Introduction
The success of a company depends on the company’s attention to the short-term decisions. Short-term decisions affect the management of current assets and current liabilities. The company’s liquidity position depends majorly on the level of current assets of the company. If a company is to survive in the business, it must have the ability of generating enough cash that meets its short-term (current) needs (Bhattacharya, 2004).
Working capital management is therefore an important factor in the success of a company, both in the short term and long term. The degree of solvency or liquidity depends on the extent to which the company’s current assets exceed the current liabilities.
Definition
Working capital management is a strategy in accounting that focuses on maintenance of efficient levels of the working capital components, current assets and the current liabilities. For a company to meet its operating expenses and current debt obligations, it must efficiently manage its working capital. If a company wants to improve its earnings, it must implement an effective system of working capital management (Bhattacharya, 2004).
Working capital management has two main aspects: the management of the individual working capital components, and ratio analysis.
Objectives of working capital management
The main aims of working capital management are (Pass and Pike 1984):
1. To increase the company’s profitability.
2. To ensure that the company has sufficient liquidity in order to meet its short-term obligations.
Profitability relates to the wealth maximization goal of the shareholders. Therefore, investing in current assets should only be considered if the return is acceptable. Liquidity, on the other hand, is necessary to keep the company in operation.
It’s worth noting that profitability and liquidity have conflicting goals as the liquid assets have the lowest returns.
For a company to manage its working capital effectively, it must formulate clear policies in the management of every component of the working capital. The main consideration is the working capital investment level for the operations, and the financing of the working capital.
A company must have clear policies on the management of the inventories, the trade receivables, the short-term investments, and the cash so as to minimize the chances of the managers making decisions that are not in the company’s best interests. Such decisions include giving credit to clients who are not likely to repay, and the ordering of inventories of raw materials that are not necessary.
Effective working capital management policies should reflect the corporate decisions on the investment required in current assets, and the financing methods of current assets. The policies should put into account the nature of the business of the company since every business has different requirement for working capital (Solawu, 2006). Considering a manufacturing company, heavy investment in raw materials, components and spares is required, which may result into more receivables. Such a company should have clear policies on receivables management. For a food retailer, large inventories are required for resale; however, very few trade receivables may result. A food retailer does not need to make credit sales thus no need for receivables management.
Inventory Management
Inventory is defined as a documentation of the company’s raw materials, work-in-progress and goods finished but not yet sold. It’s either direct or indirectly incurred in a company. For example, to produce tea, tea leaves are used as direct materials. Its management is of critical importance to the operations of any productive company. Efficient management of raw materials and work-in-progress facilitate a balance in the various levels of production. Managing finished goods however ensures guaranteed satisfaction of the consumer as the demand is met without a hitch arising in delivery delays. (Gopalakrishnan, 1980).
Objectives of Inventory Management
Core objective is to make certain that stock is adequate for the continuity of the company’s operations. It also aims at reducing the costs of holding an inventory, e.g. costs associated with holding finished tea in company stores (Shin and Soenen, 1998).
Types of inventory
Indispensable types of inventory include raw materials, work in progress and finished goods. For a company to realize an effective inventory management, decisions relating to commodities to stock, and how much to stock must be undertaken. A company can decide on which commodities to stock by using the material planning and sales ledgers accounts. For instance, based on how frequently a commodity is sold, a company can decide to stock more of the commodity (Gopalakrishnan, 1980).
Major approaches to inventory management include the following.
Economic Order Quantity Model
This model enables decision makers come up with an optimum quantity of stock to order solely to minimize total costs. These costs are the holding or carrying costs, ordering costs or set up costs and shortage costs. They must be minimized to increase efficiency and consequently productivity (Shin and Soenen, 1998). To determine how much to stock, the annual demand, cost of making an order and holding costs per unit order unit per annum must be known. For instance, to determine how much tea to stock, its annual demand, cost of making one order and holding cost for every order unit per annum must be used as under to arrive at the optimum stock (Gopalakrishnan, 1980).
Where :
D is the annual demand for tea
Co is the cost of making one order for tea
Ch is the holding cost per unit of tea per annum
Stock Level and its management
Decisions are made of stock level with a view to minimize costs but maximizing on efficiency in material availability. Therefore, a clear cut control levels should be put in place. For instance, minimum stock level, maximum stock level, re-order level and re-order quantity may be used to manage the stock level (Gopalakrishnan, 1980).
i. Minimum stock level
This is the minimum level which the stock should not fall. It the buffer stock level, calculated as Reorder level less the product of normal consumption and normal reorder period.
ii. Maximum stock level
This is the limit above which stock should not be allowed to go past. Each material kept in store must have a maximum level. Besides, stock should not be allowed to go past set level. It is determined as:
Maximum stock level = Re-order level + re-order Quantity - (Minimum consumption x minimum re-order period)
iii. Re-order level
This is a point that lies between minimum and maximum stock levels at which purchase orders must be placed to ensure that goods ordered are received before the minimum stock level is reached. It is the level of stocks at which replenishment must be made to avoid a stock-out and is estimated by obtaining the product of maximum consumption and maximum re-order period (Gopalakrishnan, 1980).
Pareto Analysis
Pareto analysis is an inventory management approach basically used to determine how much to optimally stock. For the analysis, items are grouped as either class A, class B or class C. Class A items are of high cost, fast moving and used highly. They are generally few and add up to only 20% of total items. Class B are the medium moving goods, accounting for only 15% of total item budget. Lastly, class C are slow moving cheap value items. They are generally many, constituting 65% of total number of items. It thus demands a company to group its core item as either fast moving, medium or slowly moving to know exactly how to optimally make an order (Bhattacharya, 2004).
Just In Time Inventory System (JIT)
This approach of inventory management helps determine when to stock. It advocates for 100% quality by ensuring that there is zero inventory and stockless production. Besides, it focuses on minimizing the time taken between the delivery and use of inventory. Basically, it upholds quality and reliability from supplier to curtail production hitches (Bhattacharya, 2004). Thus, it allows a company to benefit from reduced inventory holding, ordering and handling costs as it facilitates direct inventory movement from reception to production line. For example, a company producing tea may use a Just In Time approach to avoid costs associated with inventory holding, ordering and handling costs through ensuring that there is zero inventory in stores.
On the other hand, JIT manufacturing policy aims at reducing inventory by acting as a balance between various production stages. It is realized as a result of reorganizing company layout to minimize long queues of work in progress and production batches (Bhattacharya, 2004). Proper production planning is thus essential.
Cash Management
Cash management focuses on optimizing the available cash, increasing interests earned from other funds not put to use at a given time and reducing losses incurred as result of transmission of funds. It basically aims at establishing optimal cash balance to help meet both short term and long term company obligations. Its management is crucial in the sense that the company can easily figure how much cash is hold and the opportunity cost equal to the benefit which could have been reaped in an event where the cash was put to a different productive investment (Yong, 1996).
On the other hand, low cash associated with minimizing the foregone benefit cost might plunge a company in liquidity problems. This may make a company unable to meet its short term maturity obligations like paying off liabilities. This is why cash management is undertaken to come up with an optimum cash balance geared towards satisfying the transactional motive, precautionary motive and speculative cash motive. A number of techniques that can be used to by companies to maximize the amount of incoming cash and outflow and guarantee smooth running of business are below as was noted by Pass and Pike (1984).
Cash Budgeting
A cash budget records cash flows, i.e. recording of inflows and outflows anticipated from each functional budget. It manages cash by indicating to a company the anticipated cash inflows and out flows over a given budget duration. Expected extra cash and any likelihood of any cash shortfall can be easily identified as well. For instance, it presents detailed information to a company on the availability of excess cash that can be channeled to short term investments (Pass and Pike, 1984).
Besides, it is vital to an organization in that it eases planning of borrowing and investment. It shows the effect of each periodical demand, large stocks, unusual receipts and any laxity in accounting for receivables.
Recording Accounts Receivables
This approach upholds tracking who owes company money, how much they owe and when exactly the payment is due. It focuses on accounting for receivables and should show any outstanding total amounts and the reasons behind the why the payments are not yet made. It takes a proactive approach to fully record any unpaid bills (Yong, 1996). Accounts receivable database is often employed to follow keenly what the company is owned. Once put in place, any outstanding invoice can be accounted for.
Tracking Expenses
This approach basically helps manage the cash outflows, i.e. the company operating expenses. It efficiently manages cash by taking note of all the expenses linked with company operations. This is likely to maximize the available cash that can be used to meet any short term maturity obligations.
It is undertaken by developing a comprehensive report of every company’s expenses for each and every month that it is in operation. The expenses can be simplified further to as either rent, utilities or for office maintenance. Thorough reduction on these expenses then follow suit. For example, a company can reduce office supplies expenses by contracting and negotiating for lower prices as opposed to sourcing for supplies from store (Yong, 1996)
Creating Credit Lines
Well developed credit lines with the lenders help effectively manage cash flows and thus curtail any cash deficit. It is undertaken by establishing a line of credit that will cover the entire cash deficit times in events where sales decreases and expenses shoot.
Investing surplus cash
A company can as well manage cash surplus by investing in treasury bills and money market deposits to earn a return and thus avoid its holding costs. It is however crucial for a company to set limits of deposits to reduce likely losses due failure of these investments to perform.
Before a company commits to cash investment, factors such as yield and risk associated with the investment and ease with which returns can be achieved need to be put into consideration (Pass and Pike, 1984).
Managing cash flows
Cash flow management is another approach to manage cash effectively. This approach stresses that debt collection should be correlated to agreed credit conditions. Cash obtained should be timely banked to decrease the cost of interest charged on outstanding overdraft and to avoid the cost associated with holding cash like forfeiting returns. Also, it may be undertaken as prompt as possible to increase the level of return on cash deposits. The time between initiating payments and receiving cash into a company’s bank account --float--should be minimized as possible (Pass and Pike, 1984).
Receivables Management
Receivables are money a company is owed. Its management aims at eliminating losses and maximizing anticipated returns/profits. Its effectiveness is determined by a company’s operating terms of sales and company’s capability to match to similar terms of sale. The basic approaches that can be used to efficiently manage receivables include employment of discount for early payment, insuring against bad debts, credit control systems, trade receivables collection systems and putting in place credit analysis systems (Bhattacharya, 2004).
Credit control system
This approach of receivable management focuses on setting credit limit. It upholds that a company should ensure that the costumer is allowed credit that is in line with the terms of trade and to the credit limit of the organization. The company keeps customers account within an agreed credit limit. To promote timely payments, invoices and statements are thoroughly checked for correctness. However, this approach detests advancing of credit sales to customers who have surpassed the credit limit. By doing these, the accounts receivables will be reduced (Bhattacharya, 2004).
For example, assume that Company ABC wants to buy stock worth $100 on credit from XYZ manufacturing company whose credit limit is $90. Company ABC will not be advanced the credit as its order surpasses the credit level. Therefore, it implies that XYZ manufacturing company shall have avoided $100 receivables.
Offering discount for early payment
This approach aims at winning the customers to pay earlier enough to benefit from discounts. A company may decide to scale discounts received when payment are made at a given time, i.e. after a week, one month or after three months. It may then allow customers to pay less with respect to the duration taken to make payment. However, such discount must be lower than the total financing savings. Customers are likely to compete with time so that a larger discount is awarded. This way, the level of bad debts and long term debts is minimized thus receivables management effectiveness.
Factoring
This is the selling of a company’s debts to a third party, known as a factor, at a fee usually paid in cash. In this approach, a company gives a factor a responsibility of sales administration and debts collection. It is therefore the responsibility of the factor to ensure that the debts are fully collected by following defaulters to the letter. Besides, a factor is in position to offer cash to the company against the security of the debts. This way, it results in a decrease in the value of working capital held up in trade receivables and hence likelihood of realizing higher returns since cost of holding debts is minimized (Bhattacharya, 2004).
Invoice discounting
This approach to receivables management entails sale of trade receivables to a third party but retaining ownership over sales ledger. For instance, if a company has trade debts amounting to $1000, it may decide to sell $500 to an invoice discounting agent at a fee but retain ownership of sales ledger
Managing Payables
The level of importance of creditors vary i.e. some are more important as compared to others. Some creditors are so essential that the business cannot run without prior settling of such bills. These bills are given the top priority. Such bills include the business insurance, the licenses and permits issued by the governmental authorities, the income taxes, the company’s key suppliers, the sales taxes and the company’s payroll, the mortgage payments or rents on the business premises, the utilities like water and electricity bills, and the wages, among others. All these bills are crucial for the day to day operation of the company and should be given priority.
The less important bills must also be paid. Failure to pay such bills makes the company be in a doubtable financial position. It is important to contact the creditors regularly and give the reasons for late payment. In some cases, the debts can be eliminated through provision of goods and or services. In cases where the business has seasonal fluctuations of cash flow, a negotiation can be made with suppliers so that payments are made during high cash flow seasons.
Lessons learned
The presentation of this paper has instilled in me the significance of having optimum inventory, trade receivables, payables and cash in a company. Besides, it presents me with ability and knowledge on the scope of methods that can be employed to effectively manage cash, inventory, trade receivables and trade payables. In essence, it gives me an in depth understanding of inventory management practices like the economic order quantity model, Pareto analysis, Just In Time and the importance of having a buffer inventory and lead times. It equips me with clear understanding of how factoring and invoice discounting assists in the management of working capital.
It has as well shed light in me why effective control of trade receivables demands thorough analysis of customer’s credit merit, control of credit awarded and effective collection of trade receivables. It’s marvelous to recognize that excess cash can be invested either in treasury bills or any other instrument to earn a return to a company as this shall have reduced cash holding costs hence profitability. Lastly, the presentation gives me an understanding as to why steps must be taken to establish why large value of cash is tied up in inventories of raw materials, work in progress and finished goods.
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