LDM | Risk Management

Background

Working capital may be defined as the funds deployed by a company in the form of cash, stock, debtors and other current assets. The total sum of funds deployed in such assets is termed as gross working capital. On the other hand, net working capital is the difference between gross working capital and current liabilities. The term working capital generally means net working capital. The liquidity position of a company is dependent on the investment in the working capital.

Static vs. Dynamic Working Capital

One can view working capital in a static as well as dynamic way. According to the static view, the amount of working capital required by a company can be obtained from the information contained in its balance sheet on a specific date. Therefore, it is a snapshot picture of current assets and current liabilities on the balance sheet date.

On the other hand, working capital can be viewed in a dynamic way. Accordingly, working capital is the amount required for the smooth and uninterrupted functioning of the normal business operations of a company, ranging from the procurement of raw materials; converting those materials into finished products; selling such products in the market; and realizing the money from debtors.  

Exploiting Working Capital

If a company intends to increase the turnover or generate cash in the short run, it can achieve this objective through the adjustment in the levels of the various components of working capital. This calls for the management of working capital in an efficient way. Therefore, management should seriously thing on the management of current assets and the means of financing them.

The working capital figure of a company can be obtained from the data obtained from its financial statements. The accounts or treasury department of the company generally manages the working capital by borrowing money to meet the working capital gap; investing the surplus money in profitable way; and managing the sundry debtors and trade creditors.

The faster a business expands, the more cash it will need for working capital and investment. Good management of working capital will generate cash, help to improve profits, solidify relationships with suppliers and customers, and reduce risks. When it comes to managing working capital, time is money. If a company can get money to move faster by reducing the amount of money tied up in inventory or accounts receivable, it results in increased liquidity of the business and consequently, generation of incremental cash flow. Likewise, the business may be able to reduce its debt and interest expenses. If a company can negotiate improved terms with suppliers, e.g., obtain longer terms it can leverage financial resources in new ways.

Managing Components of Working Capital

Traditional accounting definition of working capital, i.e., the current assets less the current liabilities, can be replaced by new definition that encompasses all the processes surrounding trade creditors, inventory and the sundry debtors. Management of trade creditors can also be termed as expenditure management. So, expenditure management cycle includes formulating a purchasing strategy; preparation of procurement budget; selecting the supplier; receiving the materials; managing the discrepant materials; processing the invoice; and the payment to creditors.

Management of inventory is another component of working capital management. Management of inventory can also be termed as supply chain management. Supply chain management cycle includes formulating a supply chain strategy; deciding upon the product range; preparing the sales, production and inventory budget; raw material planning; production planning; production of goods; warehousing the products; and distribution of product.

Management of sundry debtors can also be termed as revenue management. Revenue management cycle includes formulating customer strategy; sales management; management of risks in realising the sales proceeds; contract with the buyers; processing sales order from the buyers; billing the customers; and collection of cash from sundry debtors. Management of the three core areas stated above is total approach to working capital management and covers the activities of a company relating to the supplier, the product and the buyer.

Challenges in Managing Working Capital

Managing a company’s finances and working capital is no easy task, particularly when it is experiencing rapid growth. Managers and financial officers have to find an appropriate level of working capital while maintaining an acceptable inventory management regime and gearing level. The management of creditors then becomes the focus of our attention. It has become clear that the more talented a company is at managing creditors, the less strain is placed on the finance manager to maintain an adequate level of working capital.

Working capital management is no more a balance sheet term or an activity pertaining to the area of accounts or treasury departments of a company. It is as much an operational issue as a financial one. Working capital management encompasses all the processes that surround the management of trade creditors, inventory and sundry debtors rather than being the traditional accounting concept of current assets less current liabilities.

The modern concept of working capital management is of cross-functional nature. The management requires addressing the root cause issue that are controllable within the company. Enhancement in the performance in those areas generates extra cash by unlocking the internal cash and reduces the dependence of the company on external debt to meet the working capital gap.

Effective Management of Working Capital

A real time example of effective working capital management is that of an American unit of worldwide food and facilities Management Company. The company was suffering the problem of declined cash flows because of inefficient working capital management. As an initiative to improve the working capital management, the company reduced the time in delivering the invoice to customers. This was done by automation and centralisation of billing and payment process. This reduced the delivery time by half and also contributed to shorten the payment cycle.

The next issue faced by the company was communication. While the treasury assumed that it was the manager’s responsibility for collecting receivables, the managers thought that it was the function of treasury. The company broke this communication gap and encouraged adequate communication between the different departments contributing to the recovery of debt. It introduced the training on ‘receivables and collection techniques’ in an ongoing basis to the people involved in collecting the receivables. The company then created a centralised credit and collection team in order to facilitate the grant and collection of credits. Ultimately, these measures enabled the company to decrease the number of day’s of sales outstanding to a significant level.

Conclusion

Efficient working capital management leads to increased shareholders value because it enables the company to generate more profit with less amount of capital involved. Total working capital management approach demands a change in organisational attitude and culture, which is not an easy task for the management. Improving cash flow from the internal resources is a never-ending task. The management should always endeavor to identify the ways to improve the working capital management.