Working Capital Management - Term Paper Example

Working Capital Management Submitted by: XXXXXXX Number: XXXXXXX XXXXXXX XXXXXXX XXXXXXX Submission: XX – XX – 2010 Number of Words: 2028 (Excluding Bibliography) Introduction: Capital is a major part of any business. Capital is the life and blood of the business and it is the main task of the management to ensure that capital flow is constant within the company and the cash flow constantly generates profits. This paper aims at discussing one of the most essential aspects of any business, i.e. the working capital management. The paper will discuss in detail the meaning of working capital management and many other aspects of the concept and how it relates to the company and its performance. A major focus will also be on the impact it has on the competitive nature of the business as well. Aspects like the shareholder’s concern regarding the working capital management will also be discussed in the following sections. Meaning of Working Capital Management: Working capital management refers to the money used for the making of goods and sales. It has been defined as, “A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses” (Investor Words, 2010). Working capital management involves a strong relationship between the short term assets of a company and the short term loans. The main aim of this concept is to ensure that there is enough cash in the firm to continue all the operations. It also aims at keeping enough liquidity for facing both the short term debts as well as the operational expenses. Inventories, accounts receivable and accounts payable and cash fall into the category of working capital management (Study Finance, 2010). Impact of Working Capital on the Organisation: As has been discussed earlier, working capital management is based on the needs of the company and the ability to keep liquidity level at all times. It is essential to be understood that the profit margins of a company and the working capital are inversely proportional to each other. A company with high levels of profit margins generally tend to have a low level of working capital. Similarly a company with low level of working capital will have much higher levels of liquidity (Bhattacharya, 2001). The working capital management mainly deals with the amount of liquidity of the firm and the profitability. The main aim is to ensure that both are in place while dealing with the day to day processes and operations. The short term and long terms financial planning play a major role in the overall liquidity of the company. The long term financial planning and the basic availability of the resources are both managed by the overall solvency of the company as well. Working capital management allows keeping track of the exact amount of money within the company and this helps the business keep a clear view of the financial health of the company and to ensure that the funds are used effectively (OSI, 2010). Any mismatch in the liquidity positions, i.e. the working capital management of a company can lead to devastating effects including the insolvency of companies and in a number of cases also shutting down of the company. It is important to note that good working capital management simply means that the business is able to generate cash and is also able to improve its profits and reduce risks (McClure, 2003). It is also essential to note that there is a need to meet the optimum level of working capital as well within a company. A company with high amount of working capital will have low return on investments and this leads to higher risks for the company. It is hence essential to have an optimum level of working capital within a company, and this can only be developed and met if the finance managers keep a clear knowledge of the various elements that impact the requirement of the working capital and also the current assets. When the cash, debtors and inventories of a company are well managed, the working capital itself is optimized. Working Capital and Ratios: Working capital can be better understood based on the ratios of the company. The main ratios that classify under the working capital management include all the ‘liquidity ratios’. The ratios have been discussed below: The liquidity ratios indicate the amount of cash (or liquid assets) available at the company’s disposal. The current ratio of the company is the ratio of the current assets to the current liabilities (Clayman, Fridson, & Troughton, 2008). It indicates the liquidity position of the firm and its ability to cover the current liabilities with the liquid assets (Clayman, Fridson, & Troughton, 2008). The quick ratio is computed as the ratio of the ready cash assets (current assets – inventories – prepaid expenses) to the current liabilities (Allman-Ward & Sagner, 2003). The table below provides a clear explanation of the various types of liquidity ratios and the meaning of each ratio has also been discussed here. Ratio Name Formula* Meaning Current Ratio Total Current Assets/ Total Current Liabilities = x times The current Ration provides a clear view of the amount of money that a company has in terms of its current assets to be able to cover the current liabilities. This simply shows the ability of the firm to be able to meet the liquid liability needs using the liquid assets (Drury, 2005). For example if the current assets are 15000 and the current liabilities are 10000, then the Current ratio is 1.5, which simply means that the company has sufficient capital to meet the requirements of the short term liabilities. However anything below 1 would imply that the company is under pressure to generate the cash to meet the oncoming demand. Quick Ratio (Total Current Assets - Inventory)/ Total Current Liabilities = x times This is similar to the current ratio; however the time needed for the conversion of inventory into cash is also taken into account here (Clayman, Fridson, & Troughton, 2008). This gives a more realistic view of the company. Working Capital Ratio (Inventory + Receivables - Payables)/ Sales = % Sales Here in this case, when the percentage is high, it simply implies that the sales to a great extent have an impact on the capital of the company (Drury, 2005). Here the percentage is high implies that the dependency of capital over the sales is also high. Stock Turnover Ratio Average Stock * 365/ Cost of Goods Sold = x days This ratio explains the time needed to turn over the stock (Clayman, Fridson, & Troughton, 2008). This simply implies the number of days needed to turn over the stock, i.e. X number of days. The faster the turnover the better it is for the company as it helps reduced time for lock in of investments on the stocks. Receivables Ratio Debtors * 365/ Sales = x days This ratio indicates that the amount of time it would take for the company to collect the monies that are due to them. There are a number of times where the average debt collection of the firm is increased since one or more debtors pay late. The main aim here is to keep the level as low as possible (Drury, 2005). Payables Ratio Creditors * 365/ Cost of Sales (or Purchases) = x days This is similar to the receivables ratio; however it refers to the amount of time taken by the company to clear the debts with supplier. Better negotiation with the suppliers means increased time for repayment. The company needs to have a clear agreement with the suppliers and to gain as much time as possible for the payment, however deferring without an agreement becomes a risk factor and leads to bad reputation of the company. Hence it is essential that the company focuses on achieving better credit agreements with its suppliers. The higher the number of days the better it is for the company. *(Clayman, Fridson, & Troughton, 2008) Types of Financing: There are a number of sources of finance that relate to the working capital management. It is essential to note that the short term financing is the most essential aspect here. The short term sources of finance are those which are required within a period of one year. Some examples of the sources of finance include: a) Bank overdraft - Bank overdrafts are an effective way to increase short to medium term finance. They are very beneficial, the company pays interests only on the amount withdrawn or utilized out of the overdraft. It is also a faster way to raise more capital and to overcome difficulties in times of liquidity problems, which will definitely occur during rapid expansion periods (Drury, 2005). Hence it is essential that companies negotiates with the bank and arranges for overdraft in its checking account and uses it as a contingency in case of liquidity issues. b) Trade credit is an indirect short term sources of finance, as there is no cash inflow to the company, but the outflow is deferred for a certain period. The companies can come into a contract with its suppliers and agree to settle for the supplies after a certain period, say, 6 months (Drury, 2005). This enables the companies to utilize those funds to invest in other areas and hence save on the interest that has to be paid if a loan was taken. The main disadvantage is that the company is obligated to pay its trade creditors after six months and hence has to ensure that there is sufficient cash inflow at that point in time (Preve & Sarria-Allende, 2010). There are a number of other financing methods for the working capital management as well which include, the cash reserves of the company, the payables, i.e. better credit terms with suppliers, new issue of shares, and also the profits of the company. The above mentioned are the short terms loans which are most commonly used by the company to help meet their liquidity position and in turn ensure the management of working capital. Stakeholders and Working Capital Management: The main interest of the shareholders of a company is the profitability of the company. This is simply because when a company has higher levels of profits, the shareholders receive better returns in the form of dividends. In most cases, the shareholders are no interested with the daily working of the company and how funds are managed within the company; the main interest is on the profits of the company. However, as explained earlier, the profits and working capital are closely related. When the working capital requirements increase, most companies tend to use a part of the profits to meet the requirements, hence reducing the profits (Bhattacharya, 2001). This can be a major concern for the shareholders. Hence it is essential for companies to manage their working capital well to ensure no part is taken from the profits. Thereby leaving the company in a more stable condition and also ensuring the shareholders are also happy. Conclusions: An organization which has all its finances in place and is able to keep a good balance between all the financial requirements tends to operate smoothly and is also able to compete in the markets more effectively. As has been understood from the vast research and discussion above, the working capital management is an essential aspect of every business. Any mismatch in the working capital management can have devastating impact on the company and the overall name of the company. If a company does not have the clear idea of the working capital it can lead to bankruptcy and can also lead the company having to be shut down. Hence when a company is able to take care of the working capital management effectively, it provides the company with a strong competitive advantage and permits chance to perform better in the markets. Good management of finances leads to higher levels of profits, which in turn is directly proportional to the competitive advantage of the company (Drury, 2005). Hence high profits and well maintained finances simply mean better position in the markets (Clayman, Fridson, & Troughton, 2008). Bibliography Allman-Ward, M., & Sagner, J. (2003). Essentials of Managing Corporate Cash (Essentials Series). Wiley. Bhattacharya, H. (2001). Working Capital Management: Strategies and Techniques. New Delhi: Prentice - Hall. Clayman, M. R., Fridson, M. S., & Troughton, G. H. (2008). Corporate Finance: A Practical Approach (Cfa Institute Investment). Wiley . Drury, C. (2005). Management Accounting for Business. London: Thomson Learning. Investor Words. (2010). Working Capital Management. Retrieved August 24, 2010, from http://www.investopedia.com/terms/w/workingcapitalmanagement.asp McClure, B. (2003, June 18). Working Capital Works. Retrieved August 19, 2010, from http://www.investopedia.com/articles/fundamental/03/061803.asp OSI. (2010). Chapter 6: Working Capital Management. Retrieved August 21, 2010, from http://www.osi.hu/cpd/policyresources/fmbp/chapter_06_page1_fmbp.html Preve, L., & Sarria-Allende, V. (2010). Working Capital Management (Financial Management Association Survey and Synthesis Series). Oxford University Press. Study Finance. (2010). Working Capital Management. Retrieved August 21, 2010, from http://www.studyfinance.com/lessons/workcap/ Read More