Working Capital and Inventory Management

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Questions and Answers

What is the focus of working capital management?

Annual revenues and profits

Long-term assets and liabilities

Investments in new projects

Day-to-day bills and short-term assets (correct)

In working capital management, what does a negative working capital (Current Assets < Current Liabilities) indicate?

High profitability levels

Potential liquidity issues (correct)

Effective management of long-term debt

Healthy financial position

How is working capital calculated?

$$\text{Total assets} - \text{Total liabilities}$$

$$\text{Fixed assets} - \text{Current liabilities}$$

$$\text{Current assets} - \text{Current liabilities}$$ (correct)

$$\text{Inventory} - \text{Accounts payable}$$

What is the primary purpose of evaluating working capital?

Assessing short-term financial health Signup and view all the answers

Why should current assets exceed current liabilities in working capital management?

To ensure payment of day-to-day bills and obligations Signup and view all the answers

Which financial aspect does working capital management primarily address?

Management of short-term assets and liabilities Signup and view all the answers

What is the equation to calculate assets?

Assets = Liabilities + Owner’s equity Signup and view all the answers

How are all assets funded according to the text?

Either through equity or liabilities Signup and view all the answers

What happens when an asset is bought and paid in cash according to the text?

One asset increases but another asset decreases by the same amount Signup and view all the answers

What are fixed assets also known as?

Long-term assets Signup and view all the answers

What is the defining characteristic of current assets?

They are not used up within a year Signup and view all the answers

Which type of asset usually has higher liquidity?

Current assets Signup and view all the answers

What is the main consequence of having a low level of working capital according to the text?

There is not enough cash or the business has borrowed too much through trade credit Signup and view all the answers

Why are businesses that need a lot of inventory, like retailers, likely to have higher levels of working capital than businesses that provide services?

Retailers have higher current assets (inventory) compared to their current liabilities, leading to higher working capital Signup and view all the answers

What is one of the main downsides of keeping high levels of inventory?

It ties up money in the business and the inventory might become obsolete and lose its value Signup and view all the answers

Which of the following is identified in the text as the most effective way to improve both working capital and cash flow?

Increasing equity or borrowing more long-term credit Signup and view all the answers

Which of the following ratios does NOT consider inventories when evaluating a business's liquidity?

Acid test ratio Signup and view all the answers

Study Notes

Financial Management

Auditing is the process of checking a company's accounts for authenticity by an independent firm of accountants.
The result of the auditing process is stated in the annual report.

Managerial Accounting

Provides information for the management of the business.
Helps managers make decisions like where to cut costs and how to calculate prices.
Uses data from the balance sheet and income statement to calculate figures and ratios.

Balance Sheet and Ratios

Assets = Liabilities + Owner's equity is a fundamental equation in accounting.
Assets are funded either through equity or liabilities.
Working capital or circulating capital indicates a business's ability to pay its day-to-day bills.
Working capital = Current assets – Current liabilities.
Current assets should be higher than current liabilities.

Assets

Fixed or non-current or long-term assets have a lifespan of more than one year and are intended to be used in the company for a longer time period.
Examples: property, plant, premises, buildings, machinery, and equipment.
Current or short-term assets are used up, spent in production, or sold within a year.
Examples: inventory, accounts receivables, and cash.

Liquidity

Liquidity or solvency is the ability of a business to pay its bills and repay its debts on time.
Working capital ratio or current ratio = Current assets / Current liabilities.
Acid test ratio = (Current assets – Inventory) / Current liabilities.
A low level of working capital might indicate a lack of cash or excessive borrowing.

Profitability

Profitability is a business's profit in relation to an indicator of the size of the business (usually capital employed or turnover).

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Description

Learn about the significance of working capital and inventory management in businesses. Understand how a low level of working capital and high inventory can impact a business's operations and financial health.