- 20 Marks
FM – L2 – Q103 – Working capital management
Question
The working capital (or cash operating) cycle of a business is the length of time between the payment for purchased materials and the receipt of payment from selling the goods made with the materials.
The table below gives information extracted from the annual accounts of Entity N for the past three years.
Entity N – Extracts from annual accounts
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| GH¢ | GH¢ | GH¢ | |
| Inventory: | |||
| Raw materials | 108,000 | 145,800 | 180,000 |
| Work in progress | 75,600 | 97,200 | 93,360 |
| Finished goods | 86,400 | 129,600 | 142,875 |
| Purchases | 518,400 | 702,000 | 720,000 |
| Cost of goods sold | 756,000 | 972,000 | 1,098,360 |
| Sales | 864,000 | 1,080,000 | 1,188,000 |
| Trade receivables | 172,800 | 259,200 | 297,000 |
| Trade payables | 86,400 | 105,300 | 126,000 |
Required
(a) Calculate the length of the working capital cycle (assuming 365 days in the year).
(b) List the actions that the management of Entity N might take to reduce the length of the cycle.
Answer
(A) To calculate the working capital cycle (cash operating cycle) for Entity N, we use the formula:
Working Capital Cycle = Inventory Days + Receivables Days – Payables Days
Where:
- Inventory Days = (Average Inventory / Cost of Goods Sold) × 365
- Receivables Days = (Trade Receivables / Sales) × 365
- Payables Days = (Trade Payables / Purchases_PMIC
Step 1: Calculate for Year 1
- Inventory Days:
Total Inventory = Raw Materials + Work in Progress + Finished Goods
= 108,000 + 75,600 + 86,400 = 270,000
Inventory Days = (270,000 / 756,000) × 365 = 130.36 days - Receivables Days:
Receivables Days = (172,800 / 864,000) × 365 = 73 days - Payables Days:
Payables Days = (86,400 / 518,400) × 365 = 60.83 days - Working Capital Cycle:
130.36 + 73 – 60.83 = 142.53 days
Step 2: Calculate for Year 2
- Inventory Days:
Total Inventory = 145,800 + 97,200 + 129,600 = 372,600
Inventory Days = (372,600 / 972,000) × 365 = 139.92 days - Receivables Days:
Receivables Days = (259,200 / 1,080,000) × 365 = 87.6 days - Payables Days:
Payables Days = (105,300 / 702,000) × 365 = 54.74 days - Working Capital Cycle:
139.92 + 87.6 – 54.74 = 172.78 days
Step 3: Calculate for Year 3
- Inventory Days:
Total Inventory = 180,000 + 93,360 + 142,875 = 416,235
Inventory Days = (416,235 / 1,098,360) × 365 = 138.24 days - Receivables Days:
Receivables Days = (297,000 / 1,188,000) × 365 = 91.25 days - Payables Days:
Payables Days = (126,000 / 720,000) × 365 = 63.88 days - Working Capital Cycle:
138.24 + 91.25 – 63.88 = 165.61 days
Summary:
- Year 1: 142.53 days
- Year 2: 172.78 days
- Year 3: 165.61 days
(B) Reduce the period of credit allowed to customers
- Possible disadvantage of reducing credit
- Improved credit control will cost more
- Cash discounts may be expensive to encourage prompt payment
- Some loss of sales because customers might buy from competitors offering better credit terms.
- Topic: Working capital management
- Uploader: Samuel Duah