Copperbelt University

Directorate of Distance Education and Open Learning

Term Project I

Anthony Singogo

SIN: 22900601

Master’s in business administration (General)

GBS 621: Corporate Finance

Dr. Izidin El Kalak

2023-11-28
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Term Project I
1. Answer:

According to (e-finance management), the working capital policy of a company refers

to the level of investment in current assets for attaining the desired target sales. It can
be of three categories: restricted, relaxed, and moderate. The relaxed policy has higher
and restricted has lower levels of current assets, whereas moderate places itself
between relaxed and restricted.
In a restricted policy, the estimation of current assets for achieving targeted revenue
is done very aggressively without considering any contingencies and provisions for any
unforeseen event. Basically, the firm will have minimal level of current assets and the
policy is said to be “tight” or “lean and mean”. A firm implementing this policy would
realize some benefits due to the lower level of working capital requirement in current
assets such as cash, account receivables, inventories etc. This saves the interest cost
to the company, which produces higher profitability, i.e., higher return on investment
(ROI). This policy exposes the firm to risk due to shortages which may result in work
stoppages, customers not having goods on time and the temporary redundance of
casual workers. (Ehrhardt, M. p 658, 2017).
In a relaxed policy, the firm’s anticipation of current assets for achieving the desired
revenue is prepared after thorough consultation and considering uncertain events such
as seasonal fluctuations, an unexpected change in the level of activities or sales, etc.
After the reasonable assessments, a cushion to avoid unforeseen circumstances is left
to prevent the maximum possible risk. Companies with relaxed working capital policies
assume the advantage of almost no risk or low risk. This policy guarantees the
entrepreneur of the smooth functioning of the operating cycle. Unlike, low interest rates
with restricted policy under this policy current assets attracts higher interest costs which
in turn reduces the profitability. Due to its conservative nature, this policy is also referred
to as conservative working capital policy (efinance management).
As for moderate policy, it assumes both features of restricted and relaxed policy.

Based on the data provided, RR seems to be following a relaxed current asset usage
policy. This can be inferred from the lower inventory turnover ratio compared to the
industry average, indicating that RR holds inventory for a longer period. Additionally, the
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Term Project I
days sales outstanding (DSO) ratio of 45.63 is higher than the industry average of 32,
suggesting that RR takes longer to collect payments from customers, return on equity
(ROE) ratio of 10.45 is lower than the industry average ratio of 21, and finally the asset
turnover ratio of 2.6 lower than the industry ratio of 3, is enough and appropriate
evidence to suggest that RR is assuming a relaxed working capital policy (Ehrhardt, M.
p 664, 2017).

2. Answer:

To distinguish between a relaxed but rational working capital policy and an

inefficient one, it is important to consider the industry norms and the specific
circumstances of the firm. RR's working capital policy may be considered appropriate if
it aligns with industry standards and if the firm has valid reasons for holding higher
current assets, such as seasonal fluctuations or specific customer requirements.
However, if there are no justifiable reasons and the firm's current assets are excessive
compared to industry benchmarks, it may indicate inefficiency. RR ‘s turnover ratio is
10.8 compared to an industry turnover ratio of 20, now based on the characteristics of
relaxed working capital policy RR may be paying high interest rates. RR’s fixed asset
turnover is ration is 7.75 against the industry average of 13.22, it is an indication that
RR’s current assets are not being used efficiently to generate sales. Based on this data,
one would conclude that RR’s working capital policy does not seem appropriate is this
because company assuming this policy would avoid risks due to unforeseen
circumstance and maintain the operations smoothly which is not the case with RR, as
the company is failing to meet its obligations for salaries and the bank seem not to be
willing to issue the facility (Kenton 2023).

3. Answer:

According to Arnold. G (2008), Cash-conversion cycle focuses on the length of time

between the company’s outlay on inputs and the receipt of money from the same of
goods. The shorter the cycle the fewer resources the company needs to tie up.
It is calculated as the sum of the inventory conversion period, the receivables collection
period, and the payables deferral period. Given the annual sales of $660,000 and cost
of goods representing 80% of sales, we can calculate the CCC as follows:
CCC=Days Sales Outstanding (DSO)+Days Inventory Outstanding (DIO)−Days Payable
s Outstanding (DPO)
First, we determine Days inventory outstanding:
Days inventory outstanding = 365 days /inventory turnover
DIO=365/10.8 = 33.80days.
After calculating the DIO of 33.80 days, having days sales outstanding of 45.63 days
and deferral period of 30 days, we can easily compute cash conversion cycle using the
formula above.
CCC = 45.63+33.80-30
CCC = 49.43.
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Term Project I
The company’s cash conversion cycle is 49.43 days. This implies it takes 33.80
days for the business to sale its inventory to customers and then pays its creditors or
suppliers of goods and raw materials after 30 days once customers buy on credit.
However, debtors take 45.63 days to pay for the coffee. This means that RR should
look for money elsewhere particularly, a debt facility or overdraft to clear its creditors
before receiving cash from its customers. RR’s management should thrive to revisit
policies in place that will sustain the firm’s working capital and ensure liquidity for the
business. Attention should be devoted to the receivables period and payables period.
For instance, if the credit facility for receivables is brought downwards to 20days and
payment to suppliers is extended from 30 days to 45days, this may result in RR having
continued liquidity and being able to pay for obligations as they fall due. It is vital to note
that liquid is a blood stream of any business’s survival, hence proper credit policy
should help eliminate some challenges RR is faced with and these could include but not
limited to introduction of discount for early payments.

4. Answer:

There may be reasons to suspect that RR is holding too much inventory. The
inventory turnover ratio of 10.80 is lower than the industry average of 20.00, indicating
that RR takes longer to sell its inventory. Furthermore, RR’s 33.80 days of holding on
inventory whereas the average industry takes 18.25 days (365/20), this could suggest
that RR is holding excess inventory, which ties up capital and increases the risk of
obsolescence or spoilage.
RR’s asset turnover ratio is 7.75 lower than 13.22 average ratio for the industry.
This is an indication that assets of the firm are either underutilized or lack of efficiency in
using the assets to generate sales. RR should devise a workable solution that would
see full capacity usage of assets to generate sales for the business and provide some
remedial measures to solve the ever problems the company is facing, key personnel
like marketing, production and Finance manager should be tasked to fully appreciate
the benefits of putting in place a good working capital management.
RR seem to have a high borrowing rate of 58.76 percent against the average industry
of 50 percent this justifies that RR borrows to pay for suppliers while waiting for its
receivables. RR could reduce borrowing if it extends the credit period to suppliers and
reduces receivables period. Further analysis of the industry norms and RR's specific
circumstances would be needed to confirm if the inventory level is indeed excessive.

5. Answer:

In the short run

If RR reduces its inventory without adversely affecting sales, it should have a
positive effect on free cash flow reducing inventory would release working capital,
resulting in an immediate increase in free cash flow. This is because less capital would
be tied up in inventory, allowing it to be used for other purposes. The cash saved from
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Term Project I
insurance and storage space of inventory would be used to pay salaries and
maintenance of assets for smooth production of sales. RR would use the cash to settle
short term obligations like payables and the barrowing rate would drastically reduce
from the current of 58.76 percent, RR would also save from interest cost since there is
no reason of borrowing and these savings could be used for settling utility bills and
rental.

In the long run

Reducing inventory can lead to cost savings, such as lower storage and carrying
costs. This can further improve free cash flow by increasing profitability and operational
efficiency. The firm would invest in other streams of business and in research and
development. Overall, the business’s financial statement would look healthy and
acquiring a facility from the bank for its expansion would not be a problem. Suppliers
would be paid on time and the cash- conversion cycle would be shortened and that
would boost the revenue for the business while minimizing holding costs.

In conclusion, all the three types of working capital policy are effective if well
implemented and RR should thrive to reduce the cash-conversion cycle to below 20
days since the industry CCC is 17.25 (32+365/20 – 33).
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Term Project I
References

Arnold. G, (2008). Corporate Financial Management. Fouth edition. P530

Ehrhardt, M. (2017). Corporate finance: A focused approach (6th Ed.). Boston, MA:

Cengage Learning. ISBN 9781305637108.

eFinance Management. Working capital financing policy

https://efinancemanagement.com/working-capital-financing/working-capital-policy-

relaxed-restricted-and-moderate

Kenton. W (2023). Investopedia. Fixes asset turnover.

https://www.investopedia.com/terms/f/fixed-asset-
turnover.asp#:~:text=The%20fixed%20asset%20turnover%20ratio%20reveals%20
how%20efficient%20a%20company,its%20fixed%20assets%20more%20effectivel