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Working Capital and Short Term Financing - Essay Example

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This essay "Working Capital and Short Term Financing" explores the four general phases of the working capital cycle. Working capital is a measure that represents the operating liquidity available. It is part of the operating capital and it is calculated as current assets minus current liabilities…
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Working Capital and Short Term Financing
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? of registration) The four general phases of the working capital cycle Working capital is a measure that represents the operating liquidity available to a business or a firm. It is part of the operating capital and it is calculated as current assets minus current liabilities. The working capital cycle consist of four phases this are; (1) finding the best sources of cash, (3) turning the money into short resources such as inventories and labor and also using it to pay bills, (4) using the available resources gotten with the money to provide services, (5) invoicing the customers for the services rendered. These four phases consist of the following management requirements; cash management which is identifying the cash balance available to run the day to day expenses of the business or firm so as to reduce the cash holding costs (Padachi, 2012). Inventory management is identifying the inventory levels that will enable the business to run smoothly without investment in raw materials. This requires the lead times being lowered to reduce Work in Process (WIP) and the finished goods should also be kept as low as possible. This will lead to the reduction of the reordering costs and hence increase cash flow. Debtor’s management this requires identifying the best credit mechanism for the business or the firm. The credit mechanism chosen should be able to attract customers to the firm and also make sure the firm is getting the payments on time from the credit customers. This will be optimized by increasing the revenue thus increasing the Return on Capital. Another aspect of working capital management is the Short term financing, it is achieved by identifying the most appropriate source of short term funds to run the business this can be achieved through credit granted by the supplier. It may also be necessary to use a bank loan or an overdraft (Banos-Caballera, 2010). The working capital cycle phases require short-term decisions. These decisions are normally based on outcomes in a one year period. They are therefore based on cash flows or profitability and not on capital-investment decisions. It requires close monitoring of the cash conversion cycle which is the number of days from the purchase of inventories or raw materials to the receiving payment from the customers. This normally refers to the time which the firm’s money is tied up in operations and therefore working capital phase normally aims at making sure the time is as short as possible (Block-Hirt, 2008). The primary sources of short term funds Short term funds refer to money needed to run the company in a period of less than a year. They are normally used for the day to day running of the business or firm. There are a number of short term funds available to a company which require different levels of interest rate expenses, collateral and personal guarantees. This is required to provide working capital. The short term funds are used for purchasing of raw materials or finished inventories, payment of wages, salaries and other short term expenses (Brealey, 2002). The three primary sources of short term finance include trade credit, which is normally gotten from the suppliers. It is a loan in the form of goods and inventory. The credit time period is normally 15 days to 3 months and this is normally granted on the basis of good will of the purchaser. This credit facility is given buy a supplier to the buyer of goods and by a whole seller to a retailer. When the time limit is reached the credit should be paid lack of payment can lead to seizing of the goods in the inventory (Block-Hirt, 2008). Another major source of short term loans and advances is from the commercial banks. This are mainly in the form of bank overdraft from the bank which the business has an account in. the overdraft allows the business to withdraw from its current account exceeding the available cash balance. The business is charged an interest rate that is based on the amount overdrawn and the length of time overdrawn (Cleverley, 2011). The advantage of this form of short term financing is that it is flexible. The disadvantage is that over draft costs can be pretty high especially for small upcoming companies. They therefore are normally secured on business assets which puts the business assets at risk. Another form of short term financing provided by banks includes accounts receivable financing which is a form of financing that assists cash flow management. It involves using part or all of the accounts receivable as collateral for short term loans. The collateral only includes specific invoices which are for quality customers and are not of 90 days or older (Jonathan, 2011). Leasing finance is also a source of short term finance. It is normally when a business leases an asset rather than buying the asset outright using available resources or borrowed funds. The business makes payment to the leasing company each month and the length of the lease contract depends on details of product which include cost and usable life (Muatarin, 2012). An organization's short-term investment options for idle cash Idle cash is the profits generated by the business. The company can keep excess profits that have not been invested or distributed to the owners as idle cash and is therefore the worst way to keep the money because it does not generate any income (Berger, 2005). The investment options available therefore are; Money Markets It is a market for short-term investment in government debt and other commercial papers. It is normally seen as a safe place to put money since it is the less risky option. They normally include negotiable certificates of deposits (CDs), banker’s acceptance, treasury bills, commercial paper, municipal notes, repurchase agreements and federal funds repos. They normally have a term of less than one year. This is attractive to the business since the cash won’t be tied up for long and therefore it can be used for more attractive opportunities that arise (Mathuva, 2013). Stocks Some businesses also choose to invest their idle funds in the stock market. This is the equity stake of its owners. The company can invest in the different types of share available this can be preferred stock or common stock. Shares of different companies also come with varying risks. The company benefits from either capital gains or dividends paid by the company. The business chooses the risk depending on the risk tolerance of the business. Most companies although choose to go for those with low risks because they don’t endanger the firm’s money and still bring back a positive return (Brealey,2002). Distribution to shareholders It is normally done through the payment of dividends. It is a distribution of the company’s earning decided by the board of directors, to a class of its shareholders. It is mainly paid in the amount that each share receives. That is the dividends per share. It can also be as a percentage of the current market price which is normally termed as dividend yield. This money can be distributed to the owners of the company who are the shareholders. The payment is done through dividend payout. Some companies do have the statute written on their by laws that idle cash should be distributed to share holders (Jonathan, 2011). Payment of debt Business mainly operates on a combination of debt and equity. The short term debts are the current liabilities of the company’s balance sheet. This requires that regular interest payment be made to service the debt. Therefore most companies use their idle cash to pay of the interest accumulated by the debts incurred. These debts are mainly short term debts incurred from bank overdrafts and other forms of short term loans and financing. They are normally due within a year or less. Lack of paying of the short term debts is detrimental to the company as it shows that the company is not in a good financial position and would therefore prevent investors from investing and make the available investors to sell of their share and leave the company (Block-Hirt, 2008). Float Float refers to the small amount of money that is present both in the buyers and payers account. It normally results in the delay that occurs between the time that a check is written and the money actually being deducted from the writer’s account. These balances therefore end up being double counted as part of the overall money supply (Brooks, 2010). It can also mean the number of shares of a publicly traded company available to trade. It is different from the outstanding shares and which the shareholders are allowed to buy or hold hence it may be different from the share outstanding. If the float is small many purchasing activities can affect its price. This can occur on a single large order of buying and selling of the float. A large float tends to have a lower volatility or risk since the orders would not affect the supply. It is also known as floating supply (Berger, 2005). References Berger, A. and Udell, G. (2005), A More Complete Conceptual Framework for Financing of Small and Medium Enterprises, World Bank Policy Research Working Paper No. 3795, Block-Hirt (2008): Foundations of Financial Management, The capital budgeting decision, 12th Edition, The McGraw-Hill Companies, R. Brealey, S. Myers, (2002) Principles of Corporate Finance, 7th Ed, McGraw Hill Higher Education, William O. Cleverley; James O Cleverley; Paula H Song, (2011), Essentials of health care finance, 7th Ed Sudbury, Mass. : Jones & Bartlett Learning. Roy, M. K., & Muatarin, M. (2012), Financing Small and Medium Enterprise: A case study of BASIC Bank Ltd. SDMIMD Journal of Management, 3(2), 43-62. Brooks, R., & Mukherjee, A. K. (2010), Financial management: Core concepts. Pearson. B. Jonathan, D. Peter, H. Jarrad, (2011), Fundamentals of corporate finance, (2nd ed), Global edition, K. Padachi, C. Howorth and M.S. Narasimhan, (2012), Working Capital Financing Preferences: The case of Mauritian Manufacturing small and medium-sized enterprises (SMEs), Asian Academy of Management Journal of Accounting and Finance, Vol. 8, No. 1, 125-157, D.M. Mathuva, (2013) Determinants of Corporate Inventory Holdings: Evidence from a Developing Country, The International Journal of Applied Economics and Finance Volume:7, Issue: 1 pg. 1-22, S. Banos-Caballero, P. Garcia-Teruel, P. Martninez-Solano, (2010) Working Capital management in SMEs, Accounting and Finance, AFAANZ volume 50, issue3, pages 511-527. Read More
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