Managing the working capital for optimal results

With the downturn in economic activities, it is increasingly difficult for companies to raise finance through external sources. The difficulty is both in terms of the exorbitant cost of borrowing and the availability of borrowing funds. The problem notwithstanding that companies must continue to operate and only require a chunk of finance to operate. The need to continue operation vis-a-vis the suffocation experience in finance sourcing now leads to companies looking more critically inward as a bailout of the situation. One of the various ways of looking inward is managing working capital to achieve the best possible.

Essentially, working capital consists of cash, debtors, stocks, and creditors. A balanced working capital is that which has all these aspects in proper mix. The way to achieve this mix is to pay serious attention to every aspect of the make-up. Not doing so may amount to trading off one for another, which may mean that the benefits derived from one aspect will be eroded by the shortfall from another. Each aspect of the whole will be considered in turn.

Cash management involves determining the actual cash requirements of the organization and planning the best ways to attain such requirements incurring the minimum cost. The emphasis on cost is essential because it is not sufficient to have all your cash requirements to carry out a particular project. In contrast, if the interest payment on such cash injection is much more than the profit, the project will turn out at the end of the year.

The cash budgeting technique is typically employed through effective forecasting to determine the cash requirement on a quarterly or a half-yearly basis. However, the choice of a relatively short period has to do with the understandable limitations of forecasting in becoming a reality. It provides a useful guide as it draws times from historical trends, level of current operations, and planned growth in the immediate future. Cash Budgeting considers both the aspects of income generation and cost incurrence. It helps monitor how costs are incurred to achieve planned targets, which is usually some savings for the subsequent periods. It extends to paying attention to collectibles per planned targets as well. Whichever aspect is not closely monitored will lead to targets not being attained.

In the economists ‘view, cash management will also bring out the requirements, considering the three fundamental reasons for holding money. That is for transactional precautionary and speculative purposes. The need to conform with this standard is seen in inflation, with every index of economic activities fluctuating. Proper cash management, therefore, keeps the company stable even in the face of helpless uncertainty.

Another aspect of cash management that requires attention is that of the banking policy. In companies where the cash flow is goods, a daily banking policy is typically employed. This could be by taking all that is collected within the banking hours to the bank immediately or banking the cash takings of the previous day first thing every morning. Nevertheless, for organizations whose cash flow is intermittent, a policy that considers the cost elements, the security of cash not banked, and other logistic factors are generally in place. Though some aspects of this have now been resolved by other channels such as POS (point of sales) and direct transfer to bank accounts, some organizations are still involved in physical cash transactions.

Due to some seasonal variation in sales, the shortfall is unavoidable in a specific year period. The means of meeting such shortfall without affecting the operation drastically form another aspect of cash management. It is often dangerous where there is a shortfall because it may mean losing investment opportunities that may arise. In the same vein, excess cash holding does no good to the organization.

Debtors’ crises result from credit sales to customers with the agreement that the customers will pay at a determinable future date. Therefore, the presence of debtors creates a gap between the profitability of a company and its liquidity position. Whereas a particular business venture may be profitable based on its turnover, i.e., the practical level of sales attained, when this is largely on credit sales i.e., debtors taking a greater of the sales, the company may be in an adverse financial situation. The physical cash is not just there, meaning that the company has a liquidity problem.

Having this in mind, therefore, a credit policy is usually put in place, stipulating the maximum period of credits allowed customers. It should be borne in mind that in some kinds of businesses, credit sales are unavoidable. The customers play an essential role in ensuring that the goods produced get to the final consumers. The essential linkage provided by the distributors (customers) allows them to enjoy the benefits of being given a future date to pay for the goods supplied to them. It is not always difficult for a monopoly market to set a maximum period of grace for credit sales. In a competitive environment, the situation is not as rosy.

This first step is to determine the debtors’ repayment period by comparing the total debtors at the end of a period with the total credit sales multiplied by the number of sales in the year if the calculation is in days.

The figure so arrived at will compare with the industry average to achieve either of two objectives. Suppose the debtors’ repayment period of a particular company is higher than the average in the industry. In that case, it may mean that the credit policy currently in place is to relax towards debt collection. On the other hand, if it is less, it may mean that other competitors have more favorable credit policies towards their customers. In the first instance, the danger is that the liquidity position may be dangerously affected as all monies are tied down in debtors, with the usual incidences of bad debts or doubtful debts being on the greater side. A corrective measure, therefore, must be taken. This may include granting trade discounts for prompt payments at a percentage that will consider the benefits and the cost of such a discount. Such consideration will form the basis of the percentage to be granted. While in the second instance, the possibility of losing the market to the competitors is high, as the distributors will prefer a company with a more favorable credit policy.

Stocks or inventories constitute the essential aspect of the current aspects of a company, especially in the manufacturing industry. The stock requirement must be known both for its adequacy to meet current operational requirements and Ad hoc requirements. In considering stock level, many factors are taken into consideration.

These factors are at what level is most economical to order, otherwise known as economic order quantity (EOQ) which is a balancing of various cost elements such as carrying cost (cost of storage), ordering cost (cost of placing cost usually administrative cost), the benefits of bulk purchase, the conditions of stock in terms of the durability of storage as well as the adequate requirement of the company. Today, where the logistics are effective, Just-In-Time (JIT) has replaced the rigors of EOQ.

Economic Order Quantity is generally determined by applying mathematical formulas using the differential equation of minimum and maximum points. The EOQ is at the point where minimum costs are attained for ordering the particular quantity.

In most cases, bulk purchase always attracts some discounts. Taking advantage of this means that less will be required than if a purchase has been on an ad-hoc basis. However, decisions on a bulk purchase will bear in mind the nature of goods, whether perishable or not, the availability of storage facility or otherwise, and the danger of pilferage.

The storage’s durability takes into account the existing condition of the warehouse vis-a-vis the humidity level the goods must be subjected to; some chemicals are required to be stored in a freezing environment. A warehouse with a faulty air conditioning system will not meet the needs of storing such chemicals.

The requirements of the company need when considering in the light of carrying excess stocks is that capital, i.e., money, is unnecessarily tied down that would have been utilized in other aspects of the company’s operation. On the other hand, having a stock-out situation will mean the inability to fulfill a customer order, which may lead to loss of market and goodwill, which are essential to sustaining operation and growth, especially in a competitive environment.

Creditors arise due to the company buying goods on credit terms from its customers with an agreement to pay at a future date. Sometimes a company may not be in a position to pay it and hence defer such payments. The benefits of credit purchase may be seen from the effect of a stock-out; the situation with the danger of losing a viable customer or market altogether with a creditable supplier willing to bail out this situation will always be averted.

Like debtors, creditors’ repayment period is also determined by comparing the creditors at the end of the period with total credit purchases multiplied by the number of days in a year. A lower repayment period than the average in the industry points to prompt settlement of creditors, while a higher period than the industry average means delayed payments to suppliers.

An Effective policy takes cognizance of the two situations. If a lower repayment than the average means prompt settlement, it may also mean that a good advantage or nearly cost-free of creditor financing is not taken. Since no additional cost is being incurred by delayed payment, the result is more beneficial to the company than a below-average repayment period. However, a higher-than-average repayment may signal danger. The Source of supply may be lost as suppliers may no longer be interested in supplying on credit. The resort to cash purchase may become burdensome, that specific contracts may slip off the company’s hands. The effects will be the gradual loss of the market, unfavorable liquidity positions, and additional costs of storing unsold goods. If not correctly managed, it may lead to the eventual collapse of such a company.

The interplay of all the elements of making capital require adequate attention for a company’s survival. A company that neglects them does so at its own risk.

Oluwadele is a Chartered Accountant and Public Policy Scholar based in Canada.