Identifying Varying Conditions

Management uses policies and techniques for the management of working capital such as cash, inventory, debtors and short term financing.

Learning Objective

Identify the four main areas of variability of working capital management

Key Points

The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow.
Identify the appropriate credit policy and the appropriate source of financing, given the cash conversion cycle.

Terms

Work in process
Work in process (WIP) or in-process inventory includes the set at large of unfinished items for products in a production process. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage.
Finished good
Finished goods are goods that have completed the manufacturing process but have not yet been sold or distributed to the end user.

Full Text

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

There are four main areas of variability that must be managed

1. Cash management

Identify the cash balance that allows for the business to meet day-to-day expenses, but reduces cash holding costs.

2. Inventory management

Identify the level of inventory that allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow. Besides this, the lead times in production should be lowered to reduce work in process (WIP) and similarly, the finished goods should be kept on as low level as possible to avoid over production.

Inventory

Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow.

3. Debtors management

Identify the appropriate credit policy (i.e., credit terms which will attract customers such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on capital or vice versa).

4. Short-term financing

Identify the appropriate source of financing, given the cash conversion cycle. The inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring. "

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