Management of Working Capital - Coursework Example

Management of Working Capital Table of Contents Introduction 3 Definition of working capital 3 Significance of working capital management 4 Working capital cycle 6 Methods to manage working capital 6 Working capital management of Tesco and Sainsbury 7 Recommendation 8 Conclusion 8 Reference 9 Bibliography 12 Introduction Working capital refers to the difference between the current assets and current liabilities of an organization. An efficient management of working capital aims towards maintaining an optimum balance of the various components of working capital (Filbeck & Krueger, n.d.).Success of a business depends on the effective management of receivables, payables and inventory. By minimizing the funds blocked in current assets the firm is able to bring down the financing costs and increase the fund availability. The management effort brings back the non-optimal current assets and current liabilities to their optimal levels. A discussion relating to working capital cycle, methods of managing working capital, working capital management in UK companies and suggestions for improvement has been presented below. Definition of working capital The working capital of the business is defined as the net of current assets over current liabilities. It is an important liquidity measure of the firm. The current assets include not only cash, receivables but also inventories as it can be easily liquidated whereas the current liabilities include short term loans and creditors (University of California, n.d.). A business with scarce working capital faces difficulty in meeting its short term obligations from the available cash resources if there is a sudden or continuous fall in sales. Therefore, it is important to maintain an optimum amount of working capital in the business and it must be carefully monitored by the managers (Nix & McFetridge, n.d.). Significance of working capital management Working capital forms an important part of a firm’s operations. Maintaining an ideal level of inventory ensures that the firm does not have to face the problem of material deficit in meeting its production targets. Similarly the receivables figure in the balance sheet indicates the willingness of the firm to extend goods on credit. As credit sale is risky the management must be careful in the choice of debtors. Working capital consists of current assets like cash, inventory and current liability like creditors and short term loans. The pattern of all the above components of working capital varies with the business cycle. When there is a fall in the market demand there is a rise in the stock of finished goods. Later when this fall in demand takes the form of recession the firm lowers the stock of inventories, delays the payment of loans and accelerates the realization of receivables. This implies that with the worsening of the recession there is a decrease in the working capital. Therefore the efficient management of working capital acts as a defence to revenue downturn (Georgetown University, n.d.). Working capital management is an important part of corporate management. All kinds of organizations irrespective of their size require sufficient capital for performing their daily operations. The management of working capital is crucial for the survival, solvency, liquidity, and profitability of the business. An organization must determine the requisite amount of working capital and maintain it evenly. However care must be taken to ensure that there is neither a shortage nor an excess of working capital as both overcapitalization and undercapitalization have negative effects on the liquidity and profitability of the business. This means that neither overstocking nor under stocking of materials is desirable. There must be a trade-off between credit period granted to the debtors and the credit period received from the creditors. Ideally the credit period granted to the debtors should be less than the credit period allowed by the creditors which is technically termed as float. An adequate amount of cash and bank balances must be maintained so as to keep the necessary provisions for any contingency. The long-term and the short term needs of the business must be carefully planned without keeping the cash and bank balances idle. For an effective management of the resources the business requires the services of expert finance professionals. A company that fails to maintain an ideal amount of working capital can face serious solvency and liquidity related problems. If the current liabilities are more than the current assets the net working capital becomes negative which is not a good sign. Maintaining high levels of inventory and blocking more than half the assets to the debtors, keeping insignificant level of cash and bank balances highlights poor management of working capital. A mismanagement of the working capital components like maintaining higher current liabilities over current assets means that the company will not be able to raise its sales volume due to scarcity of short term capital resources. Without a rise in the sales volume the company will not be able to increase its current assets thereby keeping the working capital low as there is no scope of using the internal resource for generating working capital (Mukhopadhyay, n.d.). Working capital cycle The working capital cycle or operating cycle refers to the time period between the commitment of cash payment on credit purchases and the ultimate realization of cash from the credit sale of goods and services. This is expressed as- Operating cycle = Inventory period + Accounts receivable period (Academia.edu, 2009). The goal of the management is to shorten the length of the operating cycle without impacting the efficiency of business operations. This helps in improving the returns of the business by lowering the working capital investment. This can be achieved by reducing the time taken for the conversion of raw materials into finished goods, quick realization of credit sales, lengthening the credit payment period etc. (Correia, et al., 2007). The important working capital ratios include accounts receivable period, accounts payable period, inventory turnover ratio, current ratio, quick ratio and Working Capital to Total Assets. Methods to manage working capital The successful management of working capital aims at finding an ideal balance between profitability and liquidity. It is important for the firm to maintain sufficient liquidity for meeting its day to day obligations like wages, salaries but at the same time it must maintain an ideal level of inventory so that the production can be carried on uninterruptedly. There are various ways by which the management can successfully manage their working capital needs. The ideal current ratio of the company should be 2:1 or close to it. To achieve this company must aim at maintaining an optimum amount of inventory such that the problem of stock-out never surfaces and there is no idle inventory as well. The management must aim at quick conversion of raw material into production so that the idle time of inventory can be reduced. While granting credit to the customers the management can provide the incentives of early payment in the form of cash discount. This will lower the account receivable period of the business. Giving cash discounts stimulates payment and reduces the working capital requirement of the business. For dealing with the suppliers of materials the policy is very simple and straightforward. If there is incentive of making early payments i.e. cash discounts are not allowed by the suppliers then the full credit term must be used. On the other hand if making an early payment entitles to cash discounts then this must be availed especially if the effective annual return earned is more than the cost of making the payment (Mott, 2008, P231). Working capital management of Tesco and Sainsbury Sainsbury is an important food and drug retailer dealing in grocery and retailing (London Stock Exchange-a, 2010). The current ratio of the company for the financial year 2009 is 0.55. This has always been below 1 as is evident from the past ratios of 0.66, 0.71, and 0.80 in the year 2008, 2007 and 2006 respectively. Ideally this ratio should be 2:1 or can be close to it. The quick ratio of the company is 0.31 for 2009. There has been a gradual fall in its quick ratio from 0.68 in 2006 to 0.50 and 0.40 in the following years. The quick ratio of the company must be close to 1 (London Stock Exchange-b, 2010). Tesco is a food and wholesale company engaged in retailing and other related activities (London Stock Exchange-c, 2010). The current ratio of Tesco for the year 2009 is 0.78. This has improved over the years. In the year 2006 the company maintained a current ratio of 0.52 that gradually increased to 0.56 and 0.61 in the following years. The quick ratio of the company is 0.63; this was even less at 0.38 in the previous year (London Stock Exchange-d, 2010 Recommendation The above two companies have a low liquidity as is evident from their current and quick ratio. For improving its liquidity the companies can either lower the inventory or increase the cash position by reducing the credit period granted to the debtors. This will improve the cash position of the companies thereby raising the current assets of the business. For improving the quick ratio the companies can aim at quick conversion of materials into finished goods as this will increase the sales thereby increasing the company debtors. Conclusion The management must aim towards maintaining an ideal amount of working capital for the profitability and liquidity of the business. Efforts should be made at striking the right balance between the current assets and current liabilities. This requires maintaining optimum inventory levels, accelerating the realization of receivables and delaying the payment to the suppliers. Reference Academia.edu. 2009. Cash cycle & Operating Cycle. Current Assets Management: Value Based Working Capital Decisions. Available at: http://ue-wroc.academia.edu/documents/0040/6441/fCAM_vbwcd_wue01_06_v07X2009_.pdf [Accessed on February 6, 2010]. Correia, C. Flynn, D. Uliana, E. Wormald, M. 2007. Financial Management. Juta and Company Ltd Filbeck, G. Krueger, M.T. No date. Introduction. An Analysis of Working Capital Management Results Across Industries. Available at: http://www.bsu.edu/mcobwin/majb/uploads/pdf/vol20num2/filbeck.pdf [Accessed on February 6, 2010]. Georgetown University. No date. Importance of working capital management. Working Capital Policy. Available at: http://faculty.msb.edu/dromsw/Droms09.ppt#4 [Accessed on February 6, 2010]. London Stock Exchange-a. 2010. Company Information. Summary. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB00B019KW72GBGBXSET1 [Accessed on February 6, 2010]. London Stock Exchange-b. 2010. Performance Ratios. Fundamentals. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB00B019KW72GBGBXSET1 [Accessed on February 6, 2010]. London Stock Exchange-c, 2010. Company Information. Summary. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB0008847096GBGBXSET0 [Accessed on February 6, 2010]. London Stock Exchange-d. 2010. Performance Ratios. Fundamentals. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB0008847096GBGBXSET0 [Accessed on February 6, 2010]. Mott, G. 2008. Accounting for Non-Accountants: A Manual For Mangers And Students. Kogan Page Publishers. Mukhopadhyay, D. No Date. Working capital management in heavy engineering firms — A case study. ICWAI. Available at: http://www.icwai.org/icwai/knowledgebank/fm48.pdf [Accessed on February 6, 2010]. Nix, E.P. McFetridge, L.M. No Date. Background of Study. THE IMPORTANCE OF WORKING CAPITAL IN THE FINANCING OF CURRENT ASSETS. Available at: http://www.sbaer.uca.edu/research/sbida/1987/PDF/06.pdf [Accessed on February 6, 2010]. University of California. No Date. The role of working capital in investment process. Available at: http://elsa.berkeley.edu/~bhhall/papers/HallKruiniker94%20workcap.pdf [Accessed on February 6, 2010]. Bibliography Brigham, F.E. Houston, F.J. 2007. Fundamentals of financial management. Cengage Learning. Rachin, R. 1997. Return on investment manual: tools and applications for managing financial results. M.E. Sharpe. Read More