WORKING CAPITAL MANAGEMENT
INTRODUCTION:
The term working capital refers to the amount of capital which is readily available to an organisation. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities).
Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business".
Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business".
Thus:
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
In a department's Statement of Financial Position, these components of working capital are reported under the following headings:
Current Assets
• Liquid Assets (cash and bank deposits)
• Inventory
• Debtors and Receivables
Current Liabilities
• Bank Overdraft
• Creditors and Payables
• Other Short Term Liabilities
Working capital is the money you will need to keep your business going until you can cover your operating costs out of revenue. As a small business owner, it will be wise to have enough working capital on hand to cover items such as the following during the first few months that you are in business:
• Replacing inventory and raw materials: you will need to fund the purchase of inventory out of working capital until you start to see cash from sales, which could take months.
• Paying employees: even the most loyal worker wants to get paid on time, regardless of how much or how little cash your firm earns during its first months.
• Paying yourself: unless you have made other arrangements, you will need to withdraw some money to support yourself.
• Debt payments: if you have borrowed money to get started, you probably have to begin repaying it right away. Missing your first loan payments will not do your credit rating any good.
• An emergency fund: you need some cash on hand to cover unforeseen shortfalls that may result from any number of factors such as delays in getting your space ready, a slow paying client, or slow business.
The five most common sources of short-term working capital financing are:
• Equity: If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These funds might be injected from your own personal resources or from a family member, friend or third-party investor.
• Trade Creditors: If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem.
• Factoring: Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is often used by new businesses.
• Line of credit: Lines of credit are not often given by banks to new businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
• Short-term loan: While your new business may not qualify for a line of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup.
The two most common sources for long-term working capital financing are:
• Bonds: These debt securities are promises made by the issuing company to pay the principal when due and to make timely interest payments on the unpaid balance.
• Long-term loan: Commercial banks make loans to borrowers who can repay the principal with interest, and they will often require collateral for upwards of 85 - 90 percent of the loan value. You will need to demonstrate a track record of sales revenues to justify your ability to make periodic installments. Unfortunately, as a small business or start up, your fledgling business idea probably doesn't have either the sufficient assets or customer base to warrant serious consideration for a bank loan.
Debt vs. Equity Assessments
It is essential that you assess the relative merits of each form of funding for your specific business.
DEBT EQUITY
Take on Creditors Take on Partners
Low Expected Return High Expected Return
Smaller Funding Amounts Larger Funding Amount
Periodic Payments No Short-Term Payments
Maturity Date Open-Ended " Exit" Date
More Restrictions Less Restrictions
Partners/creditors
Whoever provides your firm with funding will, to some degree, become part of your management team. An equity partner will have direct input into decision making while a lender does not have this access.
Company returns
Equity partners will likely expect your venture to generate after-tax annual profits of 35 to 45 percent on the equity they invested. Creditors are only concerned with your ability to generate pre-tax cash flow to cover periodic interest expenses on the debt.
Funding amount
Equity partners can provide your firm with more up-front capital to allow you to fund all the projects necessary to achieve your growth objective. What a lender can fund is based solely on your ability to make loan installments, and that will likely be quite small early on in the life of your business.
Payments
Equity does not get "paid back" each month or each quarter--it represents partners in the firm. But lenders will expect loan repayment to begin the month after you close escrow on the loan.
Maturity
Equity partners have no guarantees on when they may get their funds plus a (hefty) return out of your business. It could be after an acquisition, a subsequent round of funding or the IPO. Creditors, however, are removed from the balance sheet at a set date upon the final payment on the loan.
Restrictions
Both funding types can require contractual terms that limit your use of funds and the types of policies implemented, but lenders often have much more restrictive loan provisions than do equity investors.
ADVANTAGES OF USING DEBT DISADVANTAGES OF USING DEBT
Debt is not an ownership interest in the business. Creditors generally do not have voting power. Unpaid debt is a liability of the business. If it is not paid then the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization.
The payment of interest on debt is considered a cost of doing business and is fully tax deductible. Your business must earn at least enough money to cover for the interest expense, otherwise you may not be able to pay you interest which may lead to default (financial distress).
ADVANTAGES OF USING EQUITY DISADVANTAGES OF USING EQUITY
Unlike obligation of debt, your business will not have any contractual obligation to pay for equity dividend. Equity is an ownership of the business. So an equity partner will have a direct say about your business.
Equity financing also allows your business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time.
One must examine each of these trade-offs in detail before deciding which is best for your firm. Then you can establish a set of funding priorities to guide you in your negotiations with potential equity or debt funding sources.
Working capital has a direct impact on cash flow in a business. Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to make any venture successful.
Factors Influencing Working Capital Requirements
The working capital requirement of an organization depends upon the following factors :
? Nature of business
The working capital requirement of a firm is closely related to the nature of its business. A service firm, which has a short operating cycle and sells predominantly on a cash basis, has a modest working capital requirement. On the other hand, a manufacturing concern, which has a long operating cycle and which largely sells on credit, has a very substantial working capital requirement.
? Seasonality of operations
Firms, which have marked seasonality in their operations usually, have high fluctuating working capital requirements. The working capital need of a firm is likely to increase during the season when its product is having more demand and decrease significantly when the product is having low demand.
? Production policy
A firm marked by pronounced seasonal fluctuation in its sales may pursue a production policy, which may reduce the sharp variations in working capital requirements. For example a firm may choose to maintain a steady production throughout the year rather than intensifying the production activity during peak business season.
? Market conditions
The degree of competition prevailing in the market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required and generous credit terms may have to be offered to attract customers. If the market is strong and competition is weak, a firm can manage with a smaller finished goods inventory. Also the firm can insist on cash payment.
? Conditions of supply
The inventory of raw materials, spares and stores depends on the conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory. However, if the supply is unpredictable and scant then the firm would have to acquire stocks as and when they are available and carry larger inventory on the average.
Working Capital Cycle
Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire.
The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.
There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.
The Working Capital Cycle
Each component of working capital (namely inventory, receivables and payables) has two dimensions TIME and MONEY. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit; you effectively create free finance to help fund future sales.
If you ....... Then ......
Collect receivables (debtors) faster You release cash from the cycle
Collect receivables (debtors) slower Your receivables soak up cash
Get better credit (in terms of duration or amount) from suppliers You increase your cash resources
Shift inventory (stocks) faster You free up cash
Move inventory (stocks) slower You consume more cash
It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc. If you do pay cash, remember that this is now longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment - loans, equity, leasing etc. Similarly, if you pay dividends or increase drawings, then the cash outflows and they remove liquidity from the business.
“More businesses fail for lack of cash than for want of profit.”
The calculation for different steps of the working Capital cycle is being shown in the following table:
2004 2005 2006
Gross Working capital cycle In Crore 218 128 98
Average Collection Period In Days 121 82 66
Average Payment Period In Days 22 20 29
Net Working Cycle In Days 196 108 69
Net Working Capital Cycle
The working capital cycle has been calculated for NFCL for the financial years 2004, 2005 and 2006. This information shows that there has been significant improvement in the working capital structure of the organization. The net working capital cycle has been steadily decreasing. These all indicates good inventory management on raw materials.
Collection Period vs Payment Period
The average collection period has also decreased over the three tears period whereas the average payment period has increased, thus the gap between the receivable and payable time has reduced allowing the firm to use their funds more frequently, as the flow of cash improved. This has resulted in fall in the net working cycle of the firm which is quite good.
Though still the scenario is that NFCL is paying cash early whereas they receive cash late. This could lead to cash shortage and thus can create in working capital management.
Sources of Additional Working Capital
Sources of additional working capital include the following:
• Existing cash reserves
• Profits (when you secure it as cash!)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include:
• Pressure on existing cash
• Exceptional cash generating activities e.g. offering high discounts for early cash payment
• Bank overdraft exceeds authorized limit
• Seeking greater overdrafts or lines of credit
• Part-paying suppliers or other creditors
• Paying bills in cash to secure additional supplies
• Management pre-occupation with surviving rather than managing
• Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
Handling Receivables (Debtors):
Cash flow can be significantly enhanced if the amounts owing to a business are collected faster.
“Late payments erode profits and can lead to bad debts.”
Slow payment has a crippling effect on business, in particular on small businesses who can least afford it. If you don't manage debtors, they will begin to manage your business as you will gradually lose control due to reduced cash flow and, of course, you could experience an increased incidence of bad debt. The following measures will help manage your debtors:
1. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves.
2. Establish clear credit practices as a matter of company policy.
3. Make sure that these practices are clearly understood by staff, suppliers and customers.
4. Be professional when accepting new accounts, and especially larger ones.
5. Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc.
6. Establish credit limits for each customer and stick to them.
7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue accounts.
11. Consider accepting credit /debit cards as a payment option.
12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old.
Recognize that the longer someone owes you, the greater the chance you will never get paid. If the average age of your debtors is getting longer, or is already very long, you may need to look for the following possible defects:
• weak credit judgment
• poor collection procedures
• lax enforcement of credit terms
• slow issue of invoices or statements
• errors in invoices or statements
• Customer dissatisfaction.
Debtors due over 90 days (unless within agreed credit terms) should generally demand immediate attention. Look for the warning signs of a future bad debt. For example
• longer credit terms taken with approval, particularly for smaller orders
• use of post-dated checks by debtors who normally settle within agreed terms
• evidence of customers switching to additional suppliers for the same goods
• new customers who are reluctant to give credit references
• receiving part payments from debtors.
“Profits only come from paid sales”.
The act of collecting money is one which most people dislike for many reasons and therefore put on the long finger because they convince themselves there is something more urgent or important that demands their attention now.
There is nothing more important than getting paid for your product or service. A customer who does not pay is not a customer. Here are a few ideas that may help you in collecting money from debtors:
• Develop appropriate procedures for handling late payments.
• Track and pursue late payers.
• Get external help if your own efforts fail.
• Don't feel guilty asking for money, its yours and you are entitled to it.
• Make that call now and keep asking until you get some satisfaction.
• When asking for your money, be hard on the issue - but soft on the person.
• Don't give the debtor any excuses for not paying.
Managing Payables (Creditors):
Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity problems. Consider the following:
There is an old adage in business that if you can buy well then you can sell well. Management of your creditors and suppliers is just as important as the management of your debtors. It is important to look after your creditors - slow payment by you may create ill-feeling and can signal that your company is inefficient (or in trouble!).
Remember, a good supplier is someone who will work with you to enhance the future viability and profitability of your company.
Inventory Management
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up in stocks. Remember that stock sitting on shelves for long periods of time ties up money which is not working for you. For better stock control, try the following:
• Review the effectiveness of existing purchasing and inventory systems.
• Know the stock turn for all major items of inventory.
• Apply tight controls to the significant few items and simplify controls for the trivial many.
• Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
• Consider having part of your product outsourced to another manufacturer rather than make it yourself.
• Review your security procedures to ensure that no stock is going out the back door.
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.
Cash flow Management:
In its simplest form, cash flow is the movement of money in and out of your business. It could be described as the process in which your business uses cash to generate goods or services for the sale to your customers, collects the cash from the sales, and then completes this cycle all over again.
Inflows. Inflows are the movement of money into your cash flow. Inflows are most likely proceeds from the sale of your goods or services to your customers. If you extend credit to your customers and allow them to charge the sale of the goods or services to their account, then an inflow occurs as you collect on the customers' accounts. The proceeds from a bank loan is also a cash inflow.
Outflows. Outflows are the movement of money out of your business. Outflows are generally the result of paying expenses. If your business involves reselling goods, then your largest outflow is most likely to be for the purchase of retail inventory. A manufacturing business's largest outflows will mostly likely be for the purchases of raw materials and other components needed for the manufacturing of the final product. Purchasing fixed assets, paying back loans, and paying accounts payable are also cash outflows.
What to Do with a Cash Surplus
Managing and improving your cash flow should result in a cash surplus for your business. A cash surplus is the cash that exceeds the cash required for day-to-day operations. How you handle your cash surplus is just as important as the management of money into and out of your cash flow cycle.
Two of the most common uses of extra cash are:
• paying down your debt
• investing the cash surplus
• Paying Down Debt
Paying down any debt you may have is generally the first option considered when deciding what to do with a cash surplus. Rightfully so because a short-term investment of your cash surplus is not likely to yield a return equal to or greater than the rate of interest on any of your debt. It doesn't make any sense to invest a cash surplus at 5 percent when you can pay down a bank loan that is charging interest at 12 percent.
• Investing the Cash Surplus
When investing a cash surplus, it's only natural to seek the highest rate of return for your investment. There are many investment opportunities available for your cash surplus. You must consider the advantages and disadvantages as well as the levels of risk, maturity, liquidity, and the yields of each of your investment opportunities. The following are just a few of the investment opportunities you may have:
• checking accounts with interest
• sweep accounts
• treasury bills and notes
• certificates of deposit (CDs) and money market funds
Managing a Cash Flow Deficit
A cash flow deficit arises when payments are due and the cash balance is too low to meet the obligations. When you do have a cash flow shortage, it's important to remember that there are some expenses you must pay on time. These include payroll, payroll taxes and insurance.
To manage a cash flow shortage there are several ways:
• Obtain a short-term loan. A number of nonprofit lenders and for-profit banks provide short-term loans to nonprofit organizations. These institutions provide "working capital loans" intended to help nonprofits cover operating expenses while they are waiting for a grant or contract disbursement. Generally, these loans are for a short term (less than 90 days) and you will be expected to repay them once the funds from the grant or contract are received.
• Speed up collection of accounts receivable. Sometimes, you may be able to speed the collection of money that is owed to you. For example, if there are government agencies that owe you money, you could ask for an upfront payment in advance of the scheduled payment. Or, a foundation may be willing to rearrange its disbursement schedule if you anticipate a cash deficit. Again, the cash flow statement can help you structure your receivables with your funders to avoid cash flow deficits.
• Increase fundraising efforts. Because your cash flow projections show when to expect cash flow surpluses and deficits, you might consider rearranging your fundraising schedule to accommodate your cash flow needs. For example, you could move a direct-mail appeal to an earlier date if you know you will need income sooner in the year.
• Liquidate investments. Perhaps there are stocks, bonds or certificate-of-deposit accounts (CDs) that you can liquidate. If you are investing in CDs, you can structure them so that they mature when you need the cash. For example, the organization in the example could have opened a CD during the previous year that matures in the month of January, providing much needed funds and limiting the organization's reliance on its line of credit.
• Cut expenses. There may be expenses in your budget that could be deferred or cut. It's important that you keep an eye out for line items that continue to outpace your budget.
• Delay payment to vendors. If you're really in a bind, you may want to consider negotiating with your vendors. Perhaps you have bills that are due within 30 days that can be extended to 60 or 90 days. Explaining your situation honestly and requesting a revised payment schedule is much better than simply ignoring the bills.
INTRODUCTION:
The term working capital refers to the amount of capital which is readily available to an organisation. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities).
Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business".
Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business".
Thus:
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
In a department's Statement of Financial Position, these components of working capital are reported under the following headings:
Current Assets
• Liquid Assets (cash and bank deposits)
• Inventory
• Debtors and Receivables
Current Liabilities
• Bank Overdraft
• Creditors and Payables
• Other Short Term Liabilities
Working capital is the money you will need to keep your business going until you can cover your operating costs out of revenue. As a small business owner, it will be wise to have enough working capital on hand to cover items such as the following during the first few months that you are in business:
• Replacing inventory and raw materials: you will need to fund the purchase of inventory out of working capital until you start to see cash from sales, which could take months.
• Paying employees: even the most loyal worker wants to get paid on time, regardless of how much or how little cash your firm earns during its first months.
• Paying yourself: unless you have made other arrangements, you will need to withdraw some money to support yourself.
• Debt payments: if you have borrowed money to get started, you probably have to begin repaying it right away. Missing your first loan payments will not do your credit rating any good.
• An emergency fund: you need some cash on hand to cover unforeseen shortfalls that may result from any number of factors such as delays in getting your space ready, a slow paying client, or slow business.
The five most common sources of short-term working capital financing are:
• Equity: If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These funds might be injected from your own personal resources or from a family member, friend or third-party investor.
• Trade Creditors: If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem.
• Factoring: Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is often used by new businesses.
• Line of credit: Lines of credit are not often given by banks to new businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
• Short-term loan: While your new business may not qualify for a line of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup.
The two most common sources for long-term working capital financing are:
• Bonds: These debt securities are promises made by the issuing company to pay the principal when due and to make timely interest payments on the unpaid balance.
• Long-term loan: Commercial banks make loans to borrowers who can repay the principal with interest, and they will often require collateral for upwards of 85 - 90 percent of the loan value. You will need to demonstrate a track record of sales revenues to justify your ability to make periodic installments. Unfortunately, as a small business or start up, your fledgling business idea probably doesn't have either the sufficient assets or customer base to warrant serious consideration for a bank loan.
Debt vs. Equity Assessments
It is essential that you assess the relative merits of each form of funding for your specific business.
DEBT EQUITY
Take on Creditors Take on Partners
Low Expected Return High Expected Return
Smaller Funding Amounts Larger Funding Amount
Periodic Payments No Short-Term Payments
Maturity Date Open-Ended " Exit" Date
More Restrictions Less Restrictions
Partners/creditors
Whoever provides your firm with funding will, to some degree, become part of your management team. An equity partner will have direct input into decision making while a lender does not have this access.
Company returns
Equity partners will likely expect your venture to generate after-tax annual profits of 35 to 45 percent on the equity they invested. Creditors are only concerned with your ability to generate pre-tax cash flow to cover periodic interest expenses on the debt.
Funding amount
Equity partners can provide your firm with more up-front capital to allow you to fund all the projects necessary to achieve your growth objective. What a lender can fund is based solely on your ability to make loan installments, and that will likely be quite small early on in the life of your business.
Payments
Equity does not get "paid back" each month or each quarter--it represents partners in the firm. But lenders will expect loan repayment to begin the month after you close escrow on the loan.
Maturity
Equity partners have no guarantees on when they may get their funds plus a (hefty) return out of your business. It could be after an acquisition, a subsequent round of funding or the IPO. Creditors, however, are removed from the balance sheet at a set date upon the final payment on the loan.
Restrictions
Both funding types can require contractual terms that limit your use of funds and the types of policies implemented, but lenders often have much more restrictive loan provisions than do equity investors.
ADVANTAGES OF USING DEBT DISADVANTAGES OF USING DEBT
Debt is not an ownership interest in the business. Creditors generally do not have voting power. Unpaid debt is a liability of the business. If it is not paid then the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization.
The payment of interest on debt is considered a cost of doing business and is fully tax deductible. Your business must earn at least enough money to cover for the interest expense, otherwise you may not be able to pay you interest which may lead to default (financial distress).
ADVANTAGES OF USING EQUITY DISADVANTAGES OF USING EQUITY
Unlike obligation of debt, your business will not have any contractual obligation to pay for equity dividend. Equity is an ownership of the business. So an equity partner will have a direct say about your business.
Equity financing also allows your business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time.
One must examine each of these trade-offs in detail before deciding which is best for your firm. Then you can establish a set of funding priorities to guide you in your negotiations with potential equity or debt funding sources.
Working capital has a direct impact on cash flow in a business. Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to make any venture successful.
Factors Influencing Working Capital Requirements
The working capital requirement of an organization depends upon the following factors :
? Nature of business
The working capital requirement of a firm is closely related to the nature of its business. A service firm, which has a short operating cycle and sells predominantly on a cash basis, has a modest working capital requirement. On the other hand, a manufacturing concern, which has a long operating cycle and which largely sells on credit, has a very substantial working capital requirement.
? Seasonality of operations
Firms, which have marked seasonality in their operations usually, have high fluctuating working capital requirements. The working capital need of a firm is likely to increase during the season when its product is having more demand and decrease significantly when the product is having low demand.
? Production policy
A firm marked by pronounced seasonal fluctuation in its sales may pursue a production policy, which may reduce the sharp variations in working capital requirements. For example a firm may choose to maintain a steady production throughout the year rather than intensifying the production activity during peak business season.
? Market conditions
The degree of competition prevailing in the market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required and generous credit terms may have to be offered to attract customers. If the market is strong and competition is weak, a firm can manage with a smaller finished goods inventory. Also the firm can insist on cash payment.
? Conditions of supply
The inventory of raw materials, spares and stores depends on the conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory. However, if the supply is unpredictable and scant then the firm would have to acquire stocks as and when they are available and carry larger inventory on the average.
Working Capital Cycle
Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire.
The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.
There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.
The Working Capital Cycle
Each component of working capital (namely inventory, receivables and payables) has two dimensions TIME and MONEY. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit; you effectively create free finance to help fund future sales.
If you ....... Then ......
Collect receivables (debtors) faster You release cash from the cycle
Collect receivables (debtors) slower Your receivables soak up cash
Get better credit (in terms of duration or amount) from suppliers You increase your cash resources
Shift inventory (stocks) faster You free up cash
Move inventory (stocks) slower You consume more cash
It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc. If you do pay cash, remember that this is now longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment - loans, equity, leasing etc. Similarly, if you pay dividends or increase drawings, then the cash outflows and they remove liquidity from the business.
“More businesses fail for lack of cash than for want of profit.”
The calculation for different steps of the working Capital cycle is being shown in the following table:
2004 2005 2006
Gross Working capital cycle In Crore 218 128 98
Average Collection Period In Days 121 82 66
Average Payment Period In Days 22 20 29
Net Working Cycle In Days 196 108 69
Net Working Capital Cycle
The working capital cycle has been calculated for NFCL for the financial years 2004, 2005 and 2006. This information shows that there has been significant improvement in the working capital structure of the organization. The net working capital cycle has been steadily decreasing. These all indicates good inventory management on raw materials.
Collection Period vs Payment Period
The average collection period has also decreased over the three tears period whereas the average payment period has increased, thus the gap between the receivable and payable time has reduced allowing the firm to use their funds more frequently, as the flow of cash improved. This has resulted in fall in the net working cycle of the firm which is quite good.
Though still the scenario is that NFCL is paying cash early whereas they receive cash late. This could lead to cash shortage and thus can create in working capital management.
Sources of Additional Working Capital
Sources of additional working capital include the following:
• Existing cash reserves
• Profits (when you secure it as cash!)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include:
• Pressure on existing cash
• Exceptional cash generating activities e.g. offering high discounts for early cash payment
• Bank overdraft exceeds authorized limit
• Seeking greater overdrafts or lines of credit
• Part-paying suppliers or other creditors
• Paying bills in cash to secure additional supplies
• Management pre-occupation with surviving rather than managing
• Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
Handling Receivables (Debtors):
Cash flow can be significantly enhanced if the amounts owing to a business are collected faster.
“Late payments erode profits and can lead to bad debts.”
Slow payment has a crippling effect on business, in particular on small businesses who can least afford it. If you don't manage debtors, they will begin to manage your business as you will gradually lose control due to reduced cash flow and, of course, you could experience an increased incidence of bad debt. The following measures will help manage your debtors:
1. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves.
2. Establish clear credit practices as a matter of company policy.
3. Make sure that these practices are clearly understood by staff, suppliers and customers.
4. Be professional when accepting new accounts, and especially larger ones.
5. Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc.
6. Establish credit limits for each customer and stick to them.
7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue accounts.
11. Consider accepting credit /debit cards as a payment option.
12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old.
Recognize that the longer someone owes you, the greater the chance you will never get paid. If the average age of your debtors is getting longer, or is already very long, you may need to look for the following possible defects:
• weak credit judgment
• poor collection procedures
• lax enforcement of credit terms
• slow issue of invoices or statements
• errors in invoices or statements
• Customer dissatisfaction.
Debtors due over 90 days (unless within agreed credit terms) should generally demand immediate attention. Look for the warning signs of a future bad debt. For example
• longer credit terms taken with approval, particularly for smaller orders
• use of post-dated checks by debtors who normally settle within agreed terms
• evidence of customers switching to additional suppliers for the same goods
• new customers who are reluctant to give credit references
• receiving part payments from debtors.
“Profits only come from paid sales”.
The act of collecting money is one which most people dislike for many reasons and therefore put on the long finger because they convince themselves there is something more urgent or important that demands their attention now.
There is nothing more important than getting paid for your product or service. A customer who does not pay is not a customer. Here are a few ideas that may help you in collecting money from debtors:
• Develop appropriate procedures for handling late payments.
• Track and pursue late payers.
• Get external help if your own efforts fail.
• Don't feel guilty asking for money, its yours and you are entitled to it.
• Make that call now and keep asking until you get some satisfaction.
• When asking for your money, be hard on the issue - but soft on the person.
• Don't give the debtor any excuses for not paying.
Managing Payables (Creditors):
Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity problems. Consider the following:
There is an old adage in business that if you can buy well then you can sell well. Management of your creditors and suppliers is just as important as the management of your debtors. It is important to look after your creditors - slow payment by you may create ill-feeling and can signal that your company is inefficient (or in trouble!).
Remember, a good supplier is someone who will work with you to enhance the future viability and profitability of your company.
Inventory Management
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up in stocks. Remember that stock sitting on shelves for long periods of time ties up money which is not working for you. For better stock control, try the following:
• Review the effectiveness of existing purchasing and inventory systems.
• Know the stock turn for all major items of inventory.
• Apply tight controls to the significant few items and simplify controls for the trivial many.
• Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
• Consider having part of your product outsourced to another manufacturer rather than make it yourself.
• Review your security procedures to ensure that no stock is going out the back door.
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.
Cash flow Management:
In its simplest form, cash flow is the movement of money in and out of your business. It could be described as the process in which your business uses cash to generate goods or services for the sale to your customers, collects the cash from the sales, and then completes this cycle all over again.
Inflows. Inflows are the movement of money into your cash flow. Inflows are most likely proceeds from the sale of your goods or services to your customers. If you extend credit to your customers and allow them to charge the sale of the goods or services to their account, then an inflow occurs as you collect on the customers' accounts. The proceeds from a bank loan is also a cash inflow.
Outflows. Outflows are the movement of money out of your business. Outflows are generally the result of paying expenses. If your business involves reselling goods, then your largest outflow is most likely to be for the purchase of retail inventory. A manufacturing business's largest outflows will mostly likely be for the purchases of raw materials and other components needed for the manufacturing of the final product. Purchasing fixed assets, paying back loans, and paying accounts payable are also cash outflows.
What to Do with a Cash Surplus
Managing and improving your cash flow should result in a cash surplus for your business. A cash surplus is the cash that exceeds the cash required for day-to-day operations. How you handle your cash surplus is just as important as the management of money into and out of your cash flow cycle.
Two of the most common uses of extra cash are:
• paying down your debt
• investing the cash surplus
• Paying Down Debt
Paying down any debt you may have is generally the first option considered when deciding what to do with a cash surplus. Rightfully so because a short-term investment of your cash surplus is not likely to yield a return equal to or greater than the rate of interest on any of your debt. It doesn't make any sense to invest a cash surplus at 5 percent when you can pay down a bank loan that is charging interest at 12 percent.
• Investing the Cash Surplus
When investing a cash surplus, it's only natural to seek the highest rate of return for your investment. There are many investment opportunities available for your cash surplus. You must consider the advantages and disadvantages as well as the levels of risk, maturity, liquidity, and the yields of each of your investment opportunities. The following are just a few of the investment opportunities you may have:
• checking accounts with interest
• sweep accounts
• treasury bills and notes
• certificates of deposit (CDs) and money market funds
Managing a Cash Flow Deficit
A cash flow deficit arises when payments are due and the cash balance is too low to meet the obligations. When you do have a cash flow shortage, it's important to remember that there are some expenses you must pay on time. These include payroll, payroll taxes and insurance.
To manage a cash flow shortage there are several ways:
• Obtain a short-term loan. A number of nonprofit lenders and for-profit banks provide short-term loans to nonprofit organizations. These institutions provide "working capital loans" intended to help nonprofits cover operating expenses while they are waiting for a grant or contract disbursement. Generally, these loans are for a short term (less than 90 days) and you will be expected to repay them once the funds from the grant or contract are received.
• Speed up collection of accounts receivable. Sometimes, you may be able to speed the collection of money that is owed to you. For example, if there are government agencies that owe you money, you could ask for an upfront payment in advance of the scheduled payment. Or, a foundation may be willing to rearrange its disbursement schedule if you anticipate a cash deficit. Again, the cash flow statement can help you structure your receivables with your funders to avoid cash flow deficits.
• Increase fundraising efforts. Because your cash flow projections show when to expect cash flow surpluses and deficits, you might consider rearranging your fundraising schedule to accommodate your cash flow needs. For example, you could move a direct-mail appeal to an earlier date if you know you will need income sooner in the year.
• Liquidate investments. Perhaps there are stocks, bonds or certificate-of-deposit accounts (CDs) that you can liquidate. If you are investing in CDs, you can structure them so that they mature when you need the cash. For example, the organization in the example could have opened a CD during the previous year that matures in the month of January, providing much needed funds and limiting the organization's reliance on its line of credit.
• Cut expenses. There may be expenses in your budget that could be deferred or cut. It's important that you keep an eye out for line items that continue to outpace your budget.
• Delay payment to vendors. If you're really in a bind, you may want to consider negotiating with your vendors. Perhaps you have bills that are due within 30 days that can be extended to 60 or 90 days. Explaining your situation honestly and requesting a revised payment schedule is much better than simply ignoring the bills.