What is Working Capital Management?

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Working Capital Management

It is not uncommon these days to hear businesses facing a cash crunch to run their operations. Production has been impaired due to broken supply chains – suppliers are either not shipping on time or expecting longer credit cycles. Customers, on the other hand, want longer credit cycles as they too are facing a cash crunch. As a result, businesses are hard-pressed for cash, they have to run their factories at reduced capacity due to lack of demand but yet incur those fixed costs. 

In these times, businesses with prudent working capital management policies will be able to ride the storm better. So what’s a good working capital management policy in these times? The CMA curriculum offers some good learning points for finance professionals helping their employers tide over these unprecedented times. 

We already know that working capital is the money needed to run the day to day operations and is calculated as the difference between current assets and current liabilities. A good working capital management is one which reduces the time between cash paid to suppliers and cash received on account of sales. This is also called the Cash Conversion Cycle (CCC). The shorter the time duration, the better are the chances that the business is able to finance its operations internally. On the contrary the longer the CCC, the greater is the need to finance the operations from other sources.

How does the business achieve a shorter CCC?

I. On the supply side, it would make sense for the business to extend the vendor payment as much as possible. This is measured as Accounts Payables Deferral Period(PDP) which is the time between the two journal entries

Inventory Dr. – To Accounts Payable (Narration: Inventory received from the supplier)

Accounts Payable Dr. – To Cash (Narration: Cash paid to the supplier for inventory received)

II. Secondly, in an ideal Utopian world, the business would be able to sell all its inventory as soon as it’s available to be sold. Unfortunately, we don’t live in a Utopian world and matters have been made worse by the pandemic. So realistically the business should aim to hold the inventory as little time as possible which is the time between the below two journal entries which is also called the Inventory Conversion Period(ICP)

Inventory Dr. – To Accounts Payable (Narration: Inventory received from the supplier)

Accounts Payable Dr. – To Sales (Narration: Credit Sales)

III. The salesman might get a pat on the back award on the sale generated above but remember it’s a credit sale and ultimately the customer has to pay cash in the future. This cash can then be plowed back into operations as working capital. So it’s now on the collections department which can enforce upon the customer to pay at earliest or pay before the credit period so that the cash comes in with a minimum credit period. This is the time between the below two journal entries below and this is also called the Receivables Collection Period(RCP) or Days Sales Outstanding (DSO)

Accounts Receivable Dr. – To Sales (Narration: Credit sale made to the customer)

Cash Dr. – To Account Receivables (Narration : Cash received for credit sales)

Cash Conversion Cycle = ICP + RCP – PDP.

From a working capital management perspective, the entity always aims to maximize PDP and minimize ICP and RCP. 

The pandemic has forced businesses to be frugal than ever before. While negotiating longer payable periods with suppliers and shorter receivable periods with customers, one needs to keep in mind that the suppliers and customers are also exposed to the same dire circumstances and will be pushing back. The goal is to stretch the strings without breaking the same.  

Apart from reducing the cash conversion cycle, businesses should take a 360-degree review to improve its chances of survival. Inventory movement needs to be relooked at both from the supply side and demand side and stocking schedules and availability can be refined based on the circumstances.  Variable costs need to be reviewed. Eliminating or postponing any avoidable costs can help relieve some stress on cash funds. Operational as well as strategic decisions need to be balance sheet focused rather than being focused on the income statement. Alternate short term financing options can also be considered. 

Last but not the least, strengthening of the cash forecast reporting systems will help take insightful and timely decisions. 

The ability to ride out the disruption and uncertainty caused by the ongoing pandemic will force finance professionals to become resilient and adapt to unconventional and uncharted ways and means of working.

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