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A REPORT ON
WORKING CAPITAL MANAGEMENT
[CASH IS KING]
SUBMITTED TO: SUBMITTED BY:
SIR YASIN ZIA
DEPARTMENT OF BUSINESS MANAGEMENT & SCIENCE
Traditional analysis of working capital is defensive; it asks "Can the company meet its short-term cash obligations?" Working capital accounts tell about the operational efficiency of the company. The length of the cash conversion cycle (DSO+DIO-DPO) tells how much working capital is tied up in ongoing operations. And trends in each of the days-outstanding numbers may foretell improvements or declines in the health of the business. The three reasons why the firms hold cash are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions.
WORKING CAPITAL MANAGEMENT
Involves the relationship between firm short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund operations, reinvest and meet capital requirements and payments. Understanding a company's cash flow health is essential to making investment decisions. A good way to judge a company's cash flow prospects is to look at its working capital management (WCM).
What Is Working Capital?
Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. Among the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength.
Working capital is the difference between current assets and current liabilities:
Net working capital (NWC) = current assets – current liabilities Current assets are assets which are expected to be sold or otherwise used within one fiscal year. Typically, current assets include: • Cash • Cash equivalents • Accounts receivable • Inventory • Prepaid accounts which will be used within a year • short-term investments Current liabilities are considered as liabilities of the business that are to be settled in cash within the fiscal year. Current liabilities include: • Accounts payable for goods, Services or supplies • Short-term loans • Long-term loans with maturity within one year • Dividends and interest payable or accrued liabilities such as accrued taxes.
Working capital, on the one hand, can be seen as a metric for evaluating a company’s operating liquidity. A positive working capital position indicates that a company can meet its short-term obligations. On the other hand, a company’s working capital position signals its operating efficiency. Comparably high working capital levels may indicate that too much money is tied up in the business. The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company’s cash flow. Excess cash and nonoperational items may be excluded from the calculation for better comparison. As a measure for effective working capital management, therefore, another more operational metric definition applies: (Operative) net working capital = Inventories + Receivables – Payables – Advances received + Advances Made Where:
• • • • •
Inventory is raw materials plus work in progress (WIP) plus finished goods Receivables are trade receivables Payables are non-interest-bearing trade payables Advances received are prepayments received from customers Advances made are prepayments paid to suppliers
A frequently used measure for the effectiveness of working capital management is the so-called cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) it takes a company to get back one monetary unit spent in operations. The operative NWC positions are translated into “days outstanding”—the number of days during which cash is bound in inventory and receivables or financed by the suppliers in accounts payable. It is defined as follows: CCC = DIO + DSO – DPO Where: • Days inventories outstanding (DIO) = (average inventories ÷ cumulative cost of sales) × 365 (Average number of days that inventory is held) • Days sales outstanding (DSO) = (average receivables ÷ cumulative sales) × 365 (Average number of days until a company is paid by its customers)
• Days payables outstanding (DPO) = (average payables ÷ cumulative purchases) × 365 (Average number of days until a company pays its suppliers) Optimizing the three components of operative NWC simultaneously not only accelerates the CCC, but also goes hand in hand with further improvements.
Why Firms Hold Cash
The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity.
Holding cash as creating the ability for a firm to take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount that is greater than the carrying costs of holding the inventory.
Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected, cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for.
Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.
Ways To Manage Cash
Firms can manage cash in virtually all areas of operations that involve the use of cash. The goal is to receive cash as soon as possible while at the same time waiting to pay out cash as long as possible.
Float is defined as the difference between the book balance and the bank balance of an account.
Policy For Cash Being Held
Here a firm already is holding the cash so the goal is to maximize the benefits from holding it and wait to pay out the cash being held until the last possible moment.
The goal for cash management here is to shorten the amount of time before the cash is received. Firms that make sales on credit are able to decrease the amount of time that their customers wait until they pay the firm by offering discounts. For example, credit sales are often made with terms such as 3/10 net 60. The first part of the sales term "3/10" means that if the customer pays for the sale within 10 days they will receive a 3% discount on the sale. The remainder of the sales term, "net 60," means that the bill is due within 60 days. By offering an inducement, the 3% discount in this case, firms are able to cause their customers to pay off their bills early. This results in the firm receiving the cash earlier. The customer payments are sent to post office box maintained by bank and bank personnel retrieve the payments and deposit them into the firm’s bank account. (Collection centers at different locations).
• Lock Box System
The goal here is to put off the payment of cash for as long as possible and to manage the cash being held. By using a JIT inventory system, a firm is able to avoid paying for the inventory until it is needed while also avoiding carrying costs on the inventory. JIT is a system where raw materials are purchased and received just in time, as they are needed in the production lines of a firm. How Do We Value Inventory? The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement and statement of cash flow. There are three inventory-costing methods that are widely used by both public and private companies:
FIFO • FIFO gives us a better indication of the value of ending inventory
(on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost
LIFO • LIFO isn't a good indicator of ending inventory value because the
of goods sold. Increasing net income sounds good, but it also has the potential to increase the amount of taxes that a company must pay.
left over inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.
Average Cost • Average cost produces results that fall somewhere between FIFO
Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund operations, reinvest and meet capital requirements and payments. Understanding a company's cash flow health is essential to making investment decisions. A good way to judge a company's cash flow prospects is to look at its working capital management (WCM). The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company’s cash flow.