F1 7.05 Use of Resources Ratios: Working Capital

In this session we shall start to look at Use of Resources Ratios. We shall consider what they try to measure and then go through the following ratios:

• Inventory turnover
• The Working Capital Cycle which combines the following
  • The Inventory Holding Period (days) ratio;
  • The Trade Receivables Collection Period (days) ratio; and
  • The Trade Payables Payment Period (days) ratio

Use of Resources Ratios

Use of resources ratios provide information on how efficiently a business uses its assets. In this session we shall focus on those relating to a business’ working capital and in the next session we shall look at those relating to other assets.

Working Capital

Working capital is the net current assets of a business; that is, its current assets less its current liabilities.

Good working capital management is important for any business. Too little working capital can lead to cash flow problems and poor liquidity, whilst too much working capital can hide inefficiencies and indicate poor management.

Inventory Turnover

Inventory turnover calculates how many times a business uses up or sells its inventory in a year. It is a measure of how well a business manages its inventories and is presented as a number of times.

The formula is shown below.

Illustration

A company’s financial statements are shown below.

To calculate Inventory Turnover we will use the Cost of Sales (£8,610) from the Statement of Profit or Loss and the Inventory (£1,190) from the Statement of Financial Position.

Inventory Turnover: 8,610/1,190 = 7.24 times

Evaluating Inventory Turnover

Generally, an inventory turnover that is higher than its comparator is good as it means that the business is selling or using its inventories more quickly and has less money tied up in this asset. Remember that it costs money to hold inventory, a suitable holding space is required and it costs money to raise the funds required to buy them.

There are circumstances however where a high inventory turnover could indicate that the business is holding too little inventory and may lose sales, or incur delays in its production processes, due to stock-outs.

The Working Capital Cycle

The working capital cycle attempts to calculate the amount of time that cash is tied up in buying and selling goods. A business might for example, purchase an item of inventory which is then held until it is sold. The business might take a period of credit from its supplier but also might have to offer its customer a period of credit before it pays the business. The working capital cycle is therefore based on:

• The amount of time the inventory is held by the business
• The amount of time the customer takes before paying the business
• The amount of time the business takes before paying its supplier

In order to calculate the working capital cycle we must calculate and then combine three other separate ratios.

The formulas used to calculate the separate ratios are shown below.

All of these ratios are presented as a number of days and whilst these are often shown to the nearest day, they can also be shown to a number of decimal places.

Illustration

We will use the same example as used above for calculating Inventory Turnover

The Inventory Holding Period (days) ratio uses the Cost of Sales from the Statement of Profit or Loss and Inventory from the Statement of Financial Position.

Inventory Holding Period (days): 1,190/8,610 x 365 = 50.45 days

The Trade Receivables Collection Period (days) ratio uses Revenue from the Statement of Profit or Loss and Trade Receivables from the Statement of Financial Position.

Trade Receivables Collection Period (days): 1,380/15,030 x 365 = 33.51 days

The Trade Payables Payment Period (days) ratio uses Cost of Sales from the Statement of Profit or Loss and the Trade Payables from the Statement of Financial Position.

Trade Payables Payment Period (days): 1,260/8,610 = 53.41 days

The Working Capital Cycle can now be calculated using the above ratios.

Working Capital Cycle: 50.45 + 33.51 – 53.41 = 30.55 days

Evaluating the ratios

Negative working capital cycles

It is possible for some types of businesses to have a negative working capital cycle. A supermarket, for example, is likely to have a short-inventory holding period (as most of inventories will be sold within a few days), its trade receivables collection period is almost non-existent (since its customers pay for their goods at the point of sale) but its trade payables payment period might be relatively long (as supermarkets are often in a powerful position from which to negotiate payment terms with suppliers).

Working Capital Cycle: reasons for change

The working capital cycle will be affected by any changes that affect its constituent ratios. Examples of reasons why these may change are shown below.

Formulae variations

It is quite common for the above ratios for inventory holding period, trade receivables collection period and trade payables payment period to be calculated using slightly different formulae.

For example, some accountants will use an average of the inventories, trade receivables and trade payables at the start and end of the year rather than use the year-end figures. This is done in order to reduce the risk that short-term fluctuations in the year-end figures will affect the ratios.

Other variations would include using sales made on credit rather than total sales when calculate the trade receivables collection period (thought this information is generally unavailable to external stakeholders) and using purchases rather than cost of sales when calculating the trade payables payment period.

The ratios covered above are however, widely used and are consistent with those examined by the AAT.

Question 1

A company’s statement of profit or loss and statement of financial position are shown below.