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Working capital management and liquidity risk
Published on October 31, 2017 25 min
Other Talks in the Series: Accounting Records and Accounts
Hello, this is Huw Morgan from the Alliance Manchester Business School. This is the ninth talk in the series of lectures on accounting records.
This session follows on from the previous session on working capital management, looking at controls Shaun can add to his accounting records for inventory and trade receivables to manage liquidity risk. We also consider how to value both types of asset, particularly where there are uncertainties in their ability to generate adequate future economic benefits.
In session eight, Shaun's statement of financial position and income statement was analysed to assess the businesses working capital efficiency, using the cash-conversion period. Shaun held on to inventory for about six weeks, quite a concern given most of his inventory is perishable ingredients, fruit smoothies, and health drinks. Shaun's business also allowed customers to delay paying him for almost three months on average, which raises concerns on their recoverability, a potential for bad debts, as well as the impact this has on liquidity.
Shaun faces a dilemma in deciding an appropriate level of inventory. Too little inventory, will cause stock-outs, production delays and loss of customer goodwill if products are unavailable when demanded. Too much, and Shaun faces higher storage costs, more supervision costs to ensure quality control, allocating the oldest inventory to production first to avoid it going bad, security costs to reduce the risk of theft, as well as the economic cost of tying up cash. Shaun could try to work out an ideal average inventory level to hold, which would minimise inventory costs using a theory called Economic Order Quantity.