Working capital management - Essay Example

?Working Capital Management Introduction Working capital management is a complex process through which a company ensures that it maintains sufficientcash inflows in order to meet its short term debt obligations as well as operating expenses. In other words, the system of working capital management intends to establish a relationship between a firm’s current assets and current liabilities. Implementation of an effective working capital management system will certainly assist a company to improve its earnings. Ratio analysis and management of separate elements of working capital are two major aspects of working capital management. Organisations normally give great emphasis on working capital management, because ineffective use of working capital may end up in net losses. Since the management of working capital is crucial for companies irrespective of their size and nature, well structured corporate governance strategies are inevitable for properly dealing with the working capital spending. This paper will discuss the significance of working capital management and various approaches to the management of inventory, receivables, cash, and payables. 1. Management of working capital As discussed above, nowadays firms give specific focus on working capital management because thoughtless short term financing has already caused several corporate failures. As Bokadiya (2011) points out, there are two concepts associated with the management of working capital: gross concept and net concept. The gross concept indicates current assets and this model is known as quantitative aspect of working capital. In contrast, the net concept reflects the difference between current assets and current liabilities and this concept is commonly referred to as qualitative aspect of working capital. The gross concept mainly focuses on optimum investment in current assets and current asset financing; whereas the net concept pays specific attention to liquidity position of the firm and permanent sources of working capital. There are a wide range of factors such as nature and size of business, manufacturing cycle, operating efficiency, profit appropriation, taxation policy, dividend policy, and government regulations that affect working capital management. Working capital estimation is a difficult task for firms in accordance with its nature and size; hence, different firms follow different methods to estimate working capital. Generally, conventional method, operating cycle method, cash cost technique, and balance sheet method are the major approaches adopted for the estimation of working capital. Longenecker, Petty, Palich, and Moore (2009, p.576) describe that the working capital is primarily used to purchase raw materials for production purposes. Through the production process, the raw materials are converted into finished goods and which is then reconverted into cash by the sales process. This whole process is called working capital cycle (ibid). Effective management of working capital assists organisations to deploy current assets and current liabilities efficiently and thereby to maximise short term liquidity. A well structured system of working capital management entails short term decisions generally relating to the next financial period. The process of working capital management mainly involves two steps; forecasting the amount of working capital and determining the sources of working capital. Through proper management of working capital, a firm aims to make optimum level of investment in various working capital assets. This process may also aid companies to assess the optimal mix of short term and long term capital. In addition, effective working capital management can be of great help to choose appropriate means of short term financing. Management of inventory, receivables, cash, and payables are different aspects of working capital management. Inventory management is of great importance in modern business transactions as this process plays a evident role in establishing balance between purchase and sales (Indian Institute of Materials Management, n.d). The traditional inventory management focused on two aspects-how much to order and when to order. However, the modern complex business models forced firms to penetrate into different aspects of inventory management in order to efficiently serve customer needs. Fixed order quantity approach or ‘Q’ model is a modern inventory management technique by which organisations fixes order quantity at a certain level on the basis of demand, value, and inventory related costs. This method is widely used today as it is the most appropriate technique for high value and critical items. In addition, ABC analysis, VED analysis, perpetual inventory system, EOQ analysis, and periodical inventory valuation are some of the approaches to inventory management. “Receivables” can be simply defined as the amount of debt receivable for the goods or services offered on credit. The receivables management establishes a trade-off between profitability and cost (Citi, 2008). Through this process, firms establish their credit policy and collection policy and maintain an effective control over account receivables. Credit terms including credit period, trade discount, cash discount, and quantity discount play a great role in determining the size of investment in receivables. Credit rating is an important tool of receivables management and it includes 5 C’s such as character, capacity, capital, collateral, and conditions. Firm usually consider general business factors and some special factors before fixing its credit policy. Cash management indicates efficient collection and disbursement of cash and often it deals with temporary investment of cash. Generally, a firm wishes to hold certain amounts of cash with itself as a result of three motives such as precautionary motive, speculative motive, and transaction motive. Receipt and disbursement method and adjusted net income method are the major techniques used to carry out two cash management functions: cash planning and cash forecasting. When cash inflows are more than cash outflows, it is called a positive cash flow and every firm tries to accelerate cash inflows and decelerate cash outflows. Quick conversion of payment into cash, lock box system, and decentralised collection are some of the approaches to accelerate cash inflows whereas interbank transfer, centralisation of payments, paying on last date, adjusting payroll funds, and payable through draft polices decelerate cash outflows. Finally, cash budget is an efficient tool of cash management to estimate cash receipts and cash disbursements during a future period of time. Finally, effective management of payables is also essential to ensure that the organisation properly serves its sundry creditors. The payables management evaluates the validity and authenticity of recorded payables and this procedure secures the reliability of general ledger accounts and timing of payments. Inefficient investigation and authorisation of payments may cause troubles to organisations as this condition would lead to unnecessary increase in operational expenses. As Bragg (2009, p.652) points out, payables centralisation and vendor master file analysis are some of the approaches practiced by organisations to enhance efficiency and effectiveness of accounts payables management. Ratio analysis is a very helpful tool for organisations to deal with cash management, inventory management, and accounts receivable and payable management. Under this method, ratios are calculated from current year financial statement and are evaluated by comparing to that of previous years or other companies so as to judge the performance of the company. In addition, inventory ratio, working capital ratio, and the collection ratio are the key ratios that can determine the performance effectiveness of working capital management. Significance of working capital management “Working capital is the life blood and nerve centre” of any form of business organisation (Bose, 2006, p.310). A company must always keep an appropriate amount of money with itself in order to effectively meet its day to day requirements. It is clear that fixed assets cannot be easily converted into cash within a short period of time; and hence the company has to compulsorily keep sufficient current assets to pay off its creditors on time. Inadequate flow of working capital greatly affects the efficacy of supply chain management. To illustrate, the production department must timely obtain raw materials in right quantity to deliver ordered units of products to sales department within the specified time. Hence, a shortage of working capital will precisely lead to an interrupted supply of raw materials and this situation will ultimately affect the efficacy of supply chain activities. Similarly, excessive holding of current assets would also affect the operational efficiency of a firm as this situation may cause the firm to realise a substandard return on investment. Hence, the system of working capital management is significant in determining the profitability and growth of a firm. Sometimes, creditors may unexpectedly demand firms to pay their owing. Under such circumstances, a firm must have adequate working capital to pay off their creditors readily; otherwise, it would adversely affect the market stature of the firm. This system not only assists an organisation to survive unforeseen contingencies, but also allows expansion when the firm thinks a new policy could benefit it. It is observed that there is a positive correlation between sales and current assets of a firm. An increase in sales directly leads to a proportional increase in current assets and therefore working capital management is indispensable to regulate the flow of current assets properly and efficiently. Reheman and Nasr (2007) state that a firm’s profitability is determined in part by the way its working capital is managed. Generally, over 50% of a firm’s total capital is invested in current assets. Although the capital budgeting process pays due attention to the management of fixed assets, there is no system to ensure a positive cash flow. Hence, the establishment of a well structured working capital management system is essential to secure more than half of the total capital of a firm. In an emergency situation, organisations may acquire fixed assets on lease but there are no alternative ways to attain current assets. Additional investments in current assets will certainly cause financial loss, which could be avoided by managing working capital efficiently. Furthermore, working capital requirements of an organisation are most often financed by external sources such as banks and other financial institutions; hence, it is necessary to utilise borrowed money in the best possible way because otherwise, the financial situation of the organisation will get worsened. 2. Learning outcomes As a management student, this assignment is of great help to me to understand the significance of working capital management and various aspects of the management of inventory, receivables, cash, and payables. From this assignment, I could understand that effective working capital management is equally important just like fixed asset management. Thoughtless use of working capital may cause the failure of an organisation as working capital is the life blood of every firm. New market entrants tend to concentrate on production and promotional activities giving less focus on working capital management. Economic theories suggest that production cost minimisation is the fundamental and the best strategy to enhance the growth of business. An organisation cannot economically operate its production activities unless it effectively manages working capital flows. However, modern marketers are not well aware of the significance of working capital management as there are no specific systems in practice for regulating working capital flow. From this paper, I could assess which of the existing system would be beneficial for dealing with cash as well as inventory management. In addition, the paper also gives insights on the different aspects of the management of account receivables and payables. This paper strongly recommends entrepreneurs to pay specific attention to the maintenance of working capital flow as this factor plays a considerable role in determining the profitability of a firm. This paper imbued me with new insights regarding the successful operations of an organisation. I think I would achieve business growth by focusing more on working capital management rather than promotional activities. However, it seems that establishing an effective working capital management policy is a difficult task, and hence one needs to devote more time to this process. Industry experiences show that an effective corporate governance strategy assists firms to design a specific framework for working capital management; therefore, such a policy is beneficial for companies to get rid of all troubles associated with the process of floating capital management. In other words, corporate governance is essential to ensure flawless appropriation of working capital and thereby sustainable growth of the organisation. In total, reasonable maintenance of working capital flow aids organisations to ensure operational success to a great extent. This paper greatly assisted me to envisage my future business framework. References Bokadiya, M 2011, ‘What do you mean by working capital’, Publish Your Articles, Viewed 29 November 2011, Bragg, SM 2009, Controllership: The Work of Managerial Accountant, John Wiley & Sons, New Jersey. Bose, DC 2006, Principles of Management and Administration, Prentice-Hall of India, New Delhi. Citi 2008, ‘Receivables management solutions’, Viewed 29 November 2011, Indian Institute of Material Management n.d, ‘Purpose of inventory management’, Viewed 29 November 2011, Longnecker, JG, Petty, JW & Moore, CW 2009, Small Business Management: Launching & Growing Entrepreneurial Ventures, South-Western Cengage Learning, USA. Raheman, A & Nasr, M 2007, ‘Working capital management and profitability: Case of Pakistani firms’, International Review of Business Research Papers, vol.3, no.1, pp. 279-300. Read More