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Importance of working capital

Small trade or business plays an important role in the economy any country. They plays a vital role in the creation of employment and enterprise culture. The small business failure rate is very high as compared to large businesses. It has been verified from studies that in the United Kingdom and United States the small business are week due to lack of management of working capital and inadequate financial management of long-term financing and this is the root cause of failure among the small businesses. Atrill.P. (2001).

According to Lindley.M.L,Harvey.A.D.(1990),working capital of a business imitate in the form of short-term uses of funds in an organization. Shot term funds can be consider as a term with in a year, thus the funds complete cycle within a year called short term working capital. The working capital cash which company used to obtain raw material or render services and then when utilized the result will come in inflow of cash. it is common the utilization of stock and in result of sales obtain a sufficient amount of cash thus required working capital. The cycle of working capital required control and planning.

Nach.R. et.al. (2003), working capital is the division of assets and liabilities into current and non current allows working capital. Working capital can be used to calculate the ability of an entity to repay obligations.

Dunn.E.P (2001) explains that in need of two types of capital in any organization. First is called fixed asset capital which is related to heavy investments those are being made in any organizations. Second working capital is a flexible cash and it moves up and down with the activities of businesses. Working capital cycle can be link with the cash operating cycle. Working capital of any organization consist on short term net assets, such as debtors, cash flow, less creditors. Working capital management needs to do management on current assets and current liabilities in all aspects. The companies can low down their risk of insolvency by maximizing return on their assets.

Working capital Management:

According to Atrill.P. (2001), working capital management is essential to the business financial health without regard to its size whether the firm is large or small. Organizations invest working capital in their business that are very high in proportion compared to the proportion to the other total assets employed so, therefore it is a matter of responsibility to use in to an efficient and effective way. Mostly small businesses are good at managing its working capital. it is imperative to control tight on the cash flow.

Working capital Planning:

Working capital of an organization can be defined as current assets and current liabilities. Cash flow of an organization is considers when managers would like to take any decisions. For the working capital management the decisions would be taken to control credit policies. In other words, organizations review its working capital by reviewing its policies every year for that has taken for credit policies.

Management take into account the assessment of its working capital by reviewing the credit given to customers, taken from their suppliers, the cost of stock holding and the ratios of cash inflows and out flows. It has been proved from research that the main objectives of small firms is survival and there stability rather than profit maximization. Cash flow information of any organization was mainly taken into account and it is important for external bodies such as banks and for the performance evaluation.

(FINANCIAL ACCOUNTING AND REPORTING B)

RRY ELLIOTT JAMIE ELLIOTT SIXTH EDITION 2001-2002)

The working capital of any organization is tied up in raw material or in finished goods.

INVENSTMENT IN RAW MATERIALS:

Particularly production and manufacturing facilities tied up their mainly capital in their raw materials those goods which are not transformed in to the productive process.

Types of physical stock:

Safety or buffer stock: The basic understanding of safety stock is that it prevents for any interruption of production which usually results from being run out of stocks.

Purchase of economies: The companies usually buy a bulk quantity for economies of scales in terms of large quantity discounts. Some of the raw material like coke does not need any shelter space for storage. In reflection of that some of the material needs storage space and that cost companies so companies tradeoff the quantity discounts with holding cost.

Stock holding cost: Stock holding cost of raw material has significance in formation of optimum inventory level.

Rate of production: The rate of production is depends on the planned changes in production and changing the sales volume with corresponding changes in production rate will result in stocks significantly above or below the planned level.

Cost and availibility of funds: In any activity there is an opportunity cost involved. Availability of funds are limited and the firms are limited to use those funds on stocks and some times opportunities gone. In changing customer behavior and demand there is an uncertainty in to keep the optimum level of stock while minimize the demand risk or narrow your market. Normally companies use the external rate of interest to measure an opportunity cost.

The investment in work in progress:

The are two type of inventory the second

The flow of Working capital:

Effective working capital management wants to imitate its dynamic nature and its individual components. Working capital is as a whole and as a individual component element is The composition of working capital as a whole, and of its component elements, is regularly shifting. Working capital can be demonstrated by the assets and liabilities of business and it is categories in the following.

Debtors: Debtors of organizations are those who Individual debtors appear when firms start credit sales on credit terms and conditions. Debtors however, remain exist as an asset until the account has not been cleared or settled down. debt. At the time of settlement of account the following cash been turned in to another term which is called working capital. Credit sales of an organizations creates new debtors every time.

Creditors: Creditors are formed when purchases are being made in respect of purchases are made on credit terms. Those outstanding amounts are liabilities of the companies and acquired cash until it is settled, and it is change in another term called working capital-cash, being made from credit purchases. It is an ongoing process as new credit purchases or funding transactions made finally it is resulting in a creation of new creditors.

Cash and Bank: Usually cash and banks positions are continuously change on daily firms receipts and payments. The changing positions of cash at bank are associated with working capital, in due course these are connected with purchases of fixed assets, payments and fundings.

The challenging aspect that face any management is constantly controlling the elements of working capital. The elements of working capital are constantly move in a cycle of purchases, sales payments, credit or cash terms. The business cycle includes from the transformation process through sale of a finished goods or services to the end user or customer. The business cycle can be understood by the following figure with the help of given components which relates to the integrated elements of working capital.

Working capital Cash Flow

Inventory Transformation period

Debtors

Collection

period

Creditor

Deferral period

Purchases of

resources

~Payment of

Creditors

Sale of Output

Payment of debtors

The working capital cycle given us an understanding of link between the integrated elements of working capital those who work together for the success of the business and complete business cycle. The business cycle starts from the purchases of the raw material or input components which then transformed into to another elements. The following are the business cycle elements of business cycle are:

Inventory transformation period: this is the period of time from the purchase of the input resources (eg. raw material), through the transformation process (manufacturing and holding of finished product), to the point where the finished product is sold to the customer. This period will vary from sector to sector; it could be very short, particularly the age of materials is an important factor. The end of the inventory transformation period( the sale of finished goods) represents the commencement of the next element of the cycle.

Debtors Collection period:

This is the period of time between the point of sale and the receipt of cash from the customer. In the case of cash sales this period will be effectively zero. In the case of credit sales it can be substantially longer, depending, at least in part on the customary terms of trade in this particular industrial sector.

Creditor deferral period:

This is the period of time between the purchase of the resource input and the payment to the supplier. In the case of cash purchases it is effectively zero. In the case of credit purchases it may represents a substantial period of time. In the U.K companies often take two to three months, or more to pay their suppliers. The end of creditor deferral period, with the outflow of cash to the supplier, is the commencement of the final element of the working capital cycle, the cash-conversion period. The represents the period of time between the outflow of cash to suppliers and the inflow of cash from customers. In general term, an enterprise would prefer to have a shorter rather than a longer cash-conversion period, because by doing so it would be reducing the time that it had cash investment in short-term productive assets. A core objective of management of working capital must be the reduction of the cash-conversion period. While this must be an important objective, it must be tempered by the objectives relating to the reasons why inventory is held at all, why credit terms are give to customers and why credit is taken from suppliers.

Reference:

Accounting for managers JOHN GLYNN, JOHN PERRIN & MICHAEL MURPHY SECOND EDITION.

Pike.R, Neale.B. (2006), said that the treasure is a person, who is nominated for this job, deals with major finance decision. The investment could be in terms of small, long and short term decisions. There are several ways in which the firm or organization can invest surplus money by depositing money in bank or buy instruments or in case of manufacturing concern they tied up money in inventories to get higher returns.

In order to increase profitability however and continue the business usually organizations put monies into raw material and partially finished goods. Firms invest their monies into raw material to get quantity discounts from their suppliers, but at optimum level because money always has an opportunity cost. Managers’ responsible for production or services are responsible for output and work in progress (WIP) inventory are needed at an optimum level to prevent from run out of stocks. Example. Production stoppage and lost sales.

The following example has been taken from McCosker.P. (2000),

Dublin limited has provided the following information based upon the year 31 January 1999.

Credit Sales £1,200,000

Credit purchases £650,000

Average stock £80,000

Average debtor £200,000

Average creditors £54000

With the help of few examples ratios we can calculate the length of Dublin’s working capital cycle as follows:

We can use the stock days ratio to calculate the average length of time that goods remain in stock.

Average Stock * 365 days= 80,000 * 365 = 45 days

Credit purchase £650,000

The average time taken for cash to be collected from a credit sale is calculated as

Average debtors *365days=200, 000*365=61 days

Credit sales £1,200,000

The working capital cycle for Dublin Ltd can be summarized as follows:

Stock received today is held for 45 days

Less:

Credit period offered by supplier 31days

14 days

Add:

Credit period offered to customers 61 days

Length of working capital cycle 75 days

The longer the cycle of working capital the greater the level of resources tied up in working capital From the above example of Dublin they could have reduce the stock turn over and debtors collection period in the same manner each as just five days, its investment in working capital would fall as follows.

Stock £71,000

Debtors £184,000

A savings of £25,000

3 The optimum level of working capital

According to McCosker.P. (2000), It has been suggested that those organizations have 2:1 ratio difference in current assets to current liabilities is essential to ensure that the firm’s will not face cash flow trouble.

However, the working capital requirement is depend on company to company or industry to industry.

Table 2: Comparison of working capital by industry

 

Tesco y/e

Airtours y/e

Man Utd y/e

 

28/2/98

30/9/98

31/7/97

 

£m

£m

£000s

Current assets

Stock

584

17.0

3,565

Debtors

133

413.8

10,731

Short terms investments

196

11.1

22,400

Cash at bank and in hand

29

364.2

23,244

 

942

806.1

59,940

Creditors: amounts falling due within one year

2,712

802.0

29,468

Working capital

1,770

4.1

30,472

Profit on ordinary activities before taxation

832

140.3

27,577

Current ratio

0.35

1.01

2.03

Acid test

0.13

0.98

1.91

Cash to current liabilities

0.01

0.45

0.79

Source: The importance of working capital McCosker.P. (2000)

The above table shows that the all three plc companies are successful in there business and profitable. It is shown in the above table that Manchester United meet up the current ratio of 2:1 which is suggested according to finance point of view. However, Tesco plc calculation shows some trouble because 35 pence of current assets and 13 pence of quick assets is flashing on every £1 current liabilities. Tesco is covering one pence for every £1 of current £1 of current liabilities and that suggest that Tesco would might suffer liquidity problems. Mean time Tesco is a big brand and consider as a big super market chain in the United Kingdom with the network of more than 600 stores and the annual profit on ordinary activities before taxation in excess of £800 million.

If we have another look on Airtours it shows short of the suggested current ratio of 2:1, although quick asset ratio of 1:1 is satisfactory. Figure shows 2:1 ratio is inappropriate, and the organization will depend on the life of the business and the trade in which it is operating Each of our plc’s is profitable and is considered successful in its field. However, it is apparent from Table 2 that only Manchester United plc meets the 'suggested' current ratio of 2:1. Indeed Tesco appears to be in real trouble with only 35 pence of current assets and 13 pence of 'quick' assets for every £1 of current liabilities. Worse still, if we consider the ratio of cash to current liabilities, Tesco has only one pence of cash coverage for every £1 of current liabilities suggesting severe liquidity problems. Yet Tesco is the largest supermarket chain in the UK with over 600 stores and an annual profit on ordinary activities before taxation in excess of £800 million.

Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets ratio of 1:1 is satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the amount of working capital required by an organisations will vary depending upon the nature of its business and the industry in which it is operating.

The working capital of Tesco is low and if look at the nature of the business Million or Billions of customers throughout the U.K everyday purchase their groceries from Tesco by paying for their goods in cash before leaving the tills.

The items sold in Tesco have a different shelf life depend on the classification of the product. Being a market leader Tesco rely on daily deliveries of stock for the replenishment from their supplier at interval of time. Additionally the forecasting enables managers to predict orders from daily sales levels. The nature of the business enables Tesco to run business on an optimized level of stock.

The most of the sales in Tesco is on cash as compare to credit card purchases, the number of debtors are low. The company can think to invest surplus cash balances in short term investments for maximizing the return to its investors.

If we think about Tesco liabilities buying at Tesco is on credit terms indeed the stock sold on cash released profit before payments are matured. Tesco even pays its suppliers. Creditors include corporation tax and dividends, the cash on which Tesco knows when these are going to be paid.

Going through the nature of the business it is knew that majority of the cash sales, very few Account receivables, optimized level of stock and most of the replenishment is on credit basis does not shows a problem and Tesco is able to run with negative working capital.

If we look to Airtours, the customer normally pays in advance for their holidays it is clearly that cash flow is not a matter of thing and they can also minimize there bad debts. Tesco, Airtours sales can be consider a seasonal during the period January to June. Now it’s a matter of consideration that at this point planning is necessary because it ensure that they will be able to pay to their creditors or minimize its current liabilities.

And being a tour operator, the level of stocks are relatively low. Company debtors always compromise amounts which paid in advance in order to book the hotels and accommodation so customers always pay in advance.

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