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Working Capital Management


Working Capital Management
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Working Capital Management example

Let us conclude by seeing how the phenomenon of managing receivables and payables can affect the balance sheet of a business.

We have a company that has a sales per day of $1000 and purchases per day of $500.
At the moment the company is collecting its receivables on average in 45 days and is paying its receivables on average in 30 days.  This company has no cash as we see on the balance sheet, but it has a line of credit that it is using to pay its bills.

As they collect receivables the line of credit goes down as it pays its bills the line of credit goes up.  Right now the company owes $19,500 on the line of credit.  Lets assume that this company gets sloppy and it collects its receivables in 90 days.  Now its bank line of credit is sitting at $64,500 because it has not collected the cash from its customers as quickly.  The quicker you collect your receivables, the more cash you have on hand and the less you owe on your line of credit.  Just because it was a little less diligent in collecting its receivables, it owes a lot more money to the bank.  Conversely it is paying its bills rather quickly at 30 days, lets suppose that you can negotiate with your supplier are extend the credit to 60 days.  Now you only owe $4,500 on your line of credit, simply because you haven’t paid your bills as fast.  Account payable becomes greater, but this sort of credit becomes cash to you.

This little example shows you the dynamics of managing your receivables and payables.  Trying to collect your receivables quickly and trying to pay your payables as slowly as practical and acceptable to your supplier could collectively be a source of financing.  Effective management of your working capital is one important source of finance.

If we lower our receivables to 30 days and stretch our payables to 60 days, now instead of owing on the bank line of credit we are in a credit position on the bank line of credit which means we have surplus cash of $10,500.  That is why effective management of working capital is so important.  And that is also why the turnover ratios are important to help us decide if the age of receivables is appropriate and if the age of payables is appropriate.  Can we tighten up the age of our receivables, can we lengthen the age of our payables?

Analysis of Financial Statements - Profit Terms

                  Profit Terms
    PAT        Profit After Tax

    EBIT       Earnings Before Interest and Taxes

    EBIAT     Earnings Before Interest and After Taxes

    EBITDA  Earnings Before Interest, Taxes and Depreciation Allowances


    Financial Ratios

    Financial Ratios are used in the evaluation of the financial condition and profitability of a company. The ratios are calculated from the financial information provided in the balance sheet and income statements. Every firm has two basic financial objectives:

    • to be financially sound
    • to earn an adequate rate of return on invested capital
    Liquidity and Solvency tell you how financially sound the company is. Liquidity is the ability to meet short term financial obligations. Solvency is the ability to meet long term obligations.

    When analyzing financial statements you should keep in mind the principles/practices that accountants use in preparing statements.

    Types of Financial Ratios

    Liquidity Ratios:
    Current Ratio
    Acid Test Ratio
    Solvency Ratios:
    Debt/Equity Ratio
    Debt/Capitalization Ratio
    Profitability Ratios focus on earning an adequate rate of return:
    Gross Margin %
    Operating Ratio
    Return on Sales
    Return on Assets
    Return on Equity
    Return on Investment
    Turnover Ratios focus on how effective the company is in the utilization of its assets and management of its working capital:
    Asset Turnover
    Inventory Turns
    Days Receivable
    Days Payable
    Pay attention to how ratios are defined when you are analyzing them. Different people use different ways to calculate the same ratio. For example, a bank might define the Debt/Equity Ratio as Long Term Debt + Short Term Debt / Shareholder's Equity, in this module it is defined as Long Term Debt / Shareholder's Equity.



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