Control of Working Capital - Essay Example

            Managing working capital is very crucial and important in a business. Most fundamentally, working capital investment is the lifeblood of a company. Investopedia (2008) defines working capital management 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, to ensure sufficiency of cash flow in meeting its current obligations. The first, and most critical, use of working capital is providing the ongoing investment in short-term assets that a company needs to operate. A business could not open and operate without working capital finance. Another purpose of working capital is addressing seasonal or cyclical financing needs. Here, working capital finance supports the build-up of short-term assets needed to generate revenue, but which come before the receipt of cash. Adequate and appropriate working capital financing ensures that a firm has sufficient cash flow to pay its bills as it awaits the full collection of revenue. When working capital is not sufficiently or appropriately financed, a firm can run out of cash and face bankruptcy. Working capital is also needed to sustain a firm’s growth. As a business grows, it needs larger investments in inventory, accounts receivable, personnel, and other items to realize increased sales. Lastly, working capital is used to undertake activities to improve business operations and remain competitive, such as product development, ongoing product, and process improvements, and cultivating new markets.

            The components of working capital usually comprise all the components of Current Assets (Petroff, June 1, 2001). However, that is not always so in the nature of the working capital cycle. Some modifications to working capital may involve the exclusion of some components of current assets. The diagram below illustrates a simple working capital cycle of an organization.

There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing money to the organization). The main sources of cash are Payables (your creditors) and Equity and Loans. Each component of working capital (namely inventory, receivables, and payables) has two dimensions: (1) Time and (2) Money. When it comes to managing working capital, time is as valuable as money. If an organization can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, the cost of bank interest could be reduced or there is additional free money available to support additional sales growth or investment. Similarly, if improved terms with suppliers are negotiated (e.g. get longer credit or an increased credit limit) free finance is effectively created to help fund future sales. It can be tempting to pay cash, if available, for fixed assets (e.g. computers, plants, vehicles, etc). If cash is used for payment, then it no longer becomes available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment - loans, equity, leasing, etc. Just the same if dividends are paid or drawings are increased, these are cash outflows and, like water flowing down a plug hole, they remove liquidity from the business.

Sources of additional working capital may be derived from:

• Existing cash reserves
• Profits (when secured as cash)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Factoring of Invoices
• Long term loans

In conclusion, the financial analyst should, therefore, understand the firm’s overall financing needs and capacity and then help the organization locate and structure an appropriate source of working capital. Consequently, good management of working capital will generate cash and helps improve profits and reduce risks. It is important to always remember that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.

Part B – Factoring For Business

            Factoring is the sale of commercial accounts receivable invoices to a buyer, or factor, at a discount, in order to obtain cash on the invoices, with the factor assuming full responsibility for credit analysis, payment collection, and credit losses on the new accounts (VendorSeek, September 2007). In factoring an invoice, three parties are involved: (1) Seller – where invoice originates, (2) Debtor - recipient of the invoice who promises to pay the balance within the agreed payment terms, and (3) the Factor. Factoring is a flexible financial tool that helps improve the business's cash flow, increases credit rating, and allows the company to take advantage of supplier discounts. Two types of factoring (Factoring Quotes, 2008) are the Recourse factoring – lower cost but less risky type since it allows the factor to go back to the seller to buy back the original invoice (if payments are not received) with another creditworthy invoice; and the Non-recourse factoring - higher in cost but with the high risk involved for if the customer does not pay the invoice, the factor cannot seek payment from the seller. An example of accounts receivable factoring is when a small importer engages in factoring transactions for payment of COD purchases where the factor directly pays the supplier and the importer negotiates for more favorable terms and pricing with an overseas supplier.

            Business factoring is, therefore, a good remedy for the immediate resource of funds as long as customers are able and credible to pay the invoices on a regular basis. For the risk-takers who want to earn more with the bigger risk involved, non-recourse factoring is an option. But some business owners prefer peace of mind so they opt to settle for the recourse factoring type, the one with the lesser cost but which is more secured and less risky.