explain how the setting of a working capital target based on actual revenue may be more or less appropriate than that based on a forecast – Essaylink

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Z Industries is an operating subsidiary of a large quoted entity. Group management makes use of net current asset and liquidity ratios to evaluate period-end balance sheets. There is concern that the control exercised by Z Industries over its working capital is less than adequate.

The parent entity establishes targets for inventories, trade receivables and payables and monitors how the subsidiary achieves those targets. For Z Industries it expects:

(i) inventories to be no more than 10 per cent of sales;

(ii) trade receivables to be equal to no more than 2.5 months’ credit sales;

(iii) payables to be equal to no less than 2.5 months’ purchases.

Cash is subject to control limits. Money is put on short-term deposit when holdings exceed 110 per cent of target. This target is the residual arrived at by reference to group norms for the net current assets ratio after the targets referred to above have been applied.

When cash holdings drop below 90 per cent of target, withdrawal is made from interest bearing accounts to meet the target holding.

Requirements

(a) to discuss what shortcomings are inherent in the adoption of the above criteria;

(b) to explain how the setting of a working capital target based on actual revenue may be more or less appropriate than that based on a forecast;

(c) to suggest how trade receivables’ balances may be monitored more appropriately.

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