FM – L2 – Q103 – Working capital management

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.

(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.