EFFECTIVE WORKING CAPITAL (LIQUIDITY)

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EFFECTIVE WORKING CAPITAL(LIQUIDITY)

• By Jessica, Jack and
• Tawney ?

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What is effective working capital?

• Working capital refers to the money available to
  a business for day-to-day operations.
• WC Current assets Current liabilities
• Effective working capital is linked to the term
  liquidity. Liquidity is the ability of the
  business to pay its short-term debts.

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1. THE WORKING CAPITAL RATIO

• This formula is used as a means of calculating
  the current working capital
• ratio in any situation, it is called Current
  Ratio. Liquidity is measured by the \
• Current Ratio.
• The formula for this measurement is given as
• Current ratio total current assets/current
  liabilities (times)
• Calculating the current ratio is not difficult  
• For example
• Total current assets 40 000/ Total current
  liabilities 20 000  
• 
  2.0 times     
• (Written as a ratio 21)
• This ratio does not measure the business ability
  to pay their debts as they fall due.

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2. CONTROL OF CURRENT ASSETS

• Current assets are inclusive of cash, short-term
• deposits, customers accounts, stock (including
• work in progress, raw materials and finished
• goods), that will be converted into cash during
• the normal course of business, within a year.
• (extracted from Business Studies HSC 2nd edition
  Getting Better Results,
• Don Sykes and Kim Crawford )

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Cash

• Controlled by cash budgets (a planning and
  controlling tool)
• Cash budget sets out anticipated sources and uses
  of cash on a monthly basis.
• Enables managers to time the payment of
  significant ongoing expenses to ensure they are
  paid when their cash surpluses
• Cash outflows are easier to predict than
• cash inflows.

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Receivables

• These are customer debts.
• When a business supplies a customer with a
• product on credit, there is generally a time
  limit of
• 7-30 days for the payment to be made. As people
  are
• generally reluctant to pay bills on time, there
  are a
• number of management strategies that can be used
  to
• monitor customer repayments. These strategies
  ensure
• that all customer debt is payed on time.
• These include

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- Credit policy

• A credit policy is a set of guidelines to staff
  on
• how to monitor and collect customer debts.
• most cost-effective way of managing customer
  debts.
• A credit limit is set. Credit limits are the
  maximum value of credit the business is prepared
  to give to its customers.
• Accompanying credit limits is the credit period
  which refers to how long the customer has to pay
  the business back.
• Collection policy is implemented in case of
  customer reluctance to pay debts on time. It
  advises staff what to do if customers fail to pay
  on time.
• Customers who are notably overdue may need the
  threat of debt collectors.

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- Factoring

• Used due to cash flow problems.
• Cash flow problems come about when a large
  proportion of the working capital is locked up in
  customer debts.
• Factoring is the sale of customer debts
  (invoices) to a financier or financial
  institution.
• Factoring is an expensive option which increases
  costs and lowers profitability.
• An effective credit policy is a more efficient
  option. In some situations factoring is the
  better option, particularly during rapid growth.

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- Invoice discounting

• Means that the total payment by the customer is
  reduced
• by say 3 If the bill is paid in, for example, 7
  days instead
• of 30.
• This approach sources danger as costs are
  increased by x.
• This reduces the business competitive
  position.
• It should only be used when the business is
  growing rapidly.
• It is an important cash flow strategy to improve
  cash inflow
• when a business is experiencing a period
  of cash deficit.
• usually a lower cost strategy than using an
  overdraft to cover cash deficits.

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Inventory Control

• Refers to stored resources such as raw materials
• Is often one of the largest assets for many
  businesses.
• Businesses need inventory in order to respond
  quickly to customer orders.
• If there is no efficient inventory in a business,
  customers may take their orders to other
  competitors
• One of the best ways to manage inventory is
  through an
• inventory policy

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- Inventory policy

• Manages inventory
• It sets out such things as where the inventory is
• Stored what items are stored and how many of
  each.
• Policies are usually computerised, which makes
  new
• orders easy to check against inventories in
  stock.
• A good policy will comment on the condition or
  quality of the
• items in inventory.

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- Just-in-time (JIT)

• Each inventory system is supplied just-in-time to
  be used.
• The advantage of this system is that there is no
  storage costs and no obsolete or damaged stock
• Coca-Cola used this
• system at their
• Northmead factory.

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3. CONTROL OF CURRENT LIABILITIES

• Current liabilities Bills that have to be paid
  in
• the short term
• Most current liabilities are debts owed to the
  businesss
• suppliers and these will need to be paid as they
  fall due.
• It is important that the business keeps on top of
  short-term
• debts as they can subsequently build up and put
  the
• business under financial stress, perhaps
  consequently
• ending in business failure.
• The control of current liabilities is also linked
  with
• ethical consideration..
• how can the business expect debts to be paid on
  time, if in turn, fails
• to pay on time?

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Control of loans

• A loan is a cost which is often used as a
  substitute for
• Controlling receivables.
• Overdrafts are used by managers to pay wages that
  should be paid with overdue customer debts.
• Interest is charged on loans therefore, adds to
  expenses and reduces profitability
• Loans should be controlled through capital
  budgeting
• Capital budgeting concerned with the finance
  needed for
• particular projects.

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Control of overdrafts

• Normal operations of a business usually results
  in surpluses and deficits of cash
• Overdrafts are convenient for dealing with cash
  deficits
• Budgeting cash is a sufficient method of
  controlling overdrafts
• Cash budgets should be compiled from the cash
  flow statement
• Overdrafts should NOT be used to cover problems
  such as failure to control customer debts

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4. STRATEGIES FOR MANAGING WORKING CAPITAL
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Leasing

• A popular way of financing assets
• Payments for the asset can be matched to the
  earnings of the asset (advantage)
• Allows the business to control and use an asset
  owned by someone else in return for regular
  payments
• Almost any asset can be leased
• No upfront fees are paid therefore working
  capital is looked after

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Factoring

• Refers to the sales of customer debts to a
  financier
• Is not good for managing working capital due to
  costs factoring adds to he business
• Can be an important strategy in circumstances,
  e.g. rapidly growing business, due to the great
  deal of pressure to pay suppliers and factoring
  provides quick cash

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Sale and lease-back

• Became popular in the 1990s
• It was common for large businesses to sell the
  land and buildings they used for their operations
  to a financier
• They agreed to lease the property back for a
  certain number of years in return for regular
  payments
• This strategy improves or increases working
  capital, rather than conserving it. Money
  received can be used for additional projects
  within the expertise of the business