WORKING CAPITAL MANAGEMENT
1. Working Capital
As it has been mentioned in the previous chapter, current assets in finance are also called as working capital. It is called working capital because businesses need current assets in order to carry out its activities. Businesses make investment (tie up money) in current assets just like they make investment in non-current (fixed) assets. When a business establishes a factory, buys machinery and equipment, buys vehicles, etc. it makes investment in fixed assets. It is called fixed capital investment and some fixed capital investments require detailed analysis. In other words for fixed capital investments a project should be prepared and analyzed.
When a business holds cash it makes an investment in working capital (it makes an investment in current assets), when a business buys inventory it makes an investment in working capital, when a business makes a sale on account it makes an investment in working capital, when a business makes a prepayment it makes an investment in working capital. In all of these cases the business ties up (locks) money in current assets. Components of working capital are:
- Cash (may be kept in the business or in a bank account)
- Marketable securities (short-term investment in securities)
- Receivables (short-term)
- Inventories
- Prepayments
Working capital (also called gross working capital): Total amount of current assets.
Net working capital: Current assets – Current liabilities (current assets financed by long-term resources).
Permanent working capital: Minimum level of investment in current assets in order to maintain business.
Temporary (seasonal) working capital: Temporary increase in current assets as a result of seasonality (eg: seasonal increase in inventories or receivables).
2. Factors Affecting the Working Capital
a. The type of the firm, sales volume of the firm, the sector of the firm: The first factor that affects the working capital is the type of the firm. The composition of the working capital is different for different type of firms. Some firms manufacture only one product, some firms manufacture multiple products. Firms that manufacture multiple products carry more inventory. Some firms manufacture custom made products. They carry less inventory. B to B firms (business to business firms are the firms that sell their products or services to other businesses) have trade receivables in the form of account receivable and note receivable. On the other hand B to C firms (business to consumer firms are the firms that sell their products or services to the consumers) have credit card receivables.
The second factor that affects working capital is sales volume. As the sales volume increases amount of working capital also increases. As the sales volume decreases amount of working capital also decreaes.
The third factor that affects working capital is the sector of the firm. Firms operating in retailing sector carry merchandise inventory. They make their sales to consumers and, as mentioned above, they have also credit card receivables. Firms in the manufacturing sector carry materials, work-in process, and finished goods inventories. A hospital has receivables from Social Security Administration and insurance companies. A firm that transports passangers from the city to the airport receive cash from its customers and the most important working capital component for this firm is cash.
b. Inflation: As the inflation increases the amount of working capital also increases as a result of price increases even if the sales volume does not change.
c. Inventory turnover and receivables turnover ratios (days of receivables outstanding and days of sales in inventory): As the turnover ratios decrease the amount of working capital increases because more money is tied up in inventories and receivables.
d. Sales and purchase terms: If the firm can get materials or merchandise in short notice, in other words if the lead times are shorter, then the firm has less inventories. If the firm sells perishable products it has also less inventories. If the sales and purchases are seasonal. In ther words, if the sales and purchases concentrate in certain seasons the amount of inventories and receivables increase in those seasons. Then the amount of inventories and receivables gradually decrease.
e. Production process: As the lenght of the production process increases amount of work-in process inventory also increases.
- Capacity utilization rate: As the capacity utilization rate increases the amount of work-in process inventory also increases.
3. Ratios that Measure the Adequacy of Working Capital
Current ratio = Total current assets/Total short-term liabilities
Current ratio must be at least 1.5
Acid test ratio = (Total current assets – inventories)/Total short-term liabilities
Acid test ratio must be at least 1
Cash ratio = Cash and bank accounts/Total short-term liabilities
Cash ratio must be at least 0.25.
Large investment in current assets reduces risk (increases liquidity), but it also reduces profitability.
A firm can also increase its net working capital by reducing current liabilities (by substituting short-term financing for long-term. financing)
4. Cash Conversion Cycle
Cash conversion cycle = Days of receivables outstanding + Days of sales in inventory - Days of payables outstanding
Days of receivables outstanding = Average collection period
Days of sales in inventory = Average days in inventory
Days of payables outstanding = Average payment period
Receivables turnover = Net sales/Trade receivables
Inventory turnover = Cost of goods (cost of merchandise) sold//Inventories
Payables turnover = Cash costs and expenses/Trade payables
Days of receivables outstanding = 365/Receiables turnover
Days of sales in inventory = 365/Inventory turnover
Days of payables outstanding = 365/Payables turnover
A business must reduce days of receivables outstanding and days of sales inventory and/or increase days of payables outstanding in order to reduce cash conversion cycle. If cash conversion cycle is reduced less money is tied up in working capital.
4. Investment in Working Capital
Investment in working capital is not the same as the amount of working capital.
Amount of working capital is the total amount of current assets
Investment in working capital is the money tied up in (or locked in) the current assets.
5. Cash Management
a. Why Does a Business Carry Cash?
Types of Cash that a Business Carries
Transaction cash
Precaution cash
Speculation cash
Purpose of Carrying Cash
To meet daily payments (transaction cash),
To meet unexpected cash needs (precaution cash),
To take trade discounts,
To maintain credibility,
To realize investment opportunities (speculation cash).
Minimum cash requirement: Amount of cash necessary to meet daily payments and unexpected cash needs.
b. Components of Cash Management
Decide the amount of minimum cash requirement,
Plan cash collections and payments (disbursements) and cash shortage or surplus through a cash budget,
Collection management (selecting the collection methods that accelerate cash receipts).
Disbursement management (selecting the payment methods that make payments without trouble)
c. Factors Affecting Minimum Cash Requirement
Seasonality of working capital: If the working capital requirement increases in certain seasons the minimum cash requirement is high, otherwise low.
Purchase and sale terms: If the payments are made before collecting the receivables the minimum cash requirement is high, otherwise low.
Debt capacity (credibility) of the firm. If the credibility of the firm is high, in other words if the firm can take out a loan from the banks anytime it needs money minimum cash requirement is low, otherwise high.
Probability of collections and payments: If the probability of collecting the receivables is low the minimum cash requirement is high, otherwise low. If the firm cannot delay payments the minimum cash requirement is high, otherwise low.
6. Receivables Management
a. Components of Credit Policy
Credit period: Lenght of time buyers are given to pay for their purchases
Credit standards: Minimum financial strenght of acceptable credit customers, and the amount of credit available to different customers. Amount of credit available to different customers is also called "the credit limit" of a particular cvustomer.
The seller should examine the credibility of the buyer when deciding whether to make credit sales to that customer and the credit limit. Credibility of a business depends on the following factors.
(1) Character: Character of the owners or the managers of the business. Are they trustworthy?
(2) Capacity: Can the business generate sufficient cash to pay the receivable?
(3) Capital: Capital has two meanings. One of them is the assets of the business. The asset composition of the business should be examined. If the business has sufficient liquid assets this is a good sign. Another meaning of capital is shareholders’ equity. It should be examined whether the business has sound equity or not.
(4) Conditions: Economic conditions and effect of the economic conditions on the business should be considered.
(5) Collateral: Extra guarantee (such as personal guarentee of the owners, cash deposit and guarentees, letter of guarentee from a bank) may be demanded when credit is extented.
Credit standardars may be tough or lax depending on the criteria used by the seller.
Collection policy: Toughness or laxity in following up on slow-paying accounts.
Discounts: Discount amount and period.
b. Factors Affecting the Credit Policy
- Competitive position of the business. If the competitive position of the business is powerful, then the business can dictate its terms to the customers.
- Economic conditions: During an economic downturn credit period is lengthened, credit standards are lax, collection policy is lax, discount rate is high in order to increase sales.
- Sector practices: A business must take sector practices into account when it decides credit policy.
7. Inventory Management
a. Factors Affecting the Amount of Materials Inventory
- Planned production volume
- Seasonality of materials purchases
- Amount discount in large volume purchases
- Expectations of future materials prices
- Perishability of materials
- Lead time and relations with the suppliers
- Availability of storage area
b. Factors Affecting the Amount of Work-in Process Inventory
- Production volume
- Length of the production process
- Use of subcontractors
b. Factors Affecting the Amount of Finished Goods and Merchandise Inventory
- Expected sales
- Expectations of future merchandise prices
- Custom made or market based production
- Perishability of finished goods or merchandise
- Lead time and relations with the suppliers
- Probability of unexpected delays in production process
- Availability of storage area