Other Ratios (Cambridge International A-Level Accounting)

Working capital cycle

Spec point — how to calculate the following ratios: – working capital cycle (in days)

Working capital cycle

What is the working capital cycle?

• You need to remember the formulas for the efficiency ratios

  • Trade receivables turnover

    • $\frac{\mathrm{Trade} \mathrm{receivables}}{\mathrm{Credit} \mathrm{sales}}\times365$

  • Inventory turnover

    • $\frac{\mathrm{Average} \mathrm{inventory}}{\mathrm{Cost} \mathrm{of} \mathrm{sales}}\times365$

  • Trade payables turnover

    • $\frac{\mathrm{Trade} \mathrm{payables}}{\mathrm{Credit} \mathrm{purchases}}\times365$

How do I interpret the value?

• If the working capital cycle is shorter

  • The cash is tied up in assets for less time
  • This means it is more efficient and results in better liquidity

• If the working capital cycle is longer

  • There might be a need for additional financing to fund the working capital
  • There is a greater risk of cash flow problems

• The working capital cycle can be negative

  • For example, retail businesses sell goods for cash before paying suppliers

• Manufacturing businesses have a higher working capital cycle because the cycle starts when the raw material is purchased

How can the working capital cycle be improved?

• Reduce the amount of inventory that the business holds

  • However, low inventory risks lost sales if the goods are unavailable when needed by customers

• Collect money from customers quicker

  • However, giving customers tighter credit terms could cause them to use a different supplier

• Pay suppliers later

  • However, this could damage supplier relationships or result in late payment penalties

Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.

	$
Sales	40 000
Purchases	25 000
Inventory at 1 March 2023	7 000
Inventory at 29 February 2024	9 000
Trade receivables	11 000
Trade payables	4 000

All sales and purchases were made on a credit basis.

Calculate the working capital cycle at 29 February 2024. Round up your answer to the next whole day.

Answer:

• Calculate the average inventory

  • $\frac{\mathrm{Opening} \mathrm{inventory}+\mathrm{Closing} \mathrm{inventory}}{2}$

\frac{\ 7 000 + $ 9 000}{2} = $ 8 000$

• Calculate the cost of sales

  • Opening inventory + Purchases - Closing inventory

$7 000 + $25 000 - $9 000 = $23 000

• Calculate the required ratios

Ratio		Days
Trade receivables turnover	$\frac{11000}{40000}\times365=100.375$	101
Inventory turnover	$\frac{8000}{23000}\times365=126.95...$	127
Trade payables turnover	$\frac{4000}{25000}\times365=58.4$	59

• Calculate the working capital cycle

  • $Trade \text{receivables} \text{turnover} ( \text{days} ) + \text{inventory} \text{turnover} ( \text{days} ) > - \text{trade} \text{payables} \text{turnover} ( \text{days} )$

$101+127-59=169$

Final answer: 169 days

Net working assets to revenue (sales)

Spec point — how to calculate the following ratios: – net working assets to revenue (sales)

Net working assets to revenue (sales)

What is the net working assets to revenue ratio?

• The ratio measures how efficiently a business uses its net current assets (excluding cash) relative to its sales

  • A lower percentage is more efficient because less working capital is needed per dollar of revenue
  • A higher percentage suggests that more working capital is tied up relative to sales

Exam Hint Actions to improve the net working assets to revenue ratio also improve the working capital cycle.

Should I use the year end or average figures?

• The question will tell you which figures to use

• Average figures tend to be more representative of the performance

  • Sales take place during the year, not just at the end

• However, averages can distort the perception because changes do not take place evenly throughout the year

• The business needs to be consistent

  • If they used the year end figures, then they should continue using year end figures in subsequent years

Worked Example Omatola runs a small business by herself. She provides the following information for the year ended 29 February 2024.

	$
Sales	40 000
Purchases	25 000
Inventory at 1 March 2023	7 000
Inventory at 29 February 2024	9 000
Trade receivables	11 000
Trade payables	4 000

All sales and purchases were made on a credit basis.

Calculate the net working assets to revenue ratio for 29 February 2024 using year end balances.

Answer:

• Calculate the net working assets

$9 000 + $11 000 - $4 000 = $16 000

• Calculate the net working assets to revenue ratio

  • $\frac{Net \text{working} assets}{Revenue ( \text{sales} )} \times 100$

$\frac{16 000}{40 000} \times 100 = 40 \%$

Final answer: 40%