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Working Capital Management

Chapter Three: Financial Ratio Analysis Heading
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Introduction

Financial ratio analysis calculates and compares various ratios of amounts and balances taken from the financial statements.

The main purposes of working capital ratio analysis are:

                         to indicate working capital management performance; and

                         to assist in identifying areas requiring closer management.

Three key points need to be taken into account when analyzing financial ratios:

                         The results are based on highly summarised information. Consequently, situations which require control might not be apparent, or situations which do not warrant significant effort might be unnecessarily highlighted;

                         Different departments face very different situations. Comparisons between them, or with global "ideal" ratio values, can be misleading;

                         Ratio analysis is somewhat one-sided; favourable results mean little, whereas unfavourable results are usually significant.

However, financial ratio analysis is valuable because it raises questions and indicates directions for more detailed investigation.

The following ratios are of interest to those managing working capital:

                         working capital ratio;

                         liquid interval measure;

                         stock turnover;

                         debtors ratio;

                         creditors ratio.

Working Capital Ratio

Current Assets divided by Current Liabilities

The working capital ratio (or current ratio) attempts to measure the level of liquidity, that is, the level of safety provided by the excess of current assets over current liabilities.

The "quick ratio" a derivative, excludes inventories from the current assets, considering only those assets most swiftly realisable. There are also other possible refinements.

There is no particular benchmark value or range that can be recommended as suitable for all government departments. However, if a department tracks its own working capital ratio over a period of time, the trends-the way in which the liquidity is changing-will become apparent.

Liquid Interval Measure

Liquid Assets divided by Average Operating Expenses

This is another measure of liquidity. It looks at the number of days that liquid assets (for example, inventory) could service daily operating expenses (including salaries).

Stock Turnover

Cost of Sales divided by Average Stock Level

This ratio applies only to finished goods. It indicates the speed with which inventory is sold-or, to look at it from the other angle, how long inventory items remain on the shelves. It can be used for the inventory balance as a whole, for classes of inventory, or for individual inventory items.

The figure produced by the stock turnover ratio is not important in itself, but the trend over time is a good indicator of the validity of changes in inventory policies.

In general, a higher turnover ratio indicates that a lower level of investment is required to serve the department.

Most departments do not hold significant inventories of finished goods, so this ratio will have only limited relevance.

Debtor Ratio

There is a close relationship between debtors and credit sales to third parties (that is, sales other than to the Crown). If sales increase, debtors will increase, and conversely, if sales decrease debtors will decrease.

The best way to explain this relationship is to express it as the number of days that credit sales are carried on the books:

Credit Sales per Period x Days per period
Average Debtors

Where trading terms are 30 days net cash, and customers buy from day-to-day during the 30 day period and pay 30 days after a statement is rendered, a collection period of 45 days (the average between 30 and 60 days) would be satisfactory.

If the average collection period extends beyond 60 days, debtors are holding cash that should have flowed into the department. This means that the department is unable to satisfy pressing liabilities or to invest that cash.

The debtor ratio does not solve the collection problem, but it acts as an indicator that an adverse trend is developing. Remedial action can then be instigated.

Creditor Ratio

This ratio is much the same as the debtor ratio. It expresses the relationship between credit purchases and the liability to creditors. It can be stated as the number of days that credit purchases are carried on the books.

Credit Purchases per Period x Days per period
Average Creditors

Note that non-credit purchases (such as salaries) and non-cash expenses (such as depreciation) need to be excluded from "credit purchases" and any provisions need to be excluded from "creditors".

There is no need to pay creditors before payment is due. The department's objective should be to make effective use of this source of free credit, while maintaining a good relationship with creditors.

As with debtors, if a department has been granted credit terms of 30 days net cash, credit purchases should not be carried on the books for more than an average of 45 days. If payment is withheld for 60 days or more it is likely that creditors will become impatient and impose stricter and less convenient trading terms-for example, "cash on delivery".

The Public Finance Act 1989 (section 49) places a legal constraint on the amount of credit allowed to a department. It restricts to a maximum of 90 days the purchase of goods and services through the use of a credit card or suppliers' credit

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