Control of Working Capital

 

Control of Working Capital

-Working capital management is concerned with monitoring the cash flow of a business to ensure that it has access to cash to finance normal operations.

-It involves monitoring creditors, stocks and debtors.

 

1. Creditors

-Although some credit is both necessary and desirable for any business, it is important to monitor the level of indebtedness by the firm to outsiders. A high creditor figure will lead to problems in payment. One way to check the position is by calculating the length of time taken by the firm to pay its creditors.

 

AV payment period        =            AV trade creditors            x    365

                                             Purchase of stock on credit

 

 

-A firm should extend its credit means if it has access to means of payment for long periods.

-Another technique for monitoring the creditor figure is to rank creditors in terms of length of credit – those owed money for longest periods can be identified to ensure that they are dealt with as soon as possible.

 

2. Stock

-It is necessary to maintain sufficient stock levels to continue production and satisfy demand. Capital should not be tied up in stock.

-Ratios can be employed to evaluate stock levels e.g.

 

Stock turnover       =       Cost of goods sold in a year

                                                Average cost

 

-It tells us how many times the average stock level is sold during a 12month cycle. A rise in turnover ratio suggests an increase in efficiency or rise in level of activity.

 

3. Debtors

-In most businesses credit sales are unavoidable. It is necessary to offer credit facilities, especially if competitors offer goods on credit.

-Generous credit terms are likely to increase the volume of trade but they also increase the expense of the seller, therefore it is necessary to strike a balance between good terms and a strict collection policy to minimize cash outlay.

 

Costs associated with credit

1. Lost interest –opportunity cost involved in an interest-free loan

2. Loss of purchasing power as prices rise

3. Cost of assessing customer credit worthiness

4. Administrative costs

5. Bad debt

6. Discounts for prompt payment

 

Costs of denying credit

1. Loss of customer goodwill

2. Loss of sales

3. Inconvenience of cost of collecting cash

 

-The debtor position can be monitored by a ratio

 

Debtor collection time (debtor days)    =      Average debtors             x   365

                                                                                          Total credit sales

 

 

-A lengthening of a debtor payment time over a period of time means a growing delay in the receipt of cash.

-Another technique of monitoring debtors is to rank them in terms of age of debt. The aim is to identify longstanding debts to recover the money.

-The control of debtors will involve the encouragement of prompt payment and the minimizing of bad debt.

 

4. Cash

-A period of cash outflow will deplete the cash reserves and vice-versa. By monitoring the cash position it is possible to make better use of resources available so that there will not be cash shortage or even excess cash.

-A shortage of cash can be tackled by:

a) A reduction in debtors

b) A reduction in stock

c) An increase in creditors

 

-A surplus of cash is an opportunity cost especially if the cash is held in a zero or low interest account. Any surplus should be:

a) Used to make early payments to creditors in order to claim discount

b) Deposited in interest bearing accounts

c) Used to buy marketable securities e.g. shares

d) Lent profitably to others

e) Used to make forward purchases of raw materials in situations of expected price rises