The goal of working capital management is to ensure that a company has adequate liquid funds necessary for day-to-day operating expenses, while at the same time making sure that the company’s assets are invested in the most productive way.
Drags on liquidity are when there are lags in the receipts of payments. This includes uncollected receivables, obsolete inventory, and tight credit. Pulls on liquidity are when disbursements are paid too quickly. This includes making early payments, reduced credit limits, and low liquidity positions. A primary source of liquidity includes ready cash balances, short-term funds, and cash flows management. A secondary source of liquidity includes negotiating debt contracts, liquidating assets, and filing for bankruptcy protection and reorganizations.
Operating and Cash Conversion Cycle
The streamline way of measuring cash and working capital efficiency is through the operating and cash cycles. The operating cycle is a measure of the time needed to convert raw materials into cash from a sale. Cash conversion cycle (CCC) is the operating cycle minus the days of deferral payments in accounts payable. Ultimately, it is the length of time it takes to convert resources into cash flows.
The Cash Conversion Cycle can tell three main stories being (i) the amount of time needed to sell inventory, (ii) the amount of time needed to collect receivables, and (iii) the amount of time the company can defer payments without being charged penalties.
So what should a company strive to do? They should aim to minimize their cash conversion cycle by (i) increasing their inventory turnover indicating stronger sales, (ii) increasing their receivables turnover indicating good credit and collection policies, and (iii) extending the period of credit turnover for extra liquidity (assuming there is no better opportunity cost option or penalties).
How to measure the ratios formulaically:
· CCC = Days Sales Inventory (DSI) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
· DSI = Days in a period/ Inventory Turnover
· DSO = Days in a period/ Receivables Turnover
· DPO = Days in a period/ Payable Turnover
· Inventory Turnover = Cost of Sales/Average Inventory
· Receivables Turnover = Revenue/ Average Receivables
· Payables Turnover = Purchases/Average Accounts Payable
Making sense of it through algebra:
· To have a low CCC we would want a small DSI and DSO with a maximization of DPO
· To have a low DSI we would want a larger Inventory Turnover, for a larger denominator, for a smaller DSI
· To have a low DSO we would want a larger Receivables Turnover, for a larger denominator, for a smaller DSO
· To have a high maximized DPO we would want a smaller Payables Turnover, for a smaller denominator, for a maximized DPO
Managing Cash Positions and Short Term Funds
Managing cash positions includes forecasting short-term cash flows through (i) minimum cash balances, (ii) identification through data gathering, variance reviews, and final reports; and (iii) using cash forecasting systems.
Managing short term funds can either be done passively or actively. A passive strategy is characterized by one or two decision rules for daily investments, whereas an active strategy involves constant monitoring. A passive strategy is less aggressive than active ones, places top priority on safety and liquidity, and does not necessarily offer poor returns if companies have reliable cash forecasts. When companies manage short term funds, they should integrate investment policies for guidelines. They should not be lengthy and should be understood by their (i) Purpose, (ii) Authorities, (iii) Limitations/Restrictions, and (iv) Quality.
Managing Accounts Receivables and Customer’s Receipts
The goal of managing a good accounts receivable system includes efficient processing and maintaining accurate/up-to date records that are available after payments have been received. It is also ensuring accounts receivable records are current with no unauthorized entries. It entails coordination with credit managers, coordination with treasury functions, and preparing performance measurement reports. Ways to measure performance is using an accounts receivables aging schedule, which is a breakdown of the account into categories of days outstanding.
Managing Customers’ Receipts can be complicated. However, technological advances have made processes more efficient. Checks are directed to a bank lockbox, while electronic payments are transmitted via electronic funds transfer (EFT) through either an Automatic Clearing House (ACH) or Giro systems network. Payments that clear electronically are done at point of sale (POS) systems, which captures transaction data at the physical location the sale is made. A direct debit program is an arrangement whereby the customer authorized a debit to a demand (checking) account. If payments cannot be converted electronically, a lockbox system is coordinated with the banking institution, in which customer payments are mailed to a PO Box and the banking institution deposits these payments several times a day.
Managing Inventory and Short Term Financing
Primary goal for an inventory system is to maintain the optimal level of inventory so that production and sales management can make and sell the company’s products without holding excess inventory. Overinvestment in inventory can result in liquidity squeezes. Underinvestment can create problems from losing customers. Inventory costs includes procurement, carrying (holding), stock out (opportunity costs), and (iv) Policy (general operating expenses).
Main types of bank short-term borrowing include uncommitted, committed, and revolving lines of credit. Uncommitted lines are the weakest form of bank borrowing, where committed lines are referred to as regular lines of credit. They are stronger than uncommitted because of the bank’s formal commitment. Revolving credit agreements (revolvers) are the strongest form of short-term borrowing facilities, have formal legal agreements, and are in effect for multiple years. Major objectives of short-term borrowing strategies should include ensuring sufficient capacity to handle peak cash needs, maintaining sufficient sources of credit, and ensuring that rates obtained are cost-effective than other opportunity costs. Asset-based loans are secured loans through assets. Security can come in using an asset that drives a company’s cash flow as collateral.
Managing Accounts Payable
Accounts Payable are amounts due to suppliers of goods and services that have not been paid, arising from “trade credit”, which is a spontaneous form of credit in which a purchaser of the goods or service is effectively financing its purchase by delaying the date on which the payment is made. Stretching payables, aka pushing payables beyond the due date, is sometimes done by companies, which takes advantage of vendor’s grace periods.
Factors that a company should consider as guidelines for managing their accounts payables includes (i) number and size of vendors, (ii) trade credit and cost of borrowing alternative costs, and (iii) control of disbursement float (amount of time between check issuance and clearing). Proper account payable management also takes into account trade discounts, an implicate discount rate.
Calculating Trade Discount - Rule of Thumb is to take the discount rate when it is greater than a short term investment rate (the opportunity cost):
· Step 1: 1 + Discount/(1-Discount)
· Step 2: Step 1 ^(365/Number of days beyond discount period)
· Step 3: Step 2 – 1.
· Do Note: Number of days beyond discount period = day paid – discount term. For example, if you get a trade credit that says 1%/10 net 30 and customer pays in the 21st day then you have 11 (21-10) days beyond the discount period.