With the slowdown in economic activities, it is increasingly difficult for companies to obtain financing from external sources. The difficulty is both the exorbitant cost of borrowing and the availability of loan funds. The problem, notwithstanding the fact that businesses have to keep operating and only need part of the funds to operate. The need to continue operations in the face of the stifling experience of fundraising is now leading companies to look more critically inward to bail out the situation. One of the different ways to look inward is to manage working capital for the best possible result.
Essentially, working capital is made up of cash, accounts receivable, stocks and creditors. A balanced working capital is one that has all of these aspects in a proper mix. The way to achieve this blend is to pay serious attention to every aspect of makeup. Failure to do so may be tantamount to trading off against each other, which may mean that the benefits of one aspect will be eroded by the deficit of another. Each aspect of the whole will be examined in turn.
Cash management involves determining the actual cash flow needs of the organization and planning the best ways to achieve those needs while incurring minimum cost. The focus on cost is essential because having all of your cash flow needs is not enough to complete a particular project. On the other hand, if the payment of interest on such an injection of liquidity is much greater than the profit, the project will be carried out at the end of the year.
The technique of cash budgeting is typically used through effective forecasting to determine cash flow requirements on a quarterly or semi-annual basis. However, choosing a relatively short period has to do with the understandable limits of forecasting to become a reality. It provides a useful guide as it pulls the times from historical trends, the level of current operations, and expected growth in the immediate future. Cash budgeting takes into account both aspects of revenue generation and impact of costs. It monitors how costs are incurred to meet planned goals, which usually translates to savings for subsequent periods. This also extends to the attention paid to collectibles by planned goals. Whatever aspect is not closely monitored, the goals will not be met.
From the perspective of economists, cash management will also bring out the requirements, considering the three basic reasons for holding money. This is for transactional precaution and speculation purposes. The need to comply with this standard manifests itself in inflation, as each index of economic activity fluctuates. Good cash management therefore keeps the business stable even in the face of helpless uncertainty.
Another aspect of cash management that requires attention is that of banking policy. In businesses where cash flows are assets, a daily banking policy is generally used. This could be by bringing whatever is collected in bank hours to the bank immediately or by banking yesterday’s cash receipts first thing in the morning. However, for organizations with intermittent cash flow, a policy that takes into account the elements of cost, security of unbanked money, and other logistical factors is usually in place. While some aspects of this issue have now been addressed through other channels such as point of sale (POS) and direct transfer to bank accounts, some organizations are still involved in physical cash transactions.
Due to certain seasonal variations in sales, the shortfall is inevitable in any given year. Another aspect of cash management is how to make up for such a shortfall without radically affecting the operation. It is often dangerous when there is a shortfall as it can mean the loss of investment opportunities that may arise. Similarly, excess cash does not benefit the organization.
Debtor crises result from sales on credit to customers with the agreement that the customers will pay on a determinable future date. Consequently, the presence of debtors creates a gap between a company’s profitability and its liquidity position. While a particular business enterprise may be profitable on the basis of its turnover, that is, the practical level of sales achieved, when it is largely credit sales, it is that is, with debtors taking a greater share of sales, the business may find itself in a difficult financial position. The physical cash is not just there, which means the business has a liquidity problem.
With this in mind, a credit policy is therefore generally put in place, stipulating the maximum duration of loans granted to customers. It should be borne in mind that in some types of businesses, credit sales are inevitable. Customers play a vital role in ensuring that the goods produced reach end consumers. The essential link provided by distributors (customers) allows them to enjoy the benefits of having a future date to pay for the goods supplied to them. It is not always difficult for a monopoly market to set a maximum grace period for credit sales. In a competitive environment, the situation is not so rosy.
This first step is to determine the duration of debtors repayment by comparing the total of the accounts receivable at the end of a period with the total of credit sales multiplied by the number of sales in the year if the calculation is in days.
The resulting figure will be compared to the industry average to achieve either of the two goals. Suppose the debtor repayment period of a given company is longer than the industry average. In this case, it may mean that the credit policy currently in place is to relax towards debt collection. On the other hand, if it is lower, it may mean that other competitors have more favorable credit policies towards their customers. In the first case, the danger is that the liquidity position is dangerously affected because all funds are tied up with debtors, the usual incidence of bad debts or bad debts being greater. Corrective action must therefore be taken. This may include granting trade discounts for prompt payments at a percentage that will take into account the benefits and cost of such a discount. This consideration will constitute the basis of the percentage to be granted. While in the second case, the possibility of losing the market to competitors is high, as distributors will prefer a company with a more favorable credit policy.
Stocks or inventories are the essential aspect of current aspects of a business, especially in the manufacturing industry. The need for stock must be known both for its adequacy to current operational needs and to ad hoc needs. When considering the stock level, many factors are taken into consideration.
These factors are at which level is most economical to order, also known as Economic Order Quantity (EOQ) which is a balancing of various cost elements such as cost of ownership (cost of storage), cost of order (placement cost, generally the administrative cost), the advantages of group purchasing, the stock conditions in terms of durability of the storage as well as the adequate requirement of the company. Today, where logistics are efficient, Just-In-Time (JIT) has replaced the rigors of EOQ.
The economic order quantity is generally determined by applying mathematical formulas using the differential equation of minimum and maximum points. EOQ is at the point where minimum costs are met for ordering the particular quantity.
In most cases, buying in bulk always attracts discounts. Taking advantage of this means that it will take less than if a purchase was on an ad-hoc basis. However, decisions on a wholesale purchase will take into account the nature of the goods, perishable or not, the availability of storage facilities or not, and the danger of pilferage.
The durability of the storage takes into account the current state of the warehouse with regard to the humidity level to which the goods must be subjected; some chemicals must be stored in a freezing environment. A warehouse with a faulty air conditioning system will not meet the storage needs of these chemicals.
The requirements of the business when considering transporting excess inventory are that capital, that is, money, is needlessly tied up and would have been used in other aspects of business operations. On the other hand, having a situation of out of stock will result in the inability to fulfill a customer order, which can lead to a loss of market and goodwill, essential to maintain operations and growth, especially in a competitive environment.
Creditors arise from the fact that the company purchases goods on credit from its customers with an agreement to pay at a later date. Sometimes a business may not be able to pay it and therefore defer these payments. The benefits of buying on credit are reflected in the effect of a stockout; the situation with the danger of completely losing a customer or a viable market with a trustworthy supplier willing to bail out this situation will always be avoided.
As with debtors, creditors’ repayment duration is also determined by comparing end-of-period creditors with total credit purchases multiplied by the number of days in a year. A shorter than industry average repayment period indicates prompt settlement of creditors, while a longer than industry average period means late payments to vendors.
An effective policy takes into account both situations. If a lower than average repayment means a quick settlement, it can also mean that a good or nearly free benefit of creditors financing is not being taken. Since no additional costs are incurred by late payment, the result is more beneficial for the company than a less than average repayment period. However, an above-average repayment may signal danger. The source of supply may be lost because suppliers may no longer be interested in supplying on credit. The resort to cash purchase can become cumbersome, specific contracts can escape the hands of the company. The effects will be the gradual loss of the market, unfavorable liquidity positions and additional costs of storing unsold products. If not properly managed, it can lead to the eventual collapse of such a business.
The interplay of all elements of capital creation requires adequate attention for the survival of a business. A company that neglects them does so at its own risk.
Oluwadele is a chartered accountant and public policy researcher based in Canada.