FMA 101 Topic 11 – Working Capital and Current Asset Management Assignment Answers

 

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Working Capital and Current Asset Management : LEARNING OUTCOMES

After completing this topic, you should be able to:

  • Explain and discuss working capital management, net working capital and the trade-off between profitability and risk.
  • Explain the role and meaning of the operating cycle and the cash conversion cycle, and calculate and interpret their resource requirements.
  • Discuss the funding requirements strategies for a cash conversion cycle, calculate the resource requirements and interpret the calculated outcomes.
  • Explain the role and purpose of inventory management and discuss the differing views on inventory levels.
  • Explain and discuss the ABC, EOQ, JIT and MRP inventory management systems, calculate the EOQ and reorder point, and interpret and discuss the outcomes of such calculations.
  • Explain the trade receivables management process and apply quantitative methods to evaluate changes in credit standards, credit terms and ageing schedules.
  • Explain the management of receipts and disbursements, including different types of float, speeding up collections, slowing down payments, zero-balance accounts and optimising cash balance.

 

READING 

Before continuing with this topic, please read the following:

  • Gitman et al. (2015: Chapter 15)

Please make sure that you also read this study guide carefully as it contains additional information that is not in the prescribed textbook.

 

NET WORKING CAPITAL FUNDAMENTALS

The key concepts that you must focus on are:

  • working capital management
  • working capital
  • net working capital
  • profitability in the context of working capital management
  • risk in the context of working capital management
  • technical insolvency

You must be able to explain the goal of working capital management and define or explain what activities working capital management entails.

 

You must be able to distinguish between working capital which is represented by current assets and which can be further broken down into inventory, trade receivables and other receivables, and cash and cash equivalents and current liabilities that include all short-term financing such as trade and other payables, accruals and other short-term borrowings.

 

You can summarise working capital as:

Working capital = Cash + Accounts receivable + Inventory

 

It is very important that you have a thorough understanding of each of the components of current assets and current liabilities, their roles and their functions.

 

You must be able to provide a definition of net working capital as well as the meaning of positive net working capital and negative net working capital.

 

You can summarise net working capital as:

Net working capital = (Cash + Accounts receivable + Inventory) – Accounts payable

 

You must be able to explain and discuss the effects that cash flows and the uncertainties associated with cash inflows and outflows have on working capital management and the challenges that financial managers have to deal with because of the imbalances between cash inflows and cash outflows.

 

You must be able to explain the meaning of profitability in the context of working capital management and how a business entity can increase its profitability.

 

You must also be able to explain the meaning of risk in the context of working capital management and the relationship between net working capital and risk.

 

You must be able to define technical insolvency and explain how the level of liquidity in an entity affects the risk level of the entity and its potential to become technically insolvent.

 

You must study the content of Table 15.1 in the prescribed textbook very well for you to be able to explain the trade-off between profitability and risk in terms of changes in current assets and current liabilities.

 

 

THE OPERATING CYCLE AND CASH CONVERSION CYCLE

The key concepts that you must focus on are:

  • average age of inventory
  • average collection period
  • average payment period
  • the operating cycle
  • permanent funding needs
  • seasonal funding needs

 

The level of working capital required by an entity is determined by how quickly it can convert its cash-generating activities into cash. This entails the speed with which it can turn its inventory into sales and how quickly it can turn its credit sales into cash. This process is known as the operating cycle (OC).

 

You need to be able to define the operating cycle and also identify the key components of the operating cycle and how these key components are applied to calculate the extent of the operating cycle of an entity.

 

The operating cycle can be calculated as follows:

OC = Average age of inventory (AAI) + Average collection period (ACP)

 

The operating cycle deals with the cash inflows generated by the sale of inventory and the collection of debtors’ outstanding balances.

 

The business entity, however, has to obtain finished products or raw materials and components to produce products or services for resale. This results in the entity incurring current liabilities which represent short-term financial obligations and hence cash outflows.

 

The sooner an entity has to settle its short-term obligations, the more pressure there will be on the entity to free up cash tied up in inventory and trade and other receivables in order to settle its trade and other payables commitments.

 

Current liabilities, therefore, reduce the operating cycle of a business. When the effect of current liabilities is included in the cash flow cycle, the net result is known as the cash conversion cycle.

 

You need to be able to explain the purpose of the cash conversion cycle and calculate it using the information provided.

 

The cash conversion cycle (CCC) can be calculated as follows:

CCC = AAI + ACP – Average payment period (APP)

 

Example 15.1 in the prescribed textbook explains and demonstrates how the cash conversion cycle of an entity is calculated. You need to study this example in order to understand how to use relevant information to calculate a cash conversion cycle.

 

RESOURCES INVESTED IN THE CASH CONVERSION CYCLE

A business entity needs to know how many of its resources are invested (tied up) in its cash conversion cycle at any stage. The more resources tied up in the cash conversion cycle, the higher the probability of liquidity problems and the risk of technical insolvency.

 

You need to be able to analyse and calculate the extent of the resources of an entity being tied up in the cash conversion cycle. Study Example 15.1 together with Figure 15.1 in the prescribed textbook as they explain and demonstrate this very well.

 

This example and illustration will assist you in understanding how to use relevant information to calculate the level of resources invested in the cash conversion cycle.

 

 

FUNDING REQUIREMENTS OF THE CASH CONVERSION CYCLE

The key concepts that you must focus on are:

  • permanent funding requirements
  • seasonal funding requirements
  • aggressive funding strategy
  • conservative funding strategy

A business entity needs to understand the options it has available to finance its operating activities. The starting point for the entity would be to divide its funding needs into those needs that are permanent in nature and those that are only seasonal in nature.

 

You need to take note that entities that have sales levels that remain constant over time will lean more towards permanent funding needs, while those entities whose sales tend to fluctuate according to the season, will lean towards more seasonal funding needs. Example 15.2 and Figure 15.2 in the prescribed textbook explain and demonstrate the need for permanent funding versus the need for seasonal funding and the differences in considerations very well.

 

You need to study both the example and the figure thoroughly to make sure that you understand the distinctions between permanent and seasonal funding requirements and how these funding needs are calculated. Take note that permanent and seasonal funding needs together represent the total short-term funding needs of an entity.

 

You need to distinguish between aggressive seasonal funding and conservative funding, and know the difference between the cost of short-term funds compared to the cost of long-term funds.

 

You need to be able to discuss the benefits and disadvantages of both short-term and long-term financing, and the considerations a business entity would apply when considering short-term and long-term financing in the case of both aggressive and conservative funding strategies.

 

Example 15.3 in the prescribed textbook explains and demonstrates how a business entity can calculate the costs of both an aggressive funding strategy and a conservative funding strategy, and use the outcomes of these calculations to make an informed financing decision.

 

 

STRATEGIES TO MANAGE THE CASH CONVERSION CYCLE

Study the different strategies available to an entity to manage its cash conversion cycle. You need to be able to identify and discuss the different strategies.

 

 

INVENTORY MANAGEMENT

The key concepts that you must focus on are:

  • the ABC system
  • the economic order quantity (EOQ) model
  • the just-in-time (JIT) system
  • materials requirement planning (MRP) systems

 

You must be able to critically discuss different viewpoints in terms of inventory levels.

 

You must be able to explain, discuss and evaluate the following inventory management systems used by business entities to manage their inventory levels:

  • the ABC system
  • the economic order quantity (EOQ) model
  • the just-in-time (JIT) system
  • materials requirement planning (MRP) systems

 

 

 THE ECONOMIC ORDER QUANTITY MODEL (EOQ)

The key concepts that you must focus on are:

  • order cost
  • carrying cost
  • reorder point
  • safety stock

You must be able to apply the EOQ model to calculate order costs, carrying costs, the economic order quantities, reorder points and safety inventory for business entities for different scenarios using the information provided as well as identify and explain the different components of an inventory level system.

 

Example 15.4 in the prescribed textbook both explains and demonstrates how ordering costs and carrying costs are calculated and used for decision-making. You need to study this example thoroughly.

 

Example 15.5 in the prescribed textbook both explains and demonstrates how to calculate an economic order quantity as well as the reorder point in order to maintain adequate inventory levels. You need to study this example carefully to make sure that you can perform the calculations and interpret the calculated results.

 

 

TRADE RECEIVABLES MANAGEMENT (DEBTORS; ACCOUNTS RECEIVABLE)

The key concepts that you must focus on are:

  • trade receivables management
  • credit selection and standards
  • credit scoring
  • changing credit standards

You must be able to explain what trade receivables management means and discuss the objective of trade receivables management.

 

You need to be able to explain what credit selection and standards involve. You further need to explain the five C’s of the credit selection technique and the meaning and purpose of credit scoring using examples.

 

 

CHANGING CREDIT STANDARDS

You must be able to explain the reason(s) why a business entity would want to change its credit standards.

 

You are also required to be able to analyse the effect on the profit of a business when a decision is made to change the existing credit standards. You need to be able to perform all relevant calculations using the information provided and then draw relevant conclusions or make recommendations based on the outcomes of the calculations.

 

Example 15.6 in the prescribed textbook presents, explains and demonstrates in a detailed and comprehensive way how the effect on the profit of a business entity is assessed when it decides to change its credit standards. You need to thoroughly study the procedure followed as well as how the different calculations affecting the decision are performed.

 

 

CHANGING CREDIT TERMS

The key concepts that you must focus on are:

  • cash discount
  • cash discount period
  • credit period
  • credit monitoring

You need to be able to explain what credit terms are and their role in trade receivables management.

 

Example 15.8 and Table 15.3 in the prescribed textbook explain and demonstrate how the effect of a change in credit terms is calculated to determine the impact on the profit of a business entity.

 

You need to study this example and the content of the table very carefully to ensure that you will be able to calculate the effects of changes in the credit terms on the profit of a business entity using relevant information. You must also be able to draw relevant conclusions or make informed recommendations.

 

 

AGEING OF TRADE RECEIVABLES

You need to be able to explain the purpose of an ageing schedule for trade receivables and analyse and interpret the content of such a table.

 

Example 15.9 in the prescribed textbook presents an ageing schedule and explains and demonstrates how the information in such a schedule is analysed and interpreted. Study this example carefully in order to understand how the analysis and interpretation are done.

 

Study the content of Table 15.4 in the prescribed textbook to familiarise yourself with the different credit collection techniques used by entities.

 

 

MANAGEMENT OF RECEIPTS AND DISBURSEMENTS

The key concepts that you must focus on are:

  • types of floats
  • controlled disbursing
  • zero-balance accounts

The management of monies coming into the business and monies paid from the business is one of the most critical activities in any organisation as it has a direct bearing on the daily cash position and liquidity position of the organisation.

 

You must be able to:

  • explain the importance of receipts and disbursements in organisations
  • identify, define and distinguish between different types of floats used in organisations
  • identify strategies and actions that can be applied to speed up collections (receipts)
  • identify strategies and actions that can be applied to slow down disbursements (payments)
  • explain the role, function and benefits of zero-balance
  • optimise cash balances by investing in current balances, monthly surpluses and slowing down

Study Example 15.1 in the prescribed textbook. This example explains and demonstrates how investments from cash inflows and slowing down cash outflows can be used to optimise cash balances.

 

 

ADDITIONAL SOURCES TO ACCESS FMA 101 Topic 11

Access the following websites to broaden your understanding of working capital and current asset management in the context of financial management:

  • Working capital management: https://www.edupristine.com/blog/working- capital-management, accessed 9 March
  • How to improve working capital management: http://ezinearticles.com/?How-to-Improve-Working-Capital- Management&id=397977, accessed 9 March
  • Working capital management: everything you need to know: https://www.cleverism.com/working-capital-management-everything-need- know/, accessed 9 March

 

 

FMA 101 Topic 11 SELF-ASSESSMENT EXERCISES

At the end of this chapter, there is a series of different self-test problems, warm- up exercises, problems and a more comprehensive case study. You should attempt to answer these questions, perform the calculations and use them to practise and re-enforce your learning and understanding. You may submit any of your answers to the lecturer for assessment and feedback.

 

SBS also shares copies of previous exam papers with you during the semester. The questions in these exam papers are very good examples of what you are expected to know and be able to do having studied and mastered the content of chapter 15 of the prescribed textbook and having followed the guidance provided in this topic.

 

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