The optimal cash operating cycle is achieved when debtor days and inventory days are shortened by introducing effective business strategies to align receivables and creditors in such a way that cash remains in hand to invest for new ventures.
So, the release of the working capital is about the effective usage of the cash in the business operations. Different options can be opted to manage and release the working capital that includes but is not limited to the following.
- Dynamic discounting measures are offered to the customers for early payments. Businesses that want to timely collect their dues offer cash discounts; this helps in the timely collection of the receivables.
- Effective supply chain management can be helpful in freeing up working capital. For instance, enhanced efficiency of the production functions can result in a lower number of inventory days and a lower cost of capital.
- Bargaining for the extended credit period with the suppliers can be an excellent move; it should free up the working capital. However, price factors need to be considered as well.
- Receivables can be used as collateral to fulfil the cash needs of a business. However, the cost of financing is associated with the approach. So, it’s not an organic way to achieve effective working capital management.
Working Capital Requirement
Detailed analysis of the business operations helps to determine the amount of finance needed
to meet the cost of production, inventory management, allowing credit period, and managing overall business aspect.
In simple words, the working capital is used to measure the gap between accounts payables for suppliers and accounts receivables from customers while considering days of inventory. Further, benchmarking for the working capital varies from business to business. For instance, the service sector is not expected to require intensive investment for working capital. On the other hand, manufacturing businesses are expected to have higher working capital requirements because of the complex business production.
Another perspective of analysis is that manufacturing companies have a higher potential to free up the working capital and enhance business profitability. That’s due to the fact that the service industry already has lower working capital. So, there is a lower potential to get the competitive advantage by freeing up the working capital.
How to calculate Working Capital Requirement
The formula used for the calculation of Working Capital requirement is:
Working Capital requirement= Inventory + Accounts Receivable – Accounts Payables
Working capital is used by any business to continue its daily trading operations. Its value can be easily calculated by subtracting current liabilities from current assets.
A company’s short-term financial health and operational efficiency can be measured by looking at its working capital structure. Further, businesses calculate their working capital ratios to ascertain the amount of current assets to meet the financial obligations in the short run. i.e., liquidity of a business is measured that either an entity is in a position to meet its current obligations.
Further, the business cannot run its business activities without working capital. That’s why it is necessary for any business to have strong working capital, as it assists in financing the day-to-day operational expenses. Even, during times of financial instability, a company needs to maintain its working capital requirement because it’s an important area of a business, and negligence will ultimately affect the business’s operational profitability.
How to Reduce the Working Capital Requirements for a Business?
We understand that efficient working capital leads to higher profitability and adequate business liquidity. A shorter working capital cycle enables a company to free up its cash that is stuck in the operations. On the other hand, a longer working capital cycle implies that the capital of a business is invested in operational activities rather than investing activities that could have generated an additional return.
So, businesses prefer shorter working capital to enhance their operational efficiency and liquidity position. A better way to understand the exact length of a working capital cycle is to measure the performance of a business against the peers or industry average.
To enhance the working capital efficiency, most of the entities have an aim to reduce their working capital cycle. It can be achieved by establishing a system that results in reducing inventory cycles, faster collection of debtors, and settlement of extended payment terms with suppliers. Let’s discuss these measures in detail.
1) Speedy collection of debtors
Early payments discounts play a significant role in improving the cash flows in the form of the speedy collection of debtors. Recoveries from debtors can also be made faster by updating credit terms with customers. If customers are allowed a shorter credit period, it will bring more cash into the company in lessor time. In this way, the company can utilize this cash for investment purposes. Otherwise, this cash will be just stuck in working capital, and the company won’t be able to use it in a better way.
2) Improve inventory turnover
Just in time inventory management system is a good way to minimize extra inventory pile-up in the warehouse. However, a company needs to maintain such levels of inventory that enable it to meet its current demand. Another way to minimize inventory turnover is to brainstorm policies to increase sales, which will ultimately decrease the excess inventory and reduce the time needed to convert inventory into sales.
The companies implementing the JIT system of inventory management establish a production facility near the supplier’s warehouse. It enables them to maintain the continuity of the operations.
3) Settlement of extended payment terms with suppliers
A business can settle extended credit terms with its suppliers unless it offers early payments discounts that reduce a company’s cost. Better negotiations with suppliers enable a business entity to use its cash for investment purposes instead of making earlier payments to its creditors. However, cost-related factors need to be considered for the same.
How to enhance Working Capital Usage to Increase the Profitability of a Business.
The cash collected from accounts receivables can be used to pay the creditors of a business. This strategy will help a business to meet its obligation from its own cash rather than raising short-term loans from banks or financial institutions. It will lead to reducing the interest expense that is payable if a company takes a loan. So, the cash generated from working capital reduces the interest expense of a business. It will decrease the figures of interest expense in the income statements, and the company’s net profit will improve. Hence, the profitability of a business is improved by appropriate working capital policies.
When the company is efficient in maintaining appropriate levels of inventory according to the demand in the market and the time taken to sell inventory is minimized, it reduces the inventory obsolescence cost for a company. That’s how improved inventory management strategies can reduce the risk of inventory obsolescence. In this way, working capital management policies are helpful for a business to grow and use its current assets more efficiently.
The business needs to finance its operations with debt or equity. Whether financing is via debt or equity, there is an associated cost. So, the business needs to control the use of working capital to increase its profits.
Releasing working capital or freeing up the capital can be achieved by appropriate management of the business operations in terms of inventory, receivables, and payables. To speed up the working capital cycle and control related costs, the business needs to make active efforts and ensure production process, inventory management, and collections functions do not contain frictions.
Frequently asked questions
How can we link working capital management with the Just in Time inventory management system?
Just in time system of inventory management does not require storage of inventory. It believes in the arrival and usage of the inventory. So, implementation of the techniques to control working capital leads to lower inventory holding costs and an increase in the business profitability.
How can businesses avoid cash flow problems?
The business’s cash flow problems can be avoided by adequate planning, forecasting, measuring, and monitoring the cash position. Further, if there is a maturity gap, financing can be planned on a timely basis. This helps to enhance the overall financing of the business.
Enlist a few of the effective techniques to manage the working capital.
Following are some of the techniques effective in managing working capital.
- Control inventory turnover days.
- Enhance the efficiency of the collection department.
- Bargain with the suppliers to get an extension in the credit period.
- Redesign production processes to smooth the flow.