Working capital management is an attempt made by accountants and business owners to strike a balance between profitability and liquidity.
Many people (especially small business owners) either forget or are not aware of the fact that bad-debt has ‘double cost’ – the cost of writing them off and the cost of servicing associated to bad debts until it is been written off.
A lot of fund that would have been put to productive use have been tied up in working capital without being aware of it. Working capitals are those resources at the disposal of a business that are liquid. This is the function of; Receivables, Inventories and Payables.
The Approach I will follow in this article is to x-ray these components of working capital while bringing out the hidden treasure in them (which is the aim of this article).
TRADE RECEIVABLES (DEBTORS) MANAGEMENT
Trade receivables or trade debtors are liquid asset that is in form of promissory note. A customer buys goods and promise to pay in the future.
Good receivable management has four key stages VIZ:
- Policy formulation stage. At this stage, a framework that will guide credit involvement of the business is drawn. Elements of the framework to be considered include; establishing the terms of trade such as the period of credit offered and early settlement discount to be given, whether to charge interest on overdue amount, credit access procedures, action to be taken in the case of defiance etc. in fact, this is the agreement stage if you permit me to use that word.
- Credit worthiness assessment stage. Information relating to intending credit customer is analysed here. Information could be sourced from banks, or other credit rating agencies. The greater the amount to be granted as credit, the greater the need for proper reference from the right authority.
- Credit control stage. Receivables record must be monitored continually. This primarily is the responsibility of sales ledger administration department. Smaller businesses are however not advised to have a separate department for this function. Companies can use anything to class customers. My company use ‘star’ (star1, star2,…star5) Star5 being the category of customers with the most privilege. People in this class are given the longest credit term. Note however that this is frequently reviewed so that customers can be re-classed according to their prevailing circumstances. A customer’s payment record and account receivable aging analysis is examined on a recurring basis.
- Collection and action stage. This is the second most important stage after the policy formulation stage. A proper collection system should be used. A system that will not allow customers to play prangs on the company. Also, systematic steps should be followed to recover overdue amounts. The use of reminder, visits, phone calls, refusal to grant further credit, use of a specialist debt collecting agency or legal action- as a last resort. However the company chooses to go about this, the cost-benefit concept should always be borne in mind. I.e. the administrative costs and other costs incurred in debt collection should not exceed the benefits from incurring those costs. The financial and non-financial effects of contracting a factor should also be evaluated.
The over all aim of receivable management is to reduce the receivable days. What this will do for the business is that it will release funds for further production, save the finance cost that would have otherwise been paid to banks and allow the company to take advantage of early settlement discount from its suppliers.
Inventories comprise of both; raw materials, WIP (work-in-progress) and finished goods. Depending on the company’s circumstance, inventory management techniques like JIT (just-in-time) and EOQ (economic order quantity) can be used. JIT for instance is an inventory management philosophy that advocates zero and defect-less inventory at all time.
This technique has some useful potential that can be used to release a sum of money but is not appropriate to all sectors. An example is the hospital. A stock-out that is a major drawback of JIT could prove disastrous in hospitals.
EOQ has some of its own drawback hinged on the assumptions upon which it is based. The aim of this exercise is to reduce inventory days (i.e. to reduce the number of days that cash is being tied down in stock). Again, this will release the cash for other productive uses. If you have to keep inventory, the best way to manage and track stock is by using a vertical storage carousel.
Unlike the other components of working capital management, the aim of payables management is to increase the payables days. The primary legal and ethical means of doing this is to re-negotiate with your suppliers. This however, should be done with caution so as not to be enlisted in the black list of different suppliers.
In conclusion, proper working capital management is a goldmine that any business can easily tap into to release quantum cash. Working capital management is of three kinds, Aggressive, Conservative and Moderate (Modest) method. The one to choose is dependent on the circumstances of the business and the appetite of the company towards risk.