The length of the cash operating cycle indicates that there will be 70 days between Topple Co receiving cash from sales and paying cash to suppliers. This is significantly longer than the industry average of 29 days (53 + 23 – 47) and likely to lead to liquidity problems, as evidenced by the size of the overdraft.
Topple Co expects to take approximately the same credit period from its suppliers as is taken by its own customers, whereas the industry norm is to take a significantly longer credit period from suppliers (47 days) than is taken by customers (23 days). Therefore, slow inventory turnover is the main cause of Topple Co’s long working capital cycle. This may be inevitable in the first year of trading but is it important that systems are implemented to ensure efficient inventory management. The extent of future reductions in inventory days may be limited by the nature of the business as the industry average is 53 days.
It is perhaps unsurprising that Topple Co’s receivables days is also above the industry average as the firm may have been forced to offer generous terms of trade in order to attract customers away from its more established competitors, In addition Topple Co may still be in the process of establishing and implementing credit control procedures.
On the other hand Topple Co is paying its own suppliers much more quickly than the industry norm. Although this puts pressure on liquidity, Topple Co may be taking advantage of settlement discounts offered by suppliers or, as a new firm without an established trading history, it may simply not be offered extended credit periods by suppliers.
The above comparisons to sector data must be treated with caution as working capital management may be poor across the sector, leading to benchmarks which Topple Co should not endeavour to replicate. As a long-term target Topple Co should benchmark its performance against the leader in the sector.
The current ratio indicates that, over the year, there will be $1.10 of current assets per $1 of current liabilities, which does not compare favourably with the industry average of 1.43 and may not be sufficient as Topple Co’s inventory appears to be slow moving. More relevant, therefore, is the quick ratio which indicates only $0.42 of liquid assets per $1 of current liabilities, although no industry average data is available to benchmark this figure.
The overdraft would need to be continuously monitored to ensure it remains within any agreed limit, and contingency plans put into place for refinancing. However if Topple Co is started up with an appropriate level of long-term finance then an overdraft may be avoided entirely.
Each $1 invested in working capital is expected to generate $6.30 of revenue. Although this may not appear to be a particularly efficient use of resources, the first year’s trading may not be representative. Once Topple Co becomes more established it should benchmark its sales to working capital ratio against sector data if available.
Conclusion
This article has covered the foundations of working capital management, focusing on the analysis of current assets and current liabilities. The Financial Management syllabus also demands detailed knowledge of specific models and techniques for each component of working capital – cash, inventory, receivables and payables – and a well-prepared candidate must also be competent in using these.
References:
PwC Global Working Capital Survey 2015
Mike Ashworth, a subject matter expert in financial management