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Analysis of Working Capital - Research Paper Example

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From this paper, it is clear that analysis of working capital gives the indication of effective use of the firm’s assets and ability to pay upcoming debts and expenses of the firm. Working Capital, in figures, is the difference between Current Assets minus Current Liabilities…
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Analysis of Working Capital
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Extract of sample "Analysis of Working Capital"

 Analysis of Working Capital Working capital is a financial term that is used to describe the liquidity of a company. Working capital is the amount of liquid assets or cash required to conduct the operations of the business. Working Capital is the determinant of the strength of a firm’s business/operations plan and its efficiency. An analysis of working capital also gives the indication of effective use of firm’s assets and ability to pay upcoming debts and expenses of firm. Working Capital, in figures, is the difference between Current Assets minus Current Liabilities. Working Capital = Current Assets − Current Liabilities Negative Profits of a firm is bad but Negative working capital is even worse. It depicts that the assets of the firm cannot be converted in to cash immediately and because of this reason firm can face difficulties to pay its short term debts and operational expenses. Unable to do so can cause serious consequences, at times and even termination of operations in worst case scenario. Working capital is dependent of the all the current assets and current liabilities but there are three major and critical accounts that need to be managed. These are Accounts Receivables – On Credit Sales Inventory – Raw material, Work in process and Finished Goods Inventory Accounts Payable – Current portion of all debts payable within 12 months. These accounts remain under the direct impact of the managers and are most relevant to the day to day operations for all kind of business firms. The cash from operation is consumed and generated through these accounts. In an ideal condition, cash flows in an iterative manner within these accounts in order to keep the operations running. This Cycle is known as Working Capital Cycle. The simplest Working Capital Cycle starts with the purchase of stock from a supplier on credit followed by the selling of finished goods to the buyers on Credit and Cash. Cash generated from selling is used to pay the dues to the supplier, salaries and other expenses of operations. Faster the cycle completes it loop, more the money generation will be possible through operations and need less money to fund working capital. Inadequate working capital can create problems for business of any size but small and newly opened businesses are the easy victim of it resulting in crashing the business plan in the early phase of life cycle. Managing Working Capital Managers can directly manage its Stocks/Receivables in order not to let the cash tied up also keeping the dues and payables in view to manage in time. Stocks/Inventory Level of the inventory differs from not only industry to industry but also company to company. A firm needs to figure out the optimal level of its stocks and inventory by keeping in view its sales requirements, the product, cost of storing along with the strength of its procurement and supply change. Storing the stock itself has cost associated with it not only in terms of storing facility like warehouse but also in the form of theft risk, obsolescence and breakage. Managing and cutting down avoidable expenses is an important factors for the firms to expand their profit margins. Debtors It is generally observed, longer the receivables remain outstanding, less likely it becomes to recovers them. Generating sales is the primary focus of the firms but cash generation from sales should be of same importance. Therefore, controlling and recognizing credit sales is important to manage working capital. This can be done by checking the credit rating of the customers if possible, setting credit limit and encouraging early payments by offering discount offers. Reminders to recover the over date outstanding debts should be practice to give it a try to collect the receivable. Trade Creditors and Suppliers Trade creditors are considered to me most quick short term source of funding and is conducted among the players of the industry to cover short term deficits of liquidity. It is common in B2B transactions to offer credit sales to the potential customers as business have long term relationships with each other and unlikely to default. Well managed relationship can be beneficial in time of crises if a firm cannot pay on date or wants to extend it dues. Though managing relationships is of priority by considering other aspects of the business and Payment on time should always remain the first focus by proper cash generations from operations. Cash and Cash Equivalents Cash inflows and outflows don’t match on the timelines. Backup of cash or investments in cash liquid securities can be helpful to remain on the safe side also meets the cash requirement in unforeseeable situations. There are some other techniques practiced by different business to effectively use working capital. Credit Insurance A policy to protect the holder from bad debts in terms of customer defaults and also helps to minimize business risk. Certificate of Deposit It is an issuance from a bank as a representative of Customer, to the Creditor; in order to hold its deposits if debts are not recovered. CD is used when the credit limit is over exceeded or customer credit rating is not satisfactory. Letter of Credit It is an agreement from a financial institution generally bank to pay up the credit after the delivery of product or service from behalf of customer. This technique ensures the payments. Another form is Irrevocable Standby Letter of Credit in which the institute pays the dues of the customer in the case of Default. Factoring The technique in which a firm sold out its accounts receivable for cash to another firm on discount to meet its immediate requirements is known as Factoring. The second firm now collects the receivables directly from the customers. This technique is not considered as loan but is more like of selling and purchasing of financial assets. This technique is helpful in order to meet short term needs and also limit firm’s practices of receivables collection. It also helps to maintain a smooth stream of cash and business cycle/working capital cycle to maintain liquidity. Guarantee of Payments Guarantee of Payments means to have a guarantee of third party in order to equalize the risk from debtor’s weak financial position. It helps the suppliers and customers of distant locations to develop trust in business transactions. Industry Examples Industry selected for the working capital analysis is retail industry and the focused players are J. Sainsbury and Tesco. Due to its unique business model, it will help to understand the ratios and concept behind managing working capital flow to keep the operations running. J. Sainsbury, the parent company of Sainsbury’s Super market, the third largest chain of supermarkets in United Kingdom and have the share of about 16.3%. Tesco, the largest retailer in UK, operates in international grocery and general merchandising retail chain. Tesco is also third largest Global retailer on the bases of sales and have diversified in a number of retailing businesses for example clothing, consumer goods, electronics, home, and health. The ratios relevant to analyze the working capital management are as follows. Ratio Formula Sainsbury TESCO Return on Capital Employed [Operating Profit (i.e. before Interest and Tax) /Share Capital and Reserves plus Non-Current Liabilities] * 100 9.46% 11.4% Return on Shareholders Funds [Net Profit after Long-Term Interest and Tax / Share Capital and Reserves] *100 6.6% 16.74% Gross Profit Margin (Gross Profit / Revenue)*100 5.47% 7.76% Net Profit Margin (Net Profit / Revenue) * 100 3.56% 5.9% Net Asset Turnover Sales / Total Asset less Current Liabilities 2.65 1.94 Return on Net Assets Net Profit Margin (%) x Net Asset Turnover 9.43 11.45 Stock/Inventory holding period [Stock/Inventory held x 365] / Stock/Inventory used 14.07 19.44 Debtors/Trade Receivables collection period Trade Receivables x 365 days / Sales Revenue 3.76 25.5 Creditors/Trade Payables payment period Trade Payables x 365 / Cost of Goods Sold 50.80 63.93 Current ratio Current Asset / Current Liabilities 0.53 0.76 Quick assets ratio Liquid Assets / Current Liabilities 0.29 0.56 Debt to Equity ratio Borrowings (long and short term) / Total equity 1.29 2.56 Capital Gearing ratio Borrowings (long term) / Total equity 0.38 0.54 Times Interest covered Profit before Interest and Tax / Interest charges 4.55 8.015 Liquidity or Activity Ratios are the key tools in order to measure the operation efficiency, working capital management and how assets are utilized by the company. Irrespective of the Companies and their nature of business, the Liquidity Ratios are considerably disturbing i.e. Sainsbury has 50%current assets to its currents liabilities and Tesco has 76% along with the condition of Quick Ratio that is 29% and 56% respectively. However, when it comes to the type of industry and Firms own strength, liquidity of these companies is not bad at all. This aspect is explained in the following sections. Trade Receivables collection period i.e. in how many days the credit sales realized cash. The receivables period of Sainsbury and Tesco is 4 and 25 days respectively depicting the nature of the business already very liquid and the volume of the sales against its receivable and receivable collection period explains that almost all the sales are on cash or realized at cash within few days. This nature makes feasible for both of these companies to not hold any addition current assets and can work with low liquidity ratios. The cash requirements can be met by daily cash sales. Trade Payables payment period i.e. after how many days of purchase, company pays back to its suppliers. Trade Payables Payment period also telling the story of strong position of these companies allowing its suppliers to trust and facilitate them with long credit lines making the management of working capital easier for the managers. Weak bargaining power of supplier and the strong bargaining power of customers (Sainsbury, Tesco) make supplier dependent on the customer for the business and customer gets in luxury to have long days to pay back debt. It is important for the supplier to have these customers in order to do so they offer long credit limits and due dates to keep the relationship strong. Performance Ratios, i.e. ratios related to income statement directed to measure performance of the company and its ability to generate profits on the capital invested. Profitability ratios are considered to be important in order to analyses the competitive position and performance of a company with respect to another one. In comparison with the Liquidity ratios gives another point of view. Comparing ratios of both the companies, it will be observed that the liquidity ratios of the Tesco are better as compared to Sainsbury. (Gross Margin: 7.76% vs. 5.47%, Net Margin: 6.56% vs. 5.9%, ROA: 11.45% vs. 9.43% respectively) Keeping in mind the good liquidity position as compare to Sainsbury, the performance ratios of the Tesco are also in better figure. Return on Assets, Equity along with Gross and Net profit margins are in favor of Tesco. This analysis gives the insight that managing liquidity is not only important to keep the operations running but efficient use of working capital will be fruitful in terms of performance of business as well. Conclusion and Recommendation In the light of about stated discussion, working capital has not only financial but also operational importance that determines the firm’s existence on day to day basis and there are various ways that can be opted to optimize the management of working capital and avoid unfavorable circumstances. The analysis of Working capital and its ratios becomes more beneficial by seeing in the light of respective business. The retailing industry always remain liquid due to its cash sales and importance of having Current assets and current ratio may not be as important as it can be for a firm operating in construction where the cash inflows and outflows timelines can differ significantly. Moreover, within an industry Working capital management differs, as in the case of Tesco and Sainsbury where Tesco takes tight control in its Working capital figure in comparison with Sainsbury. Therefore, Tesco is on the upper side as compare to Sainsbury in both Liquidity and Profitability Ratios. This gives a signal to Sainsbury to focus on its working capital management and Liquidity proportion in order to be more efficient and competitive in the industry where Tesco is already the leading player. References Philip McCosker, The importance of working capital, 2003 http://www.accountancy.com.pk/articles_students.asp?id=77 Business Planning Papers: Managing Working Capital http://www.planware.org/workingcapital.htm Credit Research Foundation, Terms and Techniques to Manage Receivables, Protect Assets and Enhance Working Capital, 2005 www.ccaacollect.com/Mitigating%20Risk%20Matrix.pdf Tesco PLC - Financial Statements http://uk.reuters.com/business/quotes/incomeStatement?stmtType=INC&perType=ANN&symbol=TSCO.L J-Sainsbury plc – Financial Statementshttp://www.j-sainsbury.co.uk/ar09/financialstatements/ Read More
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