Question

In an early stage business, what do you believe would be your working capital philosophy; (1) a liberal credit and collection policy to get as many customers in as possible or (2) a strict credit and collection policy to take very good care of precious working capital? Would your opinion be different if the company was funded out of your pocket or funded by a professional investment firm like Private Equity?

In a later stage business, what believe would be your working capital philosophy; (1) paying bills as soon as they come in the door to maximize vendor relationships and goodwill or (2) paying bills on he last possible day to maximize cash on hand and working capital? Would your opinion be different if the company was funded out of your pocket or funded by a professional investment firm like Private Equity?

In general in business, what do believe would be your working capital philosophy; (1) keeping a broad array and as much inventory on hand as possible to make sure that you never miss a sale or (2) stocking only a few items and maximizing the inventory turnover?

Answer 1

Working Capital = Current Assets – Current Liabilities.

Working Capital cycle is the time duration in which the current assets and current liabilities are converted into cash.

It is time required for the completion of the following:

1. Purchase of raw materials and services.
2. Conversion of raw material into work-in-progress.
3. Conversion of work-in-progress into finished goods.
4. Sale of finished goods (cash / credit)
5. Conversion of Debtors into Cash.

Working Capital cycle = Inventory Conversion Period +

Receivables Conversion Period – Deferral Period

Inventory Conversion Period =

Raw Material conversion period (RMCP) +

Work-in-Progress conversion period (WPCP) +

Finished Goods conversion period (FGCP).

RMCP is the period for which raw material is kept in store before it is issued to the production department.

WPCP is the period for which the raw material remains in the production process till it is converted to finished goods.

FGCP is the period for which the finished goods remain in store before it is sold to the customer.

Receivables Conversion Period is the time required to convert the credit sales into cash.

Deferral period is the period for which the payments to the supplier of raw material and the wages and salaries to the staff are deferred.

In an early stage of business, we have to maintain a reasonable credit and collection policy which is prevailing in the industry.

There should be a balance between the liberal and strict policy.

If the company is funded out of our pocket, we will gradually increase the investment and the credit rating of the company.

If it is invested by a professional investment firm like Private Equity, we can have more investment and a good credit rating from the beginning.

In the Later stages of business, we will maintain a healthy relation with our vendors and suppliers. We will pay in bills within a reasonable time as per the credit terms prevailing in the industry.

If the company is funded out of our pocket or funded by a professional investment firm like Private Equity. In case it is funded by a Private Equity, we can have more investment and increase our sales and profits.

Inventory Conversion Period =

Raw Material conversion period (RMCP) +

Work-in-Progress conversion period (WPCP) +

Finished Goods conversion period (FGCP).

Inventory Turnover Ratio = Cost of Goods sold / Average Inventory.

We have to maintain the average inventory so that the inventory carrying costs are not high.

We should not buy too much inventory and accumulate the non-saleable inventory.