What is Working Capital Management?

Reading Time: 3 minutes
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.

Leave a Comment

Your email address will not be published. Required fields are marked *

Featured Blogs

Leave a Comment

Your email address will not be published. Required fields are marked *

Featured Post

Banking in the Cloud

Banking in the...

Banking in the Cloud – What’s there for Accountants? Cloud...

22 Jul 21

Read more

4 Ways FinTech Firms are Preventing and Detecting Financial Frauds

4 Ways FinTech...

The FinTech sector has seen unprecedented growth over the last...

15 Jul 21

Read more

CPA Exam Tips: To-Dos For ‘The’ Month Before D-Day

CPA Exam Tips:...

The exam is knocking at the door, Prometric dates will...

8 Jul 21

Read more

a global perspective on the automation revolution

Is the Very...

In business - as in life - change is the...

29 Jun 21

Read more

5 challenges CPA face

5 Challenges CPAs...

The accounting field has undergone some radical changes over the...

23 Jun 21

Read more

6 Easy Ways to Navigate Essay Questions for the CMA Exams

6 Easy Ways...

Essay types are not amongst the ones that should keep...

14 Jun 21

Read more

US CPA certification can get you the CPA Canada designation

US CPA certification...

Yes, you heard it right! If you hold a US...

11 Jun 21

Read more

Cryptocurrencies are Reaching New Heights, so are Accounting Issues

Cryptocurrencies are Reaching...

Is bitcoin buzz an event-driven motif? Are the arguments about...

18 May 21

Read more

Bias in artificial intelligence

Um, come again?...

Machine Learning, a subset of artificial intelligence, responds to the...

4 May 21

Read more

CX Journey

How an effective...

How many of you are familiar with the ‘making of...

19 Apr 21

Read more