Every business entity, be it large or small, private, or public, needs sufficient working capital to be able to run smoothly. Lack of or inadequate working capital can impair the ability of a company to operate on a going concern basis. Generally, company needs working capital to pay salaries, purchase inventories and supplies, settle short-term debt obligations as they become due, etc. When a business is unable to accomplish any of these, some operating activities of the company may be curtailed. Imagine a company in the production process, and suddenly realized that the material is exhausted or finished. Certainly, this occurrence will disrupt production, and may result in loss of revenue or may even erode the reputation of the organization. Hence, it is essential that adequate working capital is available to ensure smooth production run and achieve operating efficiency.
Working capital may be described as a difference between current assets and current liabilities. It is the amount required for the day to day running of a business. On the flip side, working capital management represents a judicious and efficient management of each component of current assets and current liabilities including inventory, account receivable, cash & cash equivalent, account payable, short-term debt etc. to ensure the liquidity of the company. The primary purpose or objective of working capital management is to guarantee sufficient cash flow is available to meet short-term operating costs and debt obligations. Efficient working capital management is intended to ensure smooth financial operations, improve earnings, and increase profitability of a company.
This is also known as operating cycle or cash operating cycle. It is described as the length of time between when cash is paid to acquire raw materials and when cash is finally received from debtors through sales. The longer the operating cycle, the longer capital is tying down without earning return on it. Therefore, companies should strive to reduce their working capital cycle by collecting receivables promptly or delaying accounts payable, if possible.
Below is the pictorial representation of working capital cycle:
To sustain the liquidity, profitability, and going concern status of a company, each component of current assets and current liabilities in the statement of financial position must be managed effectively and given due consideration.
Cash is the most liquid asset of an organization. It represents the lifeblood of any business. The lack of which can collapse a company. Therefore, companies must maintain sufficient cash balance to:
If a company does not possess adequate cash balance, it can impair its ability to operate efficiently and settle short-term debt obligations as they fall due. This may have serious operational repercussions on the business because working capital is inadequate. This situation can also lead to the winding up of the company if it becomes a recurring issue.
However, when a company has idle funds that will not be needed or used in the next 3months or more, the funds should be immediately invested in short-term marketable securities including treasury bill, fixed deposit account, etc. to earn return. Holding too much of cash or bank balance is an unproductive way of managing asset. Any substantial surplus funds should be invested to generate additional profit for the company rather than keeping them in the bank account, yielding zero return.
Cash projection and budget for receipts and payments should be produced annually or periodically as a way of managing working capital effectively. The cash budget and forecast should be prepared separately for the same period under consideration. To ensure the budget is not exceeded, the actual cash receipts and payments including the forecast, should be benchmarked against the budget estimate. Any associated variance should then be analyzed and justified. Monitoring and controlling of cash receipts and payments will help businesses to know when there is cash flow surplus or shortfall, and in effect, improve working capital.
This involves the method of ensuring that the right quality and quantity of the relevant inventories is available at the right time and at the right place. Inventory includes raw materials, work-in-progress and finished goods that are ready for sale. It is one of the most critical assets of a business because it represents the primary source of revenue generation. Hence, efficient inventory control will enhance working capital.
Companies have divergent reasons for keeping inventories and some of which include:
These are costs associated with inventory management. The component of Inventory costs include:
These are costs incurred when an order is placed up to the point of receiving the goods into the warehouse. Examples of ordering costs include the following:
This is also known as stock-holding cost. They are costs incurred whenever material is stored in the warehouse. Carrying cost per unit is directly related to purchase price per unit. Examples of carrying cost include:
These are costs incurred when customers’ demand cannot be met because the stock is exhausted. They are the opportunity cost of not having a stock when customers are ready and willing to buy. Examples of stock-out cost include:
This is the actual cost of the items placed in stock. The cost per unit of the items may be fixed if no quantity discount is allowed. But the cost will vary if quantity discount permitted.
Inventory management is extremely important for any organization. The primary purpose of which is to ensure that stock levels are maintained so that the total relevant costs of inventory mentioned above, are kept at the barest minimum. However, the objectives that companies may want to achieve in managing inventory to ensure efficient working capital may include:
The objective of managing account receivables is to ascertain the optimum level of trade credit to be offered to customers and timely collectability of such credit. Offering credit to customers is intended to increase sales and in effect profitability. Customers’ loyalty are assured if customers are given opportunity to purchase on credit.
However, companies should design credit policies that will be consistent with the overall objective of the organization, industry standards, and best practices. The guidelines should expressly specify the credit terms for the collectibles. For instance, a company may adopt 15, 30, 45days, or more as credit terms. A responsible person or department within the organization should be assigned the responsibility of ensuring timely collection of the collectibles.
Offering too much credit or having too liberal credit terms may result in high bad debts, and which may result in liquidity problems and loss of income to the company. On the other hand, if the credit terms are too strict and unfriendly, customers may patronize the competitors where credit conditions are more favorable. This may result in loss of customers and revenue. Therefore, companies should strike a balance and design suitable credit terms that the current and potential customers will be willing to accept. Trade discount can also be extended to customers to encourage prompt payment to improve working capital.
Also, companies can automate its invoice processing to achieve efficiencies and optimum cash conversion cycles. This is because manual processing of invoices may cause delay in sending invoices to customers, loss of invoices, and inefficiencies arising from high volume of invoices to be processed.
Accounts payable represents the amount a company is owing to its suppliers or vendors arising from trade credit. It is an arrangement by which a business purchase goods on account for credit, and settlement to the supplier is deferred into an agreed future date. Usually, suppliers can give credit for 15, 30, 45, 60 days or more, depending on the supplier’s credit policy. A discount is allowed if payment is made within a specified number of days, otherwise, the full amount will be due at a specified date. For instance, the terms of “3/10, net 30” means that a 3percent discount is granted if the invoice amount is paid within 10days; otherwise, the full amount will be paid on the 30th day. The terms of discount and credit policy differ among companies, depending on the industry, level of competition and market conditions.
The earlier the settlement of trade credit to vendors, the better the creditworthiness, and the higher the future opportunities that will be extended. This will also enhance the flow of working capital because there will be regular supply of materials, high-quality products will be provided, and there will be on-time delivery.
However, if credit is delay beyond the agreed term, it will improve working capital ratios, but may damage the reputation of the company, worsen business relationships with suppliers, require firm to pay cash before supply, and impair its ability to enjoy credit facilities on a going concern basis.
Companies should avoid the tendency of delaying payments to vendors for goods supplied, except it is impracticable. And when there is going to be delay in invoice payment, suppliers should be informed immediately and agreed on the revised payment date.
Trade credit is the cheapest and most important source of short-term finance for many companies, especially where the required funds is not readily available. Identifying the appropriate source of financing inventory may be very challenging. In this case, trade credit will become handy to finance working capital. However, if there is no credit facility from supplier, it may be necessary to utilize bank loan or overdraft facility.
A firm’s suppliers may want to offer discounts to encourage early settlement. This opportunity should be grabbed if the discounts will benefit the company the more. However, if the company is short of cash, it might decide to maximize the credit period granted by the suppliers, irrespective of the settlement discounts offered.
At Adda, our accounting team can collaborate with you to develop strategies to manage your working capital efficiently. Reach out to us now.
At Adda, we pride ourselves with highly experienced and committed professionals willing and ready to collaborate with businesses to create value
info@addalli.com
Postal Code: 100213
74 Ogunnusi Road, Ojodu Ikeja, Lagos