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 inventories? How do cyclical and seasonal trends affect the company’s operating cycle, the cash conversion cycle, and investments in current assets? These strategic policy questions relate to 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 of the relevant and existing academic literature on effective working capital management and provide operational guidance to small businesses. The shorter the cash conversion cycle, the smaller the size of the company’s investment in inventory and accounts receivable and, consequently, the smaller the company’s financing needs. Although establishing ending cash balances is largely critical, some analytical rules can be applied to aid effective making of better judgments and optimizing cash flow management.
As you know, a correlate with cash is net working capital. Net working capital is not cash, but rather the difference between current assets (what a company currently owns) and current liabilities (what a company currently owes). Current assets and current liabilities are sources and immediate uses of the company’s cash, respectively. Clearly, the ability of a business to meet its current financial obligations (bills 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 regular management of cash flows, inventories, accounts receivable, accruals, and accounts payable. And because poor management of working capital can seriously damage a company’s creditworthiness and limit its access to the money and capital markets, every effort should be made to minimize the risk of business default.
The importance of liquidity cannot be overstated. Additionally, anything that negatively affects a company’s financial flexibility degrades its ability to borrow and deal with unexpected financial difficulties. A business must preserve its ability to react to unexpected expenses and investment opportunities. Financial flexibility stems from a company’s use of leverage and cash.
In practice, optimal working capital management includes the effective cash conversion cycle, the effective operating cycle, the determination of the appropriate level of accruals, inventories and accounts payable, and the corresponding financing options. The working capital policy affects the company’s balance sheet, financial ratios (current assets and quick assets), and possibly credit rating. Fundamental to the efficient management of a company’s working capital is a good understanding of its cash conversion cycle, or how long it takes for a company to convert invested cash into received cash operations.
The cash conversion cycle captures the time elapsed from the start of the production process to the collection of cash from the sale of finished products. Typically, a company buys raw materials and creates products. These products go into inventory and are then sold on account. Once products are often sold on credit, the company waits to receive payment, at which point the process begins anew. 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 pay period, the average collect period, and the average age of inventory. The operating cycle of the company is the time that elapses from receipt of raw materials to collection of payment for products sold on account. Therefore, the operating cycle is the sum of the inventory conversion period (the average time between when raw materials are received in inventory and the product is sold) and the accounts receivable conversion period ( the average time between a sale and the collection of the receipt). Note that the operations of a merchandising business involve purchasing (the purchase of merchandise), sales (the sale of products to customers, and collection (the receipt of cash from customers).
Some operational guidance:
There is a body of empirical evidence to suggest that effective working capital management begins with evaluating the operating cycle and optimizing cash flows from business operations. Management must know, understand, and anticipate the impact of cash flows on business operations and their ability to maximize the profit-producing capacity of the business. Effective cash management is critical to the success of a business enterprise. It’s about cash flows.
One of the best ways to increase cash availability is to speed up the receipt of incoming payments by reducing the aging of accounts receivable using the right combination of incentives and penalties. A business must evaluate current payment processes and identify effective options to speed up the collection of accounts receivable.
There is strong evidence to suggest that improving payment processes and switching 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, a careful analysis of cash flows and an evaluation of investment strategies and policies are required to ensure that a company has the appropriate tools necessary to maximize the company’s liquidity and optimize cash flow management.
A company optimizes cash flow management in its operating cycle by streamlining, simplifying, and improving the way it handles incoming cash receipts, making outgoing cash payments, and minimizing 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 the ending cash balance (the difference between total cash inflows and total cash outflows). The goal is a positive or ascending periodic ending cash balance; Monitor customer balances to manage accounts receivable (money owed to the company by customers); and proper prequalification processes before granting credit to clients are essential to minimize the incidence of bad debts.
A tracking system that monitors 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 constant cash flows; Reduce the speed of cash disbursements: Prudent cash flow management dictates that a business holds cash for as long as possible. Optimize cash flow management by paying on time and using all adaptations that are consistent with your financial advantage calculation. Finally, borrow long-term and long-term and short-term loans for large 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 mature.