Question

Modern Kitchens specializes on sell prefabricated kitchens. The company has stores in all major capital cities throughout Australia. It’s been established since 2001 and has seen tremendous growth but more recently has seen several overseas competitors enter the Australian market resulting in an increase in competition. This increased competition has placed significant pressure on containing costs and drawn management’s attention to a review of working capital practices. Detailed below are relevant figures and ratios to assist you in evaluating Modern Kitchen’s working capital management.

Working Capital Ratios 2016 2017 2018 2019

Accounts Receivable Days 14.0 days 18.1 days 23.1 days 31.9 days

Inventory Days 16.0 days 19.1 days 21.9 days 25.0 days

Accounts Payable Days 14.1 days 21. days 29.0 days 37.0 days

Note: Ratios are based on assuming end year figures are the average throughout the majority of the year

Extracts from Financial Statements

Cash on hand 0.20 mill 0.15 mill .01 mill (.003 mill)

Sales – all on credit 8.1 mill 6.9 mill 8.0 mill 9.0 mill

Accounts Receivable Balance 0.3069 mill 0.3453 mill 0.5044 mill 0.7894 mill

Inventory 0.1754 mill 0.2186 mill 0.2712 mill 0.3219 mill

Cost of Goods Sold 4.0 mill 4.2 mill 4.5 mill 4.7 mill

Accounts Payable 0.1534 mill 0.2417 mill 0.3574 mill 0.4762mill

Budgeted Figures

Cash on hand 0.3 mill 0.3 mill 0.31 mill 0.32 mill

Accounts Receivable Balance 0.30 mill 0.31 mill 0.37 mill 0.38 mill

Inventory Balance 0.16 mill 0.17 mill 0.20 mill 0.21 mill

Accounts Payable 0.16 mill 0.17 mill .19 mill 0.20 mill

Accounts Receivable Terms 14 days 14 days 14 days 14 days

Accounts Payable Terms 30 days 30 days 30 days 30 days

Industry Averages

Accounts Receivable Days 14 days 14 days 15 days 16 days

Inventory Days 15 days 16 days 16 days 15 days

Accounts Payable Days 30 days 28 days 25 days 20 days

REQUIRED:

Calculate (show full workings to your answer):

(i)  the dollar value of actual net working capital each year from 2016 to 2019 for Modern Kitchens.

(ii) the duration of the operating cash cycle each year from 2016 to 2019 for Modern Kitchens.

(iii) interpret the meaning of each of the figures calculated above (40-word limit)

(a) Review Modern Kitchens’s working capital management performance utilizing calculations in (a) above and information provided such as trends / benchmark figures / industry averages and budgets (300-word limit).

(b)  Once you have analyzed their performance, provide some strategies and recommendations to assist in improving any weaknesses in working capital management referring to the management of components of working capital including cash, inventory, accounts receivable and accounts payable. As part of your recommendations identify the associated potential benefits and costs of each recommendation. (400-word limit)

Answer 1

Part (i)

Please see the table below. Please be guided by the second column to understand the mathematics. You can also understand the mathematics making use of [+] / [-] sign appearing in the first column. The last row highlighted in yellow is your answer. Figures in parenthesis mean negative values. All financials are in $ mn.

Year	Linkage	2016	2017	2018	2019
Cash	A	0.2000	0.1500	0.0100	(0.0030)
[+] Accounts Receivable	B	0.3069	0.3453	0.5044	0.7894
[+] Inventory	C	0.1754	0.2186	0.2712	0.3219
[-] Accounts Payable	D	0.1534	0.2417	0.3574	0.4762
Net working capital	E = A + B + C - D	0.5289	0.4722	0.4282	0.6321

Part (ii)

Year	Linkage	2016	2017	2018	2019
Accounts Receivable Days	P	14.00	18.10	23.10	31.90
[+] Inventory Days	Q	16.00	19.10	21.90	25.00
[-] Accounts Payable Days	R	14.10	21.00	29.00	37.00
The duration of the operating cash (days)	S = P + Q - R	15.90	16.20	16.00	19.90

Part (iii)

Net working capital is the capital stuck in the day to day operations of the firm. It's a short term requirement of funds to sustain the operations. But since operating cycles rolls over, so does the net working capital. Account receivables are the funds stuck with the customer while inventory is the fund stuck in raw material, work in progress or even finished goods. In the short term, these will get converted into cash to be used in the business. Hence, working capital is in a way money stuck in the business.

Operating cash (days) is indicator of cash cycle for the firm. How long the cash is stuck in the firm? This also means a $ invested in the purchase of raw material today, will take this much time to come back to me thorough sales and collection.

Part (a)

The industry average figures and budget figures have been produced below:

Year	Linkage	2016	2017	2018	2019
Industry Averages	P
Accounts Receivable Days	Q	14.00	14.00	15.00	16.00
[+] Inventory Days	R	15.00	16.00	16.00	15.00
[-] Accounts Payable Days	S = P + Q - R	30.00	28.00	25.00	20.00
The duration of the operating cash (days)		(1.00)	2.00	6.00	11.00
Budgeted Figures
Cash		0.30	0.30	0.31	0.32
[+] Accounts Receivable		0.30	0.31	0.37	0.38
[+] Inventory		0.16	0.17	0.20	0.21
[-] Accounts Payable		0.16	0.17	0.19	0.20
Net working capital	E = A + B + C - D	0.6000	0.6100	0.6900	0.7100
Accounts Receivable Days		14.00	14.00	14.00	14.00
[-] Accounts Payable Days		30.00	30.00	30.00	30.00

In comparison to the industry averages, the company's performance is far worse. The company is nowhere closer to the industry average. The company has operating period in the range of 15 - 20 days against the industry benchmark of maximum 11 days in the year 2019. The data also shows that the situation has worsened over a period of time not only for the company but for the other players in the industry as well. This is because even the industry average has risen rapidly to 11 days.

If we look at it element wise, the company has worst performance as far account receivables are concerned. Receivable days are very high in comparison to the industry average. In the year 2019, against an industry average of 16 days, company has taken nearly twice (31.90 days) to collect the money.

Inventory holding period is also higher than the industry average by around 10 days. This is also lengthening the operating cycle of the firm. Accounts payable days are more than industry average which is better theoretically, but in the long run the firm will not be able to stretch the payments to creditors (suppliers, service providers, raw material providers, etc).

In terms of the budgeted figure also, account receivable days are worse off. Company's performance is nowhere even closer to budgeted performance.

Part (b)

Some strategies and recommendations to assist in improving any weaknesses in working capital management referring to the management of components of working capital including cash, inventory, accounts receivable and accounts payable:

• Explore the option of JIT (Just in time) inventory - this will free up the cash stuck in inventory plus requirement for storage and warehousing will decrease
• Hold inventory at the end of vendor (Vendor managed inventory) - this will free up the cash stuck in inventory plus requirement for storage and warehousing will decrease
• Work out the economic order quantity for each type of raw material based on consumption and lead time - this will help a lot in optimizing the cost of inventory
• Offer some discount on cash payment. Introduce schemes like 2/10, net 30. The discount of 2% will be attractive enough for the customers to make the payments early. This will help you reduce receivable days but in turn, we have to shell out the cash discount.
• Improve collection efficiency - follow ups and speed up collections
• Reduce the credit period to the customers - this may lead to a decline in sale but the benefit is early receipt of receivables
• Negotiate higher credit period with suppliers
• Negotiate bulk purchase discount with supplier through committed contracts but lift the inventory only when required.

Please build upon these points and create your own answer matching the word limits. I sincerely hope these points helped you.