working capital essay

Working Capital Management Analysis

Working capital management is often adopted as a strategic managerial accounting function. The main objective of working capital management is to maintain efficient levels of the two components of working capital – current assets and current liabilities – concerning each other. By efficiently managing its working capital the firm would be able to ensure that it always has sufficient liquid cash to meet its obligations on current liabilities which are short-term in nature (Investopedia). The working capital management also includes the meeting of current operating expenses from a well-maintained cash flow.

Brealey et al (2005) define the working capital to include assets and liabilities which are short-term in nature. They are also known as current assets and liabilities. The working capital management in any organization includes controlling and monitoring the book debts, inventory, and cash and bank balances of the organization. Efficient working capital management enables a company to compete effectively in the market as it can reduce its cost of producing the goods or services. The working capital management also provides the company the liquidity to meet its short-term obligations without difficulty. Any organization to achieve its financial goals should ensure that there is proper working capital management is in place. The essence of successful working capital management is to ensure that the current liability obligations of the company are met without delay. The adoption of a working capital policy and a system of cash budgeting will enable the company to optimize the utility of its working capital. This will lead the company to reach a stage where it would be easier for the company to meet its current obligations without much difficulty.

Implementing an efficient working capital management system enables a company to augment its earnings by reducing the cost of working capital locked up in undesirable items of current items like excess inventory. There are two main components of working capital management. They are; (i) management of individual components of working capital and (ii) ratio analysis

Management of Different Components of Working Capital

Generally, decisions relating to the quantum of working capital and short-term financing of the firm’s requirements are referred to as working capital management. Thus by definition, working capital management entails only short-term managerial decisions covering the next one-year period. Hence working capital decisions are always reversible. Therefore working capital management decisions do not involve complex processes like capital investment decisions. Such decisions are normally based on the cash flows into the firm and/or profitability.

Accounts receivable accounts payable and inventory are the major components of working capital that a company has to manage effectively. Cash is another important component of working capital that plays a crucial role in working capital management. The function of managing the working capital of a company can be discharged effectively by developing and introducing a cash budgeting system that takes care of the cash inflows and outflows of the organization.

One way of measuring the cash flow of the firm is the cash conversion cycle. The cash conversion cycle is calculated based on the net number of days from the outflow of cash for purchasing of raw material till the time the payment is received from the customer of the firm. The cash conversion cycle as a working capital management tool informs the management of the inter-relatedness of its decisions concerning the working capital elements like inventory, accounts receivable, accounts payable, and cash. Cash conversion cycle days exactly correspond to the total time the financial resources of the company are blocked in the conversion process. During this period cash is not available for other activities. Therefore the aim of the management always is to have a lower conversion cycle.

The working capital management function involves dealing with day-to-day cash management, collection of accounts receivables, dealing with bad debts, and the repayment of short-term loans. Thus the working capital management policy of any organization is to estimate and monitor the extent of each of the current assets account of the company and also to decide in advance how these accounts can be funded.

Inventory management aims to identify the level of inventory that allows for an uninterrupted supply of raw materials and components for production. At the same time, there should be a reduction in the amount invested in raw materials.

Ratio Analysis

The Working Capital ratios indicate how well the company can manage its working capital. “The asset management ratios are also known as working capital ratios or the efficiency ratios. The aim is to measure how effectively the firm is managing its assets.” (Net Tom) The calculation and analysis of few key working capital ratios like inventory turnover ratio, average debtors, and average accounts payable would enable the management to identify the areas where more attention is required. The average debtor indicates how many days the company takes to collect its outstanding debtors in proportion to the total sales. Average Accounts Payable implies how many days on average it takes for a company to pay off its creditors. Inventory turnover shows how many times the company can roll over its inventory. Ratio analysis enables the firm to have effective inventory management, cash management, accounts receivable, and accounts payable management.

Brealey R. A., Myers S. C. & Allen F. (2005). Principles of Corporate Finance 8 th Ed. New York: The McGraw-Hill Companies.

Investopedia ‘Working Capital Management’ . Web.

Net Tom ‘Session 14: Calculation of Ratio Analysis’. Web.

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Essay: Working capital

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Working capital is calculated by current assets minus current liabilities. Current assets are the assets that can be turned to cash within or less than one year, such as inventory, cash, bank, bill receivables, short-term investments, etc. Current liabilities are the obligations, which should be paid to creditors within or less than one year at their maturity, such as bank overdraft, bill payables, short-term loans, etc.

Working capital management is essential in financial management. An efficient working capital management may help in the financial operation of a firm and improve its earning and profitability. It is the management of current assets and current liabilities which include inventory, accounts receivables, and account payables as well as the relationship between them. Decision making which relating to working capital is also referred to as working capital management.

The purpose of working capital management is to maintain a sufficient amount of working capital to run the business as too high level of working capital would reduce the profitability of firm and too low working capital level would lead a firm to go into liquidation. It makes sure the firm has enough monetary liquidity to meet its short-term debt obligations and operating costs to ensure a reasonable margin of safety. In other words, it ensures that there is always sufficient cash on hand to pay for liabilities as they come due for payment and to satisfy the upcoming operational expenses.

Objective of Working Capital Management

The objective of working capital management is to ensure that the firm has sufficient money for short-term debt and upcoming expenses. In other words, the right ratio of assets, liabilities and working capital must be maintained by the company. There are few objectives of working capital management which are:

Maintaining the working capital operating cycle and ensuring its smooth operation

The fundamental of business operations is to maintain the cycle running smoothly. The operating cycle refers to an enterprise’s whole life cycle. Management of working capital attempts to ensure the smoothness of cycle starting from the procurement of raw material to the smooth production and delivery of the finished goods.

Lowest working capital

The net working capital should be in equilibrium. The working capital ratio should be optimized as the lower working capital indicates the risk of distraction of operating cycle and the higher working capital means the interest cost is higher. The lower ratio implicates that the company is unable to pay its current debts because of the level of current assets is low.

Minimize rate of interest or cost of capital

Working capital management focuses on minimizing the cost of capital in order to achieve higher profitability. The interest rates should be negotiated with the bank if the working capital investment involves bank finance. The way of minimizing capital cost is utilizing the long-term funds but in a proper mix. The fundamental principle of financial management should be observed seriously when deciding on the financial mix. The principle states that long-term sources of funds of same maturity should be used to finance fixed assets and permanent assets whereas short-term sources of funds should be used to finance short-term or temporary assets.

Optimal return on current asset investment

The return on investment in the current assets must exceed the weighted average cost of capital so that the owners’ wealth maximization can be ensured. This means that the rate of return received from investment in current assets should be more than the cost of capital or rate of interest. The purpose of working capital management is to gain maximum return from an investment in current assets to ensure higher profitability.

Determinants of Working Capital

Nature of business: Public utilities or service industries require low amount of working capital due to the selling of service rather than goods whereas the manufacturing or trading firms need relatively large amount of working capital together with their fixed investment of inventories.

Size of business: Small business need less working capital compared to big business concern which has to maintain high level of working capital for the purposes of paying current liabilities and investment in current assets.

Production policy: Company which reduces the level of production in off season will definitely decrease the amount of working capital. The company which continue its production process in off season will certainly require more working capital.

Credit policy: The business require large amount of working capital to finance its debtors if purchase the goods on cash basis but sell on credit term. Less working capital is needed if the goods are bought on credit term but sold on cash basis.

Growth of business: Working capital required will increase to meet its expansion need if the business is growing rapidly. If the business is shrinking, it will result in a decrease in the requirement for working capital.

Price level changes: Rising in the product prices will certainly increase the amount of working capital needed by the company because it requires more funds to purchase the materials.

Dividend policy: The firm require less working capital if it has more retained profits for dividend payment whereas the firm which lack of reserve has to invest large amount in working capital.

Business cycle: Low amount of working capital is required by the business during recession. However, economic prosperity creates demand for high level of working capital in order to develop the business.

Manufacturing cycle: The firms require more working capital if the manufacturing cycle is longer due to its complicating process of making finished goods. The lesser time involved in manufacturing process will reduce the level of working capital required.

Turnover of circulating capital: The faster the cash is recovered by the sale of goods will reduce the demand for working capital whereas more working capital is needed in case of slower turnover.

Operating efficiency: The operating efficiency is arising from the efficacy in optimum utilization of assets and the controlling of operating costs. More funds will be released for working capital due to the optimal utilization of assets.

Seasonal variations: Some businesses produce the goods seasonally only which lead to the requirement of more working capital in order to purchase the raw materials in bulk during the season.

Advantages of Adequate Working Capital

The company is able to make prompt payments to its creditors on time which in turn helps in maintaining and creating the financial reputation or goodwill of the business.

The business can benefit from favourable financing terms such as avail cash discount or trade discount on purchases from suppliers and hence the costs can be reduced.

Sufficient working capital result in high solvency and excellent credit standing which can facilitate the arrangement of loan facilities from banks and other financial institutions on easy and favourable terms.

A firm which has ample working capital can finance its day-to-day commitments and hence it will create efficiency in the business and improve the overall profits.

It ens ures uninterrupted supply of raw materials when required and continuous flow of production to satisfy customers’ orders or demands.

Sufficient working capital will help the company to encounter the business crises during depression and the unpredictably large amount of orders or peak demand.

Company with sufficient working capital can take advantage of new business opportunity to expand or grow its business and thus prevent the business from failure.

A business concern is being able to offer a credit line to its customer which can encourage them to buy more instead of purchase from the competitors.

Adequacy of working capital eases the repayment of loans and dividends to the investors quickly. This will increase the confidence of investors and facilitate the raising of additional funds in the future.

The company can exploit favorable market conditions easily such as buying the materials in bulk when prices are lower and undertake the profitable projects.

Disadvantages of Excessive Working Capital

Excessive working capital means ideal funds in the business which earn nothing. Thus the rate of return on its investment falls which will automatically affect the goodwill of the company. Lower rate of return may cause the share value and share price fall.

Redundant working capital implies too much receivables and defective credit policy which may increase the level of bad debts and adversely affect the overall profitability of the business.

The excessive working capital gives rise to speculative transactions which in turn may create more wastage of money or losses for the business.

Surplus of cash tempts the managers to expend more and redundancy of working capital may lead to overall inefficiency of the management in the company.

It may lead to accumulation and unnecessary purchase of inventories in bulk which may bring about losses or wastage and increase in storage costs.

The company may not be able to maintain its relationships with the banks and other financial organizations.

Extra working capital will destroy the control of turnover ratios which is normally used in running an efficient business. It also destroys all other guides and sign posts in conducting the business.

Levels of Working Capital

Working capital policy is a policy of the firm about its working capital and how its working capital should be financed. Organizations have to make a decision on the amount of money to be kept in cash account, the level of inventory to be maintained, the amount of receivables that allowed to build up and the risks related to working capital. There are three methods of working capital policy which are conservative, aggressive and moderate approaches.

Conservative Working Capital Policy

A conservative working capital management policy aims to minimize the risk of system breakdown by maintaining a higher level of working capital. The company which has a greater net working capital is at a comparatively low risk position. With this policy, the company can achieve the targeted revenue through the estimation of current assets, which is prepared after taking into account the uncertain events. This policy is suitable for manufacturing operations to meet seasonal variations such as a sudden change in the activities level.

Such a policy maintains a larger cash balance, perhaps even invests in short-term securities. Customers are offered more generous credit terms to increase demand. The company will hold a higher level of inventories to reduce the risk of stock-outs and to meet customer’s requirement. Prompt payments to suppliers can ensure the reputation of company and decrease the chances of running out of stock. This policy result in a lower risk of inventory or financial problems but it will decrease the profitability of company.

However, the adverse effect on this policy is the high burden of unproductive assets carried by the firm may lead to a financing cost that can affect the profitability of business. Severe cash flow problems may arise from a rapid expansion as the available finance is insufficient to meet the working capital requirements. Lack of responsiveness to customer demands and inventory obsolescence can also cause a lot of problems.

Aggressive Working Capital Policy

An aggressive working capital management policy intends to decrease an organization financing cost and increase profitability. With this policy, an organization will speed up its business cycle to increase sales and revenues. Adoption of this policy bring about the benefit of lower working capital requirement due to the low investment in current assets. As the company has a lower net working capital, it is profitable but very risky. The company holds a lower level of inventories in order to reduce costs but the chances of system breakdown by way of running out of stock will increase or loss of goodwill.

However, modern manufacturing techniques such as just-in-time system and total quality management encourage the reduction in inventory and work in progress as well as the improvement in products quality. The company only produces goods when receiving orders from their customers. The goodwill of company will increase since it can fulfil the customers demand. The customers do not care about the shorter credit term given as long as the company can provide a good quality and effective response to customer demand.

Moderate Working Capital Policy

A moderate working capital management is a balance between the aggressive and conservative approaches. It undertakes the characteristics of both policies. These characterizations can help in contrasting and analyzing the different ways of working capital management in which the individual company deals with and the trade-off between risk and profitability.

This policy presume the risk and profitability is moderate which greater than conservative but lesser than aggressive approaches. With this policy, a company has moderate level of net working capital, for example the liquidity of company is balanced since it can maintain an adequate level of cash. When the level of cash is high, the company has extra cash to invest in liquid short-term investment for the purpose of generating additional profit.

Permanent and Fluctuating Current Assets

In order to analyze the financing decisions of working capital, assets can be categorized into three different types which are non-current assets, permanent current assets and fluctuating current assets.

Non-current assets are the long-term assets from which the assets are expected to generate economic benefits more than one accounting period and it must be depreciated over their useful life. For example, office building or motor vehicles.

Permanent current assets represent the minimum level of current assets required by the company to support its normal trading activities. In other words, the company needs to maintain the base of inventory level, cash and account receivables that is necessary to meet long-term minimum requirements.

Fluctuating current assets refer to the current assets which fluctuate with the changes in normal business activity, for instance as a result of seasonal fluctuations and production or sales level. It can be considered as an additional working capital, over the permanent working capital which is required to sustain the normal business activities changes.

Parts of the working capital are formed by fluctuating current assets and permanent current assets. They may be financed by either short-term funding such as current liabilities or by long-term funding such as equity capital.

Working Capital F inancing Policies

There are three methods of working capital fi nancing policies which can help an organization to make decision based on the analysis of such policies. Three of these policies are conservative, aggressive and moderate financing policy.

Conservative Financing Policy

This approach not only finances all the non-current assets and permanent current assets, but also some part of fluctuating current assets with long-term debt and equity. It is a low risky and low profitable policy. The company is more reliance on long-term borrowing as it is relatively less risky. Before repayment is due, borrower has more time to utilize the loan proceeds. The borrower will not be affected due to the fixed interest rate even the interest rates spike up during the loan period.

Nevertheless, long-term funding is normally more costly than short-term financing. Profitability is reduced because of the higher rate of interest costs associated with long-term financing or investment line. The heavy usage of long-term finance will result in a higher liquidity, therefore it can take benefits of sudden chances or opportunities. The risk of bankruptcy is minimized as the liquidity is maintained at a higher level.

Aggressive Financing Policy

This policy finances the working capital with high risk and high profitability. The company uses long-term debt to finance all its fixed assets and a portion of its permanent current assets. The remaining part of permanent working capital and all the temporary working capital are financed by short-term funds.

In this policy, most current assets are financed by short-term borrowing. The greater usage of short-term financing is more risky because of the fluctuation of interest rates but it offers higher returns. This policy carries a higher risk of liquidity and cash flow problems in terms of saving in the long-term finance cost which conversely will produce higher profitability. As the company has greater dependability on short-term finance, it will result in lower liquidity. An extremely tight liquidity level being maintained may cause the risk of bankruptcy to be increased.

Moderate Financing Policy

The moderate approach is a middle way between the conservative and aggressive working capital financing approaches. It is also known as matching financing policy. It involves the use of long-term debt and equity sources to finance non-current assets and permanent current assets whereas the fluctuating current assets is financed with short-term debt.

This policy defines the maturity of the sources of finance should match the maturity of different types of assets. It means the expected life of funds raised to finance assets is equivalent to the expected useful life of the assets. For example, a five year loan may be raised to finance motor vehicle with expected life of five years. In short, the moderate financing policy finances the working capital with moderate risk and profitability.

Policy Conservative Aggressive Moderate

Liquidity Higher Lower Medium

Risk Lower Higher Medium

Profitability Lower Higher Medium

Overtrading (Undercapitalisation)

Overtrading refers to a situation where a business entity is operating with inadequate long term capital to support the current volume of trading, raising the risk of liquidity problems. Overtrading occurs when a business is accepting work, and trying to complete it at a level that can’t be supported by its net current assets or working capital. The business have insufficient cash and can’t obtain enough cash promptly. Overtrading arises even though the business entity is making a profit. Over-expansion of business is one of the main reasons for overtrading and therefore overtrading is also known as under-capitalization. Overtrading is particularly common in young as well as fast growing businesses.

Symptoms of Overtrading

Sales increased rapidly.

Increase in receivables.

Inventory movement is unusual.

Current and quick ratios decreased.

Accounts payable period increased.

Profit margin and cash balance declined.

Short term borrowing and gearing ratio increased.

Ways to Overcome Overtrading

Restrict or slow down the expansion of business.

Injection of new capital by issuing new share capital or obtaining long-term loans.

Establishing new payment terms with debtors for future orders.

Offering discounts for prompt payments will boost cash flow and reduce bad debts.

Negotiating payment terms with suppliers to grant longer payment terms.

Reduction of cost will improve cash flow and reduce the risk of overtrading.

Lease or hire purchase non-current assets will help smooth cash flow.

Improve inventory control as faster inventory turnover will reduce the time between customer payments and paying suppliers for goods.

Undertrading (Overcapitalization)

Undertrading is also called over-capitalization and it is the opposite of overtrading. Undertrading refers to a situation where a business entity has excessive working capital than it catered-for or needs. It will lead to a low return on investment if there are excessive inventory, receivables and cash, and very few payables, with long-term funds tied up in non-earning short-term assets. Undertrading arises when the company’s actual profits are insufficient to pay interest on debentures and borrowings and a fair return to shareholders over a time period. It is said to be over-capitalized when it fixed and current assets less than the total of owned and borrowed capital i.e. when the assets side of the balance sheet exhibits accumulated losses.

Symptoms of Undertrading

Volume of sales declined.

A high level of inventories.

Return on capital employed is low.

Excessive current and liquid ratios.

Taking shorter credit period from suppliers.

Receivables collection period being too long.

Ways to Overcome Undertrading

Idle assets can be sold for cash.

Reduction of debt obligation by negotiating with creditors.

Redeem preference shares through capital reduction scheme.

The par value and paid up value of equity shares can be reduced.

Returning the funds to the investors by distributing the cash as dividends.

Find new investments which provide a satisfactory return with the excess cash.

Bringing down the values of the assets to their proper values by removing the over-valuation policy.

A satisfactory relationship between proprietary funds and net profit can be obtained by reduction in its capital.

Cash Operating Cycle

The cash conversion cycle (CCC) measures the number of days from the beginning of the production process to receive cash from the sale of that product. In other words, the cash conversion cycle calculation measures how long cash is tied up in inventories and accounts receivables or the number of days between disbursing cash and collecting cash. CCC also called working capital cycle or cash conversion cycle. CCC is also used to measure the liquidity or the effectiveness of a firm’s working capital management. The diagram below shows how the cycle works:

Calculating the cash operating cycle:

This cycle is the average length of time (measured in days) between the payment for purchases of raw materials and collection from trade receivables.

Inventory Holding Period (Days) (Stock Days)

A measure of how long on average a business holds inventories before being sold. It is known as the inventory turnover period which is the a verage length of time between the purchase of raw materials and time taken to pay creditors who have supplied goods and services on credit.

=(Closing Payable)/(Average Purchase per day)=(Account Payable)/(Annual Purchases)×365 days

It shows the liquidity of inventories, the higher the turnover indicates that the inventories are ‘bought and sold’ quickly throughout the year. If the turnover is lower, it indicates that the company is taking a longer time to sell the product. It is beneficial for a company to hold its inventories in a short period of time. If company can sell its inventory quickly, less cash will be tied up and it is possible to generate more profits. The company should hold a moderate inventory level.

Receivables Collection Period (Debtors Days)

It indicates the number of days on average that the customers are taking to pay. It is calculated as account receivable divided by the average credit sales per day.

=(Closing Receivable)/(Average Sales per day)=(Account Receivable)/(Annual Sales)×365 days

Short collection period is usually preferred because the liquidity of the company may improve and it is better for the company’s financial position. In addition, it will decrease the risk of bad debts and administration costs on collecting receivables. The collection period depends on the credit terms allowed by the company.

Payables Payment Period (Creditors Days)

It indicates the average number of days that the company is taking to pay its creditors who have supplied goods and services on credit. If purchase figure is not available, use cost of sales.

A company should not take too long period to repay its payables, it may indicate the liquidity problem as the company may not have enough funds to pay their credit suppliers on time. Therefore, the reputation and creditworthiness of the company may be affected.

Cash operating cycle and working capital requirement

The working capital cycle is aimed in deciding the minimum amount of working capital required by a company in operation. The three elements in the cash operating cycle is not overmuch nor too small.

An excessive working capital means a larger investment in current assets and need more capital to finance it. For instance, longer time to receive payment from receivables.

The shorter working capital cycle is better for the company as the inventories are not held in hand for a longer period, payment from trade receivables is accelerated and the maximum credit can be obtained from the suppliers.

Cash Operating Cycle: Example

Extracts from the statements of financial position and income statement of a company are set out below.

Annual purchases 2 745 000

Annual cost of sales 6 272 128

Annual sales 6 802 400

Inventories:

Raw materials 964 000

Work in progress 548 128

Finished goods 2 567 893

Trade receivables 2 425 600

Trade payables 704 800

Required: Calculate the length of the cash operating cycle for the company.

Raw material turnover (964 000/2 745 000) x 365 days 128

Production cycle (548 128/6 272 128) x 365 days 32

Finished goods turnover (2 567 983/6 272 128) x 365 days 149

Credit period given to customer (2 425 600/6 802 400) x 365 days 130

Credit period from supplier (704 800/2 745 000) x 365 days (94)

Credit operating cycle 345

Before the company gets paid the cash from the sales, it takes 345 days on the average from paying suppliers for goods.

LIQUIDITY (WORKING CAPITAL) RATIO

Liquidity means having cash or access to cash to meet liabilities and manage its working capital. Normally a higher ratio indicates a better liquidity.

Two ratios for measuring liquidity are:

Current ratio

The current ratio is the ratio of current assets to current liabilities. It measures the capacity of a company to pay its current liabilities with its current assets. It can be calculated as follow:

(Current assets)/(Crurent liabilities)×365 days

A high current ratio indicates that a company is able to meet its short-term debts repayment and more liquid. Examples of current assets include cash and cash equivalents, marketable securities, short-term investments, accounts receivables, and inventories. “Rule of Thumb”; a ratio 2:1 is considered desirable in most sector, however current ratio should not be lower than 1:1.

2007(RM) 2006(RM)

Current ratio 496/552=0.90 404/202=1.84

(Figures assumed)

The current ratio has deteriorated in year 2007. For every RM1 owing as current liabilities, there is RM0.90 of cover provided by the current asset. It has come down to RM0.90 in year 2007; liquidity position of the company is getting worse which may indicate cash flow problems.

Acid Test Ratio (Quick Ratio)

It measures of how well a company is paying its current liabilities when they come due with only quick assets. It can be calculated as follows:

(Current assets-inventories)/(Crurent liabilities)×365 days

It is a ratio of liquid asset which the inventory is excluded in the calculation as the inventory is a slow-moving item and it takes a longer time to convert into cash. “Rule of thumb”; it should be 1.0 or higher. In the event of liquidation, the company can pressure the debtor to pay quickly and sell any short-term speculation within a short period of time.

Acid Test Ratio (496-364)/552=0.24 (404-202)/220=0.78

Ratio 0.24 indicates poor liquidity in year 2007. The potential new supplier is more likely to restrict the credit amount or even refusal of any credit at all.

In a conclusion, a well management in working capital is important and the working capital can be considered as key factor in a firm’s long-term success. An ineffective management in working capital may cause the business failure.

There must be an effective working capital management to make sure the firm has enough working capital to cover its debts and obligations in order to make the business runs smoothly and operates continuously. Therefore, the firm should decide which types of working capital polices and financing polices should be adopted as these policies may result in different level of risk, liquidity and profitability.

A good management in working capital will enhance the liquidity, solvency, creditworthiness and also the good reputation of the firm. We can say that it helps in avoiding the possibility of over-trading and under-trading. In addition, minimization in the risk of bankruptcy and maximization in the return on current assets investments will also be resulted from an effective working capital management.

Other than that, the financial stability of a firm can be measured by current ratio, quick ratio and working capital cycle ratio. Working capital management is really useful for a firm as it helps the firm to ensure the working capital is used in the productive way and also to ensure the business is operated in an efficient way.

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• Working Capital Mgmt.
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Types of Working Capital

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Working Capital Cycle

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Working Capital Management Explained: How It Works

What Is Working Capital Management?

Working capital management is a business strategy designed to manage a company's working capital. A company's working capital refers to the capital it has left over after accounting for its current liabilities. Working capital management ensures that a company operates efficiently by monitoring and using its current assets and liabilities to their most effective use. The efficiency of working capital management can be quantified using ratio analysis .

Key Takeaways

• Working capital management requires monitoring a company's assets and liabilities to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
• Managing working capital primarily revolves around managing accounts receivable, accounts payable, inventory, and cash.
• Working capital management involves tracking various ratios, including the working capital ratio, the collection ratio, and the inventory ratio.
• Working capital management can improve a company's cash flow management and earnings quality by using its resources efficiently.
• Working capital management strategies may not materialize due to market fluctuations or may sacrifice long-term successes for short-term benefits.

Investopedia / Sydney Saporito

Understanding Working Capital Management

Working capital is a key metric used to measure a company's short-term financial health and well-being. It is the difference between a company's current assets and current liabilities. As such, it is the capital that is left after accounting for its current liabilities. Working capital management is a strategy that companies use to manage their leftover cash.

Current assets include anything that can be easily converted into cash within 12 months. These are the company's highly liquid assets. Some current assets include cash, accounts receivable (AR), inventory, and short-term investments. Current liabilities are any obligations due within the following 12 months. These include accruals for operating expenses and current portions of long-term debt payments.

The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A company's working capital is made up of its current assets minus its current liabilities.

Working capital management monitors cash flow, current assets, and current liabilities using ratio analysis, such as working capital ratio , collection ratio, and inventory turnover ratio .

Working Capital Management Components

Certain balance sheet accounts are more important when considering working capital management. Though working capital often entails comparing all current assets to current liabilities, there are a few accounts that are more critical to track.

The core of working capital management is tracking cash and cash needs. This involves managing the company's cash flow by forecasting needs, monitoring cash balances, and optimizing cash flows (inflows and outflows) to ensure that the company has enough cash to meet its obligations.

Because cash is always considered a current asset, all accounts should be considered. However, companies should be mindful of restricted or time-bound deposits .

Receivables

To manage capital, companies must be mindful of their receivables. This is especially important in the short term as they wait for credit sales to be completed. This involves:

• Managing the company's credit policies
• Monitoring customer payments
• Improving collection practices

At the end of the day, having completed a sale does not matter if the company is unable to collect payment on the sale.

Account Payables

Account payables refers to one aspect of working capital management that companies can take advantage of that they often have greater control over. While other aspects of working capital management may be uncontrollable, such as selling goods or collecting receivables, companies often have a say in how they pay suppliers, what the credit terms are, and when cash outlays are made.

Companies primarily consider inventory during working capital management as it may be the most risky aspect of managing capital. When inventory is sold, a company must go to the market and rely on consumer preferences to convert inventory to cash.

If this cannot be completed quickly, the company may be forced to have its short-term resources stuck in an illiquid position. Alternatively, the company may be able to quickly sell the inventory but only with a steep price discount.

In its simplest form, working capital is the difference between current assets and current liabilities. However, different types of working capital may be important to a company to best understand its short-term needs.

• Permanent Working Capital: Permanent working capital is the amount of resources the company will always need to operate its business without interruption. This is the minimum amount of short-term resources vital to a company's operations.
• Regular Working Capital: Regular working capital is a component of permanent working capital. It is the part of the permanent working capital that is required for day-to-day operations and makes up the most important part of permanent working capital.
• Reserve Working Capital: Reserve working capital is the other component of permanent working capital. Companies may require an additional amount of working capital on hand for emergencies, seasonality , or unpredictable events.
• Fluctuating Working Capital: Companies may be interested in only knowing what their variable working capital is. For example, companies may opt to pay for inventory as it is a variable cost . However, the company may have a monthly liability relating to insurance it does not have the option to decline. Fluctuating working capital only considers the variable liabilities the company has complete control over.
• Gross Working Capital: Gross working capital is simply the total amount of current assets of a business before considering any short-term liabilities.
• Net Working Capital: Net working capital is the difference between current assets and current liabilities.

Why Manage Working Capital?

Working capital management can improve a company's cash flow management and earnings quality through the efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivable and accounts payable . 

Working capital management also involves the timing of accounts payable like paying suppliers. A company can conserve cash by choosing to stretch the payment of suppliers and to make the most of available credit or may spend cash by purchasing using cash—these choices also affect working capital management.

In addition to ensuring that the company has enough cash to cover its expenses and debt, the objectives of working capital management are to minimize the cost of money spent on working capital and maximize the return on asset investments.

Working Capital Management Ratios

Three ratios that are important in working capital management are the working capital ratio, the collection ratio, and the inventory turnover ratio.

Working Capital Ratio

The working capital ratio or current ratio is calculated by dividing current assets by current liabilities. This ratio is a key indicator of a company's financial health as it demonstrates its ability to meet its short-term financial obligations.

A working capital ratio below 1.0 often means a company may have trouble meeting its short-term obligations. That's because the company has more short-term debt than short-term assets. To pay all of its bills as they come due, the company may need to sell long-term assets or secure external financing.

Working capital ratios of 1.2 to 2.0 are considered desirable as this means the company has more current assets compared to current liabilities. However, a ratio higher than 2.0 may suggest that the company is not effectively using its assets to increase revenues. For example, a high ratio may indicate that the company has too much cash on hand and could be more efficiently utilizing that capital to invest in growth opportunities.

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO) , is a measure of how efficiently a company manages its accounts receivable. The collection ratio is calculated by multiplying the number of days in the period by the average amount of outstanding accounts receivable.

This product is then divided by the total amount of net credit sales during the accounting period. To find the average amount of average receivables, companies most often simply take the average between the beginning and ending balances.

The collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit. Note that the DSO ratio does not consider cash sales. If a company's billing department is effective at collecting accounts receivable , the company will have quicker access to cash which is can deploy for growth. Meanwhile, if the company has a long outstanding period, this effectively means the company is awarding creditors with interest-free, short-term loans.

Inventory Turnover Ratio

Another important metric of working capital management is the inventory turnover ratio. To operate with maximum efficiency, a company must keep sufficient inventory on hand to meet customers' needs. However, the company also needs to strive to minimize costs and risk while avoiding unnecessary inventory stockpiles.

The inventory turnover ratio is calculated as the cost of goods sold (COGS) divided by the average balance in inventory. Again, the average balance in inventory is usually determined by taking the average of the starting and ending balances.

The ratio reveals how rapidly a company's inventory is used in sales and replaced. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, meaning a company may want to consider slowing production to ease the cost of insurance, storage, security, or theft. Alternatively, a relatively high ratio may indicate inadequate inventory levels and risk to customer satisfaction.

In addition to the ratios discussed above, companies may rely on the working capital cycle when managing working capital. Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC) . This is the minimum amount of time required to convert net current assets and liabilities into cash. The working capital cycle is a measure of the time it takes for a company to convert its current assets into cash, or:

Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle - Payable Cycle 

The working capital cycle represents the period measured in days from the time when the company pays for raw materials or inventory to the time when it receives payment for the products or services it sells. During this period, the company's resources may be tied up in obligations or pending liquidation to cash.

Inventory Cycle

The inventory cycle represents the time it takes for a company to acquire raw materials or inventory, convert them into finished goods, and store them until they are sold. During this stage, the company's cash is tied up in inventory.

Though it starts the cycle with cash on hand, the company agrees to part ways with working capital with the expectation that it will receive more working capital in the future by selling the product at a profit .

Accounts Receivable Cycle

The AR cycle represents the time it takes for a company to collect payment from its customers after it has sold goods or services. During this stage, the company's cash is tied up in accounts receivable.

Though the company can part ways with its inventory, its working capital is now tied up in accounts receivable and still does not give the company access to capital until these credit sales are received.

Accounts Payable Cycle

The AP cycle represents the time it takes for a company to pay its suppliers for goods or services received. During this stage, the company's cash is tied up in accounts payable.

On the positive side, this represents a short-term loan from a supplier meaning the company can hold onto cash even though they have received a good. On the negative side, this creates a liability that needs to be managed.

Limitations of Working Capital Management

With strong working capital management, a company should be able to ensure it has enough capital on hand to operate and grow. However, there are downsides to the approach. Working capital management only focuses on short-term assets and liabilities. It does not address the long-term financial health of the company and may sacrifice the best long-term solution in favor of short-term benefits.

Even with the best practices in place, working capital management cannot guarantee success. The future is uncertain, and it's challenging to predict how market conditions will affect a company's working capital. Whether there are changes in macroeconomic conditions and customer behavior, or there are disruptions in the supply chain, a company's forecast of working capital may simply not materialize as expected.

While effective working capital management can help a company avoid financial difficulties, it may not necessarily lead to increased profitability. Working capital management does not inherently increase profitability, make products more desirable, or increase a company's market position. Companies still need to focus on sales growth, cost control, and other measures to improve their bottom line. As that bottom line improves, working capital management can simply enhance the company's position.

Working capital management aims at more efficient use of a company's resources by monitoring and optimizing the use of current assets and liabilities. The goal is to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations while maximizing its profitability. Working capital management is key to the cash conversion cycle, or the amount of time a firm uses to convert working capital into usable cash.

Why Is the Current Ratio Important?

The current ratio or the working capital ratio indicates how well a firm can meet its short-term obligations. It's also a measure of liquidity . If a company has a current ratio of less than 1.0, this means that short-term debts and bills exceed current assets, which could be a signal that the company's finances may be in danger in the short run.

Why Is the Collection Ratio Important?

The collection ratio, also known as days sales outstanding, is a measure of how efficiently a company can collect on its accounts receivable. If it takes a long time to collect, it can be a signal that there will not be enough cash on hand to meet near-term obligations. Working capital management tries to improve the collection speed of receivables.

Why Is the Inventory Ratio Important?

The inventory turnover ratio shows how efficiently a company sells its inventory. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.

Working capital management is at the core of operating a business. Without sufficient capital on hand, a company is unable to pay its bills, process its payroll, or invest in its growth. Companies can better understand their working capital structure by analyzing liquidity ratios and ensuring their short-term cash needs are always met.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Page 3. Horizon Books, 2017.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Page 4. Horizon Books, 2017.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Pages 4-5. Horizon Books, 2017.

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Effective Cash and Working Capital Essay

Working capital cycle, primary sources of short term funds, investment options for idle cash.

Working capital refers to the money that is required by the business in order to fund the day to day operations of its operations. It is useful in facilitating smooth running of the business as well as helping in generating more revenue for the business. Thus, debts and expenses can be paid when they fall due. The working capital cycle is the time taken between purchase of inventory and its components and the sale of such inventory (Smith, 1979). This cycle facilitates the effectiveness of the business working capital. The phases of working capital cycle include purchase of inventory, payments to account payables and receiving money from the accounts receivables. It also includes the cash itself. Therefore, the working capital cycle involves the phases of purchasing goods, storing, selling and waiting for the payments for goods (Lorenzo & Virginia, 2010).

The primary sources of short term finance include trade credit, advances from customers, loans from financial institutions and commercial papers. Trade credit involves taking loans in the form of goods. Therefore, a business obtains goods, sell the goods and then pay for them at a later date, thus, an enterprise is able to meet the needs of the customers by purchasing goods for resale on credit. Advances from customers involve the customers paying for the goods fully or partially in advance as a confirmation of orders. Such funds can be utilized in the business to meet its operating expenses. Businesses can also obtain funds through sale of its securities and commercial papers. Finally, the business can obtain short term loans from financial institution such as banks as well as savings and credit cooperative societies. Such short term loans form primary sources of finances for the business.

The term float is normally used with regards to cash held by the business. It refers to the amount of money that is held by the business in liquid form. The cash float held by a business represents the ready cash available in the business cash till for making day to day payments of the business. Cash float also ensures that sufficient change is available for the day’s customers (Smith, 1979). A business is expected to hold some amount of money in ready cash. However, the amount of float differs from one business to another, depending on the size of the business and the number of transactions handled. The term float may have different meanings, depending on where it is used. For example, it represents the amount given to the petty cashier to enable him/her meet petty payments that he/she handles.

Effective cash management of a business may result into idle cash. Such cash can be invested in short term investment opportunities available. It can also be re-invested in producing more goods and services, which will enable to the business to generate more cash and earn larger profits (Kim, 1996). Idle cash can also be invested in the money market. The money market investments usually earn large interests, especially if invested in government securities. The idle cash can also be invested in the stock market to enable the business earn capital gains on the stocks held. Money is held in the form of stock for speculative motives so that when the stock prices rise, the stocks are sold. Debt repayment can also be financed by the idle cash to reduce the burden of accumulating interest expenses on the debts.

Kim, Y. (1996). Advances in Working Capital Management . New York, NY: Emerald Group Publishing Limited.

Lorenzo, P. & Virginia, S. (2010). Working Capital Management: Financial Management Association Survey . Oxford: Oxford University Press.

Smith, V. (1979). Guide to Working Capital Management. Oxford: McGraw-Hill Publishers.

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Working Capital, Essay Example

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The implication of working capital in a business is the cash necessary for the daily operations which include processing the raw materials to achieve the finished items to be sold. The management of working capital in any business is the most critical challenge especially for the small business. It becomes apparent that a business has sufficient assets as well as be in a position to make profits but most of the assets at it its disposal cannot readily be liquidated. The inventory levels, payable and receivable accounts are some of the most vital items in as far as the working capital is concerned. Therefore, the management of the above mentioned items is a very important aspect in the management of the business working capital. Mismanaged its working capital is depicted by a decrease in the current assets of the business relative to the current liabilities leading to a deficiency or deficit in the working capital.

There are notable current assets mismanagement that are most likely cause of a shortfall in the working capital. It is important to note that the current assets play a vital role as statement items of the financial position of the business and this especially important for small businesses. Significant business failure is evident if the current assets are mismanaged which can be projected through the company’s inefficiency in meeting important bills once they accrue, overtrading as well as overstocking.

It is the duty of the management to take care of the business trading assets such as inventory, cash as well as trade receivables. Greater care is inevitable with respect to such items that are readily convertible in to cash within a single business cycle

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Working Capital and Its Management

Introduction.

Working Capital refers to the cash which is required by a business entity to run its day to day operations. It is a measure of the efficiency with which a company conducts its operations and the financial conditions of a company in short run (Bhattacharya 2009). The working capital is equated against the short term components of the balance sheet as follows:

• Working Capital = Current Assets – Current Liabilities

If a company has a positive working capital, i.e. the value of current assets of the company is greater than the total current liabilities’ value; then it suggests that the company can meet its short term liabilities. On the other hand, if the working capital turns out to be negative, i.e. the total current assets are less than total current liabilities; then it means that the company cannot pay off its short term liabilities. This situation is not favorable for a company as the company may run into bankruptcy due to non payment to its creditors (Bhattacharya 2009, Hill 2008).

Significance of Working Capital for a Company

The working capital ratio keeps on changing for a company and can be adjusted quickly by introducing different variations to the proportion of current assets and current liabilities held by the company. However, if the working capital ratio shows a declining trend in the long run; it may be a sign of trouble for the company. This may happen, as for instance, when the revenue generated from sale of goods starts declining and the amount to be received from the debtors of the company does not grow thus decreasing the amount of total current assets (Priester and Wang 2010).

Apart from other financial ratios, investors consider the working capital ratio of a company to get an idea as to the operational efficiency of a company. Working capital is also affected by other ratios maintained by the company. As for instance, the amount of cash which the company ties up in inventory stocks and accounts receivable cannot be instantly used by that company for paying off an obligation. Therefore, if the turnover for account receivable is slow, it will although increase the current assets of the company but the liquidity level will be low and hence indicates inefficient operations of the company (Shin and Soenen 1998, García-Teruel and Martínez-Solano 2007).

For these reasons, a company needs to manage and maintain its working capital to optimum levels by achieving suitable levels for current assets and current liabilities and ensuring that the company is efficient enough in collecting its amounts receivable from the debtors. Apart from benefits relating to potential investors, efficient management of working capital also allows a company to improve its earnings significantly (Deloof 2003, Scherr 1989).

Working Capital Management Techniques

There are various methods by which companies can manage their working capital. The choice of a particular technique for managing working capital is determined by the nature of business of the entity and the needs relating to working capital. The three most followed working capital management approaches include reducing or managing inventory levels, speeding up the collection time of receivables and reviewing the credit terms with the creditors of the business (Peel and Wilson 1996, Moore and Reichert 2006). A company needs to manage working capital by way of focusing on all the three areas mentioned above, however, based on the needs and requirements of the business, a company may opt to follow a particular course of action, i.e. the company may decide to put more emphasis on one of the identified management techniques. Apart from the internal needs and requirements of a company, the working capital management technique is also determined by the industry wide conditions and trends, competitive environment and the regulatory environment under which the company operates (Buchmann and Jung 2010, Lamberson 2004, Mathur 2002). The three identified working capital management techniques are discussed below.

• Reducing or managing inventory levels

Managing or reducing inventory levels allows a company to create a source of cash. Most of the savings related to cash can be made by managing inventories effectively. Management of inventory can be attained by bringing in efficiency in the organizational / manufacturing processes, budgeting and forecasting and addressing the imbalance among the processes related to creditors and debtors (Buchmann and Jung 2010, H. Bhattacharya 2004). The levels of inventory can be managed or reduced by a company through following techniques:

• Efficient Forecasting and Demand Planning:

By way of improving the budgeting and forecasting and getting up to date with the demand of the product dealt with, a company can reduce its inventory levels and thus becomes able to hold sufficient amount of cash reserves (Buchmann and Jung 2010, Preve and Sarria-Allende 2010).

• Efficient Supply and Delivery Mechanisms:

Nowadays business entities have developed advanced supply management systems which allow them to interact with their suppliers in accordance with the demand conditions existing in the market. This includes the application of models like Economic Order Quantity (EOQ), Just In Time (JIT), etc. (Buchmann and Jung 2010, Jain 2004).

• Efficient Manufacturing Procedures:

Optimized or efficient manufacturing processes allow companies to reduce inventory withheld in work in process. This can be achieved by companies by reducing the inventories stuck in work in process while considering the demand of the product being manufactured. In this way optimum levels of inventory are held by the company and cash reserves are increased (Buchmann and Jung 2010, Kumar 2001).

• Prioritizing of Inventory Items:

A company can manage its inventory levels by focusing on maintaining high levels of inventory stocks for those items which have a higher demand, while reducing the levels for those stock items which are slow moving and have a lower demand (Buchmann and Jung 2010).

Disadvantage of Inventory Levels Management

The management of inventory, which usually involves the reduction of inventory stocks which are maintained by a company, results in a disadvantage for the entity doing so. The disadvantage is that after reducing the size of inventory held by the company, there is a possibility that the company may not be able to cope up to demand of the customers and therefore decrease in revenues may result (McInnes 2010).

Those companies which intend to employ this management technique to improve the working capital ratio, shall analyze carefully the demand conditions in the market of their products and the ability to meet those demands with reduced inventory levels. After doing so, the companies shall decide as to whether the planned management plan will work for them or not (Jain 2004).

Speeding up the collection time of receivables

One major factor which deteriorates the networking capital structure of an organization is lack of coordination between receipt and payment of cash. In short, some companies collect the amount receivable from their customers late but pay their creditors early. This situation calls for an efficient system of managing the receipt of cash to be received from the debtors of a company (Buchmann and Jung 2010, Gentry and De La Gazra 1985). This efficiency can be attained through following techniques:

• Invoicing Cycle:

The main objective in this approach is to dispatch invoices to the debtors in a swift way. This technique, however, requires other business process to be active and efficient also. As for instance, the billing department of a company can only generate invoices to the customers promptly if there are no pending matters relating to other departments. Any disruption or discontinuity in a process will slow down the invoicing process (Buchmann and Jung 2010).

• Early Reminders to Debtors:

It is a general observation that customers tend to delay payments, which significantly affect the liquidity position of the receiving company. Early reminders help in reducing late payments by customers and thus increase cash inflows (Buchmann and Jung 2010).

• Payment Terms:

Favorable payment terms help in reducing Days Sale Outstanding (DSO). While negotiating the payment terms with the customers, the companies shall keep in mind the bargaining power of the customers to determine payment terms which are acceptable for both parties (Buchmann and Jung 2010).

Disadvantage of Collection time Reduction

When a company aims at collecting the amounts receivable from its customers before due dates, it has to offer some consideration in return to those customers who are willing to pay early. In this regard, the usual practice is the offering of discount or waiver of certain percent of the amount receivable. This discount reduces the amount received by the company due to reducing the collection time. Therefore, reducing collection time has a disadvantage of bringing down the receivable amounts (Jain 2004).

To account for this situation, companies which are intending to use this working capital management approach and at the same time do not want to experience a decrease in their earnings, shall focus on reducing the delay in collection of amounts to be received instead of offering discount for payments received before due dates (Jain 2004).

Reviewing the credit terms with the creditors of the company

As a company shall manage its cash collection time, likewise, it is also required that the company shall manage its payments to the creditors. This can be done in the following manners:

• Payment Cycle:

Although payment cycle of an entity is determined by the industry in which an entity operates and the terms and conditions attached to the agreements between the two parties, but the entity shall strive towards following a payment cycle which does not drain the cash in frequent intervals and at the same time is not unfavorable for the suppliers also (Buchmann and Jung 2010).

• Avoiding Early Payments:

To ensure the sufficiency of cash reserves, a company shall avoid very early payments and try to negotiate payment terms with its suppliers which are favorable for the management of its net working capital (Buchmann and Jung 2010).

• Payment Conditions:

Such payment conditions shall be set which allow the company to manage its working capital efficiently. To do this, the company shall negotiate the payment conditions with its suppliers from time to time to gain advantage related to extension of payment time period (Buchmann and Jung 2010).

Disadvantage of Increasing the Payment Time

Where a company decides or makes arrangement with its suppliers that the payment of the amount due will be delayed by the company, the company may go away with losing the benefit of available discounts which are available on timely payment or payments made before due date (Jain 2004).

Analysis and Discussion of the Working Capital – The Coca Cola Company and PepsiCo Inc

To present an analysis of the working capital, two real life scenarios have been considered here, i.e. The Coca Cola Company Inc. and PepsiCo Inc. Below is the table presented which includes the current assets and liabilities for the last two financial years, 2009 and 2010, for The Coca Cola Company Inc.

Table – 01: Current Assets and Liabilities of Coca Cola Company in 2009 and 2010

The information presented in the table can be used to calculate the working capital of The Coca Cola Company for two years as follows:

Working Capital (2009) = $ 17,551 million – $ 13,721 million

= $ 3,830 million

Working Capital (2010) = $ 21,579 million – $ 18,508 million

= $ 3,071 million

It can be observed that the net working capital in the year 2010 has decreased by $ 759 million. The major reason behind this decrease is that the accounts payable and short term loans have increased significantly in 2010. On the other hand, the current assets have although increased but not in the same proportion as in the case of current liabilities. Therefore, the company is experiencing a negative working capital trend from 2009 to 2010.

On the other hand, following table presents the figures related to current assets and liabilities of PepsiCo Inc. for the year 2009 and 2010.

Table – 02: Current Assets and Liabilities of PepsiCo Inc. in 2009 and 2010

The information presented in the table can be used to calculate the working capital of the PepsiCo Inc. for two years in the following manner:

Working Capital (2009) = $ 12,571 million – $ 8,756 million

= $ 3,815 million

Working Capital (2010) = $ 17,569 million – $ 15,892 million

= $ 1,677 million

Similar to the case of The Coca Cola Company Inc., the networking capital of PepsiCo Inc. has also declined from the financial year 2009 to 2010 by a huge amount of $ 2,138 million. Considering the data presented in Table – 02, there is an increase in the cash and cash equivalent component of current assets in 2010 by an amount of $ 2,000 million. Similarly, accounts and notes receivable have also increased in 2010 by $ 1,700 million approximately. However, these increases are not enough to cover the increases in different components of current liabilities. As for instance, there is a significant increase in the accounts payable and accrued expenses in 2010, i.e. $ 2,796 million. Therefore, the networking capital for PepsiCo Inc. is also moving in a negative direction.

Working Capital is a key factor in determining the liquidity of a company and it is due to this reason investors and shareholders show interest in getting to know the net working capital of a company. Working capital management is considered as one of the major areas by the management of a company as it enables a company to plan and make budgets for future periods. The primary motive behind managing working capital is to ensure that the liquidity position of a company is up to the mark. There are various ways in which a company may manage its working capital, which include managing the inventory levels, reducing the account receivable collection time period and reviewing credit terms with the creditors of the company. Along with the benefits of these techniques of managing working capital, there are certain limitations also which can be dealt with proper planning.

List of References

Bhattacharya, H., 2004. Working Capital Management: Strategies and Techniques . New Delhi: PHI Learning Pvt. Ltd.

Bhattacharya, H., 2009. Working Capital Management – Strategies and Techniques . 2nd ed. New Delhi: PHI Learning Pvt. Ltd.

Buchmann, P. and Jung, U., 2010. Best-Practice Working Capital Management: Techniques for Optimizing Inventories, Receivables, and Payables . Web.

Deloof, M., 2003. Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business Finance and Accounting , 30(3-4), pp.573-88.

García-Teruel, P.J. and Martínez-Solano, P., 2007. Effects of working capital management on SME profitability. International Journal of Managerial Finance , 3(2), pp.164-77.

Gentry, J.A. and De La Gazra, J.M., 1985. A Generalized Model for Monitoring Accounts Receivable. Financial Management , 14(4), p.28.

Hill, R.A., 2008. Strategic Financial Management . Finance and Ventus Publishing.

Jain, N.K., 2004. Working capital management . New Delhi: APH Publishing.

Kumar, A.V., 2001. Working Capital Management . New Delhi: Northern Book Centre.

Lamberson, M., 2004. Financial Analysis and Working Capital Management Techniques used by Small Manufacturers: Survey and Analysis . Web.

Mathur, S.B., 2002. Working Capital Management and Control: Principles and Practice . New Delhi: New Age International Pvt. Ltd. Publishers.

McInnes, A., 2010. Working Capital Management . Lambert Academic Publishing.

Moore, J.S. and Reichert, A.K., 2006. AN ANALYSIS OF THE FINANCIAL MANAGEMENT TECHNIQUES CURRENTLY EMPLOYED BY LARGE U.S. CORPORATIONS. Journal of Business Finance and Accounting , 10(4), pp.623-45.

Peel, M.J. and Wilson, N., 1996. Working Capital and Financial Management Practices in the Small Firm Sector. International Small Business Journal , 14(2), pp.52-68.

PepsiCo.  Annual Report 2010 . Annual Report. New York: PepsiCo Inc.

Preve, L.A. and Sarria-Allende, V., 2010. Working capital management . Oxford University Press.

Priester, C. and Wang, J., 2010. Financial Strategies for the Managers . Tsinghua University Texts.

Scherr, F.C., 1989. Modern working capital management: Text and cases . Englewood Cliffs: Prentice Hall.

Shin, H.H. and Soenen, L., 1998. Efficiency of Working Capital Management and Corporate Profitability. Financial Management , pp.37-45.

The Coca Cola Company, 2010. Annual Report 2010 . Annual Report. Atlanta: The Coca Cola Company Inc.

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Best Finance Essay Examples

Working capital.

1042 words | 4 page(s)

While companies grow in complexity and size and tend to internationalize, it is of critical strategic importance to maintain and improve the performance of working capital. Once a company intends to improve working capital, it strives to maintain a positive balance between the finished goods inventory and customer service. Top competitive companies achieve high customer service levels through low levels of finished goods inventory. They attain such results by predicting the demand on item level and further ensure its timely delivery to the right location.

There are three constituents of working capital, namely inventory, accounts receivable, and accounts payable. Top companies create much value by effectively managing inventory and effectively using supply chain capabilities to achieve the positive levels of inventory reduction. Thus, the top companies struck a balance between low and moderate finished goods inventory and high customer service by accurately forecasting item level demand.

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Some companies think that the more channel inventory is, the higher customer fill rates will be ensured. That’s a common misconception that causes poor performance of working capital. Indeed, there is an insignificant correlation between better fill rates and higher inventory levels. The top-performing companies therefore much emphasize on the management of product complexity while the amount of products in inventory is crucial for the effective performance of working capital. Competitive companies strive to create sustainable supply chain capabilities.In particular, modular supply chains assume high degree of interchanging and flexible relationships among suppliers and customers. Supply chain modularity is subject to the generic methodology applied within supply chain management which enables to better understand and cope with the problems arising in supply chains. There are various benefits involved in the concept of modularization, including labor division, effective modularization, effective interaction between suppliers and customers etc, though all these largely depend on actual capabilities of suppliers.

The modular approach has been implemented in various sectors. For instance, modular systems enhance the coordination, design and productivity processes in automotive and computer domains. The modularization of components and related design and production processes, as well as interactions between suppliers and customers enables to save costs and advance product flexibility. As such, numerous modularity applications enabled to enlarge and widen product variety without worsening operational performance. At that, modularity has become critical in terms of repetitive production and design of standard components and their integration.

Modular products benefit from the application of a modular supply chain since module suppliers, even though they are geographically remote, can use their independent ownership and managerial structures. Further, the concept of supply chain modularity provided solid grounds for outsourcing developments, especially in PC industry to save on the purchasing cost. Compared to integrality, the modularity framework enables high degree of component independence wherein components do not affect each other geographically, functionally or physically. Such interchangeability allows smooth coordination and communication of modularization processes. Various product developments performed in accordance with module integration framework enable product co-designers to eliminate material costs and development time, as well as to improve the features and functionality of products. In case of outsourcing of product modules, the interdependence between supplier and customer increases since supplier becomes maximum responsible for the design of the outsourced modules and the solution of technical problems in the course of product development. Furthermore, immediate chain design improves overall interaction, coordination and understanding of the joint processes between suppliers and customers on all stages of product development and/or innovation.

On the empirical agenda, however, the situation is worse since the sources outlining examples of product modularization are scarce and mainly indicate how supply chain performance is improved through to the supply chain design and coordination. In practical terms, the modular product approach assumes the standardization, reusing and sharing of components, which enables the launch of new products due to the combination and interchangeability of various design modules. Therefore, to reach full-fledged optimization of supply chain and operational performance new empirical studies and researches are needed with definite emphasis on the integration between supply chain design and coordination and product modularization. At that, product modularization will have positive effect on supply chain design, while the quality of supply chain coordination will depend on product innovation.

The supply chain management methodology involves reconfiguration of the supply chain structure, coordination of the supply chain, and continual advancement. Hence, supply chain management methods are applied in the construction industry to analyze, coordinate and enhance construction supply chains. The applications are various, including: reduction of logistical costs, assessment of supply chains impacts on site activities to reduce the duration and site costs; transfer of site-based activities to the higher stages within the supply chain. In particular, supply chain management enables to save time resources and costs to increase and balance products with the estimated prices. At that, product and marketing developments regarding materials within the supply chains are becoming more efficient and effective. However, chain suppliers should beware of the insufficiency of logistical competence, competitive limitations, as well as the necessity of strong focus on the industry’s projects.

Within the framework of supply chains, modularity determines non-proximity of constituents, whereas integrality determines the degree of their proximity. The architectures involving products, processes, and supply chains should be considered within the integrality-modularity framework. Supply chain modularity determines labor division with clear allocation of duties among the companies and interactions among actors involved in the common process. At that, the separation between design and execution responsibilities is of paramount importance. On the contractual basis the companies are allocated specific responsibilities as a part of the same process. However, the ‘design-and-execution’ model enables the combination of the related as a part of modular supply chain. Therein, a single organization is responsibe for design and construction functions, for example. At that, the general contractor bears overall responsibility for project completion and coordination of design and execution functions and processes. Solutions to the related problems require modular approach towards reengineering, procurement process, logistics and product development programs. At that, various actors implement joint activities within the boundaries of sole chain to solve common tasks or problems. Therefore, the successful application of supply chain modularity in the construction largely depends on the actors’ ability to share common vision and develop the same approach to problem-solving and seeking new opportunities for further improvement.

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Working Capital Essay Examples

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Essay On Working Capital Management Assignment

Type of paper: Essay

Topic: Finance , Company , Banking , Financing , Capital , Business , Strategy , Investment

Words: 3000

Published: 12/10/2021

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Response to Q1a

Strategy 1: Aggressive. As per strategy 1, the Total funds requirements are to be divided into permanent and seasonal requirements based on the premise that permanent requirements are essential and the seasonal requirements vary and hence the permanent requirements need to be allocated out of the total monthly requirements based on Polly’s assessment of short term and long term average monthly requirements as shown below. Strategy 2: Conservative. For Strategy 2, the conservative funding requires Polly to allocate the whole amount to Permanent requirements with long term funds equal to $1,500,000 and the seasonal requirements to be fulfilled only in emergency cases.Thus in each month the Permanent requirements amount to $1,500,000 while there are no seasonal requirements . Strategy 3: Trade-off. For strategy 3, An amount equal to $4,500,000 needs to be funded with long term funds and the rest with short term funds. Thus the funding requirements will be reflected as in the table below

Response to Q1b

As per Polly’s assessment, the short term financing costs are 6% and Long term financing costs are 10%. Thus as per strategy 1(aggressive), the total financing costs are as follows: Total Short term Financing costs = 6% X Total annual Short term fund requirements Total Short term Financing costs=6% X $45,000,000=$2,700,000 Total Long term financing costs= 10%XTotal annual long term fund requirements Total Long term financing costs=10%X$18,000,000=$1,800,000 Total financing costs = $2,700,000+$1,800,000=$4,500,000

As per strategy 2 (Conservative),

Total short term financing cost= 6%X0=0 Total Long term financing costs=10%X18,000,000=$1,800,000

Total financing costs are $1,800,000

As per strategy 3(Trade off), Total short term financing cost=6%X$21,000,000=$1,260,000 Total long term financing cost=10%X$42,000,000=$4,200,000 Total financing costs are=$1,260,000+$4,200,000=$5,460,000

Response to Q2

Expected annual average current assets= $6,000,000 Net working capital=Current Assets-Current liabilities Net average annual working capital= Average annual current assets-average annual current liabilities . Also, Average annual current liabilities=Average annual seasonal financing And Average annual seasonal financing= Total seasonal financing/12

As per strategy 1,

Total seasonal financing= $45,000,000 Total current liabilities=$45,000,000 Average annual seasonal financing=$45,000,000/12=$3,750,000 Net average annual working capital= $6,000,000-$3,750,000=$3,250,000

As per strategy 2,

Total seasonal Financing=0 Total current liabilities=0 Average annual seasonal financing=0 Net Annual working capital=$6000,000

As per strategy 3,

Total seasonal financing =$21,000,000 Total current liabilities=$21,000,000 Average annual seasonal financing=$21,000,000/12=$1,750,000 Net average annual working capital= $6,000,000-$1,750,000=$4,250,000

Response to Q3

The profitability risk trade-off Net working capital=Current Assets-Current liabilities Also, cost of financing is the cost of acquiring working capital. Thus an increase in working capital is proportional to an increase in the current assets and a decrease in the current liabilities.

Thus the risk and profitability as related to the cost of working capital can be tabulated as below

As per Aggressive Strategy (1), the firm would borrow from $1,500,000 to $9,000,000 according to the seasonal requirement schedule shown above, at the prevailing short- term rate. The firm would borrow $1,500,000 or the permanent portion of its requirements at the prevailing long term rate . Also, as per this strategy, the total cost of acquiring working capital is $4,50,000 which is high, thus Profitability and risk associated are low. As per Conservative strategy(2), the firm would borrow for seasonal requirements only in the cases of emergency and thus the short term requirements shall be met with the balance of the permanent funds let after funding the long term requirements. The firm would borrow $1,500,000 or the permanent requirement at the prevailing long term rate . Also, as per this strategy, the total cost of acquiring working capital is $1,800,000, which is low, thus the profitability as well as the risk of doing business in this case are high . As per trade-off strategy (3), the firm would borrow from $1,500,000 to $6,000,000 according to the seasonal requirement schedule shown above. The firm would borrow from $1,500,000 up to $4,500,000 or the permanent portion of its requirements at the prevailing long term rate. Also, as per this strategy, the total cost of acquiring working capital is $4,60,000 which is the highest, thus Profitability and risk associated are lowest. Recommended strategy. In this case, the lowest costs associated with Strategy 2, the conservative strategy, make it the most favourable. Possibly a unique combination of low costs but high profitability make it attractive but also warrant greater risk .

Response to Q4

Prime Interest rate = 2.5% Overdraft premium rate = 3.5% Total interest rate = 6% Thus Annual Interest cost = 6% X $ 9,00,000 X 365/365= $54,000 Average unused balance = Overdraft limit – Average annual overdraft Thus average unused balance = $1,500,000 - $900,000=$6,00,000 Therefore Commitment fee = 0.5% X Average annual unused balance Commitment fee = 0.005 X $6,00,000=$3000 Total costs = Interest cost + commitment fee = $54,000 + $3,000=$57,000 Thus effective annual interest rate = ($57,000/$900,000) x 100= 6.34%

Case2: Report

Report to: Fletcher Peters As requested, my report regarding the alternative methods of financing the seven companies is attached. I have discussed the various options available for each company, including its effect on working capital, and then recommended the option I consider to be the most appropriate for the given circumstances.

Mistral Yachts

Discussion of company Mistral Yachts is a private company founded in 1970 to build quality Yachts. The company’s current debt ratio is higher than the industry average of 36%. The shares are owned by ten partners and none of them have the financial strength to put additional funds into the business. The business is thus hard pressed for funds. The company has a decent profit of $1,200,000 after tax. However, in order to succeed in the future it needs an additional $6,500,000 in near future to fund the expansion and stay competitive.

Viable financing options

The company can not afford long term financing options and also does not need the finance to be very expensive which is the usual condition for a fast and easy financing. Thus the various viable options for Mistral yachts are Preference shares and ordinary shares with private placement. The company must not go for ordinary shares with rights offering as the existing shareholders do not have any funds to invest. Additionally, the company can go for a bank overdraft to meet its short term finance needs for business expansion .

Recommendation

The most appropriate financing method for the company would be a mix of Ordinary shares with private placement and a bank overdraft facility, which will serve the need based finance needs of the company.

Impact on working capital

The recommended financing option for the company will help it increase its working capital with an optimum cost of acquiring the capital. The bank overdraft is a relatively easy and reasonably priced option and the shares with private placement can help finance the business expansion in a moderate fashion .

Kemmerer Wines Ltd.

Discussion of company Kemmerer Wines Ltd. Is a financially stable company with high equity to debt ratio. The company wants to establish a new plant in a new location and the company is already listed on the stock exchange with good earnings and dividends per share. The company needs additional $3.3 million for the new winery.

The company being stable enough can go for long term bank loans as well as offer additional shares and debentures to the existing equity. Another good option can be the preference shares or ordinary shares with rights options. The company can also easily get a loan on its equity and may partially go for factoring .

The most appropriate option for the company would a mix of ordinary shares with rights options along with a bank loan or bonds on its equity.

The recommended finance option would indeed increase the working capital and increase the liquidity of the company to a greater extent with a moderate cost of acquiring and maintaining the capital .

Orchard Fresh Canning Company

Discussion of company The Orchard Fresh Canning Company is a canned fruit company selling on a 60 day credit. In contrast, the raw materials and fruits are purchased within 30 days period. Thus there is a considerable time lag between receivables and payables. Thus the company is obviously in need of short term, working capital loans to finance its day to day operations . The company has a long term mortgage loan to be serviced. The increase in demand calls for an expansion and additional funding for the company and the same is estimated at $550,000.

The various appropriate financing options for the company are factoring as it has greater accounts receivables than usually the accounts payable and can afford to sell its accounts receivable to limited extent. Additionally, it can go for a bank overdraft facility. Another option is to go for a long term mortgage bank loan which is an appropriately non expensive option given its apparent lack of liquidity .

For a company like Orchard Fresh, a combination of the Factoring and the bank overdraft facility will be most appropriate. The former will take advantage of its supposed favourable accounts receivable position, while the latter will be beneficial as a moderately priced, and readily available and flexible financing option, given its existing mortgage loan from bank .

The recommended finance option for this company will serve to help manage the working capital better and will help capitalize on its current assets in the short term, which it is in need of especially with additional fund requirements for business growth .

Parson Healthcare Ltd.

Discussion of company Parson Healthcare is a financially stable company and listed on the stock exchange. The share value growth reflective of the business growth is 7% and is higher than the industry average of 5%. However, the debt ratio of the company is much higher at 42% than the industry average of 25%. Also, the price to earning ratio of the company shares is much lower at .058 as compared to industry average of 0.15. This makes the company less profitable, though liquidity is not much of a problem due to faster growth. In order to further fuel expansion, it needs $5 million in cash .

The company can go for a partial leasing arrangement for operations and do the Marketing itself as it has an established business and fast growth. A leasing arrangement can do away with operational expenses and bottlenecks. Another viable option for it is to go for a long term bank loan with over drafting facility as an inexpensive means of financing, since the company is currently low on profitability .

Considering the overall condition of the company, it will be advisable for it to go for a long term bank loan with over drafting as owing to its assts and fast growth, it will easily get bank finance on a comparatively low to moderate cost of acquiring funds .

The recommended finance option is going to improve increase a the working capital in both short run as well as on a relatively longer term with a lower end cost of acquiring working capital .

Silver Hill Mining Company

Discussion of company The Silver Hill mining company is a financially strong company with lower than industry average debt ratio as well as Total assets worth $120 million. The shares earning to price ratio is well within the industrial average limit of 8 to 13 per share. Thus the profitability is decent. The company needs an initial finance of $12 million to finance the acquisition of mining rights to ascertain the viability of mining in a given area. This is a risky investment and warrants a low cost and fast available option. If successful, another $12 million are required to expand the mining operations into the area .

The company can go for the preferential shares or the ordinary shares with private rights offering option. For the additional $12 million, the company may go for a combination of ordinary shares with private placement and bank overdraft.

The company must go for ordinary shares with private rights offering as this will maintain the equity as well as help acquire fast but moderately priced finance given the fact that the company is already into shares which are earning a decent price. Additionally a bank overdraft facility may be suitable for the additional $12 million if the project is found viable .

The net impact on the working capital would be to strengthen the liquidity part and also a ready and abundant availability for such a huge project.

The Way Bowling Lane and Bar

Discussion of company The Way Bowling Lane and Bar is supposedly a new Entrepreneurial venture. As the business owner of the supposed business, Bud Greer has a fair knowledge of the market and is confident of succeeding in the business. He already has access to a building available at a low cost and ideal for the ten pin bowling business. He needs $2,00,000 for the business out of which he has $50,000 from his savings thus he needs an additional $200,000 for the business .

Since this is a new business, and the fund requirement is not on a very higher side, the best way for Bud would be to borrow from friends and/or relatives. Also he can go for debts with warrants for share purchases, later on.

In this case for starting the business, it is recommended that Bud should borrow from family/friends as this is the safest and easiest method of finance in the given circumstances. Once the business builds up a little, he can apply for a short term bank loan and also get an overdraft facility .

Initially, the business will require the working capital to limited extent as this is a service oriented business. Thus the working capital needs can initially be met with the recommended finance option for the business .

GC Engineering Ltd.

Discussion of company GC Engineering Ltd is dealing in latest computerized technologies. Although it is a big company in terms of assets, its financial health is currently not in best condition. The company’s debt ratio is slightly higher than industry average and the shares are selling slightly below the industry average. The growth is slowing owing to rising fuel prices and high currency exchange rate owing to its 70% export oriented business. It needs an additional $10 million to support a business growth at desired level .

The most viable options for the company at this stage are the ordinary shares with the private placement option as a fast and moderately priced finance option. Also, it might go for a Debt with warrants for share purchases along with a partial bank loan .

The recommended finance option for the company is floating ordinary shares with private placement option as it will help build assets that can further be used as a finance option for expansion.

The working capital requirements of the business are high as the business expansion requires huge funds for starting and managing routine operations. The recommended option will serve to provide finance for working capital to the company with ease and at a moderate price and this will build up reserve working capital .

Gitman, L. J., Juchau, R., & Flanagan, J. (2010). Principles of Managerial Finance. Pearson Higher Education AU. Hill, R. A. (2013). Working Capital Management, Theory and Strategy. Retrieved from Bookboon.com: http://www2.aku.edu.tr/~icaga/kitaplar/working-capital-management.pdf Padachi, K., Howworth, C., & Narasimhan, M. S. (2012). Working Capital Financing Preferences:The Case of Mauritian Manufacturing Small and Medium Sized Enterprises(SMEs) . AAMJAF, 125-157.

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