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Working Capital Management

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EK 335
Working Capital Management


INTRODUCTION

Most companies concentrate their managerial effort on controlling profit. They try to increase sales revenue, reduce their production cost and control their overheads. Operational budgets are drawn up, standard costs are set and considerable effort is expended on identifying and rectifying variances of actual results against these budgets and standards.

However, too few companies worry very much about managing another, possibly equally important, part of their business - the area of working capital management.

But, managing the area of working capital can make the difference between business survival and business failure.

Many profitable companies fail each year because their management teams fail to manage the area of working capital. They may be profitable, but they are not able to pay the bills.

WORKING CAPITAL

Working Capital is the name given to the "short-term" area of the balance sheet. Working Capital includes four balance sheet items:
  • stock - stocks of raw materials, partly completed production and finished goods awaiting sale
  • debtors - amounts owed TO the company, mainly from customers in respect of sales made on credit
  • creditors - amounts owed BY the company, mainly to suppliers of raw materials, services (electricity, water, telephone, rent, etc.) but also, possibly, unpaid tax demands, unpaid dividends and other items
  • cash - bank balances, cash holdings and short term investments

Working Capital includes the current assets and current liabilities areas of the balance sheet. Working Capital can be called by its alternative name - "Net Current Assets".

AN EXAMPLE OF WORKING CAPITAL

Imagine that the following figures have been extracted from a company's balance sheet:

()
CURRENT ASSETS
Stocks 2,700,000
Debtors 4,000,000
Cash 5,000
TOTAL CURRENT ASSETS 6,705,000
CURRENT LIABILITIES
Creditors 1,705,000
NET CURRENT ASSETS 5,000,000

What do these figures tell us?

  • Certainly, there are stocks but, surely, a company needs stocks if it is to run its business.

  • Certainly, there are debtors but, surely, that is just a consequence of making credit sales.

  • There does not seem to be much cash available so, maybe, the directors should be considering taking a loan or issuing more shares.

  • There are creditors, but it does take the accounts department a little time to process incoming invoices.

That is probably the total amount of analysis that many companies would make.

Let's take one step further and realise that THE COMPANY HAS 5 MILLION TIED UP IN WORKING CAPITAL. MONEY THAT IS THE PROPERTY OF THE COMPANY. MONEY THAT MAY NOT BE EARNING ITS KEEP.

TOWARDS MANAGING THE WORKING CAPITAL

Let us look at the figures again but, this time, include some basic financial ratios, such as stock days, debtor days and creditor days.

()
CURRENT ASSETS
Stocks 2,700,000 75 days
Debtors 4,000,000 70 days
Cash 5,000
TOTAL CURRENT ASSETS 6,705,000
CURRENT LIABILITIES
Creditors 1,705,000 35 days
NET CURRENT ASSETS 5,000,000

We now see that the company is holding enough stock to run the business for 75 days, allows its customers an average of 70 days to pay their bills, yet pays its own bills in only 35 days.

Stock is expensive to keep. The more stock there is, the larger the warehouse needs to be (more rent, electricty, heat, etc.), the more people have to be employed in the warehouse (more salaries, social security, etc.), the more chance there is of the stock becoming obsolete and damaged - or, even, stolen.

The longer the debtor period, the more chance there is that debts will turn out to be bad debts, or will take considerable effort (and, thus, cost) to collect.

THIS IS IN ADDITION TO THE COSTS OF FINANCING THE WORKING CAPITAL.

Surely, it would not be too unreasonable for the company to only carry only 40 days stock and to insist on our customers paying within 35 days. The company's own payment period of 35 days already seems reasonable.

Implementation of these suggested stock and debtor periods would decrease the stock from 2,700,000 (75 days) to 1,440,000 (40 days). The debtors would fall from 4,000,000 (70 days) to 2,000,000 (35 days).

Let us include these revise the figures in the figures that we have already examined.

()
CURRENT ASSETS
Stocks 1,440,000 40 days
Debtors 2,000,000 35 days
Cash 3,265,000
TOTAL CURRENT ASSETS 6,705,000
CURRENT LIABILITIES
Creditors 1,705,000 35 days
NET CURRENT ASSETS 5,000,000

Note that the effect of adopting these more reasonable working capital policies is to increase the cash from a mere 5,000 to a much more reasonable 3,265,000. This is company money - it has previously been used to finance excess stocks and excess debtors.

This extra 3.26 million of cash could be invested. If it was to earn a return of only 10% per annum, there would be 326,000 extra profit in a full year - in addition to savings in warehouse rent, warehouse salaries, warehouse services, bad debts and debt administration.

POSSIBLE PROBLEMS WITH IMPROVED WORKING CAPITAL MANAGEMENT

The more that a company reduces its raw material stock, the more risk there will be that the company would have to discontine production, due to stock unavailablity. Ceasing production for this reason is expensive - the company will still have to pay the wages and may be short of finished stock for a period.

The more that a company reduces its finished goods stock, the more chance there is that customers will have to be sent to competitors due to shortage of stock available for sale. The company would lose profit and there is a chance that the customer would stay with the competitor.

The quicker that customers are required to pay, the more chance there is that they will buy from competitors who are offering better (i.e. longer) credit terms. But, if a customer only comes to your company because you are offering long credit terms, do you really want that customer ? Do you want to concentrate on QUALITY of sales rather than QUANTITY of sales ? The longer that a company takes to pay its own suppliers' invoices, the lower the amount that the company has invested in working capital. But, if the period is too long, what happens during periods of supply difficulty. The company's suppliers will supply those who pay invoices in a reasonable time - if a company is unduly tardy in paying its invoices, it may not get supplies and this may be expensive in terms of lost production, lost sales and lost profit.

FURTHER CONSIDERATIONS

There are further discussions on this topic:

Blueprint for a good Working Capital Management Policy
Reprint of Article in "The Professional Manager" - MAR 94

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