How do companies choose their operating cycle? How do companies choose their cash conversion cycle? What is the impact of the company’s operating cycle on the size and timing of investments in accounts receivable and inventory? How do seasonal and cyclical trends affect the company’s operating cycle, cash conversion cycle, and investments in current assets? These strategic policy issues relate to the optimal timing of cash flows and effective working capital management designed to maximize the wealth-producing capacity of the firm.
In this review, we will examine some relevant and existing academic literature on effective working capital management and provide operational guidance for small business enterprises. The shorter the cash conversion cycle, the smaller the size of the company’s investment in inventories and accounts receivable, and consequently, the smaller the company’s financing needs. Although establishing ending cash balances is largely a judgment, some analytical rules can be applied to help effectively make better judgments and optimize cash flow management.
As you know, a correlation to cash is net working capital. Net working capital is not cash, but rather the difference between current assets (what a business currently owns) and current liabilities (what a business currently owes). Current assets and current liabilities are the firm’s immediate sources and uses of cash, respectively. Clearly, a company’s ability to meet its current financial obligations (invoices due within a year) depends on its ability to manage its current assets and liabilities efficiently and effectively.
Effective working capital management requires the formulation of an optimal working capital policy and the regular management of cash flows, inventories, accounts receivable, accruals, and accounts payable. And because poor working capital management can severely damage a company’s solvency and limit its access to money and capital markets, everything possible must be done to minimize the risk of business default.
The importance of liquidity cannot be overstated. In addition, anything that negatively affects a company’s financial flexibility degrades its ability to borrow and weather unexpected financial difficulties. A company must preserve its ability to react to unexpected expenses and investment opportunities. Financial flexibility derives from a company’s use of leverage as well as cash holdings.
In practice, optimal working capital management includes an effective cash conversion cycle, an effective operating cycle, determination of the appropriate level of accruals, inventories, and accounts payable, and the corresponding financing options. Working capital policy affects a company’s balance sheet, financial ratios (current and quick assets), and possibly credit rating. Critical to efficient business working capital management is a good understanding of its cash conversion cycle, or how long it takes a business to convert cash invested in operations into cash received.
The cash conversion cycle captures the time from the start of the production process to the collection of cash from the sale of finished goods. Typically, a company buys raw materials and creates products. These products go into inventory and are then sold on account. Since products are often sold on credit, the company waits to receive payment, at which point the process starts all over again. Understanding the cash conversion cycle and the aging of accounts receivable is critical to successful working capital management.
As you know, the cash conversion cycle is divided into three parts: the average payment period, the average collection period, and the average inventory age. The operating cycle of the company is the time that elapses from the receipt of raw materials to the collection of payment for products sold on account. Thus, the operating cycle is the sum of the inventory conversion period (the average time between the receipt of raw materials into inventory and the sale of the product) and the accounts receivable conversion period (the average time between a sale and receipt collection). Keep in mind that the operations of a merchandising business involve purchases (the purchase of merchandise), sales (the sales of products to customers, and collections (the receipt of cash from customers).
Some operational guidelines:
There is increasing empirical evidence to suggest that effective working capital management begins with evaluating the operating cycle and optimizing cash flows from company operations. Management must know, understand, and anticipate the impact of cash flows on the company’s operations and its ability to maximize the company’s profit-producing capacity. Effective cash management is critical to the success of a business venture. It’s all about cash flows.
One of the best ways to increase cash availability is to speed receipt of incoming payments by reducing the age of accounts receivable using an appropriate mix of incentives and penalties. A company must evaluate current payment processes and identify effective options to expedite the collection of accounts receivable.
There is strong evidence to suggest that improving payment processes and moving to electronic alternatives will maximize liquidity and better manage accounts receivable costs. Liquidity is critical to the success of any business venture and effective cash management is at the core of liquidity. In practice, careful analysis of cash flows and evaluation of investment strategies and policies are required to ensure that a company has the right tools necessary to maximize company liquidity and optimize cash flow management.
A business optimizes cash flow management in its operating cycle by streamlining, streamlining, and improving the ways it manages cash inflows, makes cash outflow payments, and minimizes the aging of accounts receivable . A company needs digital records, electronic banking, strong internal controls and agile accounting systems for quick reconciliation of bank statements through timely access to bank accounts, customer records; and synchronize cash flows, accounts payable, and accounting systems to increase efficiency.
Industry best practices include analyzing monthly cash flows to determine ending cash balance (the difference between total cash inflows and outflows). The goal is a periodic increasing or positive ending cash balance; Monitor customer balances to manage accounts receivable (money owed to the business by customers); and proper prequalification processes before extending credit to customers are essential to minimizing the incidence of bad debts.
A tracking system that tracks outstanding accounts receivable and sends automatic reminders, invoices, and statements is a useful tool. Some companies use factors by selling their accounts receivable to factoring companies to ensure steady cash flows; Decreased Cash Outlays – Prudent cash flow management dictates that a business hold onto cash as long as possible. Optimize cash flow management by paying on time while using all the accommodations according to the financial advantage calculation. Lastly, borrow long term and lend short term and time big expenses by setting aside small amounts to finance large anticipated expenses. Always remember that long-term liabilities become current liabilities in the accounting period in which they come due.
