To keep an eye on Working Capital Management we have to check following factors:
Let’s discuss each and every factor in detail:
Inventory can be in one of the following states:
The raw material inventory enables a firm to synchronize its purchasing and production activities to some extent. It provides flexibility in purchasing and production. The firm can wait for an opportune buying moment without affecting its production schedule. Likewise the production schedule need not be influenced by immediate purchasing activity.
In-process inventory provides flexibility in production scheduling so that an efficient schedule and high utilization of capacity may be attained. Without in-process inventory, a bottleneck at any stage in the production process keeps the machines and facilities idle at subsequent stages. This results in delay and idle facilities.
Finished good inventory enables the firm to synchronize its production programme and marketing activities so that desirable results can be achieved on both the fronts. If adequate finished goods inventory is available, the marketing department can meet the needs of customers promptly.
Debtors and Creditors Turnover
While the business firms would like to sell on cash, the competition persuades them to sell on credit. Firms grant credit for a certain period (credit period) to increase sales. A firm’s investment in accounts receivable depends on how much it sells on credit and how long it takes to collect receivables. A rigorous collection program tends to decrease sales. But it helps in shortening the average collection period and it also reduces bad debt percentage. A lenient collection policy on the other hand would push sales up, lengthen the average collection period and increase the bad debt percentage.
The creditor turnover shows the credit worthiness of the firm. The greater the ratio, the better the firm in paying the accounts payable.
Working Capital Leverage
Working capital leverage reflects the sensitivity of return on investment to changes in the level of current assets.
WCL= CA/ (TA – ∆CA) (for decrease in current asset)
WCL= CA/ (TA + ∆CA) (For increase in current asset)
Where, CA = Current Assets ; TA = Total assets ; ∆CA = Change in Current Assets
Operating cycle implies the continuing flow from cash to suppliers, to inventory to accounts receivable and back into cash. Shorter operating cycle reflects operating efficiency of the firm.
The operating cycle focuses only on the time dimension of investment. It shows the duration of various components of the operating cycle. This analysis can be extended to take into account differential magnitudes of investment at different stages of the operating cycle. This extended analysis is called Weighted Operating Cycle. The WOC has a very useful and direct application. It can be used for estimating the working capital requirement of the firm:
Working Capital requirement= (Sales per day * WOC) + Cash balance requirement
Cash Conversion Cycle
The Cash Conversion Cycle (CCC) measures time frame during which the company converts the cash from payables to receivables which means the time frame when the cash is inside the market place.
Find more detail at Cash Conversion Cycle