A Brief Overview of Working Capital Management
Dr Ozgur Duymaz- 01 December 2020, Tuesday
Working capital management focuses on ensuring that a company has enough money to pay for its expenditures when due. To achieve this, each component of working capital must be examined. While a company's short-term investments such as cash, securities, treasury bills, stocks and trade receivables constitute its current assets, all debts that must be paid within 1 year comprise its short-term liabilities. As is known, net working capital is calculated with the formula of current assets minus short term liabilities. Holding inventories and receivables at least twice the value of the remaining amount after deducting cash and equivalents from short-term liabilities can be considered as the point where conservative working capital management begins. For example, in a company, if the sum of cash and cash equivalents is 10 units of currency and its short-term liabilities are 40 units of currency, its net short-term liability is calculated as 30 units of money. On the other hand, if it has at least 60 units of stock and short-term receivables in total, it can be said that the company manages its working capital with a conservative approach.
Short-term liabilities: 40 units of currency
Cash and cash equivalents: 10 units of currency (-)
Net short-term liabilities: 30 units of currency
Multiplier: 2.00
Inventory + short-term receivables: 60 units of currency
In this calculation, the transition from conservative working capital to aggressive working capital management is mentioned when the amount of inventory and short-term receivables falls below two times the net short-term debt.
In the conservative working capital management approach, the risk of insolvency against debts will be minimized. On the other hand, the company exercising this approach is giving up the potentially higher returns that could be obtained from the use of additional working capital by investing in long-term assets, but its liquidity increases due to more working capital and this will be in a safer position for a possible bankruptcy.
Companies that prefer aggressive working capital management can invest in long-term assets with higher potential returns, but accept a higher proportion of short-term cash flow risk in return.
The aggressive working capital management may appear as a necessity rather than a choice, in cases where the average collection period of receivables and the holding period of inventory increase while profit margin decreases. In such cases, in order to avoid bankruptcy, policies should be developed to accelerate the collection by taking into account its cost, inventory levels should be reduced to the lowest possible level by modeling the raw material order times correctly without causing loss of sales, and the debts should be delayed as much as possible by considering late payment cost. On the other hand, postponing trade payables should not cause serious financial damage to our reliable suppliers.
As the quality and collection ability of receivables increases and the holding period of inventories decreases, the tendency towards the aggressive working capital approach will increase. As the period of cash generation from the product decreases, the desire of the company to use its cash reserves in new investments will also increase.
It is very important for companies to make frequent cash forecast in order to plan their liquidity position. These estimates can even be prepared on a weekly or daily basis. The company needs to know in advance what its short-term cash needs will be so that it can be sure it has sufficient cash when it is needed. To be certain of having the needed cash, a company usually arranges a line of credit with a commercial bank that can be drawn upon for short-term needs. In order to accelerate the collection activities, early payment discounts, factoring, and crediting of the customer by the bank might be used as various financial instruments. If the company anticipates a cash surplus, it should be prepared to invest excess cash.