Working capital is defined as current assets less current liabilities.
The main elements of assets are:
* inventories,
* trade receivables,
* cash.
The elements of current liabilities are:
* trade payables,
* bank overdrafts and other short-term borrowings.
For some companies the investment in working capital can be substantial. Manufacturing business will heavily invest in raw materials, work in progress and finished goods. There are different attitudes to management of working capital as well as different attitudes towards the risks.
Working capital represents the net investment in short-term assets, which are continuously flowing in and out of business and are essential to day-to-day operations.
Managing working capital
The management of working capital is essential to the business and short term planning process. Management must be aware of various costs, including opportunity costs to manage working capital effectively. The working capital change depending on the business environment as different investments in working capital are made. These could be changes in interest rates, changes in market demand, changes in seasons or changes in the state of the economy. Internal changes such as using different production methods or even changes in the level of risk that managers are prepared to take.
For many businesses the investment in working capital is vast. Therefore, there is a considerable scope for improving working capital management. Often the working capital is not as well managed as it could be. Businesses could manage inventories better, as well as the trade receivables and trade payables. Potential savings could be huge.
It is known that smaller businesses carry more excess working capital. This is because smaller businesses tend to be less well managed. They lack in specialist skills and expertise that can be found in larger businesses. Economies of scale may also be a factor. For example, a business with twice as much revenue would not need as twice as much inventory.
Managing inventories
Business hold inventories to meet immediate needs of customers and production. Sometimes businesses hold more then it is necessary with a view of risk for interruptions in future supply. For some, inventories represent a substantial amount of assets.
There are significant costs associated with holding inventories so businesses seek to optimise it. Costs include storage and handling costs, cost of financing the inventories, cost of obsolescence or costs of opportunities for using the cash elsewhere.
For some companies the costs of financing inventories are significant in relation to their operating profits.
There are also costs associated with holding too little inventories. These are, for example loss of sales, loss of customer goodwill, purchasing inventories at a higher price, high transport costs, lost production due to shortage of materials, inefficient production scheduling.
Number of techniques can be employed to manage inventories better.
Budgeting future demand - this will be one of the best ways to ensure to ensure that future demand will be fulfilled. These budgets should deal with each product that business hold, buy or re-sale. These budgets need to be realistic. These budgets may be derived using statistical techniques or based on judgement.
Financial ratios - can be used to monitor inventory levels. Average inventory turnover ratio, for example, provides a picture of the average period in which inventories are held.
Source: Atrill P., 2-19, "Accounting and finance for non-specialists", Pearson, 11th edition
This ratio can be useful for basis of comparison and can be calculated for individual product lines, for particular categories of inventories as well as inventory as a whole.
Recording and reordering systems - a key element is a sound system for recording inventories. Periodic stock checks should be done. There should also be clear procedures for reordering, authorisation for purchases. For most businesses there will be a certain level of uncertainly in relation to predictions of demand, so a safety level of inventory may be set. The amount of buffer will depend on the level of uncertainty, the costs of running out of stock and the costs of holding of the 'buffer' stock. Carrying buffer will increase the costs associated with inventories. These may be lost of sales and production problems. Business may set relevant reorder points to avoid these issues.
Level of control - there are different levels of controls implemented according to the nature of inventories held. ABC system may be used.
ABC analysis is an inventory classification strategy that categorises the inventory into 3 categories: A,B and C. A signifies the most important goods, B - moderately necessary goods and C indicates least essential inventory.
Source: Deskera, "What is ABC analysis in Inventory control", accessed from https://www.deskera.com/blog/abc-analysis/#:~:text=Key%20Takeaways%3A-,ABC%20analysis%20is%20an%20inventory%20classification%20strategy%20that%20categorizes%20the,indicates%20the%20least%20essential%20inventory. , accessed on 22/04/2023
The majority of companies do not manage their inventory right. It is difficult to maintain the correct level of inventory when we are dealing with diverse customer demands. Good inventory system will allow to manage inventory effectively. ABC analysis enables the business owners to distinguish the products in stock and manage them depending on their worth. The aim is to make the maximum of minimum investment without wasting any resources or inventory.
Segment A - products included in this category are the most essential goods, generally 20% of the total products with 80% revenue generation.
Segment B - generally regulates 30% of the goods with 15% revenue generation, there are more in number but less in utility.
Segment C - most in number but least value with the maximum of 50% of the stock and generates 5% in revenue.
To conduct the ABC analysis we need to:
Calculate the annual consumption value - multiply the annual number of units sold by cost per unit,
Enlist all the products in descending order based on their annual consumption value,
Total the number of units sold by the annual consumption value,
Calculate the cumulative percentage of goods sold and cumulative percentage of the annual consumption value,
Divide the data into 3 categories: A - 80%, 15% and 5%.
This technique allows to streamline the inventory management. It also allows to determine customer demands to ensure that we know what the customer wants. Analysis also allows for getting a deal with suppliers. If product generates most revenue we can invest in more inventory with discounted prices. Accurate stock levels also improve customer service when stocking appropriate goods. It also speeds up the manufacturing operational cycle. The cost control of inventories need to be proportional to their value. We know that Category A items account for a large proportion of the total value, Category B items are less valuable and Category C items are relatively low in value. Different controls can be applied to different categories, for example Category A items may need more sophisticated and stricter controls.
Inventories management models - different decision models may support the inventory management.
For example EOQ - Economic Order Quantity. This model is concerned with determining the the quantity of inventories that should be ordered each time. We assume that there is constant rate of usage and inventories are reduced to zero before new ones arrive. The key costs associated with the EOQ technique is the cost of holding the inventory and costs associated with ordering them. The costs of holding inventory can be quote substantial, so EOQ seeks to find an optimum size of purchase order that will balance both of these cost elements.
The Economic Order Quantity is the calculation companies perform that represents their ideal order size, allowing them to meet demand without overspending. It is a useful formula for the business and ERPs can automate the Economic Order Quantity automations so that the business can make the best informed decisions regarding purchase orders and inventory management. This quantity can be a key metric to economic sustainability because ordering too much can lead to high holding costs. Resources may be taken from other important activities, such as R&D which could boost sale. Inventory is organisations working capital that requires ongoing operations. Too much of working capital can eat into profits.
Source: Oracle Net Suite, "Economic Order Quantity (EOQ) Defined", accessed from https://www.netsuite.com/portal/resource/articles/inventory-management/economic-order-quantity-eoq.shtml#:~:text=Economic%20order%20quantity%20(EOQ)%20is,holding%20costs%20and%20excess%20inventory. accessed on 22/04/2023
The price paid from the supplier does not affect the EOQ formula. It is only concerned with the administrative costs of placing and handling each order as well as the costs of handling the inventories. ABC system of holding inventory might be in place. There are certain limitations of the EOQ formula because it assumes that the demand is constant and there is no fluctuations, no 'buffer' inventories are required and there is no discount for 'bulk purchases". Many organisations use this function to manage inventories.
Just-in-time inventories management - in recent years many companies tried to eliminate the need to hold inventories by adapting JIT (Just-in-time). In essence, the method suggests that to have supplies delivered just in time when they are needed for production for customer order. The inventory holding costs here are moved to suppliers.
A well managed JIT system should result in reduced inventories holding costs. But failure for supplier to deliver can cause huge problems and additional costs to the business. It may serve costs but it increases risks. For it to be successful, there need to be a close relationship with the supplier. The business need to advise suppliers on the demand in advance so that supplier can plan its production. Suppler must then deliver the product in the right quantity and agreed times. Any failure to deliver may be very costly. Ideally the supplier needs to be located geographically close to the business.
Adopting of JIT would generally require re-engineering the production process, such as production layout and working practices. The production process must be quick and responsive. Information system should be develop to support the production flow.
Although business can save money of holding inventories, other costs may be incurred, such as close relationships with suppliers may result with missing on other cheaper sources of supply or supplier may charge extra for holding inventories.
JIT is viewed as the inventory control system and concerned with eliminating waste and aiming for excellence. Here, there is always an expectation that suppliers will always deliver on time, in full and to required quality. These expectations may be impossible to achieve. Production workers must be suitably trained to pursue quality. They need to work in team and adapt to changes as well as show initiative when problems arise.
JIT aligns the raw-materials purchasing directly with the production schedule. Businesses employ these techniques to increase efficacy and decrease waste in receiving goods as they are needed for production process. Kanban in the scheduling system is often used in conjuction with lean manufacturing and JIT. Combined it allows for improvement of the production operations. The Kanban system measures the lead and cycle times across the production process that helps to avoid overcapacity.
The Kanban system can be though as a signal and response system. When items are running low at the operational station, there will be visual clues on how much to order from the supply. The person using the materials places the order by the quantity specified by the Kanban and supplier provides the materials. The system creates visibility to both suppliers and buyers. It aims to limit of buildup of excess inventory and reduce inefficiencies as they are quickly identified and resolved. The process must be visual with physical cards or software. The idea is to clearly show what each step is. The idea of Kanban is to reduce work in progress and staff does not wait. For some companies Kanban is not possible to implement as it relies on stablity.
Managing trade receivables
Selling on credit brings costs, for example costs of credit administration or bad debt costs. The business must have clear policies concerning which customer should receive credit, how much credit should be offered, what length of credit are we prepared to offer, whether discounts will be offered for prompt payment, what collection policies should be adopted and how the risk of non-payment can be reduced.
Which customer should receive credit?
When we offer credit, we run risk of not receiving payments for goods and services supplied. We need to assess the customer to whom we offer credit and how much is allowed. The below 5Cs of credit provide useful factors to consider:
- Capital. The customer must appear to be financially sound before credit is expected. Their financial statements should be examined particularly in relation to future profitability and liquidity. Borrowings, capital expenditure and their contracts with suppliers should be assessed.
- Capacity. The customer must appear to have capacity to pay for the goods so their payment records should be assessed.
- Collateral. At times it might be needed to ask for security for the goods supplied on credit.
- Conditions. The industry and general economic conditions of the region and country shall be taken into consideration.
- Character. The willingness to pay will depend on honesty and integrity. We may assess the reputation of senior management and the organisation in public eyes.
Various resources are available to assess those factors:
- Trade references. References from other suppliers may be useful.
- Bank references. Banks may be in position to provide the references.
- Published financial statements. These can provide useful insights into the financial performance.
- The customer. Interviews with directors and visits to their site may be needed. Sometimes access to internal budgets is allowed.
Once the customer is considered creditworthy, the credit limit can be established. Majority of the time it is the matter of judgement.
Length of credit period
We need to decide what credit terms we can offer to customers. The length of credit may be influenced by the typical credit terms operating within the industry, the degree of competition, the bargaining power of the customers, the risks of non-payments, the capacity of the business to offer credit and even the marketing strategy of the organisation. If the business wants to increase its market share it might be more generous with credit policy in the attempt to stimulate sales. However, when extending the length of credit costs may be incurred. These may include bad debt and additional collection costs.
Cash discounts
To encourage prompt payments a business may offer a cash discount. The costs of offering discounts may be weighted against the benefits from reduction of costs and costs of bad debt.
Invoice discounting
Trade receivables can quickly be turned into cash through invoice discount. It sometimes provides with advance up to 80% of the value of the trade.
Invoice discounting allows to leverage unpaid invoices and unlock the tied up cash. It helps to efficiently manage cashflows and make plans for future investments. The invoice discounting company will typically advance a percentage of an invoice (often 90%) with the remaining balance (fees) paid once the customer pays the invoice.
Invoice discounting is a confidential financial arrangement. It allows to access money much faster. Instead for waiting to pay for an order, we take out a short term loan from the invoice of the discounting company. These companies will lend, for example 90% of the value of the invoice, and paying it the matter of days instead of weeks. Once we have received payment from the customer, we pay back the loan.
Invoice discounting is like having an overdraft facility. We sell goods to customer as usual, raise invoices, the discounted company leads us a percentage of the invoice after a small percentage, once we received payment, we re-pay the loan plus agreed fees. The fees are usually from 1% to 3%. The big advantage of it is that we know that we are going to get paid quickly, which makes a big difference to the cashflow. Invoice discounting is generally cheaper then applying for a bank loan and we have more predicted revenue stream. This makes it easier for business planning, budgeting and forecasting. The money received could be used in many ways: buy more stock or invest in the future.
Invoice factoring
It is when we sell outstanding invoices to a third-party as a mean of improving a cashflow. The factoring company will pay most of the invoices immediately, then collect payments directly from the customer. It is also referred as debt factoring. It works like this:
We provide goods and services to the customer as usual,
We invoice those customers for goods and services,
We 'sell' the invoice to the factoring company,
The factoring company pays us the bulk of the invoice, typically up to 80-90% after verifying that the invoice is valid,
The customer pays the factoring company directly,
The factoring company chases the payments.
Company may choose to use factoring agent when having a lot of outstanding invoices and the cashflow is suffering because of it. It can be cheaper and easier then the bank loan.
Credit insurance
It is often possible for supplier to insure its entire receivables, individual customer accounts or any outstanding balances. Credit insurance protect companies against risk of non-payment, often following insolvency or default of the customer. Options are available to insure key customers or even single risks.
Collection policies
A business offering credits must ensure that those are collected as quickly as possible. It is an important piece of credit control policy. It is the set of procedures to ensure payments. It includes when the customer should be contacted, how it should be contacted and so on. We need to develop customer relationships, especially with those to make the payments. By doing so the chances of prompt payments will increase.
Credit terms should be publicised, such as during the order acknowledgement, invoices and statements. Invoices should be issued as promptly as possible. This also relates to monthly statements. Ratios can also be used to assess a performance of receivables, for example "average settlement period for receivables ratio'.
Usually, a good accounting software will also provide an ageing schedule to see future predictions. This allows for identification of the patterns of the receipts. Organisations monitor a performance of credit sales as a percentage that are paid in a month for sale or paid in subsequent months. Targets may be established for the patterns and targets set to see where deviations occur. Questions for credit invoices should also be answered quickly as payments will unlikely to be paid if queries are not answered quickly. Businesses must deal appropriately with slow payers. There should be established procedures for dealing with problems. There should be timescales for sending reminders and for adding customers on 'stop list' as necessary.
Managing cash
Most businesses hold a certain amount of cash. One of the reasons for it is to meet the day-to-day commitments. A business needs a certain amount of cash to pay for wages, overhead expenses, goods purchases when they fall due. Cash is therefore the 'lifeblood' of the business and it is helpful when business profitability is put at risk.
Cash is kept for precautionary purposes. If future cashflows are uncertain, it would be important to hold a balance of cash. By holding cash we can retain the capacity to meet obligations,
Cash can also be held to exploit opportunities. For example through acquisition of competitor business when it suddenly become attractive.
The amount of cash to be held largely vary from business to business. Various factors can influence the decision. For example, the nature of the business. Some businesses have quite predictable cashflows so lower cash balances are held. Holding cash during inflation will lead to loss of purchasing power. The higher level of inflation, the greater the loss. If business has high amount of liquid assets the cash may not be required. If business can borrow easily, the cash may not be high. If the costs of borrowing for an organisation is high, it may be cheaper to hold some cash. When the economy is in the recession businesses also may want to held some cash as they may experience difficulties in receiving payments from customers.
To manage cash effectively it may be useful for a business to prepare a cash budget. It enables the managers to see the planned events and how it affects cash. The a cash surplus arise, managers are expected to use the surplus effectively. Actual cash flows need to be compared with planned cashflows and corrective actions taken when necessary.
We know that when cash is received the benefits are immediate. Direct transfers are commonly used. Businesses also set up standing orders or direct debit to carry out transfers. Bank overdrafts are also useful tools to managing cashflows.
Managing trade payables
Most businesses buy their goods and services on credit. Trade payables are the important source of finance and increase with the increased level of activity. However, business who buy supplies on credit may incur additional administration costs and accounting costs. There may be less favourable terms when purchasing on credit. Most businesses, however, have it as a norm. It is almost as an interest-free loan from a supplier. Delaying payments may be a sight of financial problems or imbalance in bargaining power.
Where a supplier offers a discount a business should seriously consider it.
Managing working capital
Many businesses do not pay as much attention to management of working capital as they should. However, benefits from careful management may be huge. It can be also a very technical task.
Working capital does not appear on the income statement but it does directly affects profits. It can account for several months worth of revenue and improving its management can give an access to free cash. It is all about reducing the time from turning obligations into liabilities.
But, we must be careful with an aggressive management. Too little inventory can disturb its operations, pre-longing suppliers payments can affect relationships or result in higher prices. But managers can improve the working capital through collecting relevant data, defining meaningful targets and managing ongoing performance. Here the selection of KPIs is very important as well as tracking it and publishing to employees.
Bibliography:
Atrill P., 2-19, "Accounting and finance for non-specialists", Pearson, 11th edition
Deskera, "What is ABC analysis in Inventory control", accessed from https://www.deskera.com/blog/abc-analysis/#:~:text=Key%20Takeaways%3A-,ABC%20analysis%20is%20an%20inventory%20classification%20strategy%20that%20categorizes%20the,indicates%20the%20least%20essential%20inventory. , accessed on 22/04/2023
Dormand C., 2020, "What is invoice discounting and how does it work?", accessed from https://gocardless.com/guides/posts/what-is-invoice-discounting/ accessed on 22/04/2023
GoCardloess, 2022, "What is invoice factoring and how does it work?", accessed from https://gocardless.com/guides/posts/what-is-invoice-factoring/, accessed on 22/04/2023
Halton C., 2022, "What is the Kanban System", accessed from https://www.investopedia.com/terms/k/kanban.asp , accessed on 22/04/2023
Oracle Net Suite, "Economic Order Quantity (EOQ) Defined", accessed from https://www.netsuite.com/portal/resource/articles/inventory-management/economic-order-quantity-eoq.shtml#:~:text=Economic%20order%20quantity%20(EOQ)%20is,holding%20costs%20and%20excess%20inventory. accessed on 22/04/2023
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