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Working Capital and Its Management

We will be looking at working capital and its management, including cash, inventory, debtors and short-term financing.

Working capital and its management 

In this post we are going to look at working capital and its management.If current assets are less than current liabilities, an entity has a working capital deficiency. It is also referred to as a working capital deficit and negative working capital. Working capital is part of operating capital, along with fixed assets such as plant and equipment. Gross working capital is equal to current assets. The calculation of working capital involves subtracting current liabilities from current assets. An entity has a working capital deficiency if its current assets are less than current liabilities. This condition is also referred to as a working capital deficit and negative working capital.If a company’s assets cannot be readily converted into cash, it may fall short of liquidity even if it possesses assets and profitability. To ensure the continuation of operations, a firm requires positive working capital. It also needs enough funds to fulfil maturing short-term debt and upcoming operational expenses. Working capital management involves managing inventories, accounts receivable and payable, and cash. Working capital is the difference between current assets and current liabilities. One should not confuse it with trade working capital, as the latter excludes cash.The basic calculation of working capital is based on the entity’s gross current assets.

Working Capital = Current Assets − Current Liabilities

The working capital cycle (WCC), also known as the cash conversion cycle, is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer this cycle, the longer a business is tying up capital in its working capital without earning a return on it. Companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. Under certain conditions, minimizing working capital might adversely affect the company’s ability to realize profitability, e.g. when unforeseen hikes in demand exceed inventories or when a shortfall in cash restricts the company’s ability to acquire trade or production inputs. The working capital and short-term financing decisions refer to working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.A managerial accounting strategy focuses on maintaining efficient levels of both components of working capital, current assets, and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

Decision criteria

By definition, working capital management entails short-term decisions—generally relating to the next one-year period—which are “reversible”. These decisions are, therefore not taken on the same basis as capital-investment decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of cash for raw materials to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.In this context, the most useful measure of profitability is the return on capital (ROC). The result is shown as a percentage. This is determined by dividing relevant income for the 12 months by capital employed. In addition, return on equity (ROE) represents this result specifically for the firm’s shareholders. A firm enhances its value by exceeding the cost of capital resulting from capital investment decisions. This is achieved when the return on capital from working-capital management is attained. ROC measures are therefore useful as a management tool in that they link short-term policy with long-term decision-making. See economic value added (EVA).Credit policy of the firm: Another factor affecting working capital management is the firm’s credit policy. It includes buying of raw materials and selling finished goods either in cash or on credit. This affects the cash conversion cycle. Read more: Long Term Capital Management

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets, which typically include cash and cash equivalents, inventories, and debtors. They also focus on short-term financing to ensure acceptable cash flows and returns. Cash management. Identify the cash balance which allows for the business to meet day-to-day expenses, but reduces cash holding costs.Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials—and minimizes reordering costs—and hence increases cash flow. In addition to this, the company should lower the lead times in production to reduce Work in Process (WIP). Similarly, it should aim to keep the Finished Goods at the lowest possible level to avoid overproduction. Implementing supply chain management techniques such as Just-In-Time (JIT) and Economic Order Quantity (EOQ) can achieve these actions.Debtors management. When identifying the appropriate credit policy, i.e., credit terms that will attract customers, ensure that any impact on cash flows and the cash conversion cycle will be offset by increased revenue, maximising Return on Capital (or vice versa). You can achieve this by considering discounts and allowances.Short-term financing. When identifying the appropriate source of financing based on the cash conversion cycle, one should consider financing the inventory, ideally through credit granted by the supplier. However, it may be necessary to utilize a bank loan (or overdraft) or “convert debtors to cash” through “factoring”.
Evita Veigas
4 min read

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