Part 3. 8. Working capital management Flashcards
What factors determine working capital requirements?
Working capital requirements change from time to time as per the size and
nature of industries as well as other internal and external factors. In general, the
following factors affect requirement or working capital.
Nature of business
The investment in working capital depends on the nature of the business,
product type and production techniques. For example, retail companies have
a low cash cycle with few credit customers, high supplies on credit terms
and a large inventory to cater to the demands of customers. Manufacturing
companies have a long cycle with significant current assets. The service sector
does not hold any finished goods and has an insignificant amount of liabilities.
Size of business
The larger the size of business, the greater the working capital requirements to
support its scale of operation. However, a small business may also need a large
amount of working capital due to high overhead charges, inefficient use of
available resources and other economic disadvantages of a smaller business.
Production policy
Some companies manufacture their products when orders are received while
others manufacture products in anticipation of future demands.
Seasonal fluctuations
If the demand for the product is seasonal, the working capital required in that
season will be higher. For example, there is greater demand for air conditioners
in summer.
Credit policies
A liberal sales credit policy demands a higher level of working capital as it
prolongs the debtors’ collection period and vice versa. However, a liberal credit
policy without consideration of the creditworthiness of the customers will
land the business in trouble and the requirements of working capital will also
unnecessarily increase. Similarly, a tight credit policy from suppliers shortens the
creditors’ settlement period and lengthens the WCC, requiring the need for
alternative finance.
Changing technology
A firm using labour-oriented technology will require more working capital to pay
labour wages.
Growth and expansion
Working capital requirements increase with the size of a firm to support larger
scales of operation.
Taxation policies
Government taxation policy affects the quantum of working capital
requirements. A high tax rate demands more working capital.
Why is working capital needed in a business? What is the optimal level
of working capital?
Working capital is the total amount of cash tied up in current assets and
current liabilities which normally includes inventories, receivables, cash and cash
equivalents, less payables. All of these are available for day-to-day operatingactivities.
Businesses need working capital in order to keep the business running.
It enables businesses:
to allow customers/trade receivables to buy on credit – offering credit
provides a competitive advantage in the market;
to carry inventories of finished goods to meet customer demand; and
to have cash to pay the bills. A company needs working capital to pay
salaries, wages and other day-to-day obligations.
The optimum level of working capital is the amount that results in no idle
cash or unused inventory, but that does not put a strain on liquid resources
needed for the daily running of the business. The company faces a trade-off
between profitability and liquidity. Management decides on the optimal level
of working capital to ensure that it is managed properly. Holding high levels of
working capital implies holding idle funds with unnecessary cost implications, a
phenomenon known as ‘overcapitalisation’. Low working capital can result in a
situation where the firm is not able to meet its demands.
How is working capital estimated from the working capital cycle?
The needs of working capital are estimated based on an understanding of the
business’s working capital cycle. WCC is directly proportionate to the amount
of working capital invested. Assuming there are 365 days in a year, WCC is the
sum of:
1 Receivables days [Trade receivables ÷ credit sales] × 365
2 Inventory days
a) FG [Finished goods ÷ cost of sales] × 365
b) WIP [WIP ÷ cost of production] × 365
c) RM [Raw material ÷ raw material purchases] × 365
3 Less: payables days [Trade payables ÷ credit purchases] × 365
Estimation of inventory: The amount to be invested in inventory is estimated
based on production budget, average holding period and cost per unit of
inventory.
RM = Production units per day × RM cost per unit (p.u.) × average RM storage
period.
WIP = production units per day × WIP cost p.u. × average WIP holding period.
FG = production units per day × cost of production p.u. × average FG storage
period.
Estimation of receivables: Accounts receivables are estimated by the average
number of days it takes to collect an account.
Receivables = credit sales units per day × average collection period
Estimation of payables: Accounts payables are estimated by the average
number of days taken to make the payment from the date of invoice.
Payables = credit purchases per day × average payment period
Overheads and expenses are also estimated on the above basis.
How does the JIT system help a company to improve its
relationships with customers and suppliers?
The key objective of the JIT system is to reduce flow times within production
systems as well as response times from suppliers and to customers. It is definedby Monden Yasuhiro as a methodology used in ‘producing the necessary items,
in the necessary quantity at the necessary time’.
Reducing the level of inventory does not just reduce carrying costs. By using this
technique, manufacturers also get more control over their manufacturing process,
making it easier to respond quickly when the needs of customers change. This
also reduces the amount of storage and labour costs a business needs.
The relationship with suppliers is an important aspect of the JIT system. If
the supplier doesn’t deliver the raw materials in time, it could become very
expensive for the business. A JIT manufacturer prefers a reliable, local supplier to
meet the small but frequent orders at shorter notice, in return for a long-term
business relationship.
What are the key features of ABC inventory control?
ABC inventory control classifies inventory items based on the items’
consumption values. In this method of inventory management, the materials
are divided into three categories: A being the items requiring the highest
investment, B being the medium level and C being the remaining items of stock
with relatively low value of consumption.
This method of inventory control helps companies to maintain tighter controls
over costly items. Better control over high-value inventory improves efficiency
and improves overall profitability. For example, stock management resources
can be dedicated to higher valued categories to save time and money. However,
since this method focuses only on monetary values, it could ignore other factors
which may be important to the business. It also requires keeping track of all
inventory items and will be successful only if there is proper standardisation of
inventories.
What are the objectives of trade receivables management?
The management of receivables is a key aspect of working capital management
as a substantial amount of cash is tied up in receivables. The ultimate goal of
receivables management is to maintain an optimum level of receivables by
achieving a trade-off between:
profitability from credit sales and
liquidity (reducing the cost of allowed credit)
The objectives of receivables management are:
1. to control the costs associated with the collection and management
of receivables: administration costs associated with receivables include
maintenance of records, collection costs, default costs and writing off bad
debts;
2. to achieve and maintain an optimum level of receivables in accordance
with the company’s credit policies; and
3. to achieve an optimum level of sales.
What are the risks of delaying payment to suppliers?
Companies may encounter the following problems by delaying payment to
suppliers:
suppliers may refuse to supply in future
suppliers may only supply on a cash basis
a company could exceed its credit period which could risk its credit status
with the supplier and could result in supplies being stopped
a company could also lose the benefit of any settlement discount offered
by the supplier for early payment
there may be loss of reputation suppliers may increase prices in future
