3. Financing Activities (Debt/Dividends/Shares).

If Accounts Payable decreases, what is the impact on cash?

Cash decrease (outflow). It means the firm used cash to pay off its suppliers.

Define "Cash Equivalents" as per the Caterpillar report.

Short-term, highly liquid investments with original maturities of three months or less.

Formula for Inventory Days?

Formula for Trade Receivables (Debtors) Days?

formula for Trade Payables (Creditors) Days?

(trade payables/Credit purchases)x365

What is the Operating Cycle?

The time from the arrival of raw materials/stock until the receipt of cash from customers (Inventory Days + Receivable Days).

What is the Cash Cycle (Cash Conversion Period)?

Operating Cycle - Trade Payables Days. It represents the "gap" that must be financed by the firm.

Define a Conservative financing policy.

Funding all fixed assets, all permanent working capital, and part of fluctuating working capital with long-term finance. Low risk, but lower profitability (idle cash).

Define an Aggressive financing policy.

Using short-term finance to fund all fluctuating assets and some permanent working capital. High risk of illiquidity.

What is the Matching Principle?

financing assets with liabilities of similar maturity (e.g., long-term debt for fixed assets).

Why might firms in developing economies be more conservative with working capital?

Less developed financial markets make it harder to access short-term loans quickly if a liquidity crunch occurs.

What are the three types of inventory for a manufacturer?

Raw Materials, Work-in-Progress (WIP), and Finished Goods.

What is the Economic Order Quantity (EOQ) formula?

.

\/2cd/h

• c=ordering cost

• d=demand

• h=holding cost

Define Buffer Stocks.

A "safety net" of minimum inventory levels held to guard against supply delays (e.g., Red Sea shipping issues).

FIFO vs. LIFO: Which results in higher inventory value during inflation?

FIFO (it assumes older, cheaper items are sold first, leaving newer, expensive items on the balance sheet).

What is the Operating Motive for holding inventory?

To act as a buffer so production doesn't stop if one stage is delayed.

What are the 5 Cs of Credit Rating?

Character, Capital, Capacity, Conditions, and Collateral.

What is Altman’s Z-Score used for?

Predicting the likelihood of bankruptcy within 2-3 years.

Define Debt Factoring.

Selling trade receivables to a factor at a discount for immediate cash.

Calculate interest of a "1.5/10, net 30" discount.

Paying on day 30 instead of 10 means paying 1.5% for 20 days. (~19.6% p.a.).

What is Pledging Receivables?

Using debt owed to the business as security for a bank loan (common in the USA, rare in the UK).

What is the Contracting Cost Motive for trade credit?

Allows the buyer to inspect goods before paying, avoiding the cost of moving funds back and forth for faulty goods.

What is Overtrading?

Expanding sales too fast without enough long-term capital, causing a liquidity crisis.

Key symptoms of Overtrading?

Rapid sales growth, falling margins, rising payable days, and hit overdraft limits.

What is Overcapitalisation?

Excessively large investment in working capital relative to turnover (inefficient asset use).

How can overcapitalised firms become takeover targets?

They have "lazy" cash or underutilised assets that another firm could use more profitably.

What is Flow of Funds Analysis?

Comparing balance sheets to find Sources and Uses of funds.

An increase in a Liability is a...?

Source of Funds (e.g., taking more credit from suppliers).

What is MAD (Mean Absolute Deviation)?

A measure of forecast accuracy (Average of absolute differences between forecast and actual).

What is a Model Audit?

Periodically matching actual results against forecasts to identify flaws in the underlying assumptions (e.g., if customers actually take 6 weeks to pay instead of 4).

Why do large firms pay Corporation Tax quarterly?

Regulatory requirement; it creates a specific "lumpy" cash outflow that must be forecasted.

How did Tesco use market power in 2024?

Delayed payments to suppliers (high Payables) to fund their own stock and customer loans.

What was Carillion's "exceptional" failure according to the FRC?

KPMG failed to audit with "professional scepticism," ignoring unreasonable management estimates on loss-making contracts.

What is Internal Hedging?

Matching inflows and outflows in the same foreign currency to avoid exchange rate risk naturally.

Define Eurobonds.

Bonds issued outside the issuer's country, usually in a foreign currency (nothing to do with the Euro currency itself).

Why is Inelastic Demand important for cash flow?

It allows firms to pass price increases to customers without a major drop in volume, protecting margins.

What is a Spontaneous Source of Finance?

finance that arises automatically from operations (Trade Payables).

How does JIT affect the Balance Sheet?

Lowers Inventory (Current Assets), releasing cash but increasing "stock-out" risk.

Define Insolvency (UK).

Inability to pay debts as they fall due OR liabilities exceeding assets.

What is Window Dressing in the context of Carillion?

Using "aggressive accounting" to hide the true state of loss-making contracts from investors.

Why did Caterpillar hold marketable securities?

To maintain liquidity for "spare" cash while still earning a small return.

Calculate Purchases if COGS = £5m, Opening Stock = £1m, Closing Stock = £1.5m.

5+(1.5-1)=5.5

What is the Pricing Motive for trade credit?

To give a "concealed" discount to specific customers without lowering the official list price.

Why does Automation increase long-term funding needs?

It swaps variable costs (wages) for high fixed costs (machines), increasing the "break-even" point.

What is HIFO inventory valuation?

Highest In, First Out (selling the most expensive items first to minimize taxable profit).

Why is MAD used for bonuses in some US firms?

To incentivise financial analysts to produce highly accurate, realistic cash forecasts.

Impact of Easy Money (low interest rates) on cash holding?

Research shows firms tend to hold higher levels of cash when liquidity is cheap.

Why is Trade Credit often seen as "lock-in"?

A customer with an established credit line is less likely to switch to a competitor who might require cash upfront.

What is a Zeta Score?

An upgraded version of the Z-score that accounts for earnings variability and debt serviceability.

Difference between Liquidity and Solvency?

Liquidity is the immediate ability to pay bills; Solvency is assets exceeding liabilities over the long term.

True/False: A profitable business cannot go bankrupt.

False. Profitable businesses often fail due to a "cash gap" (Overtrading).

Why did the EU regulate payment terms in 2022?

To stop large firms from exploiting small suppliers via excessive trade payable days (often 80+ days).

What is the Inventory Pot Concept formula?

Opening Inventory + Purchases - Cost of Sales = Closing Inventory.

How does Market Power affect the Cash Cycle?

High power allows a firm to shorten Receivable days (force customers to pay fast) and lengthen Payable days (delay paying suppliers).