Posted: June 3rd, 2022

WHAT IS WORKING CAPITAL?

Place your order now for a similar assignment and have exceptional work written by our team of experts, At affordable rates

For This or a Similar Paper Click To Order Now

INTRODUCTION
WHAT IS WORKING CAPITAL?
In earlier units, we studied capital markets and capital budgeting. Then, the focus was on longer term investing and the financing of those investments. In this unit, we turn our attention to the money needed to run the business daily. If you can appreciate the dilemma of having to pay for the raw materials and labor that go into your product long before you actually sell it and collect the money from that sale, you will understand the role of working capital.
Working capital is simply the short-term capital needed to run the business day-to-day-that is to pay the bills, make your products, and run your business. We are generally talking about short-term assets like cash in the bank, short-term investments (also known as near-cash), inventory, and accounts receivable. When you deduct the short-term liabilities (such as accounts payable, accrued payroll, and the short-term portion of long-term debt), then you have net working capital.
THE IMPORTANCE OF NET WORKING CAPITAL
Though it may seem more tactical and therefore less glamorous than the strategic nature of long-term investments, financial managers (and managers in general) spend most of their time on the daily business operation. As someone once said, “If you don’t get the short term right, then the long term doesn’t matter.”
One way to determine the health of a company is to look at the net working capital. If it is negative, chances are that the company might not be able to cover its near-term obligations from readily available funds. From the work you did on financial ratio analysis, this would manifest in a current ratio of less than 1.0.
The company may have to raise some additional working capital to remain solvent. Yet as sound as this may seem, consider the recent trend toward zero working capital. Money that is owed you but not received or inventory that has been paid for but not sold is not really very useful, yet this is what working capital is (along with cash in the bank, which also is not really a great investment). Therefore, the more recent theory is that companies should minimize working capital, even to the point where net working capital is negative—this is a good thing to have.
HOW DO YOU GET NEGATIVE NET WORKING CAPITAL?
If you think about what net working capital is, it becomes clear how to minimize it:
Cash
You should not have any more cash or cash equivalents than you need for things like compensating balances (for example, the cash banks may require if you take a loan, avoiding service charges) and meeting immediate commitments. You can usually borrow for temporary spikes in cash demand.
Accounts Receivable
Ideally, have your customer pay in advance or at the same time as shipped. If you cannot get payment until after the sale (which is usually the case), then provide trade credit terms that provide an incentive for early payment. Example: 2/10, net 30 means the customer gets a 2% credit if paid within 10 days or else the total amount is due in 30 days. Essentially you are charging 2% interest for 20 days—pretty substantial, but not uncommon in many industries. This will get the money in sooner and therefore reduce the accounts receivable. (Of course, this is a double-edged sword in that you are giving up a lot of the invoice just to get the money in a little earlier).
Inventory
In the past several years, a concept of just-in-time (JIT) inventory management has come into being. It means, as the name implies, that you do not get the stuff until you really need it so it has minimal shelf time. A lot has to go well for this to work because there is little margin for error, but some companies are getting it down to the point where parts are shipped at the point of sale and all show up the next day for assembly. There is quite a bit going on around this in supply chain management (SCM), which is currently a major area of study in most companies to manage the supply of the product.
Accounts Payable
The longer you can avoid paying someone the better. You want this account as large as possible without damaging your standing with your vendors. On the other hand, you might say it is not how big it gets, but how long you can postpone buying materials, and that is an even better strategy. If you go back to what was said about JIT, then you are not really buying your materials and components until the last minute, so you are in effect postponing the trade debt. Therefore, you are deferring the ultimate payment without protracting the credit period and possibly straining your vendor relationships. (As for employee payroll, there usually is not much you can do here except run lean; of course, almost all companies pay employees in arrears, which is okay, and some companies intentionally drag their feet on paying expenses, which has both a positive cash impact and a questionable ethic).
By following these broad strategies, a company can reduce working capital.
SO WHAT?
Inventory represents cash you once had. Accounts receivable represents cash you would like to have. Accounts payable represents cash you would like to hang onto a little longer. When you reduce net working capital, you create a one-time windfall, which can be put to better use buying things you need or acquiring new sites or facilities. In addition, however you put that cash to work generates ongoing earnings each year. Many companies that get this right have been known to generate $100 million or more; so suddenly they have a lot of money to invest and if those investments earn the 20% or so that investors are typically looking for, there is another $20 million each year.
WHAT MAKES IT ALL WORK?
Ever since Deming and Juran (two of the original quality gurus in the 1950s and 1960s), American companies, who fell behind in quality management, have been improving in this respect. In particular, Japan adopted the concepts of total quality management (TQM) in the 1950s when Deming, an American who was unsuccessful at getting American corporations’ attention, took his disciplined approaches to Japan, known at the time for poor quality. Within a decade or two, there was suddenly a quality crisis in America; not because our quality had slipped, but because Japanese and, predictably, other foreign nations’ quality had vastly improved under the principles of TQM. TQM is beyond the scope of our course, but it suffices to say that it is about eliminating errors from your manufacturing or other business processes, finding where errors occur, determining their causes, and eliminating those causes.
If you can rely upon your processes, you can be aggressive at minimizing the waste and, with the use of predictable technology, become an efficient operation that almost always has a reduced or even negative net working capital.
OBJECTIVES
To successfully complete this learning unit, you will be expected to:
Explain the cash conversion cycle and the concept of zero working capital.
Prepare a cash budget and explain various cash management techniques.
Analyze accounts receivable management policies and inventory management policies.
Compare the various methods of short-term financing and understand marketable securities.
Research and write an essay on the importance and challenges of minimizing working capital. Your paper should be 4 pages in length and include three outside references. Your writing should be well organized and clear. Writing structure, spelling, and grammar should be correct as well.

For This or a Similar Paper Click To Order Now