Eoq Formula For How Much Will Fit On A Truck Making Your Working Capital Work

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Making Your Working Capital Work

The faster your business expands, the greater the need for working capital. If you have insufficient working capital—the money needed to run your business—your venture will fail. Many businesses, which are profitable on paper, are forced to “close their doors” because they cannot meet short-term debts when they come due. However, by implementing good working capital management strategies, your enterprise can thrive; In other words, your property is working for you!

At one time or another, most businesses need to borrow money to finance their growth. The ability to get a loan is based on the creditworthiness of the business. The two major factors that determine loan eligibility are the existence and extent of collateral and the liquidity of the business. Your company’s balance sheet is used to evaluate both of these factors. On your balance sheet, working capital represents the difference between current assets and current liabilities—the capital you currently have to finance operations. That number, along with your core working capital ratio, indicates your ability to pay your bills to creditors.

By definition, working capital is a company’s investment in current assets—cash, marketable securities, accounts receivable, and inventory. The difference between a company’s current assets and current liabilities is called net working capital. Current liabilities include accounts payable, accrued expenses, and the near-term portion of loan or lease payments. The term “current” is generally defined as those assets or liabilities that will be liquidated within one business cycle, usually one year.

Decisions regarding working capital and short-term financing are called working capital management. These decisions involve managing the relationship between the company’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that your company is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operating expenses.

The true test of a company’s ability to manage its financial affairs depends on how it manages the conversion of its assets into cash that will ultimately pay its bills. The ease with which your company can convert its current assets (accounts receivable and inventory) into cash to meet its current liabilities is called “liquidity.” Relative liquidity is calculated as a ratio—the ratio of current assets to current liabilities. The rate at which accounts receivable and inventory are converted to cash affects liquidity. All other things being equal, a business with a higher ratio of current liabilities to current assets is more liquid than a company with a lower ratio.

Most business activities affect working capital by consuming or producing working capital. A company’s cash goes through various stages in the working capital cycle. The working capital cycle begins with the conversion of cash into raw materials, then the conversion of raw materials into products, the conversion of products into sales, the conversion of sales into accounts receivable, and finally the conversion of accounts receivable into cash.

The primary objective of working capital management is to reduce the time it takes for money in the working capital cycle. Obviously, the longer it takes for a company to convert their inventory into accounts receivable, and then, convert their receivables into cash, the greater the cash flow difficulties. Conversely, the shorter the company’s working capital cycle, the faster the cash and profit from credit sales.

Proper cash flow forecasting is essential for successful working capital management. To understand the magnitude and timing of cash flows, it is important to plan cash flows with the use of cash flow forecasting. A cash flow forecast provides you with a clear picture of your cash resources and the expected date of their arrival. Identifying these two factors will help you determine “what” you spend cash on, and “when” you need to spend it.

Management of working capital includes managing cash, inventory, accounts receivable, accounts payable, and short-term financing. Because the following five working capital processes are interrelated, decisions made within each discipline can affect the other processes, and ultimately affect your company’s overall financial performance.

  • Cash Management: Cash management is the efficient management of cash in a business to put cash to work faster and to put cash into revenue generating applications. Using banking services, lockboxes and sweep accounts provide both quick credit of funds received, as well as, interest income generated on deposits. Lockbox service includes collecting, sorting, totaling, and recording customer payments while processing and making required bank deposits. A sweep account is a prearranged, automatic “sweep” — by the bank — of funds from your checking account into a higher-interest-bearing account.
  • Inventory Management: Inventory management is the process of obtaining and maintaining proper assortment of inventory while controlling the costs associated with ordering, storage, shipping, and handling. The use of Economic Order Quantity (EOQ) systems and Just-In-Time (JIT) inventory systems provides uninterrupted production, sales, and/or customer-service levels at the lowest cost. EOQ is an inventory system that indicates the quantities to be ordered—which reflect customer demand—and minimizes total ordering and holding costs. An EOQ inventory system employs the use of sales forecasts and historical customer sales volume reports. A JIT inventory system relies on suppliers to ship products for just-in-time arrival of raw materials on the production floor. A JIT system reduces the amount of storage space required and lowers the dollar level of inventories.
  • Accounts Receivable Management: Accounts receivable management enables you, the business owner, to manage your entire credit and collection process intelligently and efficiently. Greater insight into a customer’s financial strength, credit history, and trends in payment patterns is paramount to reducing your risk for bad credit. While a comprehensive collection process (CCP) can greatly improve your cash flow, strengthen entry into new markets, and develop a broader customer base, CCP depends on your ability to establish appropriate lines of credit and make well-informed credit decisions quickly and easily. Your ability to quickly convert your accounts receivable into cash is possible if you implement well-defined collection strategies.
  • Accounts Payable Management: Accounts Payable Management (APM) is not just about “paying the bills.” APM is a system/process that monitors, controls and optimizes the money a company spends. It is whether or not money is spent on direct inputs to goods or services, such as raw materials that are used in the manufacture of products, or money spent on indirect materials, office supplies or miscellaneous expenses that are not direct factors. In a finished product, the objective is a management system that not only saves you money, but also controls costs.
  • Short Term Financing: Short-term financing is the process of securing funding for a business for a short period of time, usually less than a year. The primary sources of short-term financing are trade loans between companies, loans from commercial banks or finance companies, factoring of accounts receivable and business credit cards. Trade credit is a convenient source of financing arising from normal business transactions. In a prearranged contract, suppliers ship goods or provide services to their customers, who pay their suppliers at a later date.

It is a wise investment of your effort/time to pre-arrange to establish a revolving line of credit with a commercial bank or finance company. In the event you need to borrow cash, the funds will be readily available. By arranging a line of credit prior to capital (cash) needs, your company will not experience sales or production disruptions due to cash shortages.

Factoring is short-term financing obtained by selling or transferring your accounts receivable to a third party – at a discount – in exchange for immediate cash. The percentage discount depends on the age of the receivables, how complicated the collection process will be, and how collectible they are.

Business credit cards are quick and easy and eliminate fund approval. If you receive damaged goods or fail to receive merchandise that you have already paid for, using your business credit card will also protect you from losses. Depending on the type of credit card you choose for your business, you can earn bonuses, frequent flyer miles and cash back. However, keep a close eye on your spending and pay off more of your debt each month.

To effectively manage working capital, it is wise to measure your progress and control your processes. A good rule of thumb is — if you can’t measure it, you can’t control it. Five working-capital ratios to help you evaluate and measure your progress are:

  1. Inventory Turnover Ratio (ITR): ITR = Cost of Goods Sold / Average Value of Inventory. ITR indicates how quickly you are turning over inventory. This ratio should be compared to the average within your industry. A low turnover ratio indicates poor sales, and therefore, excess inventory. A high ratio indicates either strong selling or ineffective buying.
  2. Receivables Turnover Ratio (RTR): RTR = Net Credit Sales / Receivables. RTR indicates how quickly your customers are returning payments for products/services rendered. A high ratio indicates that the company operates on a cash basis or that its credit extension and collection of accounts receivable are efficient. A low ratio implies that the company should re-evaluate its credit policies to ensure timely collection of non-interest-earning loans for the firm.
  3. Payables Turnover Ratio (PTR): PTR = Cost of Sales / Payables. Calculate this ratio to determine how quickly you are paying your vendors. If you are consistently beating the industry standard, you may benefit from negotiating discounts or other favorable terms.
  4. Current Ratio (CR): CR = Total Current Assets / Total Current Liabilities. CR is primarily used to determine a company’s ability to repay its short-term liabilities (debts and payables) with its short-term assets (cash, inventory, accounts receivable). The higher the current ratio, the more able the company is to pay its liabilities.
  5. Quick Ratio (QR): QR = (Total Current Assets – Inventory) / Total Current Liabilities Also known as the “acid test ratio”, QR predicts your immediate liquidity more accurately than the current ratio because it takes into account the time required. Convert inventory to cash. The higher the QR, the more liquid the company is.

Working capital management is critically important to small businesses because a large portion of their debt is in short-term liabilities versus long-term liabilities. Small businesses can reduce their investment in fixed assets by leasing or renting plant and equipment. However, there is no way to avoid investments in accounts receivable and inventory. Therefore, current assets are especially important to the small business owner. By effectively shortening the working capital cycle, you become less dependent on outside financing. In other words, your working capital is actually working for you.

Copyright 2008 Terry H. Hill:

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