Working Capital Policies

A company needs to closely monitor its working capital levels in order to keep its cash requirements firmly in check. It can do this most effectively by instituting and enforcing a number of policies. The following working capital policies are sorted by the component of working capital that they most directly affect. Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Simply put, it is all the things you need for the process of production. The name probably gives you a little clue there. The capital, the resources which are required for the process of production is known as working capital. So to this end, what items do you include in your working capital requirement calculation? Commonly included items are a mix of current assets and current liabilities. On the assets side, we have debtors, inventory, cash and bank accounts and on the liabilities side there are creditors and short term loans if any. While the contents of what comprises the working capital of the company may differ from one company to the other, a standard rule of thumb for assumption of the capital includes all the above heads. The working capital ratio is the ratio of current assets to current liabilities and is commonly equal to 2:1. The working capital is then calculated as the difference between the current assets and the current liabilities. A well accepted norm is that the current assets need to be more than the current liabilities. Why? Because should the current liabilities mature, the company needs to be in a position to pay them off, without troubling the fixed assets. As long as the current assets exceed the current liabilities, these liabilities can be paid of when the time comes. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash

Calculation
Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

accounts receivable (current asset) inventory (current assets), and accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a shortterm claim to current assets and is often secured by long term assets. Common types of shortterm debt are bank loans and lines of credit. An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilitiesfor example has paid off some short-term creditors. Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to: Current Assets Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances. Cash balance items often attract a one-for-one, purchase-price adjustment

Working capital management

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 shortterm 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

Decision criteria
By definition, working capital management entails short-term decisionsgenerally, relating to the next one-year periodwhich are "reversible". These decisions are therefore not taken on the same basis as capital-investment decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.

One measure of cash flow is provided by the cash conversion cyclethe net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE) shows this result for the firm's

shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See economic value added (EVA).

Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.

Management of working capital

Guided by the above criteria, 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.

Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management. 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. 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 - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity 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); see Discounts and allowances. 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".

Appropriate working capital policies are: Cash Policies

Do not invest funds in illiquid investment vehicles. Even if a long-term investment opportunity offers the opportunity for outsized returns, do not make the investment unless you are sure there are sufficient funds on hand to support all reasonable working capital needs during the period when the funds will be tied up in the investment. No investment duration shall exceed the forecasting period. If you are willing to tie up cash in somewhat illiquid investments, then at least keep from making investments that

cannot be accessed for periods longer than what the company is currently forecasting. Otherwise, the company may find itself with a large cash requirement and no funds available to offset it. Accounts Receivable Policies

Do not allow payment terms greater than __ days. Do not allow the sales staff to offer terms to customers that exceed a specific number of days without prior approval by a senior manager. The maximum credit offered a customer is ___. Use a formula that best fits your industry to arrive at a reasonable maximum amount of credit to offer customers, over which a senior manager must approve the terms. Stop customer credit once days outstanding exceed __ days. This policy is designed to keep additional credit from being extended to a customer who is not paying in a timely manner.

Inventory Policies

Review inventory on hand exceeding __ days of usage. It is exceedingly difficult to adopt rules that will minimize inventory, but consider this policy to bring excessive inventory levels to the attention of management. Adopt just-in-time purchasing on qualified raw materials and merchandise. This policy is designed to minimize on-hand inventories by making purchases as late as possible and having items delivered in small quantities. Drop shipped inventory is the preferred stocking method. This policy shifts inventory ownership to the company's suppliers, who ship directly to the company's customers on its behalf.

Accounts Payable Policies

Do not pay accounts payable early. Adopt a monitoring system that highlights any payment made earlier than the due date required by the supplier. Require purchase orders for amounts exceeding $___. This policy enforces an examination of larger expenditures before they are actually made. Disallow purchases exceeding the department budget. If a manager commits to a specific expenditure level for his department, then do not allow expenditures above that level without approval by a senior manager.

The level of aggressiveness of working capital polices depends to a considerable extent upon the availability of a large, untapped line of credit. If this is available, then a company can risk an occasional negative cash situation, since cash can be readily replenishe The Importance of Managing and Accumulating Working Capital Working capital is the amount of the firms current assets: cash, accounts receivable, marketable securities, inventory and prepaid expenses.

 Managing the level and financing of working capital is necessary: to keep costs under control (e.g. storage of inventory) to keep risk levels at an appropriate level (e.g. liquidity) Net Working Capital = Current Assets - Current Liabilities Determining the Correct level of Working Capital Balance Risk & Return Benefits of Working Capital Higher Liquidity (Lowers Risk) Costs of Working Capital Lower Returns - $$ invested in lower returning securities rather than production. Example: Risk-Return Trade-off Different Approaches to Financing Conservative Approach Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets. Lower risk, lower return Moderate Approach (Maturity Matching) Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds. Moderate risk, moderate return Aggressive Approach Finance all temporary current assets, permanent current assets, and some fixed assets with ST debt. LT financing is used for the remaining fixed assets. Higher risk, higher return