AC114: Chapter 6 & 7 - Cash Budgets and Working Capital

Net working capital

Current assets − Current liabilities.

The cash needed to keep the business running.

Main trade-off in working capital management

Liquidity vs. profitability.

How can a profitable business become insolvent?

Profit isn't cash. A business can make profits but run out of cash.

Current ratio + formula

Measures ability to pay short-term liabilities.
Formula: Current assets ÷ current liabilities.

Quick ratio + formula

Measures short-term liquidity excluding inventory.
Formula: (Current assets − inventory) ÷ current liabilities.

Three efficiency ratios

• Inventory days = (Inventory ÷ Cost of sales) × 365

• Receivables days = (Receivables ÷ Sales) × 365

• Payables days = (Payables ÷ Purchases) × 365

Cash operating cycle + Formula

Time it takes for cash spent on inventory to return to firm as cash from customers.

Inventory days + Receivables days − Payables days.

Limitations of working capital ratios

Based on one point in time, affected by seasonality, and based on past data.

Overtrading

When a business grows too quickly and runs short of cash.

Holding + Ordering costs

Holding costs - Cost of storing + holding inventory (e.g storage, insurance)

Ordering/shortage costs - Cost of placing + recieving orders (e.g admin, delivery costs)

Name the five inventory control systems (RPPAJ)

1. Re-order - Order stock when it falls to a minimum set level

2. Periodic review: Stock is checked at set times and topped up with orders.

3. Perpetual inventory: Stock is updated every time goods are bought or sold.

4. ABC - Stock split into A (High volume), B (Medium), C (Low level) items

5. JIT (Just In Time) - Stock is ordered only when needed

Why do businesses use trade credit and what are the risks?

Trade credit is a convenient source of short-term finance.

Risks include credit being withdrawn, prices increasing, or discounts being removed.

Costs and benefits of giving customers credit

Costs: bad debts, administration headaches.

Benefits: higher sales and profits.

Factoring vs invoice discounting

Factoring = factor collects debts.

Invoice discounting = business still collects debts.

Trade credit insurance

Insurance against customers failing to pay.

Cash budget and why depreciation is excluded

A forecast of cash receipts and payments. Depreciation is excluded because it is a non-cash expense.

Costs of cash management

Holding too much cash creates an opportunity cost.

Holding too little creates a risk of not meeting obligations.

Responding to cash surpluses and deficits

• Short-term surplus: invest short-term or pay suppliers early.

• Short-term deficit: overdraft, delay payments, chase receivables.

• Long-term surplus: invest or expand.

• Long-term deficit: raise finance or sell assets.