Financial managers have to be aware of the funds available to operate on a day-to-day basis and this is referred to as working capital management. The key objective is to minimise the risks of insolvency and increase profitability by making sure bills are paid and overtrading /overstocking is avoided. It is calculated as follows:
Working Capital = Current Assets minus Current Liabilities.
Some of the policies a financial manager may focus on in working capital management are:
- Inventory– How to best reduce the cost of holding inventory in business.
- Receivables/Payables-How do we reduce the time it takes to receive payments and should we increase the time it takes to pay payables.
- Cash-Holding too much cash a business may lose out on profitable investment opportunities.
Cash Operating Cycle (COC)
Working capital management requires the handling of cash inflows and outflows. The cash operating cycle identifies how working capital is affected by the length of time it takes for cash outflows (eg Inventory) to turn into cash inflows (eg Cash). For example, if a firm’s receivables were taking longer to pay, the cash cycle would increase as more working capital investment is required.
When calculating the Cash operating cycle the following need to be calculated:
- Trade Receivables
- Trade Payables
- Inventory days (raw materials, WIP and finished goods)
Identifying the firm’s current short-term liquidity position is important because it helps analyse how easy it is for a business to generate cash.
It can be calculated using:
- Current Ratio – Analysis how an organisations can finance current liabilities using current assets. This ratio is more useful for firms whose inventory is highly liquid. For example, for a supermarket that can easily get rid of goods by offering them on sale.
- Quick Ratio – Analysis how an organisations can finance current liabilities using current assets excluding inventories. Inventory is excluded because some companies have difficulty turning their inventory into cash because it is not easily sold such as houses.
Note that the higher the ratio the better the liquidity of business.
When a business trades at a level greater than it is actually able to handle with its current working capital then they may be in danger of overtrading. This means the business is in risk of running out of cash to finance activities.
Some of the symptoms include:
- Fall in current/quick ratios
- Increase in trade payables period
- Rapid increase in turnover
To solve this issue, a business can decide to improve its working capital management so that funds will be sufficient for the level of activities or introduce new capital such as issuing shares.
Financial managers have to ensure that they manage inventory in an efficient manner especially businesses with high inventory cost such as manufacturing companies. A balance is necessary when managing inventories because if inventory is too low then the business may lose out whilst if it is too high then it may face higher holding costs.
To calculate the average time inventory is held for in a business the inventory turnover/holding period can be used.
It is calculated as inventory divided by purchases (or cost of sales) multiplied by 365.
There are three methods a business can use to handle inventory efficiently, including:
- Economic Order Quantity (EOQ) – This model focuses on finding the optimal inventory order quantity that will minimise costs.
- Bulk Discounts – This takes into account bulk purchases of inventories that gain discounts.
- Just-in-time (JIT) purchasing – Receiving inventories from suppliers as late as possible to avoid holding cost. Note that this method makes the business vulnerable to stock-outs.
Businesses are also offered trade credit by suppliers that should be managed effectively. A business will wish to delay payments to the supplier as much as possible whilst still meeting creditors terms.
The time it takes for the business to pay payables can be calculated using:
Payables divided by credit purchases multiplied by 365 days.
Delaying payments may cause bad relations with suppliers, which if the business ever needs an extended payment period this could result in the supplier refusing to supply the goods and can even result in the credit facilities being taken away
Most businesses offer credit to customers and this is a cost to the business because interest is charged on any amounts taken from the bank to finance credit. A credit policy is developed to manage credit offerings efficiently.
The time it takes for the business to receive payments for receivables can be calculated using:
Receivables divided by credit sales multiplied by 365
A credit control policy considers:
- Debt collection– How much does it costs to collect debts
- Controlling credit– Deciding on the credit limits
- Credit analysis systems– Asses the creditworthiness of customers using references eg Bank references and Trade references,
Note that the longer the credit terms the higher the risk of bad debts.