Managing Working Capital: It Depends upon the Type of Business - Coursework Example

Managing Working Capital Working Capital management ‘is to manage each of firm’s current assets and current liabilities to achieve a balance between profitability and risk that contributes positively to the firm’s value. (Lawrence J Gitman, page 628)1 For attaining such a balance between profitability and risk, the nature of business plays a decisive role. Profitability is the result of exploitation of assets to produce operative activities of the company so that revenue can be increased at as much decreasing costs as possible. On the other hand firm’s short term risks are that firm will not be able to meet its short term obligation when those become due. It is the basic rule that greater the net working capital the lower is such risks of meeting short term obligations. This is because higher net working capital brings more liquidity and accordingly the firm feels more comfortable in meeting it short term liabilities. But higher working capital comes at cost depending upon the nature of business and that affects the resultant profitability of the company. Therefore working capital management is trade off between such profitability and risks as per the type and nature of business involved. Current assets of the company are considered working capital and ‘net working capital is the difference between current assets and liabilities’ (Lawrence J Gitman, page 628)2. Management of working capital refers to the management of current assets as well as current liabilities, but the major thrust is on managing the current assets. Working capital management is an important aspect of financial management because normally current assets are substantial portion of total investment; and also because this investment is required to be geared quickly to bring the required rise in revenue. It is ‘the process of planning and controlling the level and mix of current assets of the firm as well as financing these assets.’(Bhalla V K, page 1)3 The main aspects of working capital are arrangement of short term financing, negotiations of credit terms that are suitable to the company, control of movement of cash, administration of accounts receivable, and to utilize or invest short term surplus fund in an effective way. Features of working capital The two main characteristics of current assets are that their life period is short (say up to an operating cycle), and secondly current assets are transformed from one current asset to the other in order to achieve a trade off between profitability and risk. The short life span of working capital components and their transformation from one form of current asset to another has major impacts on business operations. It is felt that decisions relating to working capital are repetitive in nature. The difference between future profit and present value is almost insignificant. Moreover, the close interaction among different components of current assets make it imperative that the management of one component cannot be undertaken without considering the effects on other current assets. For example if a company has gathered large quantity of finished inventory, it may have to provide liberal credit terms and laxity in credit policy to promote revenue. Factors influencing working capital Working capital of a company is affected by a number of factors stated hereunder: Nature of business greatly influences the working capital policy of a company. A service firm which has short operating cycle and which sells predominantly on cash basis require modest working capital. On the other hand a manufacturing company or an export house in UK which has a long operating cycle and which sells largely on credit has substantial working capital requirements. Firms that have marked seasonality in their operations usually have highly fluctuating working capital requirements. The working capital of air conditioners manufacturing company will be significantly higher in summer months and lower during the winter period. Production policy of the company also influences working capital requirements. A firm marked by pronounced seasonal fluctuations in its sales may pursue a production policy that may reduce the sharp variations in working capital requirements. For example an air conditioner manufacturing company may maintain a steady production through out the year, rather than intensify production activities during the peak seasons. The degree of competition in the market has also an important bearing on working capital needs. When competition is keen, a large inventory of finished products is required to serve the customers instantly. If a market is weak the firm can manage with smaller inventory of finished goods because customers can be served with some delay. There are other market conditions like rising costs due to diminishing currency value and taxes that have effects on working capital requirements. One of the reasons for shifting production of toy manufacturing by a UK company Bedlam Puzzles from china back to UK was not only the lead in the painted toys but also increasing manufacturing costs resulting from rising Chinese Yuan. Tim Webb and Heather Stewart (27 April 2008)4 reported in The Observer that ‘until 2007 Bedlam Puzzles, like many western toy manufacturers, made all its games in china. It decided to move production to UK last year, partly because of soaring cost in China. In just one year, its costs there had increased by 20 per cent. A stronger Yuan increased shipping costs and the time lag in getting production to the UK market were also factor.’ The inventory of raw materials, spares, and stores also depends on the conditions of supplies. If the supply is prompt and adequate, the firm can manage with small inventory. However, if the supply is unpredictable, the firm has to ensure continuity of production, and would carry sufficiently large inventory to carry on production uninterruptedly. Level of Current Assets It is important to take a decision about the level of investment in current assets. Under a flexible policy (also called Conservative policy) the investment in current assets is high. That means firm maintain high level of cash and market securities, inventories, grants generous credits to customers leading high level of debtors. On the other hand under a restrictive policy (also called aggressive policy) the firm maintains a low level of investment in current assets. This means firm keeps cash, market securities, inventories etc. at low level, and maintains strict terms of conditions resulting into low level of debtors. But consequences of both policies are different. A flexible policy results in fewer production stoppages and ensures prompt delivery to customers. A restrictive policy leads to frequent production stoppages, delayed deliveries to customers, and loss of sales. These are the costs that the firm may have to bear to keep investments in current assets at low level. “Aggressive investment policy results in minimal level of investment in current assets in current assets versus fixed assets. In contrast a conservative investment policy places a greater proportion of capital in liquid assets with the opportunity cost of lesser profitability.”(Talat Afza and Mian Sajid Nazar, page 7-8)5 Therefore a firm is required to maintain an optimum level of current assets. This involves a trade off between costs that arise with current assets and costs that fall with current costs. The former are called ‘carrying costs’ and the later ‘shortage costs’. Carrying costs are in the nature of costs of financing a higher level of current assets. Shortage costs result from disruption in production, loss of sales, and loss of customer goodwill. UK export companies are required to adjust their working capital levels in view of current financial crisis impact on different economies of the world. These effects are more intense on growing economies. But as per minutes of the Monetary Policy Committee Meeting held on 5- 6 November 2008 ‘the direct trade effects for the United Kingdom economy in the more vulnerable emerging markets should be relatively limited as they account for only small fraction of UK exports. But there could be indirect impacts, as these economies accounted for rather more of world output.’(Page 3-4)6. Accordingly there may not be drastic change in working capital levels of UK exporters and importers but subtle changes are not ruled out. Current Assets Financing Policy There may be permanent current assets and temporary current assets. It is an established policy that long term financing is used to meet non- current assets as well as peak working capital requirements. When the working capital requirements are less than its peak level, the surplus from long term financing may be invested in liquid current assets (cash and marketable securities).In another strategy the long term financing is also used to meet permanent working capital requirements and a portion to temporary or fluctuating working capital requirements after meeting the needs of fixed or non- current assets. However during seasonal upswings only short term financing sources are used and when seasonal down swings are experienced, then only the surplus from short term financing is invested in liquid assets. ‘With an aggressive financing policy, the entity finances part of its permanent assets but with short term debts. This policy generally provides the highest expected return but is very risky. Under a conservative financing policy, the entity would have permanent financing (long term debt plus equity) which exceeds the permanent base of assets.’(John Ogilvie, page 76)7 However with regard to financing, the basic principle is that maturity of the sources of financing should match the maturity of assets being financed. The rationale of this matching principle is simple. When short term finances are used to finance long term asset, the entity will have to periodically refinance the asset. This is not only risky but also very inconvenient. Therefore it makes sense to ensure that the maturity of the assets and sources of financing are properly matched. It is observed that UK exporters and importers normally use long term sources of owners’ capital and debt capital for permanent requirement of working capital and for short term funding of temporary requirement of working capital ‘the existence of ECGD greatly facilitate proceedings and possibly reduce the rate of interest.’(Graham Mott, page 290)8 Operating Cycle and Cash Cycle Four key events in the production and sales cycle of any entity influence the level of investment in working capital. These events are purchase of raw material, payment of raw material, sale of finished goods, and collection from receivables. An entity starts business with purchase of raw materials. If those are credit purchases then those are paid after a gap of credit period allowed by the suppliers. This way accounts payable are created. Then the entity converts the raw material into finished goods and makes sale of such finished products. The time period between the purchase of raw material and sale of finished products is the investment period. Normally customers pay their dues some time after the sales. The period that elapses between date of sales and the date of collection of receivables is the accounts payable period. ‘If the company does not have significant accounts payable period, the accounts payable cycle may not have to be incorporated into operating cycle.’(Gary L. Maydew, page 392)9 The time between the purchase of raw material and collection of cash from receivables is called operating cycle, whereas the time between the payment for raw material purchases and collection of cash from receivables is referred to as cash cycle. ‘The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments.’(Pat Dorsey and other, page 212)10 The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to operating cycle less accounts payable period. These portions of operating cycle can also be calculated in the form of ratio as under: Inventory period= Average inventory / (Annual cost of goods sold/ 365) Average Receivable period = Average accounts receivable/ (annual sale/ 365) Average payable period = Average accounts payable/ (annual cost of goods sold/ 365) It is helpful to monitor the behavior of overall operating cycle and its individual components. The process of credit period management in international trade is more complex and also affects the working capital requirement greatly. ‘This is partly because international operations typically expose a firm to exchange rate risk. It is also due to danger and delays involved in shipping goods long distances and in having to cross at least two international borders.’(Lawrence J Gitman, page 645)11There is another problems being faced by UK exporters. Export orders are to be serviced by purchases inclusive of VAT. That means exporters from UK need additional cash or working capital to comply the regulation of VAT. Under the present circumstances, when export trade is facing credit crunch and gloomy outlook, the UK companies exporting goods to different countries should follow the basics of managing working capital. It is required that they should maintain an optimum level of working capital investment. Such a level can be attained by bringing about a trade off ‘between high profits and high risks associated with low levels of current assets and high levels of current liabilities against the low profit and low risk that result from high level of current assets and low level of current liabilities.’(Lawrence J Gitman, page 655)12 In other words the exporter should try to attain a working capital policy that seeks a balance between export profits and risks (or liabilities), and at the same time contribute effectively to the growth of shareholders’ wealth. The exporters should maintain a smart cash conversion cycle so that time involved in converting inventory to finished goods, to export sales, realization of export receivables and finally in making payment to accounts payable should lowered as much as possible. Following these strategies the exporters from UK will be able to manage current assets effectively, minimize the involvement of resources in current assets, and at the same time earning the desired level of profits. References: Read More