Question

In: Accounting

Design and develop a Working Capital Management Plan which you find best suited for the financial...

Design and develop a Working Capital Management Plan which you find best suited for the financial requirement of your chosen dummy company. You are encouraged to include numerical figures to support discussion of your strategic working capital plan.

Take into account the following strategic considerations:

1. Cash Management: present and discuss the implication of changing any of the components of the Cash Conversion Cycle.

2. Receivables Management: explore the possibility and discuss the implication of changing the company’s credit terms and policies.

3. Inventory Management: consider the proposal of adopting the best inventory management practice/s which you find helpful in increasing inventory turnover and reduction of inventory costs.

4. Payable Management: propose a plan to fully maximize the credit terms offered by suppliers, without sacrificing the company’s payment credibility.

Solutions

Expert Solution

A1)Working capital is a measure of the company’s efficiency and short term financial health. It refers to that part of the company’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. It is a company’s surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources. Funds thus, invested in current assets keep revolving and are constantly converted into cash and this cash flow is again used in exchange for other current assets. That is why working capital is also known as revolving or circulating capital or short-term capital.

Formula for Working Capital: “Current Assets – Current Liabilities”

Illustration to calculate working capital:

Components of the balance sheet: (Rs)

Current Assets

Current Liabilities

Cash

1500

Accounts payable

1500

Marketable securities

500

Accrued expenses

1000

Accounts receivables

2000

Notes payable

500

Inventory

2500

Current portion- long term debt

1500

Total current assets

6500

Total current liabilities

4500

WC = CA- CL

=6500-4500

=2000

Net working capital is defined as the excess of current assets over current liabilities. Working capital mentioned in the balance sheet is an indication of the company’s current solvency in repaying its creditors. That is why when companies indicate shortage of working capital they in fact imply scarcity of cash resources.

Factors effecting working capital:

• Nature of business: generally working capital is higher in manufacturing compared to service based organizations

• Volume of sales: higher the sale, higher the working capital required

• Seasonality: peak seasons for sales need more working capital

• Length of operating and cash cycle: longer the operating and cash cycle, more is the requirement of working capital

A2) The term credit policy refers to those decision variables that influence the amount of trade credit, i.e., the investment in receivables. The firm’s investment in receivables are affected by some uncontrollable factors like economic conditions, industry norms, competitions etc., but it can certainly influence the level of trade credit through its credit policy within these constraints imposed externally. Further, whenever some external factors change, the firm can accordingly adapt its credit policy.

 Tight or Loose Credit policy: The credit policy of any firm may broadly be classified as ‘tight’ credit policy or ‘loose’ credit policy. Firms with tight credit policies tend to sell on credit only to those customers who have the highest quality credit ratings. On the other hand, array of customers, including customers with relatively low credit ratings. In fact, firms follow credit policies which range between tight and loos credit policies. Credit policies differ in their effects on the firm’s sales costs and profits. Generally, firms pursuing loose credit policies will have higher sales and profits as compared to similar firm following tight credit policies. Loose credit policies stimulate sales because the potential customer’s base is broadened. But firms with loose credit policies can incur higher bad debt losses and face the problem of liquidity as compared to the firms with tight credit policies. A tight credit policy follows tight credit standards and terms and as a result, minimise costs and chances of bed debts. Such policies do not pose the serious problems of liquidity. But they restrict sales and profit margins. The objective of credit management, therefore, should be the achievement of a balance that maximises the overall return of the firm. Thus, the decision to grant trade credit involves a trade-off. Certain benefits will accrue to the firm from establishing a particular trade credit policy and certain costs will be incurred. The firm’s problem is to compare the costs and benefits involved to determine its best level of receivables. The costs and benefits to be compared are marginal costs and benefits.

 Cost-Benefits Trade-off: The determination of optimum investment in receivables involves a trade-off between costs and benefits. The major considerations in costs are liquidity and opportunity costs. Liquidity consideration concerns the possibility of receivables being collected in time and at full value. As the firm’s policy become loose, the chances of the bed debts increase and collection period gets extended. This poses a problem of liquidity. Loose credit policy also involves large investment in receivables and thus, adds to opportunity costs. On the other hand, profitability is expected to improve when credit policy is relaxed. Loose policy tends to expand sales and the increased revenue results. The optimum credit policy will be determined by the trade off between liquidity and profitability. It is indicated that the firm becomes less liquid as its credit policy relaxes. But profitability increase as the credit policy becomes more and more liberal. The optimum credit policy should occur at a point where there is a trade off between liquidity and profitability.

The success or failure of a business depends to a large extent on its level of sales as a rule, the higher the sales volume, the grater the profit and the healthier the firm. Sales, in turn, depend on a number of factors, some of which are controllable by the firm. The major controllable variable which affects sales or sales price are product quality, advertisement and firm’s credit policy. Credit policy, in turn, consists of these three elements

 Credit Terms

 Credit Standards

 Collection Policy

Credit Terms The stipulation under which the firm sells on credit to its customers is called terms. A firm should carefully decide upon the terms of credit. The decision of the terms on which credit will be granted may cover the various aspects of a credit policy, namely, selection of credits customers, approval of credit periods, acceptance of sale discount and provision regarding the instruments of security for credits to be accepted. The terms should be determined in the light of the needs of the firm and the established practices of concern in this regard. This selection of credit customers should be made on the basis of the amount of bed debt losses which a firm can absorb in any given period. The amount funds tied up in receivables is directly related to the limits of credit granted to customers. These limit should never be ascertained on the basis of the subject’s own requirements; they should be based upon the debts paying power of customer and his ledger record of the orders and payment.” The time duration for which credit is extended to the customers is referred to as credit period. It is generally stated in terms of net date. Usually the credit period of the firm’s governed by the industry norms, but firms can extend credit for longer duration to stimulate sales. If the firm’s bed debts built up it may tighten up its credit policy as against the industry norms. Cash discount is another aspect of credit terms. Many firms offer cash discount as inducements for customers to pay their bills early. If payment is made by a certain date the buyer can pay less than the full amount of the invoice. The cash discount terms indicate the rate of discount and the period for which discount has been offered. If a customer does not avail himself of this offer, he is expected to make the payment by the stipulated date. “To make cash discount an effective tool of credit control, a firm should also see that it is allowed to only those customers rho make payments of due date” Credit terms can be used as an investment to push sales. The most desirable credit terms, which increase the overall profitability of the firm, should be offered to customers. The financial manager should compare costs and benefits f alternate credit terms to find out the most desirable credit terms, finally, the credit terms of a firm should lay stress upon the receipt of securities for the credits to be granted. Credit sales may be got secured by being furnished with instruments such as trade acceptance, promissory notes, or bank guarantees.  Credit Standards The credit standard followed by the firm has an impact on sales and receivables. The sales and receivable levels are likely to be high, if the credit standards of the firm are relatively loose. Liberal credit standards tend to push sales up by a higher incidence to bad debts loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects. They tend to depress sales, reduce the incidence of bad debts loss, decreases the investment in receivables, and lower the collection cost. The firm’s credit standards are influenced by “Five C’s” of credit:- character, capacity, capital, collateral and conditions. Character refers to the profitability that a customers will try to honour his obligations. This factor is of considerable importance, because every credit transaction implies a promise to pay. Capacity is gauged by his past record, supplemented by physical observation of the customer’s plant or store and business methods. Capital is measured by the general financial position of the firm as indicated by a financial ratio analysis, with special emphasis on the tangible net worth of the firm. Collateral is represented by assets that the customer may offer as a pledge for security of the credit extended to him. Condition refers to the impact of general economic trends on the firm or to special developments in certain areas of economy that may affect the customer’s ability to meet his obligations. Normally, a firm should lower its credit standards to the extent profitability of increased sales exceeds the associated costs. The extent to which credit standards can be liberalised should depend upon the matching between the profits arising due to increased sales and the costs to be incurred on the increased sales.

 Collection Policy: A collection policy is required because all customers do not pay the firm’s bills in time. The collection programme of the firm, aimed at timely collection of receivables. It may consist of the following:  Monitoring the state of receivables.

 Despatch of latter to customers whose due date is approaching.

 Telegraphic and telephonic advice to customers around the due date.

 Threat of legal action to overdue accounts.

 Legal action against overdue accounts. The basic idea underlying formulation of collection policy is to ensure the earliest possible payment on receivables without any customer losses through ill will. Prompt collection of accounts tends to reduce investment required to carry receivable and the cost associated with it. Percentage of bad debts is very likely to decrease. The most important variable of credit policy is the expenditure on collection of accounts. Other things being equal, greater the amount spent on collection efforts, the lower the percentage of bad debts losses and shorter is the average collection period and vice-versa. However, the relationship between collection expenditures and bad debts losses is not as linear as it appears. In determining the most suitable collection policy for the firm, the financial manager must strike balance between the costs and benefits of different collection policies.

Working capital Approaches:

A) Matching or hedging approach: This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets.

Example: A fixed asset which is expected to provide cash flow for 5 years should be financed by approx 5 years long-term debts. Assuming the company needs to have additional inventories for 2 months, it will then seek short term 2 months bank credit to match it.

B) Conservative approach: it is conservative because the company prefers to have more cash on hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower return”.

C) Aggressive approach: The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.

A3)Often the interrelationships among the working capital components create real challenges for the financial managers. Inventory is purchased from suppliers, sale of which generates accounts receivable and collected in cash from customers to pay off those suppliers. Working capital has to be managed because the firm cannot always control how quickly the customers will buy, and once they have made purchases, exactly when they will pay. That is why; controlling the “cash-to-cash” cycle is paramount.

The different components of working capital management of any organization are:

• Cash and Cash equivalents

• Inventory

• Debtors / accounts receivables

• Creditors / accounts payable

A) Cash and Cash equivalents:

One of the most important working capital components to be managed by all organizations is cash and cash equivalents. Cash management helps in determining the optimal size of the firm’s liquid asset balance. It indicates the appropriate types and amounts of short-term investments alongwith efficient ways of controlling collection and payout of cash. Good cash management implies the co-relation between maintaining adequate liquidity with minimum cash in bank. All companies strongly emphasize on cash management as it is the key to maintain the firm’s credit rating, minimize interest cost and avoid insolvency.

B) Management of inventories:

Inventories include raw material, WIP (work in progress) and finished goods. Where excessive stocks can place a heavy burden on the cash resources of a business, insufficient stocks can result in reduced sales, delays for customers etc. Inventory management involves the control of assets that are produced to be sold in the normal course of business.

For better stock/inventory control:

o Regularly review the effectiveness of existing purchase and inventory systems

o Keep a track of stocks for all major items of inventory

o Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long

o Outsourcing should also be a part of the strategy where part of the production can be done through another manufacturer

o A close check needs to be kept on the security procedures as well

C) Management of receivables:

Receivables contribute to a significant portion of the current assets. For investments into receivables there are certain costs (opportunity cost and time value) that any company has to bear, alongwith the risk of bad debts associated to it. It is, therefore necessary to have a proper control and management of receivables which helps in taking sound investment decisions in debtors. Thereby, for effective receivables management one needs to have control of the credits and make sure clear credit practices are a part of the company policy, which is adopted by all others associated with the organization. One has to be vigilant enough when accepting new accounts, especially larger ones. Thereby, the principle lies in establishing appropriate credit limits for every customer and stick to them.

A4) Management of accounts payable:

Creditors are a vital part of effective cash management and have to be managed carefully to enhance the cash position of the business. One has to keep in mind that purchasing initiates cash outflows and an undefined purchasing function can create liquidity problems for the company. The trade credit terms are to be defined by companies as they vary across industries and also among companies.

Factors to consider:

o Trade credit and the cost of alternative forms of short-term financing are to be defined

o The disbursement float which is the amount paid but not credited to the payers account needs to be controlled

o Inventory management system should be in place

o Appropriate methods need to be adopted for customer-to-business payment through e-commerce

o Company has to centralize the financial function with regards to the number, size and location of vendors

Time and money concept in Working Capital:

Every component of working capital (namely inventory, receivables and payables) has two dimensions TIME and MONEY, in managing working capital. By making the money move faster around the cycle, one can reduce the amount of money tied up. This helps the business generate more cash or it will need to borrow less money to fund its working capital. Consequently, it would either reduce the cost of interest or have free funds to support additional sales growth or investments of the company. Similarly, if one can negotiate on better terms with suppliers i.e. get an increased credit limit or longer credit; it will effectively create additional cash to help fund future sales.

Hence to conclude, Working capital in lay men terms can be compared to the blood vessels in any human body which makes the body function properly and thus make maximum utilization of the human or company assets.


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