This research is on the Management of Working Capital and covers such areas as cash management, accounts receivable, inventory and other areas of the topic
There is no universal definition of working capital that is accepted by everyone. Some have made it quite simple stating it was the difference between current assets and current liabilities. Others consider it as being equal to the total of current assets. The prime object of any business is to make a profit. Whether or not this is accomplished depends to a great extent on the manner of its administration of working capital. However there are special problems in connection with these funds which require special operating and financial skills of a very high order. Especially is this true as the complexity of the business increases.
The first area to be considered is that of cash management. In many respects this is the most important item in the business operation, as it is both a means and an end of any particular enterprise. Return of the investment normally takes place through the payment of cash, and in the event of liquidation, cash becomes the final medium that is used in paying off the claims. It is important in day to day operation because it is the form of liquid capital that can be assigned to new uses. The decision to expand the business may depend upon the availability of cash. It also affects the ability to borrow. Cash is particularly important during the early phases of any new business.
There is no easy formula for the amount of cash a company should retain. There are many factors including the manufacturing cycle, the sales and collection cycles and maturing of debt. Expansion is frequently a factor. The general economic outlook and the financial and banking situation are important. Then there is the matter of prices and their direction. In recent years this has been dramatically up due to the continued inflationary spiral. The current asset, cash, has no problem of valuation though and thus is carried on the company books at its face value (Husband & Docerey 1972, pp. 390-395).
Since cash happens to be the most liquid of all assets, the reasons for holding on to it are for future conversion to another asset, for the later purchase of some service, or for repayment of debt. The daily requirements of business require some. A minimum must be kept in bank accounts to prevent the chance of overdraft, and the cashier needs change for her register. One of the major problems here is self evident. Cash disbursements do not always coincide with intake. Thus some must be kept in the bank account to be ready when needed. Thus the basic use of cash is to meet company disbursement requirements and is kept for such transactions. Bank creditors expect a firm to carry reasonable amounts of cash because these are normally deposited in the banks and are there for bank usages while in such accounts. Thus it is common practice to carry more cash than is actually required. The banks have often encouraged this by offering more service to those depositors who carry larger amounts of cash in their accounts.
In determining the minimum amount of cash, consideration has to be given to what is required to run the business. Some firms obviously require more cash than others. However, what is actually retained is often strongly influenced by outsiders and their requirements or desires, such as those of the bank, rather than internal financial management. From the point of view of the latter, it would be best to take all excess cash and invest it in income-producing investments of some type.
It is also good management and a prudential principle to establish a maximum cash level as well as a minimum. Theoretically the two should be equal, but it doesn’t turn out that way in practice. The cost of investing very small amounts or for very short periods of time is not worth it and thus the maximum amount allowable is somewhat above the minimum.
The major disadvantage of carrying excess cash is cost, that is, an opportunity cost. Cash lying in a checking account or in a vault or safe obviously is producing nothing. If it were invested even in low-term interest or short-term government securities some return would come in. This would improve the firm’s profitability. It means also that there are more commitments to creditors than should be the case. If an excess of cash is permanently the case, the firm obviously should find some longer run investment, or repay it to creditors.
In order to improve cash position, leaks should be stopped. One of these is theft by employees or others with access to it. Normally though cash has the most stringent security measures attached to it to prevent this. Some firms seek to speed up collections of accounts receivable, Care has to be taken not to damage goodwill among clientele by excessively harsh methods. That would do more harm than good. However, a larger firm could substantially increase its average cash balance by getting the money in on an average of even a couple of days sooner.
On the opposite side, disbursements can be delayed. This of course can damage credit rating if done beyond the expected time. Cash discounts can be lost. In general this is not too good a method if done beyond the due date of the accounts. Other solutions if more cash is needed is long term creditor capital, sale of stocks or other assets which are redundant.
Float can be reduced. This is the amount of useless cash caused by the time lag between the writing of a check and the point of time it is credited to the checking account or company books. This is being remedied more and more through EDP. Banks are now working on automatic transfer of funds procedures so as time goes on this will become less and less of a problem (Donaldson & Pfahl, 1969, pp. 511-518).
Securities investment or bonds have already been suggested. This is in the area of short term investment. The object of course is to put this cash lying around for short periods to work and produce income. Care of course must be exercised here. The fluctuation in the market, especially if it was a bear market, might more than offset any contemplated gain and the firm Would be worse off than before. Because of this, the portfolio is more limited than that kept for other, more long range purposes. The most common are government issues or securities of government agencies. It is wise. to find maturity dates that will coincide with the need of cash for business purposes. A three month period is t@e minimum considered by most financial managers. The first consideration is safety. This is covered by the investment in government securities, as nothing is safer than the federal government. However, at times this cannot be said of more localized government entities. At the time of this writing, New York City municipal bonds would not be a very good risk as an investment of company funds. A second requirement is liquidity. As indicated above, only those investments should be selected which mature at the time the funds are needed. Other investments are certificates of deposits and savings accounts (Donaldson & Pfahl, 1969, pp. 518-519).
Another area of importance is accounts receivable. From a cursory examination it would appear that these were potential capital rather than actual capital. When the money comes in the business gains the cash from them. There is always the matter of slow accounts and bad ones, some of this money will be realized with difficulty or not at all. Through experience though any given company will have a pretty good idea of what these figures are in connection with their business. These accounts however lack availability before they come in unless they were used as security for short @term loans. The amount that any company can invest in receivables is a function of the volume of credit sales, the credit terms which the company extends, and the collection policy. In most industries credit terms are set by trade practices. These will change- with economic and social conditions.
The extent of money tied up in accounts receivable has shown a steady growth. In 1948, including receivables from the U.S. government, was 31.2 percent of total current assets of all U.S. corporations, excluding banks and insurance companies. By 1955 it had risen to 38 percent and 1960 45.1 percent. The 1969 figure was 48.2 percent. Thus credit has been heavily extended. In, 1955 commercial receivables approximated $76 billion compared with a total inventory investment of $39.8 billion. Such a state of affairs has appeared but rarely in the past, and then it was only during war or semiwar conditions. It may represent a relatively permanent readjustment of the relationships between receivables and inventory. In 1969 the figures were $264.2 billion and inventories $183.4 billion (Husband & Docerey, 1972, pp. 399-400).
From the standpoint of dollar value, inventories constitute the principal item of working capital of the majority of the trading and industrial concerns. Composite data for U. S. corporations show that inventories constituted between 24 percent and 27.5 percent of the total assets between 1947 and 1950. The pattern was essentially the same during the next couple of decades. In recent years inventories represented from 42@o to 48 percent of working capital (Husband & Docerey, 1972, p. 401).
Management of inventory is set up to regulate the size of the investment of goods kept on hand, the type of goods carried in stock, and turnover rates. Adequate stocks must be available for production requirements. Sales must be maintained so there must be enough to meet the needs of clientele when they want them or they will go elsewhere. Sometimes in major industries when delivery schedules can be calculated to the hour, companies have been known to carry as little as a 24 hour supply of raw materials for their needs during the summer when the weather is good. This is obviously cutting it pretty close and firms have gotten into trouble doing this when they did not foresee emergencies on the horizon. A tight schedule requires close coordination between purchasing, traffic and production departments. A smooth economy on the outside is also a factor which aids in this. It is obvious that energy shortages, massive labor disputes, double-digit inflation can all have a deleterious effect on such close-knit operations. However , to the extent that this can be made to work, it means that much less money tied up in idleness and producing no income for the firm. Computerized operations have helped out tremendously in the task of cutting down points of delay and wasteful practices. It recognizes instantly the effects of purchases, sales, shipments and other factors, and compares the data with stocks on hand with order points on a continuous basis.
Thus pertinent matters that affect the financial well-being of the enterprise arise from such things as seasonal variations in the product line, the amount of time required for smooth flow of the operations. A firm with a reasonably stable volume of business throughout the year will obviously have a more simple inventory problem than one with wide seasonal fluctuations. The latter-type firm will have an inventory that constantly varies to finance and will probably have to carry out more financial transactions. Firms with rapid turnover or short processing cycle will need to tie up less capital in inventories than will firms have low turnover and longer processing cycles.
Unwise stocking of raw materials can play havoc with a business. Insufficient inventory will disrupt flow of goods through the plant. Sudden changes in price of inventories can affect the competitive –.position. Because of this variable characteristic of inventories, they can be a vital weakness in large companies which on the surface appear to be successful institutions.
The inventory valuation methods most commonly used are specific cost, first-in first-out (fifo), average cost, last-in first-out (lifo) and cost or market, whichever is lower. The first four of these are variations of actual cost. Specific costs can be used where items can be identified and the cost of each is known, such as pieces of jewelry, art works and other such items. Fifo uses the most recent price paid as a basis of valuation of closing inventory. This results in inflated inventory value in periods of rising prices and understated values in periods of declining prices. Today obviously the latter is rare indeed. By pricing inventory at the cost of the most recent acquisitions, it puts the oldest cost into the cost of goods sold during the period and has a tendency to inflate earnings during times of rising prices. The average cost method is a simple, weighted, or moving average and attempts to price inventory at the average of prices paid over a given period of time. Lifo is the reverse of fifo and results in matching current costs against current revenues, so that earnings are less inflated by rising costs. As a rule, the valuation basis of the inventory does not change despite price fluctuations unless prices fall below the levels at which the basic inventory items are carried. This situation would be rare today.
In all of this conservative accounting anticipates no profit and provides for all possible losses. That is the theory anyhow. Inventory valuation reserves are used to anticipate future declines as a result of style, or technological change, or other events which could reduce inventory valuations. It is a balance sheet evaluation and provides protection against overstatement of the working capital position.
The major objective in selecting a method for inventory pricing is to choose one that most clearly reflects periodic income. Considerations involved,include the physical nature of the inventory, the frequency and size of price fluctuations, the rate of turnover, and the average size. It would seem that where sales prices are promptly influenced by changes in reproduction costs, lifo would be appropriate. Where no such cost relationship exists, fifo or some average-cost method would be more appropriate. In some cases on method of valuation is applied to one portion of the inventory and another to different portions (Husband & Docerey, 1972, pp. 401-403).
Thus it can be seen by all of this that this area of working capital is most important to the financial position of a company. Thus all businesses need to look close to home to find places where cash reserves can be freed for profitable use. If done properly it will not only help keep clerical costs in line but gather in additional cash which can be applied to business growth. It represents a real opportunity. Certain corporations have found this to be true. A major oil company was able to reduce the cash in its gathering and disbursing system by 75@o providing over $25 million for marketing and refining expense. A large railroad which showed a cash balance of only $9 million has through better gathering and disbursing systems gotten $17 million to finance a major equipment acquisition program. A leading insurance company with a cash balance of $8 discovered $18 million more and put it to work, and so it goes.
Accounting statements usually understate the size of each balance. Storekeeping practices of the accounting function usually are a hindrance to imaginative cash management. One of the causes is decentralized responsibility for processing cash receipts, disbursements and maintaining relationships with
Other problems which have a bad effect here are the absence of reasonably accurate daily cash forecasting system. Banks are used in cities which are not part of the Federal Reserve system and as such are lacking in important banking facilities. There is lack of information on float in major disbursement accounts, and cash in transit in parts of the cash gathering system. There is no record of individual accounts showing purpose, activities, tangible and intangible services. and average bank ledger balance. There is no current analysis of the cost to the company and profitability to the bank of each major banking relationship. There is limited use of other administrative services provided by banks such as draft payment plans, lockboxes, deposit transfer checks, zero balance accounts and other automatic procedures, more and more of which are becoming available through EDP sophistication. Balances are maintained in a large number of banks and accounts for disbursing purposes. These represent areas of potential improvement of cash position.
A representative mean of the Fortune 500 firms of even one day’s reduction of cash-in-hand would be well over $100, 000 in recurring annual savings. For a smaller concern, the figure obviously would not be as large but nevertheless no less significant to them. Companies can estimate on a rough basis the value of reducing a day’s cash-in-hand by dividing the sales by 365 and multiplying the answer by 6 percent. The figure obtained by this represents not net cash freed but rather savings received annually from the cash thus freed.
Thus when opportunities are identified and savings targets are established, management should proceed to implement the changes needed to reduce costs and free corporation cash reserves for profitable use. Some of these may be independent, such as the closing of inactive or unnecessary accounts. Others are interdependent such as the modification of cash collection procedures . A company can certainly expect long range benefits from appraising its cash handling policies and capitalizing on the unreached potential. Thus as indicated already, clerical costs can be reduced in the areas of cash gathering and disbursing, but even more important, large sources of funds can be tapped for business growth (Searby, 1968, pp. 71-80).
Models provide aid in determining where such savings can be effected. By using one, it has been determined that the fluctuations of the demand curve over time will cause changes in both inventory policy and credit terms. These changes tend to smooth out the fluctuations in demand. The results indicate that both production and credit terms could change over time. An example of this is seasonal changes in demand. It should be kept in mind that this model ignores costs associated with changes in credit terms and thus results in a continual shifting of them, which surely is not practical. However, the results do indicate that credit terms should change with seasonality even when they are not continuous over time. The model indicates that inventory and e credit functions should be coordinated and integrated, which has been advocated already in this paper. Recognition of interface of credit in inventory management will certainly achieve the result of better decisionmaking (Schiff & Lieber, 1974, pp. 133-140).
In financing working capital, the important place here is when a business gets started. Initial funds will have to be available, apart from capitalization of business in terms of plant and other tangible assets, to meet the payroll, pay monthly bills, have some change in the cash register. Sources available depend on the reputation of the person going into business, and what he is worth. If he is in poor financial condition, difficulties multiply. Apart from this phase, working capital comes from the accounts receivable or it will not be in business very long. The real problem as has been observed is not the financing of working capital, but rather the putting to work of the working capital that is not being used in order to provide funds for the company to expand. That is the problem involved in this phase of the operation.
The projection of cash receipts and expenses can be done by using any convenient basis. Cash balances must be kept sufficient to purchase inventories and satisfy monthly demand. This will alleviate the need for short term loans to cover such expenses due to fluctuations in marketing of a seasonal nature. There- must be allowance for payment of dividends if they are to be made. In addition payment of indebtedness must be considered. The primary purpose of a cash reserve is to provide management with a ready supply of funds during the peak period of demand when marketing securities are at a minimum or non-existent and cash is invested in inventories or receivables. Errors at this point in forecasting and projecting sales and costs can have the greatest impact on the ability of the firm to finance these assets or to maintain liquidity in case the anticipated sales fail to materialize. In a large portion of the firms, the risks for the year aren’t constant. Thus this affords occasion to invest them in short term securities as has already been mentioned. Thus by carefully predicting sales and product demand, a wise manager can take full advantage of every opportunity to put excess cash to work for the periods available to him (Curran, 1969, pp. 170-183).
Lease arrangements are available which are alternatives to purchase of equipment, cars and other items. The factors involved are quite complex and cash management is not necessarily the determining factor, as it enters into the area of depreciation, tax advantages or disadvantages and that type of thing which will vary from company to company, All lease arrangements provide some sort of rental payments. These payments are constant. The same amount will have to be put out each month, unless some special arrangement is made. Obviously this rental will have to be sufficient to cover the costs of the lessor and permit him a profit for his trouble. Insurance costs to him may be different than those of the lessee – probably higher! There are usually restrictions on its use. There are usually recovery provisions in the event of default. If the item becomes obsolescent during the life of the lease, payments still continue. Thus it can be seen that while the lease will mean regularity of cash outflow, there are many other items to consider which will be more costly to the firm in the long run.
Perhaps the major disadvantage of the lease is lack of control over it by the lessee. He may be dispossessed at the termination of the lease and unable to replace it. Payments must be made for the length of the lease, and it cannot be disposed of to prevent outflow of cash if its value has disappeared or is marginal. In case of default, the lessor is liable not only for the missed payments but for any other losses the lessor would suffer for the remainder of the lease. The lessor is in fact a creditor of the lessee. All of this means this device should be used with utmost care (Donaldson & Pfahl, 1969, pp. 260-262).
In summary, the most important areas for consideration in the area of working capital are cash inflow and outflow, adequate inventory control measures, and prudent policy toward accounts receivable and collection matters. Sophisticated EDP equipment is coming into use which will cut down transit time which is lost and thus put considerable sums of money to work that are now idle in the mails or going through some bookkeeping system. All of these areas need careful study and consideration by management and financial control so that these funds can aid corporate profitability.