Working Capital Components - Coursework Example

DISCUSS BY FULLY GIVING VARIOUS EXAMPLES FROM VARIOUS COMPANIES OF YOUR CHOICE, HOW POOR WORKING CAPITAL MANAGEMENT CAN BE A SOURCE OF CORPORATE FAILURE? WHAT EFFECTIVE WORKING PRACTICES MAY HELP REMEDY THE SITUATION? By Name Course: Instructor: Institution Affiliation: Submission Date Table of Contents Working Capital Cycle 3 Cash Conversion Cycle 3 Symptoms and Causes of Poor WCM 3 Strategic Reasons 3 Financial Reasons 5 Poor working capital and corporate failure 7 Examples from Failing Companies 10 Steps for Effective Working Capital 17 18 Conclusion 18 References 19 Working Capital Components Cash: For working capital, a cash is the money that is accessible to the company either in cash basis or at the bank. Cash is generated from the most liquid assets of the company such as the sale of inventory (Mathur, 2007). Inventory: The items in store for sale make the inventory of a company. Sale of inventory generates cash for paying daily operations. Account Receivables: All short- term sources of income to the business such as debts support the financial health of the company. The duration of clearing debts should be shorter such that the company is able to acquire supplies, settle bills, and pay for labor among other operational activities (Mathur, 2007). Account Payables: The acquisition of materials and supplies requires the company to pay. Paying creditors makes account payables’ a spending activity and is classified under current liabilities. Working Capital Cycle Working capital cycle involves the stages and steps that daily operations take with reference to current assets and current liabilities. Current assets involve cash at hand and at bank as well as the inventory at hand. Current liabilities on the other hand include all the money needed to clear short-term payments such as creditors. The working capital cycle involves the acquisition of materials or supplies, the cost of converting materials into finished products, cost of labour and storage of the products, and distribution of products to customers to make profits (Henry, 2008). Cash Conversion Cycle The cash conversion cycle involves the measure of time needed by a company to sell inventory, timeframe the company needs to collect receivables, and the maximum period afforded to pay creditors without inviting penalties (Bettis, Gambradell, Helfat, & Mitchel, 2011). Symptoms and Causes of Poor WCM Strategic Reasons Symptoms and causes of poor working capital differ from company to company and from industry to industry. However, based on a company’s strategic approaches, a poor working capital management is incurred if the company does not balance its current assets with its current liabilities in such a manner that all short-term liabilities can be handled with the most liquid assets Nag, R, Hambrick, &. Ming-Jer, 2007). The symptoms of poor working capital management include the inability of the company to meet all its financial obligations within the set period, creditors demanding to be paid upfront or within a short period, debtors taking too much time to clear debts, increased duration for clearing inventory, and decreased interest supplier-efficiency towards the company (Kyriazoglou, 2012). Companies that manage their expenses and make profits have to devise stable and reliable working capital cycle (Sagner, 2010). The working capital cycle includes the activities of ordering or acquiring materials from suppliers, investment of cash to production processes, facilitation of storage for the finished products, and generation of cash from the sale of goods. Based on these activities, companies’ have to establish their liquidity positions in order to measure how capable they are at settling debts (Matz, 2011). In dealing with a problematic cash flow situation, a company must aim at establishing a cash culture by securing cash incentives and improving key performance indicators. The establishment of a cash culture influences the working capital cycle such that a company strategizes on how to manage its account payable and account receivables. With a defined approach to the management of these working capital components, a company is able to establish cash culture that incorporates closer and much reliable pattern of handling revenue and short-term costs (Sadler, 2003). Additionally, the amount of service a company can extend to its customer must relate or mimic the nature of customer demand. A company promising quality services to customers but lacking a mechanism to handle the cumulative demand enters a state of overtrading. Overtrading involves the interaction between customer orders and the ability of the company at hand to meet that demand. In this case, cash is the major variable or factor to consider based on the output of a company as well as its scope (Lasserre, 2012). A company with a large target market but with limited capacity to deliver the orders to customers is considered an overtrading company. By overtrading, a company becomes vulnerable to industry and financial problems. Industry problems include the research conducted by rivals which provides information about a gap in the market. On the other hand, financial problems affect the financial management of the company. These are explained in the next subtitle. Financial Reasons The financial reasons resulting to a poor working capital management involve the company’s relations with its customers and the basis of sales. The company’s debt collection period should be short such that inventory is converted into cash within a short timeframe. Long debt collection periods show the company’s inefficiency in collecting debts (Boyd, Gove, and Hitt, 2005). Additionally, increased penalties from creditors show unstable cash conversion cycle. On the other hand, current liabilities exceeding current assets show signs of a failing working capital management and unstable cash flow (Pina, Toress, & Yetano, 2011). With reference to the financial impact of overtrading as earlier identified as a major working capital management strategy, it is observed that companies allowing customers to acquire products on credit basis face higher trade risks when overtrading occurs. Research warns that overtrading can compromise the development of a successful company and lead to business failure (Češnovar, 2006). On the other hand, the effects of overtrading are much adverse to newer businesses which focus more on acquiring wealth but do not access their capability to meet the demand. Overtrading is an example of working capital mismanagement and shows poor system if managing demand and supply. This mismanagement also leads to poor customer-to-cash cycle such that customers do not have a sense of responsibility in meeting their payment obligations. A compromise on the customer-to-cash cycle leads to poor credit rating as creditors have to absorb payment delays. A continued trend in these lines of working capital mismanagement leads to poor working capital unable to sustain current and other short-term obligations. In the management of financial and strategic approaches, a company should outline its source of capital as well as its use of the capital. For-profit companies, capital can be acquired from the sale of shares for publicly traded companies (Mathur, 2007). On other hand, based on daily activities and availability of payments’ grace periods, a company is able to acquire capital from its suppliers. To the suppliers, deferred payments result to a debt which the company can settle on a later date. Following the aspect of deferred payments, the company is able to provide customer with products and make profit from the sales. However, since an existing debt has to be serviced, the company services its debts with creditors. On the contrary, one major problem of this approach is based on poor visibility and forecasting. With reference to negative working capital, visibility and forecasting are major areas companies must manage their working capital with. Considering negative working capital, companies that rely on suppliers to boost their capital positions face two challenges (Merna, and Al-Thani, 2011). Firstly, due to the unpredictable nature of markets, companies are unable to predict customer behavior and are also incapable of controlling outcome. Based on a practical example, if a company secures supplies worthy €1 million on credit basis with a debt clearance period of over 3-months and below 6-months, the company should ensure that the supplies value after trade must generate enough revenue to settle the outstanding debt and at the same time generate profits. If the company is unable to accurately predict the inventory days of its stock, it runs the risk of trading at a loss. Assuming, due to financial stabilization, the cost per unit reduces at the market having acquired materials at a higher cost, the revenue generated from the sale of the products with the dropped prices makes a company unable to meet its obligations of paying the creditors. This situation weakens the company’s ability to hold on to cash making it vulnerable of going bankrupt (Drake, and Fabozzi, 2010). Secondly, the challenge of poor visibility in corporations involves the company’s inability to identify and make use of a functional working capital management strategy. Poor visibility involves unreliable predication of sales’ outcome, unstable approach to acquiring and settling supply costs, and poor management of account receivables. When a company is not well-versed with managing costs and foretelling the possible reception of its products by customers, it also suffers from supply acquisition problems (Henry, 2008). Such problems include the inability to order for products that will meet current demand. Additionally, the company suffers from inability to regulate availability of products to sell to customers. In the long run, higher frequency of customer disappointments is registered which pushes demand for products to rivals. A business entity without a target market cannot sustain its operations and may not be able to meet its short-term responsibilities. Based on product and customer segmentation, a companies has a better change at corporate success by targeting and satisfying the needs of different customers with products that fit their demand preferences. On the contrary, the corporate failure results from poor predictability and difficulties of tracking and estimating demand (Chew, 2013). Poor working capital and corporate failure Poor working capital is associated with corporate failure in three major ways. Firstly, poor working capital involves mismanagement of resources such as time. Time mismanagement in working capital involves the duration debtors take to pay and the amount of time creditors are able to extend to the company (Češnovar, 2006). Secondly, poor working capital involves the management of reporting systems in terms of inbound cash and outbound cash. Inbound cash is the amount the company gets from the sale of inventory as well as the efficiency of debtors in clearing payments. Outbound cash involves the funds required to settle short term liabilities such as operational costs and supplies. Thirdly, poor working capital involves the mismanagement of cash and inventory. Cash mismanagement is the company’s strategy of deliberately forfeiting business terms with service providers such as labor, distribution channels, and deferring payments. Inventory mismanagement involves the acquisition of more orders than the company can possibly meet with its current inventory. Additionally, inventory mismanagement involves the inability of the company to clear its inventory within the shortest period possible. Long periods in clearing inventory show that the company is inefficient at generating cash (Colley, Doyle, Hardie, Logan, & Stettinius, 2007). Following the poor working capital practices mentioned above, corporate failure follows if the company’s inventory management involves overtrading. Overtrading involves the taking of orders that a company is unable to meet. Through poor inventory management, the company is unable to forecast how much inventory is safely capable of meeting customer demand. This approach invites deferred or disputed invoices and limits the company’s efficiency at collecting receivables. On the other hand, a poor working capital resulting from creditor terms for collecting payments upfront or within short duration invites poor visibility and forecasting complications. Following unpredictability of sales and return on assets, corporate failure involves the company’s inability to manage input while at the same time having problems of converting inventory to its maximum value. Based on customer perspectives, a company that poorly manages its inventory incurs receivables’ challenges among them the inability of the company to meet specific customer demand. Corporate failure is associated with poor customer and product segmentation. This shows that the company is unable to stock products that meet customer demands. Additionally, poor product segmentation complicates the company’s ability to predict inventory days (Češnovar, 2006). Inventory days make up the period its takes a company to sell its inventory and clear stock. Inventory items include the different types of products stored and awaiting distribution upon order reception. If a company is unable to target the right customers with their preferred products and therefore incurs increased inventory days. Additionally, increasing inventory portfolio must target a set customer segment to rely on and to promote fewer inventory days for each set of product segments. Effects on corporate performance for the two companies include poor sales and increased inventory days. From poor inventory management, corporate failure comes as a result of the company’s inability to convert inventory into cash to settle short-term debts. Additionally, too many inventory items with a poor product segmentation approach leads to under par returns and invites cash-flow complexities. Poor generation of revenue leads to increased duration for debtors to pay and reduces creditors’ tolerance with the company’s payments’ uncertainty. The combined effect of poor accounts receivables and accounts payables is the inevitable loss of corporate efficiency and destruction of trade relations with both customers and suppliers. A business entity in this position is unable to grow its sales value, generates small profits, and faces higher chances of failure during financial crises or in a highly competitive market (Chorafas, 2002). Inventory items and days relate to customer and product segmentation which can lead to corporate failure if no customer segment provides demand for a certain item within the inventory. With poor supply chain planning, the company was not able to identify what products were made for what customer segment. With a problem influencing a company’s output, inventory management is a major setback since a company should not estimate inventory days for its entire inventory items. On the other hand, with poor customer segmentation, a company could not identify the specific position of inventory that could be converted to cash through sales (Lasserre, P., 2012). As it is the concern with customer-to-cash cycle for companies with poor operating strategies, customer segmentation allows companies to address customer demand based on availability of orders (Brigham, and Houston, 2011). Segmented market allows the company to outline and analyze the demand patterns for order fixing, the number of customer segments, and the purchasing power of different customer segments. Products targeting a specific customer segment have to coincide with the purchasing trends of the target customer segment. Fast-selling products indicate high liquidity of the company while increased inventory days indicate a problem with inventory management. Fast-sales show a dependable liquidity position but also require refined inventory management. Two approaches of refining the inventory management process include the reduction of inventory items (brands, models, and iterations) and shortening of inventory days. Longer inventory days and long list of inventory items result to corporate failure as the company does not have a manageable cash flow. Examples from Failing Companies Company 1: Electric Utilities Company (EUC) In the management of various daily activities that have an effect on the way a company handles its cash flow, it is identified that EUC suffers from poor customer-to-cash cycle. Among the challenges that face the company include mismanagement of financial drivers at operational level, poor control mechanisms across the customer-to-cash processes with an effect of over 40% in account receivables, and negative effects of high organizational decentralization resulting to poor visibility (REL, 2012a). Affected area Problem Solution Outcome Financial Drivers Poor focus on fiscal drivers at production level Review of contract management Reduction in invoicing delays Established cash culture Accounts Receivables 40% delay in accounts receivables Effecting reliable collection process considering commercial clients Optimization of billing systems Outsourcing activities to re-organize bad-debt process Reduction of accounts receivables by €600 within 2 financial years. Organizational Structuring Poor visibility; highly decentralized organizational structure Review of contract management Re-structuring of the departments’ reporting, accounting, and resource allocation Common Key performance indicators as well as cash oriented incentives across all departments Company 2: Hexion (H) In Hexion’s working capital management strategy, there are various lines of activities that are poorly managed. Among these include poor inventory management, order processing, product relevance to sales, and poor planning in supply chain management. The company suffers from poor management of inventory and has resulted to a 16% inefficiency. Among the opportunities that the company has considered, one involves the offsetting of 16% in inventory days. Since the company has a longer period for clearing stock, the cash cycle of the company is poor as it takes more time to clear the stock. Higher inventory days mean poor or under par generation of revenues. Additionally, the company has a poor order processing approach one that makes the process inaccurate and costly to the company. Associated outcomes from poor order processing include delays in delivery, delivery to the wrong clients, and lengthening the number of days it takes the company to collect debts. The inaccurate order processing is also associated with the company’s poor supply chain management. In this case, the inbound and outbound supplies do not have a strategic transitioning process and therefore inventory is subjected to mistaken First-In-First-Out approach paving way for the expiration of products or lengthening the duration for settling costs with creditors. Poor conversion of the most liquid assets indicates that the company will take longer to settle payments with creditors. A continued trend in these lines facilitates accelerated demand for payments by the creditors (REL, 2012b). Areas Affected Problem Solution Outcome Inventory management Poor Inventory management Training and developing procurement personnel Research and Development Operations Optimization Reduction of 16% in inventory in one third of a financial year Order Quantity Accuracy Poor order processing approach Customer segmentation Higher accuracy in delivering orders to the specific customer segments Supply Chain Management Poor supply chain planning Product segmentation Improved sales value Fewer inventory days Products’ relevance to Sales Unsatisfactory inventory management Resource Planning Improved resource planning in material acquisition, purchase, and production Table 2: Hexion Company 3: Aerospace and Defense Company (A&DC) Aerospace and Defense Company faces three challenges of processing payments from customers, poor reporting of payments and payments terms, and suffers from unmanaged cost focus. With poor invoice processing, the company incurs longer durations in collecting from its debtors and therefore decreases its ability to clear with its creditors. The longer it takes the company to pay up its short-term obligations, the company affects its relations with trade partners. Additionally, the company does not have a clear focus on costs as it does not have a mechanism to facilitate systematic handling and processing of payment terms. The company is unable to predict its cash-cycle as debtors have the upper hand of delaying payments since no stable mechanism is in place to offset this challenge (REL., 2012c). Affected Areas Problem Solution Outcome Invoice processing Late payments Full implementation of accounting policy 50% reduction in disputed invoices Payment Terms Poor reporting of payment terms Analysis for finding opportunity to reduce working capital Payment terms extended to 8,000 vendors Global Purchasing Negative impact of working capital cost focus Electronic payment and discrepancy management €67 million working capital recovery Enactment of KPIs to regulate payment terms and performance Table 3: Aerospace and Defense Company Company 4: Royal FrieslandCampina (RFc) Royal FrieslandCampina suffers from three major aspects that have influenced the manner in which the company is able to covert its current assets into cash. Since the company’s operations increased, the company’s handling of supplies allows it to increase inventory such that there are different products available to customers at any given time. However, the company’s expanding inventory portfolio does not have an inventory management system to handle the increasing inventory traffic. On the other hand, enterprise management is a problem affecting accounts receivables. Debts and revenue generation are poorly managed areas that have contributed to a $285 million worth of unutilized capacity. Additionally, the company’s inability to focus and relate with the changing inventory traffic has decapitated its ability to not only forecast market trends, but has also compromised its ability to meet credit obligations. Possible outcome from the state of affairs include deteriorated ability to focus on corporate relations with trade partners and inability to predict the duration required to clear stock and order for more supplies (REL, 2012d). Areas Affected Problem Solution Outcome Inventory Management Increasing inventory with constant inventory strategy Implementing optimized inventory management system Fewer inventory days, Fewer inventory items Improved inventory management Accounts Receivables Poor Enterprise Performance Management Implementing enterprise-wide program Targets the generation of $285 million in cash-flow generation Accounts Payable Poor Forecasting Accurate calculation of stock requirements Improved efficiency based on manageable accounts payables Table 4: FrieslandCampina Company 5: Integrated Telecommunication Services Company (ITSC) ITSC was primarily state-owned and among the challenges it faces is organizational, structural, and cultural problems. The organization lacks organizational culture which trade partners have difficulties relating with the changing nature of business approaches. Structurally, the organization does not at have a central reporting unit from which all business strategies and plans can be managed and executed from. Additionally, the company has poor debt collection mechanism and therefore its debtors have longer periods until they clear their debts. On the other hand, the company suffered from short-term periods allowed by creditors and therefore suffers from insufficient cash at hand or at the bank. The insufficiency of the company in generating cash limits its ability to invest or pay up short-term opportunities or obligations. Lastly, the company has a deteriorated rating with its suppliers. The suppliers have a poor credit rating towards the company and therefore they demand for payments much earlier fearing that the company may not be able to meet its obligations (REL, 2012e). Affected Areas Problem Solution Outcome State ownership Poor organizational, structural, and cultural aspects Rationalizing of processes and structures Reduction of €998 million in working capital Debt Long debt clearance period Shortening debt collection period €534 millions in trade receivables €175 million from faster billing Credit Short credit payment period Increasing credit clearance period. Increased from 41 to 50 days in 15 months Credit Rating Poor crediting management Centralizing supplier management Improved Credit ratings Table 5: Integrated Telecommunication Services Company Steps for Effective Working Capital 1. Assessing future funding needs A firm must assess its funding requirements such that it is aware of how it would acquire capital and how it would use it to grow. 2. Working capital needed Working capital is the interaction of current assets and liabilities. A company requires understanding and to accurately predict the source and use of assets to meet current liabilities. Forecasting helps the company in improving visibility while at the same time, mitigating the possibility of overtrading. 3. Current working capital assessment Since a company must operate as it implements operational strategies, effective working capital can be derived from current working capital by assessing areas that require fixing. Inventory management is an example of areas that a company can assess to improve its working capital. 4. Assessment of Payables and Receivables An effective working capital involved the analysis of how the company trades and how it handles debtors and creditors. An effective working capital ensures that debtors have a sense of responsibility and clear their payments within a short period. Additionally, the company should manage its suppliers in a manner that allows more time before it clears its payables. This approach allows companies within the retail industry to operate with a negative working capital (can acquire supplies on credit and pay for them after finished products are sold). 5. Application of credit trading Since cash is part of working capital, effective working capital involves the preference of buying on credit rather than cash. This approach makes the company able to predict demand and order supplies to meet it. Upon selling; a company, which was initially in possession of no inventory, is able to acquire revenue capable of paying the creditors and retaining the profit. 6. Testing the Working Capital plan Upon the planning for an effective working capital (steps 1 through 5), a company must test the effectiveness of the working capital strategies. Through this method, a company can identify opportunities to improve the effectiveness of its working capital and has an upper hand at identifying problematic areas in its strategies to sustain an effective working capital. Conclusion Management of these working capital components, a company is able to establish cash culture that incorporated closer and much reliable pattern of handling revenue and short-term costs (Sadler, 2003). Based on low quality and delayed deliveries, a company incurs a major overtrading problem with the potential of ruining the business mission as well as its corporate goals. A compromise on the customer-to-cash cycle leads to poor credit rating as creditors have to absorb payment delays. Among unavoidable outcomes of poor working capital management include either filing for bankruptcy or allowing bidders to acquire the company and transform its business environment and financial stability (Drake, and Fabozzi, 2010). Best working capital can be derived from assessment of future funding needs, working capital needs, current working capital position, assessment of payables and receivables, application of credit trading, and testing of the working capital plan. Based on product and customer segmentation, a company has have a better change at corporate success by targeting and satisfying the needs of different customers with products that fit their demand preferences (Chew, 2013). From poor inventory management, corporate failure is a result of the company’s inability to convert inventory into cash to settle short-term debts. A business entity in this position is unable to grow its sales value, generates small profits, and faces higher chances of failure during financial crises or in a competitive markets. References Bettis, R., Gambradell, A., Helfat, C., & Mitchel, W. (2011). Theory in strategic management. Strategic Management Journal, Vol. 35, No. 10; pp. 1411-1413. Boyd, B., Gove, S., and Hitt, M. (2005). Construct Measurement in Strategic Management Research: Illusion or Reality? Strategic Management Journal, Vol. 26, No. 3; pp. 239-257. Brigham, E., and Houston, J. (2011). Fundamentals of Financial Management. Ohio: Cengage Learning. 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