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Working Capital Management

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MANAGEMENT OF WORKING CAPITAL

The analogy has often been made that cash is the lifeblood of any business. Take it away and the business will surely expire. A transfusion will miraculously bring the patient back from the brink of death, but only if:

  • The blood is of the right kind
  • the problem causing the leakage is attended to

In other words, the financial requirements of any business must be tailored to suit that businesse's own particular needs. For example, fixed assets should be financed by long term loans and capital. Working capital requirements should be attended to by short term finance, e.g overdrafts.

It goes without saying that before capital is injected into the business it should first be ascertained whether all unnecessary leakages have been plugged. Otherwise, in time, the transfusion will follow the same route.

To control and exploit the cash cycle through your business so that it can continue to function on a day-to-day basis,is therefore, the hub of working capital management.

The fundamental principle of working capital management is having just the right amount of money available when needed. Every rand in the business should be earning its maximum return wherever employed.

The accounting definition of working capital is the difference in R-value between the current assets and current liabilities of a business. In common terms, however, one refers to working capital as being the short-term financing of a business through a combination of various day-to-day sources.

The working capital cycle

Working capital can be broken down into the following major components: cash (or bank overdraft), stock, debtors, creditors. Each of these items can have a major influence on the working capital (or simply cash) that any business requires on an ongoing basis. For example, when a business starts up, the owner may inject a certain amount of cash into the business which will enable him to purchase his initial stock, pay his workers their first months wages and cover other overheads such as rent. He then sells his product and this income may be utilised to purchase more stock, pay more wages and overheads and perhaps even have a surplus over for his own use. The quicker he can turn his stock over to receive payment, the sooner the working capital cycle will be completed.

Figure 1 - working capital cycle

In reality, extra considerations must be taken into account. Stock is purchased but is very rarely sold immediately and usually remains on the shelf for a period of time. While stock lies on the shelf, cash is tied up which could otherwise have been used for a multitude of purposes. A potential profit might be represented but until that stock is sold no profit has been made. Until your debtors pay you, no cash is released back into the business. Once the stock is sold, it should be paid for straight away, but credit is often granted. The result is that cash is often tied up in debtors.

The art of working capital management

It was mentioned earlier that the art of working capital management lies in using each rand employed in the business to its maximum effect: in other words, tying up a minimum of capital while still ensuring the desired return.

In the most simplistic terms, good working capital management revolves around the time it takes for each rand invested in the business to return in cash with a little more value attached to it. The longer this process takes the more potential there is for losses.

(It is argued that too little working capital employed in an expanding business environment can lead to an overtrading problem. However, here we are concerned with the effective and productive use of funds and not the availability of funds).

Where then can the working capital flow be interrupted?
  • Stock - Cash resources are inevitably comitted to a stock holding. Thus the business has a priority to convert the stock back into cash (and profit) in as short a time as possible so that those funds can be reinvested into stock. Business is ongoing so if some of the goods on the shelf are not sold, the businessman has to look around for alternative sources of revenue with which to fund new purchases. In short, he has to commit extra cash to his stock holding. In addition, there is a cost in holding slow-moving or dead stock. The funds tied up in this manner could have been earning interest if they had been invested. Instead, the owner would need to use his overdraft, thus paying out instead of receiving interest. Paying close attention to various stock turnover rates will indicate which lines are not moving. Although these items are inevitably the large ticket items, the balance between profitability and cash generation should never be upset.
  • Debtors - One method of turning stock over faster is to give or extend credit. This may improve profitability in the books but it does slow down the working capital cycle. The goods are no longer on the shelf, but neither is the cash on hand. Only after the expiry of the credit period is payment likely to be made.Once again, within the credit period, cash is not available for reinvestment. Any additional purchases may have to be via a bank overdraft which once again bears an additional cost. Debtors, especially in times of recession or hardship, will also not pay unless pressed to do so. Thus, in reality, the debtors period could well be longer than anticipated. All in all, an item of stock could conceivably spend a month or two on the shelf and another month in the form of a debtor before the amount in cash is returned to the business for further use. In the meantime the owner has had to pay for further purchases and running expenses.
How can the working capital cycle be improved ?

Working capital can be improved by increasing the rate of stock turnover and/or cutting back on debtor days. Within each of these categories there are a multiplicity of strategies, e.g. eliminating slow moving/unprofitable lines, offering discounts, arranging consignment stock facilities, prompt billings, charging penalty interest, etc.

Another major source of working capital finance is creditors. Creditors can, in effect, finance the operation without the owner being called upon to commit any of his own funds.

In this way, goods can be bought on credit and be sold before the creditor has to be paid. In practice, strict control has to be kept on creditors and the type of stock that is purchased so that the working capital relationship is not eroded, thereby losing its effectiveness.

  • Return on investment - One can have a vastly different working capital outlay while performing the same activity. Having a large amount invested in stocks and debtors does not necesarily mean large profits, but it can mean a drop in the prime calculation that every businessman is interested in: the return on investment. The object of working capital management is to trim down on stocks and debtors and get the cash coming in faster within the comfort zone of the business. In normal periods of business activity, cash which had completed the working capital cycle would be re-invested in stock and the whole process would begin again. Each time the return on rands committed would increase. By efficiently using those resources, half the assets employed could double the output.
Working capital and inflation

The factor of inflation usually contributes to a two-pronged attack on working capital. The first is the increase in the price of goods purchased that will occur over time. The second is the increase in the selling price that will be passed on to the consumer. Looking at the first point one will notice that, in a continuing spiral of inflation, to buy the same quantity of goods will require more cash. In fact an additional portion of gross profit has to be allocated to the repurchase of stock.

Example 1.  
Day 1 Day 30
Buys 100 bags at R1 each (R100) Sells 100 bags at R2 each (R200)
  Now repurchases 100 bags at R1.20 each (R120)    i.e. Funding of new purchases R100 (initial investment + R20 gross profit)

One might, at this point, say that the owner will cover himself by increasing his own prices but in many cases this increase in price may 1) make him uncompetitive, 2) decrease the demand for the product, 3) bring a substitute product into contention. This phenomenon is accentuated in a recessionary climate.

Example 2.    
Day 1 Day 30 Day 60
Buys 100 bags (R100) Sells 100 bags (R200) Buys 100 bags (R120) Profit after repurchase = R80 Sells 70 bags at R2.40 each (R168) Buys 70 bags at R1.30 each

A probable consequence is that purchases cost more and consumers buy less so that profits already diminishing through the need to finance "inflated" purchases are vulnerable to an absolute drop in turnover. This, in turn, has consequences for the need to stay above break-even point and contribute towards the fixed costs. (Remember, fixed costs stay constant irrespective of level of sales) Not understanding the impact of inflation on working capital has been the cause of many business failures.

Conclusion

The use of other peoples money in your business is usually an expensive resource. Before looking outside for finance, examine your own working capital cycle to make sure that every rand of your own internal funds is being fully utilised.

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