ACCA Applied Skills · Financial Management

Determining working capital needs and funding strategies: formula sheet

Full chapter guide

Key formulas

Working capital: Working capital = current assets − current liabilities; Also called net current assets. Positive does not guarantee liquidity if assets are mostly slow-moving inventory.
Current ratio: Current ratio = current assets ÷ current liabilities; A liquidity measure. Compare with the industry and the firm's own history, not a fixed target.
Quick (acid test) ratio: Quick ratio = (current assets − inventory) ÷ current liabilities; Excludes inventory because it may be slow to turn into cash.
Working capital cycle: Cycle = inventory days + receivable days − payable days; A shorter cycle means less funding is tied up. Also called the cash operating cycle.
Inventory days: Inventory days = (Inventory ÷ Cost of sales) × 365; For a manufacturer you may split into raw materials (÷ purchases or material usage), WIP and finished goods (÷ cost of sales). Use the cost base the question suggests.
Receivables days: Receivables days = (Trade receivables ÷ Credit sales) × 365; Use credit sales if given. If only total revenue is given, use it and state the assumption.
Payables days: Payables days = (Trade payables ÷ Credit purchases) × 365; If purchases are not given, use cost of sales and state this assumption.
Cash operating cycle: Cash operating cycle = Inventory days + Receivables days − Payables days; Measured in days. Use 365 days unless told otherwise.
Funding tied up: Working capital investment ≈ Net current operating assets = Inventory + Receivables − Payables; Link the cycle to a cash amount to cost the funding.
Current ratio: Current assets ÷ Current liabilities; Often expressed as x : 1. A common rule of thumb is around 1.5 to 2, but it varies by industry.
Quick ratio (acid test): (Current assets − Inventory) ÷ Current liabilities; Rule of thumb is around 1, but retailers with fast cash sales often sit lower.
Inventory days: Inventory ÷ Cost of sales × 365; Use cost of sales. For raw materials or WIP, use the matching cost base if given.
Receivables days: Trade receivables ÷ Credit sales × 365; Use revenue if credit sales are not given, and say so.
Payables days: Trade payables ÷ Credit purchases × 365; Use cost of sales if purchases are not given, and state the assumption.
Cash operating cycle: Inventory days + Receivables days − Payables days; A shorter cycle means less funding is needed for working capital.
Current ratio: Current assets ÷ Current liabilities; Falls in overtrading. Very high in overcapitalisation. Compare with the industry and prior years, not a fixed target.
Quick ratio: (Current assets − Inventory) ÷ Current liabilities; A sharper test of liquidity because inventory may be slow to turn into cash.
Receivable days: Trade receivables ÷ Credit sales × 365; Use revenue if credit sales are not given. Lengthening days suggest weak credit control.
Inventory days: Inventory ÷ Cost of sales × 365; Rising days may mean overstocking. In overtrading, inventory often rises in absolute terms with sales.
Payable days: Trade payables ÷ Credit purchases × 365; Use cost of sales if purchases are not given. Rising days in a growing, cash-short firm signal stretched suppliers.
Revenue growth versus capital growth: % growth in revenue compared with % growth in equity and long-term debt; Overtrading shows revenue growing much faster than long-term capital.
Gearing and interest cover: Debt ÷ Equity (or Debt ÷ (Debt + Equity)); Profit before interest and tax ÷ Interest; Overdraft growth raises gearing and cuts interest cover, which limits further borrowing.
Current assets to sales ratio: Current assets ÷ Sales; Higher ratio = more conservative. Lower ratio = more aggressive. Compare with the industry or with the firm's past figures.
Current ratio: Current assets ÷ Current liabilities; A supporting liquidity measure. A high ratio suggests a conservative position, but check the industry norm.
Return on capital employed (ROCE): Operating profit ÷ Capital employed × 100%; Capital employed includes working capital. Cutting current assets lowers capital employed and raises ROCE if profit is unchanged.
Cost of holding extra current assets: Extra investment × Financing rate; Use this to put a money value on the cost of a more conservative policy.
Policy rule: Conservative = low risk, low return. Aggressive = high risk, high return. Moderate = in between; Memorise this trade-off. It is the basis of most written answers.
Permanent current assets: Permanent current assets = minimum level of current assets needed over the period; Read it from the lowest point in the forecast. Do not use the average.
Fluctuating current assets: Fluctuating current assets = total current assets − permanent current assets; This is the seasonal or variable part. It changes month by month.
Matching policy: Long-term finance = non-current assets + permanent current assets; short-term finance = fluctuating current assets; The benchmark against which the other two policies are judged.
Conservative policy: Long-term finance > non-current assets + permanent current assets; The excess long-term finance covers part of the fluctuating assets. Short-term finance is lower than under matching.
Aggressive policy: Long-term finance < non-current assets + permanent current assets; Short-term finance covers some permanent assets. It is higher than under matching.
Short-term finance required: Short-term finance = total assets − long-term finance in use; Use this when a question gives the long-term finance and asks for the balancing amount.
Closing cash balance: Closing balance = Opening balance + Receipts − Payments; The closing balance of one month is the opening balance of the next.
Net working capital: Net working capital = Inventory + Receivables − Payables (+ cash if included); Follow the question's definition. Most growth questions use inventory, receivables and payables only.
Receivables balance: Receivables = Annual credit sales × receivable days ÷ 365; Use credit sales only. Use 360 or 52 weeks if the question says so.
Inventory balance: Inventory = Annual cost of sales × inventory days ÷ 365; Use the base the question gives, usually cost of sales.
Payables balance: Payables = Annual credit purchases × payable days ÷ 365; Use purchases if given. If not, use cost of sales as a stated approximation.
Increase in working capital: Funding needed = New net working capital − Old net working capital; A rise is a cash outflow. A fall releases cash.
Cash received from credit sales: Cash received in month = Sales of earlier month × % paying after that credit period (less discounts taken); Apply the lag to the month of sale, not the month of receipt.

Quick revision

Working capital = current assets − current liabilities; the aim is to balance profitability and liquidity.
Operating cycle = inventory days + receivable days − payable days.
Inventory days use average or closing inventory ÷ cost of sales × 365; receivable days use receivables ÷ credit sales × 365; payable days use payables ÷ credit purchases (or cost of sales) × 365.
Current ratio = current assets ÷ current liabilities; quick ratio = (current assets − inventory) ÷ current liabilities.
Ideal ratio values vary by industry; do not treat 2:1 or 1:1 as a rule that always applies.
Overtrading is expanding too fast on too little long-term capital: rising sales, falling liquidity, growing overdraft.
Overcapitalisation means too much working capital: high cash, slow inventory and receivables, poor returns.
Aggressive investment policy holds low current assets: higher risk, higher potential return.
Conservative investment policy holds high current assets: lower risk, lower return.
Matched financing funds permanent assets with long-term finance and fluctuating assets with short-term finance.
Aggressive financing uses more short-term funds: cheaper usually, but riskier due to refinancing.
A cash forecast includes only cash movements: leave out depreciation and adjust for credit timing.

Common mistakes

Stating that the objective is to maximise liquidity. Fix: Say the objective is a balance between liquidity and profitability, supporting shareholder wealth.
Assuming a high current ratio is always good. Fix: A very high ratio may mean idle cash, excess inventory or slow-paying customers, which reduces returns.
Using revenue instead of cost of sales for inventory days. Fix: Inventory is held at cost, so divide by cost of sales. Only use revenue if the question gives nothing else, and say so.
Adding payables days instead of subtracting them. Fix: Remember payables are supplier credit that reduces the cash you must fund. Write the formula with the minus sign before you start.
Including inventory in the quick ratio. Fix: Always write current assets minus inventory first, then divide.
Using revenue for inventory days. Fix: Inventory is held at cost, so use cost of sales.
Treating overtrading as a sign of losses Fix: Remember that overtrading firms often report growing profit. The problem is cash and liquidity, not profit.
Recommending more overdraft to fix overtrading Fix: Recommend long-term finance such as equity or term loans. Overdraft is the cause of the mismatch.
Confusing investment policy with financing policy Fix: Ask: is the question about how much is held in current assets (investment), or how they are funded (financing)? Answer only the one asked.
Saying a conservative policy gives higher profit Fix: Conservative holds more idle assets, so return is lower. The benefit is lower risk, not higher profit.

Exam tips

In written answers, always name both liquidity and profitability and explain the trade-off with scenario facts.
In objective questions, distrust any option that says one objective should be maximised at the expense of the other.
Compare ratios with industry norms or prior years. A ratio alone earns little.
Link overtrading and overcapitalisation to the two ends of the balance; examiners like this pairing.
Finish recommendations with a risk or cost, since every action affects the other objective.
Check which cost base each ratio uses and state any assumption in a written answer. Markers reward a stated assumption.
In objective tests the distractors usually come from the wrong base or from adding payables. Check the formula before choosing.
In Section C, always interpret: which component changed, what it means for funding, and a recommendation. The calculation alone earns only part of the marks.