Management of working capital is other name of Short term financing . ( current assets less current liabilities ). One of the main aims is to reduce the amount of short term finance that companies need to borrow for their day to day operations. The more money that is tied up in current assets, the more capital is needed to finance those current assets. Essentially, as well as using its working capital as efficiently as possible, a company may use short term borrowings to finance its stock, debtors or cash needs.
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Companies will try minimize their levels of working capital so as to avoid short-term borrowing. Here we look at the main elements of efficient working capital management and three important techniques be used to control working capital levels.
Cash Element in Short Term Financing
Cash is the lifeblood of a business. Companies need cash to survive. Businesses will try to keep enough cash to manage their day-today business operations. (For example purchase stock and pay creditors), but not to maintain excessive amounts of cash. Businesses prepare cash budgets, which enable them to forecast the levels of cash that they will need to finance their operations. They may also use the liquidity and quick ratio to assess their level of cash. If despite careful cash management the business’s short-term cash requirements are insufficient then the business will have to borrow
Debtors Elements in Short Term Financing
Debtors management is a key activity within a firm. It is often called credit control. Debtors result from the sale of goods on credit. There is, therefore, the need to monitor the receipts from debtors to see that they are in full and on time.
There will often be a separate department of the business concerned with credit control. The credit control department will, for example, establish credit limits for new customers, monitor the age of debts and chase up bad debts. In particular, they may draw up a debtors age schedule. This will profile the age of the debts and allow old debts to be quickly identified.
Debtors Collection Model
A useful technique designed to maintain the most efficient level of debtors for a company is the debtors collection model. A debtors collection model balances the extra revenue generated by increased sales with the increased costs associated with extra sales(i.e., credit control costs, bad debts and the delay in receiving money).
The model assumes that the more credit granted the greater the sales However, these extra sales are offset by increased bad debts as the business sells to less trustworthy customers. Whether the delay in receipts means that the business receives less interest or pays out more interest depends on whether or not the bank account is overdrawn. Usually, the cost of capital is used to calculate the financial costs of the delayed receipts.
Stock in Short Term Financing
For many businesses, especially for manufacturing businesses, stock is often an extremely important asset. Stock is needed to create a buffer against excess demand, to protect against rising prices or against a potential shortage of raw materials and to balance sales and production.
Stock control is concerned not primarily with valuing stock, but with protecting the stock physically and ensuring that the optimal level is held. Stock may be stolen or may deteriorate.
For many businesses such as supermarkets the battle against theft and deterioration is never- ending. A week-old lettuce in a supermarket is not a pleasant asset!! For supermarkets, stock can also be a competitive advantage.
Two common techniques associated with efficient stock control are:
- The economic order quantity model
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Just-in-time was developed in Japan, where it has an an method deliveries of stock control. It seeks to minimize stock holding costs by the careful timing of deliveries and the efficient organisation of production schedules. At its best, just-in-time works by delivering stock just before it is used. The amount of stock is thus kept to a minimum and stock holding costs are also minimized. In order to do this, there is a need for a very streamlined and efficient production and delivery service. The concept behind just-in-time has been borrowed by many UK and US firms. Taken to its logical extreme, just-in-time means that no stocks of raw materials are needed at all. One potential problem with just-in-time is that if stock levels are kept at a minimum there is no stock buffer to deal with unexpected emergencies. For example, in the fuel blockade of Autumn 2000 in the UK, many supermarkets ran out of food because they had kept low levels of stock in their stores.