The Working Capital Management: Success in managing debtors, stock and creditors affect cash.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.



Debtors

Many local businesses are plaqued by slow payment of invoices and it is a problem in many other countries too.

A statutory right to interest has been in place for a number of years but nothing seems to make much difference.

An improvement can significantly affect working capital.

It is a great problem for managers, who sometimes are frightened of upsetting customers and feel that there is little that they can do.

This is  completely the wrong attitude.

Customer relations must always be considered, but a great deal can be done.

Some practical steps for credit control are summarized below:

• Have the right attitude; ask early and ask often.
• Make sure that payment terms are agreed in advance.
• Do not underestimate the strength of your position.
• Give credit control realistic status and priority.
• Have well-thought out credit policies.
• Concentrate on the biggest and most worrying debts first.
• Be efficient; send out invoices and statements promptly.
• Deal with queries quickly and efficiently.
• Make full use of the telephone, your best aid.
• Use legal action if necessary.

This may sound obvious but it usually works.

Be efficient, ask and be tough if necessary.

Stock

The aim should be 

• to keep stock as low as is realistically feasible and 
• to achieve as high a rate of stock turnover as is realistically feasible.

In practice, it is usually necessary to compromise between 

• the wish to have stock as low as possible, and 
• the need to keep production and sales going with a reasonable margin of safety.

Exactly how the compromise is struck will vary from case to case.  

Purchasing and production control are highly skilled functions and great effort may be expended on getting it right.

"Just in time deliveries" is the technique of arranging deliveries of supplies frequently and in small quantities.  In fact, just in time to keep production going.

It is particularly successful in japan where, for example, car manufacturers keep some parts for production measured only in hours.

It is not easy to achieve and suppliers would probably like to make large deliveries at irregular intervals.  

It may pay to approach the problem with an attitude of partnership with key suppliers, and to reward them with fair prices and continuity of business.

Finished goods should be sold, delivered and invoiced as quickly as possible.

Creditors

It is not ethical advice, but there is an obvious advantage in paying suppliers slowly.

This is why slow payment is such a problem and, as has already been stated, the control of debtors is so important.

Slow payment is often imposed by large and strong companies on small and weak suppliers.

Slow payment does not affect the net balance of working capital,but it does mean that both cash and creditors are higher than would otherwise be the case.

Apart from moral considerations, there are some definite disadvantages in a policy of slow payment:

• Suppliers will try to compensate with higher prices or lower service.
• Best long-term results are often obtained by fostering mutual loyalty with key suppliers; it pays to consider their interests.
• If payments are already slow, there will be less scope for taking longer to pay in response to a crisis.

For these reasons it is probably not wise to adopt a consistent policy of slow payment, at least with important suppliers.

It is better to be hard but fair and to ensure that this fair play is rewarded with 

• keen prices, 
• good service and 
• perhaps prompt payment discounts.

There may be scope for timing deliveries to take advantage of payment terms.  

For example, if the terms are 'net monthly account', a 30 June delivery will be due for payment on 31 July.  At 1 July delivery will be due for payment on 31 August.

Working Capital

This is the difference between current assets and current liabilities.

It is extremely important.

• A business without sufficient working capital cannot pay its debts as they fall due. 
• In this situation it might have to stop trading even if it is profitable.

Possible alternatives might include:

• raising more capital,
• taking out a long-term loan, or
• selling some fixed assets.

Never forget the importance of working capital

Working capital is the difference between assets realizable in the short term and liabilities payable in the short term.

It includes cash held and money owed.

Quickly realizable assets are the next best thing to cash.

If you can get the working capital right, you should be safe.

Try hard to achieve this.

Improve Cash Flow - Part 2 of 2

Previously we looked at generating cash from operations, capital expenditure and financing.  Here, we look at working capital.  This is a measure of the operating efficiency and liquidity of a business.

Working capital is the difference between current assets and current liabilities.  In other words the amount of cash required to finance inventory and trade receivables net of trade payables.  Cash tied up in inventory or money owed by customers cannot be used to pay short-term obligations, and therefore businesses need to release cash from these sources where possible.

Minimize inventory levels.
There are many methods of inventory management.  A well known technique is JIT ("just-in-time"), used mainly in manufacturing.   Goods are produced only to meet customer demand.  All inventory arrives from suppliers just in time for the next stage in the production process.  This technique minimizes inventory levels.

Minimize and control cash owed by customers.
It is important to follow procedures and be organized in collecting customer debts.  

Maximize the payment period to suppliers.
Delaying payments to suppliers will not generate cash but it will delay its outflow.  Many businesses use supplier credit as a source of finance.  Large and powerful customers are often accused of dictating extended payment terms, which add pressure to a small business's cash flow.  Extended credit should be negotiated as opposed to taken, to avoid problems in the future.  Businesses rely on their suppliers to keep their operations flowing, so payment terms should always be agreed in advance.

"Creditors have better memories than debtors; creditors are a superstitious sect, great observers of set days and times!"

Release working capital to pay short-term obligations.

Examples of Companies with Large Working Capital

Northern Pipe Line Company



In 1926, this company had:



Total Equity: capital and surplus of $4,235,000,

represented by

Current Asset: $3,489,000 of cash assets, $33,000 of other current assets, and

Fixed Asset: $1,319,000 of net plant,

less

Total liabilities: $606,000.



Total business done was only about $500,000.



A good part of the net earnings of $375,000 ( $9.375 per share) came from investments in railroad bonds.



The stock sold for an average value of $2,880,000 ($72 per share for 40,000 shares), which was considerably less than the cash assets alone.



These cash assets had been accumulated mainly out of annual charges for depreciation.



Dividends had been generous in relation to earnings and amounted to $6 per share in 1926.



The business, formerly very prosperous, had lost a good part of the volume and, with it, its appeal to investors.



Clearly, the outside stock-holders were at a great disadvantage in having so much of their capital tied up in cash funds that were held by an unattractive enterprise.



The management claimed that it was necessary or advisable to retain this money, because some day they MIGHT want to build a new pipe line.



It required a strenuous proxy contest to change the management's thinking.



Later, cash distributions of $70 per share ($2,800,000) were made as a return of capital, and the stockholders' over-all position was greatly improved.



----



Colt's Manufacturing Company.



This company emerged from the war with over $10 million in working capital, largely cash; but in 1946 its sales were only $5.0 million, and in 1946-1948 it lost money in the aggregate.



In this instance, the management embarked on two unrelated lines of business, in order to find additional employment for the large plant facilities and current assets. (However, the funds committed were held down to modest figures.)



The new lines did not prove successful, at least as far as enabling the company to show an adequate return on the owner's capital.



The stock sold persistently for much less than the working capital alone. (In 1947 the average price was 31, against net current assets or working capital of over $50 per share.)



Large stockholding interests, having previously obtained places on the board and having studied the company's problems and possibilities with care, finally decided that the capital should be reduced substantially by repurchasing a large proportion of the outstanding stock.



In 1950, following a call for tenders of stock, 125,000 shares, or 64% of the total, were bought in at a price as high as the working-capital value of $53.



The remaining shares had the same prorata interest as before in the current assets, and a much larger interest in the plant. This move was unquestionably beneficial both to the stockholders who sold back and to those who retained their stock, which sold as high as 65 soon after the repurchase.

Ref: Security Analysis by Graham and Dodd

The Paradox of Large Working Capital in Mediocre Companies

1. A prosperous company would appear more likely to accumulate excessive capital than a nonprosperous one.

2. Strangely enough, this is not true. Most prosperous companies, in our dynamic economy, have been able to expand their business more or less steadily, and this expansion has supplied a satisfactory outlet for the retained earnings.

3. On the other hand, many concerns that have shown mediocre results over a long period of years will in one way or another end up by holding too much of their stockholders' capital.

• This is often the result of a persistently low dividend, together with some fairly large accumulation of profits in boom periods.
• Sometimes new capital is raised by stock sales which later turn out to be redundant.
• In frequent cases the accrual of substantial annual depreciation and depletion charges results in gradually transferring the fixed assets into cash, with a consequent excess of working capitals.

4. Consequently, the question whether too much capital is being used in the business becomes of practical moment to stockholders only in the case of nonprosperous companies. (After all, properous companies do not present problems to their stockholderss except in the matter of dividend policy.)

• It is an area in which the interests of stockholders and managements are likely to clash vigorously.
• The more dubious the company's prospects - which means generally the less satisfactory its past results - the more anxious management is to retain all the cash it can in the business;
• but the stockholders would be well advised to take out all the capital that can be safely spared, because these funds are much more valuable to them if in their own pockets, or invested elsewhere, than if left in a nonprosperous business.

Ref: Security Analysis by Graham and Dodd