It is paramount that companies manage their current assets very well so that they can cover maturing short term obligations as well as long term liabilities. This is where the concept of Working Capital Management comes about. The aim is to ensure that the company continues to operate by having adequate resources to settle operating expenses as well as maturing obligations. Working Capital Management includes management of cash, payables, debtors and inventories (Bhattacharya, 2004)To determine the working capital position of the company, ratios can be used.
These ratios include; liquidity, efficiency, profitability, etc. Liquidity ratios show the ability of the company to meet maturing and long term obligations. Efficiency ratios indicate how the company utilizes the assets at its disposal while profitability ratios indicate how the company uses its assets to generate sales.
1. Liquidity ratioCurrent ratio = current assets =$921,000Current liabilities $457,000 =2:1Quick ratio= current assets-inventory =$(921,000-491,000)Current liabilities $457,000 =0.9:1Receivable ratio=sales =$2,035,000 =4.
9Debtors $413,000Average collection period= 365 =365 =74 daysReceivables turnover 4 .92. Efficiency ratiosTotal assets turn over=cost of sales =$1,428,000Total assets $1,590,000 =0.9Inventory turnover = cost of sales =$1,428,000Inventory $491,000 =3timesPayables turnover = cost of sales =$1,428,000Accounts payable $205,000 =7 times3.
Profitability ratiosGross profit ratio=gross profit =$607,000Net sales $2,035,000 =29.83%Net profit ratio=net profit =$85,000Net sales $2,035,000 =4.18% Ratio analysisAll of Reed’s Clothiers liquidity ratios are worse off compared to the industry’s ratios. This shows that the company’s working management is unfavorable.
The efficiency ratios, total assets turnover, inventory turnover, payable turnover are all less than the industry averages. This indicates that the company generates fewer sales for every dollar of assets held by the company. Inventory turnover means that the company’s goods are turned into cash very few times in the year. The receivables also form the bulk of the sales of the company which is higher than the industry averages (Bhattacharya, 2004)Profitability ratios indicates how the company cost containment strategies work. Low profitability may indicate that the costs are out of control hence the low profitability. Reed’s clothiers’ gross profit and net profit ratios are less than the industry averages. This earns that reed’s clothiers earns lower profit for every shilling of sales (Bhattacharya, 2004)Question 2Although it is desirable that a company should have more assets to pay off maturing obligations, a balance has to be struck between holding too much or too little inventory.
Therefore, working capital management is really a balancing act. Despite the fact that Reed’s clothier’s liquidity ratios are lower than the industry averages; this is as a result of high amount of obligations. An inventory sale is aimed at realizing cash that can be used to settle maturing obligations given the lenient credit terms offered by Reed’s clothiers. The other objective that will be achieved is to move the old stock that is holding the much needed cash.Question 3Reed’s clothier’s purchases suppliers at terms of 3/10 net 60 and sells at net 30. This means that he has to sell first to pay for the supplies.
Now, an extension of the selling terms exerts pressure on the cash position of the company. If Reeds tightens his working capital policy there will be no effect on the level of sales because it will be in line with the current industry averages. The customers will not move to the other sellers because there are no better terms.
The effect of a tight working policy is more cash and hence less pressure on the liquidity position (Bhattacharya, 2004)Question 4Pro forma financial statements are the forecasted financial statements. Pro forma statement use pas trends to forecast future performanceReed’s clothiers’ income statementFor the year ending 1995 (000s)Net sales 1,938Cost of sales (67%) (1,298.6)Gross profit 638.54General and administrative expenses (18.
2%) (116.396)Depreciation and amortization (1.7%) (32)Interest expenses (1.2%) (23.256)Income taxes (4.9%) (94.962)Ne income (7%) 135.66Question 5A computerized stock control system will suffice for Reeds clothiers because it will avoid holding unnecessary stocks.
The computerized system will be linked with level of stocks such that if stock in any given type of stock diminishes, the system automatically places order. The net effect of this is that there is no holding of excess stocks. The seller and suppliers are linked so as to avoid delays in supplying inventories (Bhattacharya, 2004)Question 6Accounts receivables control basically involves the analysis of credit standards, credit terms and collection policy. Credit standards are factors considered in giving lines to customer’s which depends on character, capacity and condition of the customer. The credit lines are the policy followed when extending credit and depends on the credit period and cash discounts. The company can use factoring by selling its receivables to a factor. The factor will provide the cash to the company.
The factor will be in charge of all credit sales by approving them. This, therefore, reduces the chances of bad debts. The customers will pay directly to the factor and not the company (Bhattacharya, 2004)Question 7The increment in sales is not related to a rise in inventories because the sales growth is as a result of a lenient credit and collection policy. This has resulted in more credit sales which create more receivables.
The payables on the other have to be increased in order to acquire more stock.Question 8The cost of not taking the cash discounts offered by suppliers is equal to the amount of the discounts foregone (Bhattacharya, 2004)The total purchases =cost of sales +closing stock—opening stock= 1,428,000+491,000=$1,919,000Terms of credit =3/10 net 603%*$1,919,000=$57.57SummaryAs seen above it is clearly evident that working capital management is an important task is management of the company’s assets. A sound working capital management policy will achieve a balance between holding more assets which could lead to liquidity problems and holding fewer assets.
Reeds need to formulate a policy that is strict because the other players in the industry have more stringent policies. This means that Reeds Clothiers is not gaining any advantage by adopting such a lenient policy.ReferencesBhattacharya, H. (2004). Working Capital Management.
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