WORKING CAPITAL

DEC 2007 Q4 (a) / DECEMBER 2013 Q3 (d)

The objectives of working capital management and the conflict that may arise between them (3m) (1m objective 2m conflict)

 The objectives of working capital management are profitability and liquidity.

 The objective of profitability is to increase the profitability of company via investment for the survival of the business.
 The objective of liquidity is to ensure the company has sufficient liquid resources to maintain day-to-day cash flows
 However, often times, these objectives tend to conflict one another as funds hold in the form of cash generates no return.
Also, short term investment generates small return and the cash will be caught up in the short term. This will make no
liquid resources available to the company, hence, unable to meet the working capital management objectives.
 Good working capital management therefore should strike a balance between the objective of profitability and liquidity

DECEMBER 2013 Q3 (d)

The central role of working capital management in financial management (3-4m)

 The company are able to meet its short term obligation as they fall due
 The company is efficient and effective enough in cash management to run day-to-day operations
 The company maintain an optimal level of current assets and investment in order to earn return to meet profitability
objectives
 Liabilities are efficiently managed in such a way where the company has sufficient finance available.
 The company can make the best decision relating to working capital

JUNE 2014 Q2 (a)

whether a working capital cycle should be positive or negative (4m)

 The working cycle of CSZ Co is positive 110 days.

 This means that the company pays its trade suppliers on average 110 days before it receives cash from its customers.
 This represents that CSZ Co will require finance, which could be funded from short-term or long-term source.

 If the working capital cycle had been negative, CSZ Co would have been receiving cash from its customers before it needed
to pay its trade suppliers.
 A company which does not give credit to its customers, such as a supermarket chain, can have a negative working capital
cycle.

 Even if companies might generally prefer to be paid by customers before they have to pay their suppliers, however, it is not
the choice of the company whether the working capital cycle should be positive or negative.
 This is because the length of the working capital cycle depends on its elements, which are inventory days, trade receivables
days and trade payables, and these elements usually depend on the nature of the business undertaken by a company and
the way that business is conducted by its competitors.
 The length of the working capital cycle is usually therefore similar between companies in the same business sector, but can
differ between business sectors
DECEMBER 2011 Q2 (a)

The meaning of the term ‘cash operating cycle’ and the relationship between the cash operating cycle and the level of
investment in working capital, including a discussion of relevant working capital policy and the nature of business operations.
(7m)

Cash operating cycle

The cash operating cycle is the average period of time which elapses between the point at which cash begins to be
expended on the production of a product and the collection of cash from a customer.
It is the sum of the average inventory holding period, the average production period and the average trade receivables credit
period, less the average trade payables credit period.

Relationship between cash operating cycle and the level of investment in working capital
The relationship between the cash operating cycle and the level of investment in working capital is that an increase in the
length of the cash operating cycle will increase the level of investment in working capital.
The length of the cash operating cycle depends on working capital policy in relation to the level of investment in working capital,
and also on the nature of the business operations of a company.

Working capital policy

 Companies with the same business operations may have different levels of investment in working capital as a result of
adopting different working capital policies.
 An aggressive working capital policy uses lower levels of inventory and trade receivables than a conservative policy, and
so will lead to a shorter cash operating cycle.
 A conservative working capital policy, in contrast, with higher levels of inventory and trade receivables, will lead to a
longer cash operating cycle.
 The higher cost of the longer cash operating cycle will lead to a decrease in profitability while also decreasing risk, for
example the risk of running out of inventory.

Nature of business operations

 Companies with different business operations will have different cash operating cycles.
 For example, a manufacturing company will require more investment in working capital as they have a high level of
inventory.
 In contrast, a company supplying services, will require lower investment in working capital as they have lower level of
inventory
JUNE 2011 Q4 (b)(i)

Factors that influence the formulation of working capital policy (7m)

Nature of business
 It influences the formulation of working capital policy as companies with different nature will require different level of
investment
 In example, a manufacturing company will require more investment in working capital as they have a higher level of
inventory compared to a service company which may have a low level of inventory

Operating cycle
 The length of operating cycle and the desired investment in current asset will determine the amount of working capital
finance needed.
 Woking capital policies will be formulated in order to optimised the operating cycle

Terms of trade
 In order to maintain competitive advantage, the working capital policy will be formulated by taking into consideration
terms of trade offered by competitors.
 The terms of trade must be comparable to those of competitors and the level of receivables would be determined by the
credit period offered and the average period taken by customers

Risk appetite of the company

 A key factor of formulation of working capital policy, will be the risk appetite of the company
 For example, a risk-averse company will tend to operate with higher levels of inventory and receivables than a company
which is more risk-seeking.

JUNE 2008 Q3 (a)

The key factors which determine the level of investment in current assets. (6m)

Length of cash operating cycle

 The cash operating cycle is the period of time between when a company settles its accounts payable and when it receives
cash from its accounts receivable
 Operating activities during this period need to be financed and as the cycle lengthens, the amount of finance needed
increases.
 Companies with longer operating cycles than others in the same industry sector, will therefore require higher levels of
investment in current assets.

Terms of trade
 These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases,
and any penalties for late payment.
 A company whose terms of trade are more generous than another company in the same industry sector will therefore
need a higher investment in current assets.

Risk appetite
 Even within the same industry sector, companies will have different policies regarding the level of investment in current
assets, depending on their attitude to risk.
 A company with a conservative approach to the level of investment in current assets would maintain higher levels of
inventory, offer more generous credit terms and have higher levels of cash in reserve than a company with a aggressive
approach.

Industry in which organisation operates

 Another factor that influences the level of investment in current assets is the industry within which an organisation
operates.
 Manufacturing industries will have long operating cycles due to the length of time needed to manufacture finished goods
and so will have higher levels of investment in current assets than retail industries, where goods are bought in for resale
with minimal additional processing and where many goods have short shelf-lives.
PILOT PAPER Q3 (d)

The key factors to be considered when formulating a working capital funding policy. (7 marks)

Analysis of asset
 When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent current
assets and fluctuating current assets.

 Permanent current assets represent the core level of working capital investment needed to support a given level of sales.
As sales increase, this core level of working capital also increases.

 Fluctuating current assets represent the changes in working capital that arise in the normal course of business operations
For example, when some receivables accounts are settled later than expected, or when inventory moves more slowly than
planned.

 Under a matching working capital funding policy, therefore, long-term finance should be used for long-term assets which
are permanent current assets and non-current assets.
Short-term finance is used to cover the short-term changes in current assets represented by fluctuating current assets.

Short and long-term debt

 Long-term debt has a higher cost than short-term debt in normal circumstances, for example because lenders require
higher compensation for lending for longer periods, or because the risk of default increases with longer lending periods.
 However, long-term debt is more secure from a company point of view than short-term debt since, provided interest
payments are made when due and the requirements of restrictive covenants are met, terms are fixed to maturity. Short-
term debt is riskier than long-term debt because, for example, an overdraft is repayable on demand and short-term debt
may be renewed on less favourable terms.

WC financing policy
 A conservative working capital funding policy will use a higher proportion of long-term finance than a matching policy,
thereby financing some of the fluctuating current assets from a long-term source.
This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.

 An aggressive working capital funding policy will use a lower proportion of long-term finance than a matching policy,
financing some of the permanent current assets from a short-term source such as an overdraft.
This will be more risky and more profitable than a matching policy.

Other factors
 Other factors that influence a working capital funding policy include management attitudes to risk, previous funding
decisions, and organisation size.

 Management attitudes to risk will determine whether there is a preference for a conservative, an aggressive or a matching
approach.

 Previous funding decisions will determine the current position being considered in policy formulation.

 The size of the organisation will influence its ability to access different sources of finance.
A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to
raise additional long-term finance, whether equity of debt.
JUNE 2009 Q3 (a)

The working capital financing strategy of HGR Co. (7 marks)

 Working capital financing policies can be classified into three types which are conservative, aggressive and moderate
policy, depending on the extent to which fluctuating current assets and permanent current assets are financed by short-
term sources of finance.

 Permanent current assets are the core level of investment in current assets needed to support a given level of business
activity or turnover, while fluctuating current assets are the changes in the levels of current assets arising from the
unpredictable nature of some aspects of business activity.

 A conservative working capital financing policy uses long-term funds to finance non-current assets and permanent current
assets, as well as a proportion of fluctuating current assets.

 This policy is less risky and less profitable than an aggressive working capital financing policy, which uses short-term funds
to finance fluctuating current assets and a proportion of permanent current assets.

 A moderate working capital investment policy is a middle way between the aggressive and conservative approaches, which
uses long-term funds to finance long-term assets (non-current assets and permanent current assets) and short-term funds
to finance short-term assets (fluctuating current assets).

 The statement of financial position shows that HGR Co uses trade payables and an overdraft as short-term finance and
equity finance (shareholder’s funds) or traded bonds as long term finance.

 In terms of the balance between ST and LT finance, 83% of current assets [14000/(140002935) x 100] are financed by ST
funds and only 17% are funded by LT finance.

 Since a high proportion of short-term finance is preferred, APX Co appears to be adopting a more aggressive approach to
finance their working capital.

 Reliance on short-term finance makes this riskier than a matching approach, but also more profitable due to the lower cost
of short-term finance.

 Following an aggressive approach to financing can lead to overtrading (undercapitalisation) and the possibility of liquidity
problems
DECEMBER 2009 Q4 (c)
The working capital financing policy of the company – specific to the company’s environment (6m)

 Working capital financing policies can be classified into three types which are conservative, aggressive and moderate
policy, depending on the extent to which fluctuating current assets and permanent current assets are financed by short-
term sources of finance.

 Permanent current assets are the core level of investment in current assets needed to support a given level of business
activity or turnover, while fluctuating current assets are the changes in the levels of current assets arising from the
unpredictable nature of some aspects of business activity.

 A conservative working capital financing policy uses long-term funds to finance non-current assets and permanent current
assets, as well as a proportion of fluctuating current assets.

 This policy is less risky and less profitable than an aggressive working capital financing policy, which uses short-term funds
to finance fluctuating current assets and a proportion of permanent current assets.

 A moderate working capital investment policy is a middle way between the aggressive and conservative approaches, which
uses long-term funds to finance long-term assets (non-current assets and permanent current assets) and short-term funds
to finance short-term assets (fluctuating current assets).

 The current statement of financial position shows that APX Co uses trade payables and an overdraft as short-term finance
and bank loan as long term finance.

 In terms of the balance between ST and LT finance, 89% of current assets (100 x 4·1/4·6) are financed by ST funds and only
11% are funded by LT finance. Since a high proportion of current assets are permanent in nature, APX Co appears to be
adopting a more aggressive approach to finance their working capital.

 The forecast statement of financial position shows a lower reliance on short-term finance, since 79% of current assets (100
x 5·36/6·75) are financed from short-term sources and 21% are financed from long-term sources. This decreased reliance
on an aggressive financing policy is sensible, although with a forecast interest coverage ratio of only 3·7 times (3·469/0·94),
APX Co has little scope for taking on more long-term debt.

 An increase in equity funding to decrease reliance on short-term finance could be considered.

JUNE 2012 Q2 (b)

The similarities and differences between working capital policies in the working capital investment and working capital
financing (9m)

It can be said that both working capital investment policy and working capital financing policy use similar terminology, but they
have differences in terms of their meaning and application.

In term of differences in their meaning and application, working capital investment policy is concerned with the level of
investment in current assets, with one company being compared with another. Working capital financing policy is concerned
with the relative proportions of short-term and long-term finance used by a company.

While working capital investment policy is therefore assessed on an inter-company comparative basis, assessment of working
capital financing policy involves analysis of financial information for one company alone.

Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets.
Working capital investment policy does not require this analysis.
Permanent current assets represent the core level of investment in current assets that supports a given level of business activity.
Fluctuating current assets represent the changes in the level of current assets that arise through, for example, the
unpredictability of business operations, such as the level of trade receivables increasing due to some customers paying late or
the level of inventory increasing due to demand being less than predicted.

Working capital financing policy relies on the matching principle, which is not used by working capital investment policy.
The matching principle holds that long-term assets should be financed from a long-term source of finance. Non-current assets
and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance,
while fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan.

Both working capital investment policy and working capital financing policy use the terms conservative, moderate and
aggressive.

In investment policy, the terms are used to indicate the comparative level of investment in current assets on an inter-company
basis. One company has a more aggressive approach compared to another company if it has a lower level of investment in
current assets, and vice versa for a conservative approach to working capital investment policy.

In working capital financing policy, the terms are used to indicate the way in which fluctuating current assets and permanent
current assets are matched to short-term and long-term finance sources.
An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed
from a short-term finance source.
A conservative financing policy means that permanent current assets and a portion of fluctuating current assets are financed
from a long-term source.

An aggressive financing policy will be more profitable than a conservative financing policy because short-term finance is cheaper
than long-term finance, as indicated for debt finance by the normal yield curve (term structure of interest rates).
However, an aggressive financing policy will be riskier than a conservative financing policy because short-term finance is riskier
than long-term finance.

For example, an overdraft is repayable on demand, while a short-term loan may be renewed on less favourable terms than an
existing loan. Provided interest payments are made, however, long-term debt will not lead to any pressure on a company and
equity finance is permanent capital.
DECEMBER 2008 Q2 (b)

Whether or not the company is overtrading. (10m)

2006 2007
Sales/net working capital 26,720/1,000 =26·7 times 37,400/1,225 =30·5 times
Inventory days (365 x 2,400)/23,781 =37 days (365 x 4,600)/34,408 =49 days
Receivables days (365 x 2,200)/26,720 =30 days (365 x 4,600)/37,400 =45 days
Payables days (365 x 2,000)/23,781 =31 days 365 x 4,750)/34,408 =51 days
Current ratio 4,600/3,600 =1·3 times 9,200/7,975 1·15 times
Quick ratio 2,200/3,600 =0·61 times 4,600/7,975 =0.58 times
Turnover increase 37,400/26,720 =40%
Non-current assets increase 13,632/12,750 =7%
Inventory increase 4,600/2,400 =92%
Receivables increase 4,600/2,200 =109%
Payables increase 4,750/2,000 =138%
Overdraft increase 3,225/1,600 =102%

Overtrading or undercapitalisation arises when a company has insufficient capital to support its level of business activity.
Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due. Overtrading could be analysed using the following ratios

Rapid increase in turnover

Gorwa Co has experienced a 40% increase in turnover over the last year.
However, the investment in working capital has not matched the increase in sales, since the sales/net working capital ratio has
increased from 26·7 times to 30·5 times.

Increase in inventory days (compared with TO)

Inventory days have increased from 37 days to 49 days
Inventory has increased by 92% compared to the 40% increase in turnover.
This indicates that Gorwa Co is taking longer before selling its inventory
It is possible that inventory has been stockpiled in anticipation of a further increase in turnover

Increase in receivable days (compared with TO)

The receivables days has increased from 30 days to 45 days.
In this case, receivables have increased by 109% compared to the 40% increase in turnover.
This means that Gorwa’s receivables are taking longer time to repay the debt than they used to, indicating a lack of credit
control
This has contributed to a weakening of the cash position

Increase in payables days

The trade payables days has increased from 31 days to 50 days
This indicates that Gorwa is taking longer time to repay their debts than they used to
This may be due to fact that Gorwa Co is lacking of cash
Increase reliance on ST finance
The overdraft of Gorwa Co has more than doubled in size to $3·225 million, while trade payables have increased by137%
Both increases are much greater than
the 40% increase in turnover
This could mean that Gorwa Co is facing liquidity problem, and increases its reliance on short-term sources of finance, including
overdraft, trade payables and leasing.
Decreases in the current ratio and the quick ratio
The current ratio of Gorwa Co has fallen from 1·3 times to 1·15 times, while its quick ratio has fallen from 0·61 times to 0·58
times.
This indicates that Gorwa Co’s liabilities has increased and requires a higher amount of capital to settle their short term
obligations
There are therefore clear indications that liquidity has fallen over the period and that Wobnig Co has a weaker liquidity position
than similar companies on an average basis.
However, the current assets of the company do still exceed its current liabilities, so it does not yet have a liquid deficit
Conclusion
From the calculations and financial analysis above, it is clear that Gorwa Co is going through overtrading issue. A more
meaningful and complete analysis could be undertaken if appropriate benchmarks were available.
JUNE 2012 Q2 (a)

Using suitable working capital ratios and analysis of the financial information provided, evaluate whether Wobnig Co can be
described as overtrading (undercapitalised). (12 marks)

2011
Sales/net working capital 14,525/984 = 15 times
Inventory days 365 x 2,149/10,458 = 75 days
Receivables days 365 x 3,200/14,525 = 80 days
Payables days 365 x 2,865/10,458 = 100 days
Net profit margin 100 x 4,067/14,525 = 28%
Current ratio 5,349/4,365 = 1·2 times
Quick ratio 3,200/4,365 = 0·7 times
Net working capital 5,349 – 4,365 = $984,000
2010
10,375/939 = 11 times
365 x 1,092/6,640 = 60 days
365 x 1,734/10,375 = 61 days
365 x 1,637/6,640 = 90 days
100 x 3,735/10,375 = 36%
2,826/1,887 = 1·5 times
1,734/1,887 = 0·9 times
2,826 – 1,887 = $939,000

Overtrading or undercapitalisation arises when a company has insufficient capital to support its level of business activity.
Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due. Overtrading could be analysed using the following ratios

Rapid increase in turnover

Wobnig Co has experienced a 40% increase in turnover over the last year.
However, the investment in working capital has not matched the increase in sales, since the sales/net working capital ratio has
increased from 11 times to 15 times.

Increase in inventory days (compared with TO)

Inventory days have increased from 60 days to 75 days, which are longer than the period for similar companies of 55 days
Inventory has increased by 97% [(2149-1092)/1092] compared to the 40% increase in turnover.
This indicates that Wobnig Co is taking longer before selling its inventory
It is possible that inventory has been stockpiled in anticipation of a further increase in turnover

Increase in receivable days (compared with TO)

The receivables days has increased from 61 days to 80 days, which last year they are close to the value for similar companies of
60 days but they are now 33% [(80-60)/60] more than this
In this case, receivables have increased by 85% [(3200-1734)/1734] compared to the 40% increase in turnover.
This means that Wobnig’s receivables are taking longer time to repay the debt than they used to, indicating a lack of credit
control
It appears that Wobnig Co has offered more generous credit terms to its customers, although another explanation the
receivables are difficulties in settling their debt, such as recession.
This has contributed to a weakening of the cash position
Increase in payables days
The trade payables days has increased from 90 days to 100 days, which are longer than the period for similar companies of 85
days.
This indicates that Gorwa is taking longer time to repay their debts than they used to
This may be due to fact that Gorwa Co is lacking of cash
Increase reliance on ST finance
The overdraft of Wobnig Co has increased by six times to $1.5 million, while trade payables have increased by 75% [(2865-
1637)/1637]
Both increases are much greater than the 40% increase in turnover
This could mean that Wobnig Co is facing liquidity problem, and increases its reliance on short-term sources of finance, including
overdraft and trade payables
Decreases in the current ratio and the quick ratio
The current ratio of Wobnig Co has fallen from 1·5 times to 1·2 times, which are lower than the value for similar companies of
1.7 times, its quick ratio has fallen from 0·9 times to 0·7 times, lower compared to the value for similar companies of 1.1 times
This indicates that Wobnig Co’s liabilities has increased and requires a higher amount of capital to settle their short term
obligations
There are therefore clear indications that liquidity has fallen over the period and that Wobnig Co has a weaker liquidity position
than similar companies on an average basis.
However, the current assets of the company do still exceed its current liabilities, so it does not yet have a liquid deficit

Conclusion
From the calculations and financial analysis above, it is clear that Gorwa Co is going through overtrading issue. A more
meaningful and complete analysis could be undertaken if appropriate benchmarks were available.
MARCH/JUNE 2016 Q1

Evaluate whether Crago can be considered to be overtrading and discuss how overtrading can be overcome (10m)
20X5 20X4 Sector
Sales/net working capital 17,100/200 =86 times 12,000/1,000 =12 times
Inventory days 360 x 2,500/8,550 =105 days 360 x 2,100/7,500 =101 days 65 days
Trade receivable days 360 x 2,000/17,100 =42 days 360 x 1,000/12,000 =30 days 30 days
Trade payables days 360 x 1,900/8,550 =80 days 360 x 1,250/7,500 =60 days 50 days
Current ratio 4,500/4,300 =1·05 times 3,100/2,100 =1·5 times 1·7 times
Quick ratio 2,000/4,300 =0·5 times 1,000/2,100 =0·5 times 0·8 times

Overtrading or undercapitalisation arises when a company has insufficient capital to support its level of business activity.
Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall
due. Overtrading could be analysed using the following ratios

Rapid increase in turnover

Crago has experienced a 42.5% (17,100/12,000) increase in turnover over the last year.
However, the investment in working capital has not matched the increase in sales, since the sales/net working capital ratio has
increased from 12 times to 86 times.

Reduction in inventory days (compared with TO)

Inventory days have slightly increased from 101 days to 105 days, which are longer than the period for sector average of 55 days
Inventory has only increased by 19% [(2,500-2100)/2,100] which is smaller compared to the 42.5% increase in turnover.
This indicates that Crago is taking longer before selling its inventory compared to the last year’s and sector’s average

Reduction in receivable days (compared with TO)

The receivables days has increased from 30 days to 42 days, which last year they are close to the value for similar companies of
30 days but they are now 40% [(42-30)/30] more than this
In this case, receivables have increased by 100% [(2,000-1000)/1,000] compared to the 42.5% increase in turnover.
This means that Crago’s receivables are taking longer time to repay the debt than they used to, indicating a lack of credit control
It appears that Crago has offered more generous credit terms to its customers, although another explanation the receivables are
difficulties in settling their debt, such as recession.
This has contributed to a weakening of the cash position

Increase in payables days

The trade payables days has increased from 60 days to 80 days, which are longer than the period for sector average of 50 days.
This indicates that Crago is taking longer time to repay their debts than they used to
This may be due to fact that Crago is lacking of cash

Increase reliance on ST finance

The overdraft of Crago has increased by 182% [(2,400-850)/850] to $2.4 million, while trade payables have increased by 52%
[(1,900-1250)/1,250]
Both increases are much greater than the 40% increase in turnover
This could mean that Crago is facing liquidity problem, and increases its reliance on short-term sources of finance, including
overdraft and trade payables

Decreases in the current ratio and the quick ratio

The current ratio of Crago has fallen from 1·5 times to 1·05 times, which are lower than the value for similar companies of 1.7
times, its quick ratio maintained the same at 0.5 but lower compared to the value for similar companies of 0.8 times
This indicates that Crago’s liabilities has increased and requires a higher amount of capital to settle their short term obligations
There are therefore clear indications that liquidity has fallen over the period and that Crago has a weaker liquidity position than
similar companies on an average basis.
However, the current assets of the company do still exceed its current liabilities, so it does not yet have a liquid deficit

Conclusion
From the calculations and financial analysis above, it is clear that Gorwa Co is going through overtrading issue. A more
meaningful and complete analysis could be undertaken if appropriate benchmarks were available.

Overcoming overtrading
Overtrading or undercapitalisation can be overcome by increasing the long-term capital of a company.
This could be achieved by Crago raising either new debt finance or new equity finance.
Alternatively, the balance between the level of business activity and the amount of long-term finance could be restored, for
example, by calling a halt to the rapid expansion of sales until Crago Co has consolidated its financial position
JUNE 2012 Q2 (c)

How Miller-Orr model would be used to manage the cash balances (2m)

The Miller-Orr model provides decision rules about when to invest surplus cash (if a cash balance increases to a high level),
and about when to sell short-term investments (if a cash balance falls to a low level).

By using these decision rules, the cash balance is kept between the upper and lower limits set by the Miller-Orr model.

When the cash balance reaches the upper limit, $50,000 is invested in short-term securities. This is equal to the upper limit
minus the return point ($275,000 –$225,000).

When the cash balance falls to the lower limit, short-term securities worth $25,000 are sold for cash. This is equal to the return
point minus the lower limit ($225,000 – $200,000)

DECEMBER 2012 (c)

The factors to be considered in determining the optimum level of cash to be held by a company (5m)

The transactions need for cash

 The amount of cash needed for the next period can be forecast using a cash budget, which will net off expected
receipts against expected payments.
 This will determine the transactions need for cash, which is one of the three reasons for holding cash.

The precautionary need for cash

 An estimate of the transactions need for cash will be based on assumptions about the future and will therefore be
subject to uncertainty.
 The company a need to maintain a cash buffer for unforeseen contingencies or any unexpected need for cash
 The is because actual need for cash may be greater than the forecast need for cash.
 This is the precautionary need for cash.
 In determining the optimal level of cash to be held, a company will estimate the size of this cash buffer, for example
from past experience, because it will be keen to minimise the opportunity cost of maintaining funds in cash form.

The speculative need for cash

 There is always the possibility of an unexpected opportunity occurring in the business world and a company may wish
to be
 prepared to take advantage of such a business opportunity if it arises.
 It may therefore wish to have some cash available for this purpose.
 This is the speculative need for cash.

The availability of finance

 A company may choose to hold higher levels of cash if it has difficulty gaining access to cash when it needs it.
 For example, if a company’s bank makes it difficult to access overdraft finance, or if a company is refused an overdraft
facility, its precautionary need for cash will increase and its optimum cash level will therefore also increase

DECEMBER 2014 Q1 (c)

Whether a short-term cash surplus during the three-month period should be invested in shares listed on a large stock market
(3m)

 If the company generates a short-term cash surplus, the cash may be needed again in the near future.
 In order to increase profitability, the short-term cash surplus could be invested, for example, in a bank deposit
 However, the investment selected would normally not be expected to carry any risk of capital loss.
 Shares traded on a large stock market carry a significant risk of capital loss, and hence are rarely suitable for investing
short-term cash surpluses.
DECEMBER 2010 Q3 (b)

The benefits of a just-in-time (JIT) procurement policy (5m)

Reduce holding costs

If a company adopt JIT, they will order supplies only when it needs them, reducing the level of inventory held by a company,
therefore holding costs could be reduced to a minimum.

Lower level of investment in WC

Since inventory levels have been minimised, lower level of investment in working capital is needed.

Improve relationship with suppliers

Since high demands will be placed on suppliers to deliver on time and with 100% quality, the relationships with suppliers will be
closed and improved

Improve operating and production process

In order for the JIT system to function effectively, improvements of operating efficiency and production process will be required
to make sure inventory between different stages of the production process is eliminated

Improve labour productivity

Improved labour productivity and lower reworking costs should result from a smoother flow of materials through the process
due to the increased emphasis on the quality of supplies

Reduce materials handling costs

Due to improved materials flow through the production process, there will be a reduction in materials handling costs
JUNE 2008 Q3 (b) / DECEMBER 2013 Q3 (b)

The ways in which factoring and invoice discounting can assist in the management of accounts receivable (6m)

Factoring (4-5m)

 Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money it is
due to collect
 This involves a company turning over administration of its invoicing, sales accounting and debt collection servicer to a
factor.
 The factor will assess the creditworthiness of new customers, record sales, send out statements and reminders, collect
payment, identify late payers and chase them for settlement, and take appropriate legal action to recover debts where
necessary.
 The factor will also offer finance to a company based on invoices raised, usually up to 80% of the face value of invoices
raised.
 The finance is repaid from the settled invoices, with the balance being passed to the issuing company after deduction of a
fee equivalent to an interest charge on cash advanced
 If factoring is without recourse, it offers credit protection for the client's debts, whereby the factor takes over the risk o
loss from bad debts.
 However, if a non-recourse service is provided, the factor, not the firm, will decide what action to take against non-payers

Invoice discounting (1-2m)

 Invoice discounting is the purchase (by the provider of the discounting service) of trade debts at a discount.
 The invoice discounter does not take over the administration of the client's sales ledger
 This enables the company from which the debts are purchased to raise finance, where the invoice discounter will offer to
purchase selected invoices and advance up to 75% of their value.
 At the end of each month, the factor will pay over the balance of the purchase price, less charges, on the invoices that have
been settled in the month
 The client's customer will only become aware of the arrangement if they do not pay their debt to the client.

DECEMBER 2010 Q3 (d)

The factors that should be considered in formulating working capital policy on the management of trade receivables (8m)

The level of investment in trade receivables

If the amount of finance tied up in trade receivables is substantial, receivables management policy may be formulated with the
intention of reducing the level of investment by tighter control over the way in which credit is granted and improved methods of
assessing client creditworthiness.

The cost of financing trade credit

If the cost of financing trade credit is high, there will be pressure to reduce the amount of credit offered and to reduce the
period for which credit is offered.

The terms of trade offered by competitors

In order to compete effectively, a company will need to match the terms offered by its competitors, otherwise customers will
migrate to competitors, unless there are other factors that will encourage them to be loyal, such as better quality products or a
more valuable after-sales service.

The level of risk acceptable to the company

Some companies may feel that more relaxed trade credit terms will increase the volume of business to an extent that
compensates for a higher risk of bad debts. The level of risk of bad debts that is acceptable will vary from company to company.
Some companies may seek to reduce this risk through a policy of insuring against non-payment by clients.

The need for liquidity

Where the need for liquidity is relatively high, a company may choose to accelerate cash inflow from credit customers by using
invoice discounting or by factoring.

The expertise available within the company

Where expertise in the assessment of creditworthiness and the monitoring of customer accounts is not to a sufficiently high
standard, a company may choose to outsource its receivables management to a third party, i.e. a factor.
JUNE 2013 Q3 (b)

Discuss the key elements of a trade receivables management policy (7m)

The key elements of a trade receivables policy are credit analysis, credit control and receivables collection.

Credit analysis

 The main objective of credit analysis is to ensure that credit is granted to customers who will settle their debt in
accordance with the agreed terms of sale.
 Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to a
customer’s financial history.
 In order to do this, the company needs information, which can come from a variety of sources, such as trade references,
bank references, credit reference agencies, published accounts and so on.
 As a result of assessing the creditworthiness of customers, a company can decide on the amount of credit to offer, the
credit terms to offer, or whether to not offer credit at all
 Credit analysis helps a company to minimise the possibility of bad debts by offering credit only to customers who are likely
to settle their debt.
 Credit analysis also helps a company to minimise the likelihood of customers paying late, causing the company to incur
additional costs on the money owed, by indicating which customers are likely to settle their accounts as they fall due.
.
Credit control

 This is to ensure that the terms under which credit was granted are being followed by customers
 It is important that customers settle outstanding accounts on time and keep to agreed credit limits.
 It would be useful for the company to prepare an aged receivables analysis at intervals to check the number of overdue
accounts and the amount of outstanding cash.
 The management could focus on areas where action needs to be taken to encourage payment by client.
 The customers need to be made aware of the amounts outstanding on their accounts and reminded when payment is due.
 This can be done by providing regular statements of account and by sending reminders letters when payment is due

Receivables collection

 The objective here is to ensure timely and secure payment when they are due
 Overdue accounts must be followed up in order to assess the likelihood of payment and to determine what further action
is needed
 Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for
ensuring that these procedures are followed.
 Legal action should only be considered as a last resort, in order to recover the outstanding amounts, since it often
represents the termination of the business relationship with a customer.
PILOT PAPER Q3 (c)

The key areas of accounts receivable management (6m)

There are four key areas of accounts receivable management: policy formulation, credit analysis, credit control and collection
of amounts due.

Policy formulation

 This is concerned with establishing the framework within which management of accounts receivable in an individual
company takes place.
 The elements to be considered include establishing terms of trade, such as period of credit offered and early settlement
discounts
 This consider the decision on whether to charge interest on overdue accounts; determining procedures to be followed
when granting credit to new customers; establishing procedures to be followed when accounts become overdue, and so
on.

Credit analysis

 The main objective of credit analysis is to ensure that credit is granted to customers who will settle their debt in
accordance with the agreed terms of sale.
 Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to a
customer’s financial history.
 In order to do this, the company needs information, which can come from a variety of sources, such as trade references,
bank references, credit reference agencies, published accounts and so on.
 As a result of assessing the creditworthiness of customers, a company can decide on the amount of credit to offer, the
credit terms to offer, or whether to not offer credit at all
 Credit analysis helps a company to minimise the possibility of bad debts by offering credit only to customers who are likely
to settle their debt.
 Credit analysis also helps a company to minimise the likelihood of customers paying late, causing the company to incur
additional costs on the money owed, by indicating which customers are likely to settle their accounts as they fall due.

Credit control

 This is to ensure that the terms under which credit was granted are being followed by customers
 It is important that customers settle outstanding accounts on time and keep to agreed credit limits.
 It would be useful for the company to prepare an aged receivables analysis at intervals to check the number of overdue
accounts and the amount of outstanding cash.
 The management could focus on areas where action needs to be taken to encourage payment by client.
 The customers need to be made aware of the amounts outstanding on their accounts and reminded when payment is due.
 This can be done by providing regular statements of account and by sending reminders letters when payment is due

Receivables collection

 The objective here is to ensure timely and secure payment when they are due
 Overdue accounts must be followed up in order to assess the likelihood of payment and to determine what further action
is needed
 Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for
ensuring that these procedures are followed.
 Taking legal action or employing a specialised debt collection agency should only be considered as a last resort, in order to
recover the outstanding amounts, since it often represents the termination of the business relationship with a customer
 The costs involved here is important, as the costs incurred should never exceed the benefit of collecting the overdue
amount.
SEPTEMBER 2016 Q31 (c)

How Nesud Co could improve the management of its trade receivables (10m)

Nesud Co could use many techniques in managing trade receivables, by doing credit analysis, credit control, collecting amount
due, offering early settlement discounts and using factoring and invoice discounting

Credit analysis

 Nesud Co can seek to reduce its exposure to risk of bad debt or late payment by doing credit analysis offering credit only to
customers who will settle their debt in accordance with the agreed terms of sale.
 Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to a
customer’s financial history.
 In order to do this, Nesud Co needs information, which can come from a variety of sources, such as trade references, bank
references, credit reference agencies, published accounts and so on.
 Credit analysis also helps Nesud Co to minimise the likelihood of customers paying late, causing the company to incur
additional costs on the money owed, by indicating which customers are likely to settle their accounts as they fall due.

Credit control

 Nesud Co needs to make sure that its credit customers follow the terms of trade agreed under which credit was granted
 It is important that customers settle outstanding accounts on time and keep to agreed credit limits.
 It would be useful for Nesud Co to prepare an aged receivables analysis at intervals to check the number of overdue
accounts and the amount of outstanding cash.
 The management could focus on areas where action needs to be taken to encourage payment by client.
 The customers need to be made aware of the amounts outstanding on their accounts and reminded when payment is due.
 This can be done by providing regular statements of account and by sending reminders letters when payment is due

Receivables collection

 Nesud Co must ensure its receivable are able to make timely and secure payment when they are due
 Overdue accounts must be followed up in order to assess the likelihood of payment and to determine what further action
is needed
 Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for
ensuring that these procedures are followed.
 Taking legal action or employing a specialised debt collection agency should only be considered as a last resort, in order to
recover the outstanding amounts, since it often represents the termination of the business relationship with a customer

Early settlement discount

 Nesud Co could encourage its credit customers to settle outstanding amount by offering early settlement discount.
 This will offer a reduction in the outstanding amount (the discount) in exchange for settlement before the due date
 This may shorten average credit periods and reduce the investment in accounts receivable and therefore reduced interest
costs of the finance invested in trade receivables.
 However, Nesud Co must weigh the benefit in cost saved against the cost expected to arise from the discounts allowed.

Using factoring or invoice discounting

 Nesud Co might use a factor to help manage its accounts receivable, either on a recourse or non-recourse basis.
 The factor could offer assistance in credit assessment, managing accounts receivable and collecting amounts owing.
 For a fee, the factor could advance a percentage of the face value of outstanding invoices.
 Invoice discounting is a service whereby a third party, usually a factor, pays a percentage of the face value of a collection of
high value invoices.
 When the invoices are settled, the outstanding balance is paid to the company, less the invoice discounter’s fee
MARCH/JUNE 2017 Q31 (b)

Discuss FIVE techniques that Pangli Co could use in managing trade receivables (10m)

Pangli Co could use many techniques in managing trade receivables, by doing credit analysis, credit control, collecting amount
due, offering early settlement discounts and using factoring and invoice discounting

Credit analysis

 Pangli Co can seek to reduce its exposure to risk of bad debt or late payment by doing credit analysis offering credit only to
customers who will settle their debt in accordance with the agreed terms of sale.
 Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to a
customer’s financial history.
 In order to do this, Pangli Co needs information, which can come from a variety of sources, such as trade references, bank
references, credit reference agencies, published accounts and so on.
 Credit analysis also helps Pangli Co to minimise the likelihood of customers paying late, causing the company to incur
additional costs on the money owed, by indicating which customers are likely to settle their accounts as they fall due.

Credit control

 Pangli Co needs to make sure that its credit customers follow the terms of trade agreed under which credit was granted
 It is important that customers settle outstanding accounts on time and keep to agreed credit limits.
 It would be useful for Pangli Co to prepare an aged receivables analysis at intervals to check the number of overdue
accounts and the amount of outstanding cash.
 The management could focus on areas where action needs to be taken to encourage payment by client.
 The customers need to be made aware of the amounts outstanding on their accounts and reminded when payment is due.
 This can be done by providing regular statements of account and by sending reminders letters when payment is due

Receivables collection

 Pangli Co must ensure its receivable are able to make timely and secure payment when they are due
 Overdue accounts must be followed up in order to assess the likelihood of payment and to determine what further action
is needed
 Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for
ensuring that these procedures are followed.
 Taking legal action or employing a specialised debt collection agency should only be considered as a last resort, in order to
recover the outstanding amounts, since it often represents the termination of the business relationship with a customer

Early settlement discount

 Pangli Co could encourage its credit customers to settle outstanding amount by offering early settlement discount.
 This will offer a reduction in the outstanding amount (the discount) in exchange for settlement before the due date
 This may shorten average credit periods and reduce the investment in accounts receivable and therefore reduced interest
costs of the finance invested in trade receivables.
 However, Pangli Co must weigh the benefit in cost saved against the cost expected to arise from the discounts allowed.

Using factoring or invoice discounting

 Pangli Co might use a factor to help manage its accounts receivable, either on a recourse or non-recourse basis.
 The factor could offer assistance in credit assessment, managing accounts receivable and collecting amounts owing.
 For a fee, the factor could advance a percentage of the face value of outstanding invoices.
 Invoice discounting is a service whereby a third party, usually a factor, pays a percentage of the face value of a collection of
high value invoices.
 When the invoices are settled, the outstanding balance is paid to the company, less the invoice discounter’s fee.
JUNE 2010 Q1 (b) / DECEMBER 2012 (d)

Discuss the factors to be considered in formulating a trade receivables management policy (8m)

The factors to be considered in formulating trade receivables management policy will relate to the key areas of credit
assessment or analysis, credit control and collection procedures.

Credit analysis

 The main objective of credit analysis is to ensure that credit is granted to customers who will settle their account in
accordance with the agreed terms of sale.
 In offering credit, a company must consider the factor it will be exposed to the risk of late payment and the risk of bad
debts.
 To reduce these risk, the company need to do credit analysis, or the assessment of creditworthiness, which is undertaken
by analysing and evaluating information relating to a customer’s financial history.
 In order to do this, the company needs information, which can come from a variety of sources, such as trade references,
bank references, credit reference agencies, published accounts and so on.
 As a result of assessing the creditworthiness of customers, a company can decide on the amount of credit to offer, the
credit terms to offer, or whether to not offer credit at all.

Credit control

 This is to ensure that the terms under which credit was granted are followed by customers
 It is important that customers settle outstanding accounts on time and keep to agreed credit limits.
 Factors to consider here are, therefore, the number of overdue accounts and the amount of outstanding cash.
 This information can be provided by preparing an aged receivables analysis at intervals.
 Another factor to consider is that customers need to be made aware of the amounts outstanding on their accounts and
reminded when payment is due.
 This can be done by providing regular statements of account and by sending reminder letters when payment is due.

Collection procedures

 The objective here is to ensure timely and secure payment when they are due
 Overdue accounts must be followed up in order to assess the likelihood of payment and to determine what further action
is needed
 Procedures for chasing late payers should be clearly formulated and trained personnel must be made responsible for
ensuring that these procedures are followed.
 Legal action should only be considered as a last resort, in order to recover the outstanding amounts, since it often
represents the termination of the business relationship with a customer.
 A key factor to consider here is that the benefit gained from chasing overdue amounts must not exceed the costs incurred.

JUNE 2015 Q3 (b)

How the creditworthiness of potential customers can be assessed (3m)

The creditworthiness of potential customers can be assessed by analysing and evaluating information relating to a customer’s
financial history. The information could be obtained from various sources

References
Potential customers should supply a bank reference and a trade or other reference when seeking credit on purchases.

Credit rating
The company should check the credit rating of the potential customer, which can be checked by a credit rating agency or credit
reference agency.

Maintain file of financial information

For large value customers, a file should be maintained of any available financial information about the customer. This file should
be reviewed regularly. Information is available from the company's annual report and accounts.
JUNE 2009 Q3 (c) / SEPTEMBER/MARCH Q3 (b)

Two ways to reduce the risk associated with foreign accounts receivable (4m)
How risks arising from granting credit to foreign customers can be managed and reduced (8m)

A company could reduce the risk associated with foreign accounts receivable by

Export credit insurance

The risk could be reduced by arranging an export credit insurance.
Export credit insurance give the company the conditional assurance that payment will be made if the foreign buyer is unable to
pay. In other word, it protects the company against the risk of non-payment by a foreign buyer for export debts.

Creditworthiness assessment
The risk of foreign accounts receivable becoming bad debts can be reduced by performing the same creditworthiness
assessment processes on foreign credit customers as those used with domestic credit customers, such as seeking credit
references and bank references.

Documentary credit
The risk of non-payment by foreign accounts receivable can be reduced by raising a documentary credit (international letter of
credit) linked to the contract for the sale of goods. This gives the company a secure risk-free method of obtaining payment. It
could be guaranteed by a bank in the foreign customer’s country.

Forfaiting
Forfaiting is a method of export finance whereby a bank purchases from a company a number of sales invoices, usually obtaining
a guarantee of payment of the invoices. The forfeiter buys the foreign accounts receivable from a seller at a discount and takes
on all of the credit risk from the transaction (without recourse).

Advances against collections

This is where the exporter asks their bank to handle the collection of payment (of a bill of exchange or a cheque) on their behalf,
the bank may be prepared to make an advance of up to 80% to 90% of the value of the collection to the exporter.
DEC 2007 Q4 (c)

The ways in which PKA Co could improve the management of domestic accounts receivable (7m)

Reducing bad debts

 The bad debts had increased from 5% to 8% of credit sales in the last year
 This bad debt can be reduced by assessing the creditworthiness of new customers before offering them credit and
introduce a policy detailing how this should be done, or review its existing policy, if it has one, since it is clearly not working
very well.
 In order to do this, information about the solvency, character and credit history of new clients is needed.
 This information can come from a variety of sources, such as bank references, trade references and credit reports from
credit reference agencies.
 Whether credit is offered to the new customer and the terms of the credit offered can then be based on an explicit and
informed assessment of default risk.

Reduction of average accounts receivable period

 Customers have taken an average of 75 days credit over the last year rather than the 30 days offered by PKA Co, i.e. more
than twice the agreed credit period.
 As a result, PKA Co will be incurring a substantial opportunity cost, either from the additional interest cost on the short-
term financing of accounts receivable or from the incremental profit lost by not investing the additional finance tied up by
the longer average accounts receivable period.
 PKA Co needs to find ways to encourage accounts receivable to be settled closer to the agreed date.
 PKA Co could take the initiative by introducing more favourable early settlement terms and perhaps reducing the average
accounts receivable period.