Essentials of Working Capital Management

James Sagner, James S. Sagner

• Publisher: Wiley
• Year: 2010
• Print ISBN:
  9780470879986
• eBook ISBN:
  9780470916926
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Finanzas

A comprehensive primer for executives and managers on working capital management

With limited access to credit and short term funding, it is increasingly important that companies focus on working capital management to free up funds and optimize liqidity. Written in the easy-to-follow Essentials Series style, Essentials of Working Capital Management covers the main components of working capital.

• Covers the latest trends around working capital
• Discusses a range of working capital topics, including cash management, banking relations, accounts receivable, inventory, accounts payable, and foreign exchange
• Analyzes the efficient utilization of current assets and liabilities of a business through each phase of the operating cycle
• Examines the planning, monitoring, and management of the company's collections, disbursements and concentration banking
• Explores the gathering and management of information and forecast data to effectively use funds and identify risk

Focused on how businesses can continue to be successful in these difficult times, specifically in relation to the limited credit available to businesses, this book puts practical guidance at your fingertips so you can put them to work right away. A comprehensive case introduces each major section of the book, and suggested solutions are included in a book appendix.

CHAPTER 1
Concepts in Working Capital Management

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After reading this material you will be able to:

• Understand the concept of working capital.
• Appreciate the components used in managing working capital.
• Determine how ratio analysis is used in understanding working capital.
• Consider traditional and modern ideas of working capital management.

Working capital is the arithmetic difference between two balance-sheet-aggregated accounts: current assets and current liabilities. This calculation is done in a currency, such as U.S. dollars, which is the convention we will be using in this book.

Working Capital Concepts

Both current assets and current liabilities are comprised of several ledger accounts as shown in italics in Exhibit 1.1. For the company presented in this balance sheet—we’ll call it the Rengas Company—the amount of working capital is $425,000, calculated as current assets ($650,000) less current liabilities ($225,000).

Concepts in Working Capital Management

EXHIBIT 1. 1

Description of Working Capital Accounts

The accounts noted in italics are briefly explained below, with chapters of this book devoted to appropriate management procedures.

• Cash accounts and short-term investments. These account categories include cash on hand and in bank accounts, and any short-term investments that are expected to be turned into cash within one year. We’ll review the management of cash in Chapters 2 and 3, and of banking relationships in Chapter 4.
• Accounts receivable. This category of current assets includes all credit sales where the customer is expected to pay by a future date specified on an invoice. Most companies have small amounts of uncollectible credit sales, and an account called ‘‘allowance for doubtful accounts’’ may be deducted from accounts receivable to reflect this experience. We’ll examine receivables in Chapter 5.
• Inventory. Most companies hold some combination of raw materials, work in process (that is, partially manufactured and assembled), and finished goods. There are various accounting practices for valuing inventory and management concepts regarding inventory, which will be discussed in Chapter 6.
• Payables. The accounts payable account represents the amounts owed to creditors for purchases. Payroll is the other significant component of payables. Issues regarding payables will be reviewed in Chapter 7.
• Other working capital accounts. Prepaid expenses and accrued expenses often appear on balance sheets. Prepaid expenses are assets paid in advance of expenses as incurred. For example, insurance is paid in advance of the incurrence of the expense. Accrued expenses are costs that have been incurred as of the date of a balance sheet but not paid. An example is payroll for employees whose expenses have been incurred but not yet paid.

There are numerous considerations in the optimal management of working capital. For example, what are appropriate procedures to manage cash? To reduce accounts receivable? To improve the performance of accounts payable? We will examine these and many other issues throughout this book.

Ideas Basic to Working Capital

Various concepts and conventions are used to explain and illustrate ideas on working capital management.

• The term bank refers to commercial banks, although other financial services companies and some vendors provide many of the services described. Vendors are noted when the relevant topic is discussed; for example, payroll services are provided by four leading firms that are noted in Chapter 7. Freight invoice auditing firms are also discussed in that chapter, but there are so many companies in that business that we have not attempted to list them.
• Float is critical to an understanding of working capital. The concept of float refers to funds in the process of collection or disbursement. While the complete elimination of float is impossible, the calculation of the amount of float is critical in considering alternative processes. For example, in Chapter 2 we will examine the bank product of lockboxing. In deciding on the use of this service, we need to know the potential to save collection float as compared to the current system.
• Concepts that are basic to finance but not defined as working capital are reviewed in Appendix B. These include fixed assets, long-term liabilities and owners’ equity on the balance sheet, and relevant income statement accounts. In addition, we demonstrate the calculation of the cost of capital (also called weighted average cost of capital or WACC), which is used to value float. The WACC is the weighted average of a firm’s cost of debt (after tax) and cost of equity (common stock and retained earnings), and is expressed as a percentage.
• Opportunity audits should be conducted by relevant functions to analyze each element of working capital. For example, in payables, managers examine the percentage of payments made by check, the cost of those transactions, the extent of cash discounts offered and taken, the results of account reconciliation, the incidence of fraud, and other issues. As an essential part of this process, it is useful to document the delays and organizational units involved in the movement of forms, files, and other records including computer systems; see Tips and Techniques: How to Be a Working Capital Consultant.
• Once opportunities for improvement are identified and solutions evaluated, senior management should be consulted for permission to proceed. See Tips and Techniques: How to Overcome Resistance to Change for ideas on coping with internal resistance.

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TIPS AND TECHNIQUES

How to Be Working Capital Consultant

The traditional functional scheme of corporate management— such as sales, manufacturing, finance, and technology—prevents any one manager from having direct responsibility for working capital. Most often the only common manager is the chief executive officer (CEO) or chief operating officer (COO), who seldom has knowledge of or interest in the specific functioning of those activities. In order to better understand and analyze working capital flows, here are the suggested steps in a process often referred to as an opportunity audit.

1. Prepare a ‘‘payment stream matrix’’ listing the working capital flows by name, dollar volume, and manager. The matrix becomes a road map to understanding and improving the business by indicating those major activities that drive short and intermediate-term successes and failures. A working capital flow is an activity of the organization that generates a cash inflow or outflow. Inflows, or collection flows, are often products or services; outflows, or disbursement flows, are accounts payable (to vendors for purchases), payroll, and other uses of cash.
2. Use the matrix to bring other disciplines within your organization into your working capital review. It is usually necessary to involve managers in all of the functional areas of the business, including sales, operations, and finances. Input from customers and vendors can be helpful in understanding how a transaction occurs from their perspective, and to make the process...

Table of contents

• Cover
• Contents
• ESSENTIALS SERIES
• Title Page
• Copyright Page
• Preface
• Acknowledgements
• CHAPTER 1: Concepts in Working Capital Management
• PART I: CASH—TRANSACTIONS, BANKING AND CREDIT, AND FINANCIAL INSTRUMENTS
• PART II: OTHER WORKING CAPITAL ACCOUNTS— RECEIVABLES, INVENTORY, AND PAYABLES
• PART III: ISSUES IN WORKING CAPITAL MANAGEMENT
• APPENDIX A: Suggested Solutions to Widget Manufacturing Company Case—Parts I, II, and III
• APPENDIX B: Basic Financial Concepts
• APPENDIX C: Web Sites of Working Capital Market Participants
• APPENDIX D: Glossary
• About the Author
• Index