BSc Accounting and Finance: Financial Management - Essay Example

?Task Critically discuss why working capital management is considered important and the various approaches to the management of inventory, receivables, cash and payables 1. Introduction The development of critical business decisions is a complex and demanding activity. The use of appropriately customized management tools and practices can reduce the relevant risks. In any case, the current status of the organization needs to be taken into consideration – referring especially to the potential of the firm to meet its obligations within the relevant deadlines. The concept of the working capital is used in order to evaluate the potentials of a firm to respond to its current needs – the long terms needs could be also included when the concept of the permanent working capital is used. Current paper reviews the value of working capital management for modern organization; reference is made to the common characteristics of working capital and its common use for developing critical business decisions. At the same time, the practices available for the management of working capital are presented and evaluated. Emphasis is given on the following forms of working capital: inventory, receivables, cash and payables. It is proved that working capital is of significant value not just for developing important business plans but also for estimating the potentials of the organization to meet its objectives – either in the short or even the long term. It is also proved that the working capital can perform differently within organizations of different characteristics; it is assumed that working capital is volatile to the conditions of the internal or the external environment. The failure of choosing appropriate working capital management technique would be another reason for the above outcome. 2. Working capital management – description and characteristics In order to understand the value of working capital for modern businesses it would be necessary to describe the key elements of the particular concept. Then its role in the development of business activities will be made clear. In accordance with Van Horne et al (2008) the term ‘working capital’ is usually described as the current assets of the organization. However, this description is not fully accurate. Indeed, working capital reflects the organization’s current assets but its form is not standardized. In fact, working capital can be classified by referring either: a) to its components or b) the time. In the context of its components, the working capital is characterized as ‘cash, inventory or receivables’ (Van Horne et al. 2008, p.209). On the other hand, working capital can be used for serving either long term organizational needs – in this case is characterized as permanent working capital – or short term needs (Van Horne et al. 2008); in the last case, the working capital is characterized as temporary working capital and reflects the current assets used for covering emergent organizational needs. The key differentiation between the permanent and the temporary working capital is that the former is likely to be standardized while the latter is differentiated in accordance with the seasonal needs of the organization (Van Horne et al. 222008). 2.1 Reasons for the value of working capital management As explained above, working capital reflects the current assets of the organization. The value of working capital is not equal for organizations of different sizes. In the study of Jain (2004) it is explained that working capital is of particular importance for small and medium enterprises. These enterprises face difficulties in accessing institutional financing schemes (Jain 2004). Therefore, they are likely to depend highly on working capital, i.e. the funds available for the support of daily operations. It is implied that in small and medium sizes emphasis is given on temporary working capital while in large firms the permanent working capital is likely to be most appreciated by the organizations’ stakeholders. At this point the following issue needs to be highlighted: in small and medium enterprises, the temporary working capital defines the level at which the organization can cover the risks related to its operations – since the fixed assets of these organizations are usually limited, in many cases not being sufficient to cover the damages caused from organizational activities: indeed, the obligations of a small firm towards its debtors are usually higher compared to the firm’s fixed assets; for this reason, the creditors of the firm usually review its cash and its potential annual income in order to finance the firm. Under these terms, it can be noted that the working capital, at least in its temporary form, is of major value primarily for small and medium enterprises reflecting their potentials to expand their activities but also their credibility in the market. The view that working capital management mainly benefits the SMEs is also highlighted in the study of Steffan (2008); in accordance with the above researcher, the working capital management is reflected in the balance sheet of each organization – reference is made specifically to SMEs – as the result of the following equation: ‘Current assets – current liabilities = working capital’ (Steffan 2008, p.27). It is explained that the working capital is a concept used for showing the financial potentials of the firm – after covering its liabilities – so that its plans can be effectively supported. For this reason, the term ‘liquid’ is often used in order to describe a firm’s working capital (Steffan 2008). Furthermore, it is explained that the value of working capital for modern firms, especially for SMEs which do not have sufficient assets for accessing institutional finance, can be identified at the following point: by reviewing the working capital of their firm managers can check whether there is need to control the organization’s expenses so that debts can be paid. In other words, through by checking – periodically – the working capital managers can ensure the potential of their organization to respond to its obligations without delaying its projects. In accordance with Droms et al. (2010) there are many facts supporting the value of working capital management: a) ‘working capital management decisions are usually urgent’ (Droms et al. 2010, p.141); this means that even under common market conditions the need for developing such decision is likely to be emergent, not leaving time for choosing among alternative practices, b) working capital is related to the sales of each organization; this means that without controlling the working capital a manager cannot support, effectively, the organization’s sales, a failure which is likely to lead to severe business failures. Indeed, it is explained that ‘working capital grows along with sales’ (Droms et al. 2010, p.141), meaning that as the sales of a firm are increased, its working capital grows simultaneously. After reaching a particular level of growth, sales need to be financed – in order to continue to be increased; at this point, the firm’s current liabilities need to be reviewed and appropriately managed; probably, additional financing is requiring for expanding the operations of the organization. In this way, sales grows along with working capital and after a point, sales, cannot be increased without an appropriate working capital management technique. For this reason, the working capital management is considered as crucial for each organization, c) in most organizations, especially in SMEs, the working capital accounts represent the major part of the organization – often its entire assets (Droms et al. 2010); from this point of view, the working capital management is of critical importance not just for stabilizing but also for supporting the expansion of each organization’s operation. 3. Approaches used to managing inventory, receivables, cash and payables Because of the different effects of working capital on modern organizations, different approaches are likely to be used within these organizations when having to manage one or more parts (forms) of working capital, such as the inventory, the receivables, the cash and the payables. A few approaches available to managers working in the specific field are presented below. It should be noted that these approaches are indicative, meaning that they do not exclude the potential use of alternate methods for managing the above forms of working capital. Moreover, the effectiveness of these approaches cannot be guaranteed. It was revealed through the literature presented above that the working capital can affect differently the small and medium firms than the large enterprises. From the same point of view, the approaches used for the management of working capital may be more or less effective under the influence of various factors, as indicatively explained below. The techniques used by firms for the management of inventory can be differentiated – depending on the sources available, the organizational needs and the conditions of the internal and external environment. Also, the prospects for the business performance in the future are likely to influence the inventory management policies of each enterprise. In the study of Muller (2003) reference is made to an inventory management technique available to organizations, which focus on the availability of ‘the right item, in the right quantity, at the right time’ (Muller 2003, p.130). The above target, which was first highlighted in the study of Orlicky (1975), is achieved through appropriately customized IT systems. The relevant process is known as ‘materials requirement planning’ (Muller 2003, p.130) and ensures, as possible, the achievement of the above objective. The potential disadvantage of the above practice would be the following one: since it is highly depended on computerized systems, it may fails to perform effectively in all its phases, i.e. there is a risk of failure. A series of inventory management techniques is presented in the study of Bose (2006); not all of these are appropriate for organizations of different characteristics. The choice of the appropriate inventory management technique should be based on the requirements of the particular technique and its performance – as tracked in organizations with similar characteristics. These techniques are the following ones: a) the Selective Inventory control – based on the choice among a series of techniques, such as the ABC analysis (evaluation of each item in the context of the organization’s common conditions), the HML analysis (based on the price of the material involved), the XYZ analysis (based on the value of all items in storage) (Bose 2006, p.32) and so on, b) the Economic Ordering Quantity, c) the Just-in-time inventory management and d) the Setting of various stock levels (Bose 2006, p.31). The term ‘receivables’ is used for reflecting the amount that customers own to the firm as a result of the firm’s common activities (Khan et al. 2007, p.15.2). When referring to receivables, as a form of a firm’s working capital, reference is made to the credit sales. These sales need to be managed appropriately in order for the relevant amount to be collected in time – ensuring that the firm will be able to cover the costs of these sales and proceed to the purchase of the items that will be set for the sale at the next level. In accordance with Khan et al. (2007) when managing receivables, the managers of the organization need to take into consideration the following issues: a) the collection costs, i.e. the funds required for collecting the amount due by the customers, b) the capital cost, meaning the potential increase of the cost of sales because of the delay in their payment (this cost includes for instance the salary of employees that the firm has to pay in the period between the credit sales and the payment of these sales by the customer), c) the delinquency cost; it is the cost related to the delay of the customers to meet their obligations (for instance, the costs for legal action against the customers and so on) and d) the default costs; in case that the amount due is not paid it may be necessary for the firm to write off the particular debt – being considered as bad debt that could negatively affect the financial status of the organization (Khan et al. 2007). In the above context, the techniques available to the organization in order to manage its receivable are the following ones: a) to arrange the payment in instalments monitoring its payment, b) to send notification in case of delay – possibly using various collection methods (Salek 2005), c) to avoid excess a limit in its costs (collection costs and delinquency costs cannot be higher from the amount due), d) to write off the debt – in case that the amount due is not finally paid. Similar techniques can be used by the organizations for the management of their cash and payables. In any case, the following issues should be taken into consideration: a) long term targets need to be set; b) short term needs will be covered only at the level that the firm’s financial status is not severely harmed – otherwise, emphasis should be given on the management of receivables, so that the availability of cash for covering emergent needs to be ensured (Back 1997). Especially regarding the payables of the organization, negotiations should be primarily used for extending the period of repayment of the firm’s debts (Bragg 2000); then, an effective receivable management plan would ensure the stabilization of the firm’s performance. 4. Conclusion The effectiveness of management decisions cannot be guaranteed; however, the use of frameworks and practices that are already widely used can increase the chances for success of business strategies. The review of the concept of working capital management has led to the following conclusion: the specific concept is quite important for business operations – being used as the basis for the development of critical business decisions. However, the above concept has been proved to have an important weakness: its aspects are many; their control is quite difficult, a view which is supported by the fact that different approaches are used for managing inventory, cash, receivables and payables. On the other hand, there is the following option: all these strategies can be incorporated in a strategic framework used for addressing all relevant business needs. Such approach would lead to the limitation of time required for covering emergent business needs in terms of the management of its working capital. References Back, P. (1997). Corporate Cash Management: Strategy and Practice. Abington: Woodhead Publishing Bose, C. (2006). Inventory Management. New Delhi: PHI Learning Pvt. Ltd. Bragg, S. (2010). Treasury Management: The Practitioner's Guide. Hoboken: John Wiley and Sons Droms, W., Wright, J. (2010) Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know. New York: Basic Books Jain, K. (2004). Working Capital Management. Delhi: APH Publishing Khan, M., Jain, P. (2007). Financial Management. New Delhi: Tata McGraw-Hill Education Muller, M. (2003). Essentials of inventory management. New York: AMACOM Division of American Management Association Preve, L., Sarria-Allende, V. (2010). Working capital management. Oxford: Oxford University Press Sagner, J. (2010). Essentials of Working Capital Management. Hoboken: John Wiley and Sons Salek, J. (2005) Accounts receivable management best practices. Hoboken: John Wiley and Sons Steffan, B. (2008). Essential Management Accounting: How to Maximise Profit and Boost Financial Performance. London: Kogan Page Publishers Van Horne, J., Wachowicz, J. (2008). Fundamentals of financial management. Essex: Pearson Education Task 2 Discuss your personal learning outcomes from the process of completing this assignment and what changes you need to make to enhance your future career prospects. While working on this assignment I understood that the needs of modern organizations are difficult to be fully identified. In fact, even if studying carefully all aspects of an organization’s operations the development of an effective strategic plan is a challenging task; there are always critical issues that are not taken into consideration when planning an organization’s activities either in the short or the long term. This fact was revealed through the research developed on working capital; though the specific concept seemed to be simple in terms of its role and requirements, it was proved that its use for evaluating the potentials of modern organizations could be a demanding activity. At this point, this assignment taught me to focus on details and analyze carefully all issues related to a particular subject – even if certain of these issues seem to be of minor importance. Moreover, I have learned that the value of organizational concepts, such as working capital, cannot precisely defined without developing a thorough research in the internal and external business environment. In other words, the role of its organizational concept is not standardized. In the case of working capital, its value has found to be higher in SMEs, leading to the assumption that large enterprises could use alternative concepts for evaluating their financial potentials. Based on the above, I understood that in order to enhance my future career prospects I would need to proceed to the following changes: to check the background of any problem before starting reviewing the problem itself, not to be influenced by the size of an organization in order to evaluate its potentials or its risks; in fact, small firms cannot bear high risks because of their limited working capital – and their limited fixed assets. This means that the strategies of small firms may be more critical compared to those of large firms – the failures of which are usually easier to be covered. Also I would need to change my view on the methodology used when exploring critical business issues. The evaluation of these issues requires the use of analytical review of existing literature – meaning not just the literature published on the subject under examination but also on issues related to this subject, so that a clear view on all the aspects of the specific subject is achieved. Finally, I understood that the primary view on a business problem is not always the appropriate one. Usually it is only after a thorough examination of this problem that credible assumptions can be made. Using the above techniques/ practices I could improve my capabilities in analysing complex business problems; however, I would always have in mind that such problems may take a long to be fully explored; at least, it would be important that the measures initially taken for their confrontation are appropriate so that the risk of major business failure is eliminated. Read More