Determining Working Capital Needs and Funding Strategies for ACCA FM

What this chapter covers

Determining working capital needs and funding strategies: topics in the order to study them

1. 1Working Capital Management ObjectivesStart here. The profit versus liquidity trade-off is the logic behind every later topic.
2. 2Working Capital Cycle and Operating CycleGives you the core calculation of inventory, receivable and payable days that the ratios and forecasts use.
3. 3Working Capital Ratios and Liquidity AnalysisBuilds on the cycle days and adds current and quick ratios, so you can judge whether a company is healthy.
4. 4Overtrading and OvercapitalisationThese are the two failure states you recognise from ratios and symptoms, so they come after the analysis tools.
5. 5Working Capital Investment PoliciesNow you decide how much to invest in current assets: aggressive, moderate or conservative.
6. 6Working Capital Financing PoliciesFinancing follows investment, because you need to know the permanent and fluctuating current assets before you fund them.
7. 7Cash Flow Forecasting and Funding NeedsLast, because it applies everything: forecast the cash, find the gaps and choose how to fund them.

How to prepare Determining working capital needs and funding strategies

1. Learn the definitions and the profit versus liquidity trade-off in your own words, then be able to state them in two sentences.
2. Memorise the operating cycle layout: inventory days + receivable days − payable days. Practise with different data, including whether to use sales or cost of sales as the base.
3. Calculate current and quick ratios and cycle days from a short set of accounts, then write one line of comment on each result.
4. Learn the symptoms of overtrading and overcapitalisation, then practise telling them apart from a set of ratios.
5. Draw the matched, aggressive and conservative financing policies. Label permanent current assets, fluctuating current assets and non-current assets on each diagram.
6. Build several cash forecasts from scratch, paying attention to timing, non-cash items and the closing balance carried forward.
7. Finish with past-style Section A and B objective questions, then one Section C question where you must calculate and also recommend a funding action.

Common mistakes in Determining working capital needs and funding strategies

• Using the wrong base for the days calculations, for example sales for inventory days.

  Fix: Link inventory and payables to cost of sales or purchases, and receivables to credit sales, unless the question tells you otherwise.

• Writing a ratio as a number with no comment.

  Fix: After each figure, state what it means, compare it to a benchmark or prior year and say what action follows.

• Confusing overtrading with overcapitalisation.

  Fix: Remember the direction: overtrading is too little finance for the activity, while overcapitalisation is too much capital sitting idle.

• Mixing up aggressive investment with aggressive financing.

  Fix: Ask two separate questions: how much do we hold, and how do we pay for it. Answer each on its own.

• Including depreciation or other non-cash items in a cash forecast.

  Fix: List only receipts and payments in the month they occur. Apply credit terms to sales and purchases first.

• Assuming shorter or longer cycles are always better.

  Fix: Say that a shorter cycle usually frees cash, but stretching payables too far can damage supplier relations, and cutting inventory too far can cause stock-outs.

Last-day revision: Determining working capital needs and funding strategies

• ✓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.

Determining working capital needs and funding strategies practice questions

• Which of the following is the most appropriate way for a company to finance a permanent increase in its core level of working capital under …
• Which funding strategy is most likely to expose a growing business to the risk of overtrading?
• Which of the following is the most typical symptom of overtrading in a business?
• Which change would shorten an entity's working capital cycle (cash operating cycle)?
• Zeta Co has annual credit sales of $9,125,000 and annual cost of sales of $6,570,000. Average inventory is $720,000 (all finished goods), av…
• Dunmore Co has annual sales of $3,650,000, all on credit, and cost of sales of $2,920,000. It currently takes 60 days to collect from custom…
• Which of the following ratio movements, taken together, most strongly indicates overcapitalisation (excess working capital) rather than over…

Determining working capital needs and funding strategies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• CA IntermediateIntroduction to Working Capital Management
• CFA Level IWorking Capital and Liquidity
• CS ExecutiveWorking Capital Management
• CMA IntermediateIntroduction to Working Capital Management