Effective working capital management is all about keeping the investment in the current assets under control so as to minimise the amount of funding required.
But what does “keeping the current assets under control” actually mean in practice?
In this context there are really only two current assets that can be managed and which have a significant impact on cash; inventory (stock) and accounts receivable (trade debtors).
Managing inventory is always a fine balance between having enough to meet customer demand and having too much that just sits on the shelves or in the warehouse.
When it comes to managing inventory, businesses should seek the optimum level of stockholding, not the minimum level – running out of inventory could be disastrous.
There are a number of reasons for businesses to hold a lot of inventory;
- The inventory comes from a far away country and takes a long time to get here
- The inventory may soon be going up in price
- The inventory is in short supply generally
- The inventory is much cheaper if bought in bulk
- There is only one supplier of the inventory and the supplier has all the bargaining power
But that’s only okay if the inventory is not perishable – there are lots of reasons why inventory levels should be kept low too.
Some reasons for business to hold very little inventory;
- The inventory comes from a local supplier and takes a very short time to obtain
- The inventory may soon be going down in price
- The inventory is easily available from a range of suppliers – the suppliers have little bargaining power
- The inventory is likely to become obsolete (e.g. electronics)
- The inventory is perishable and will soon deteriorate
- The inventory has to be insured and warehoused adding expense to the business
Managing accounts receivable is always a fine balance between allowing reasonable credit terms in keeping with the norm in the specific industry and collecting from customers when payment is due without annoying them and driving them to the competition.
Businesses are more likely to take a soft approach to collecting their accounts receivable – especially when the economy is struggling and customers are not easy to find.
So businesses that have to hold higher levels of inventory and are reluctant to collect their accounts receivable from customers are the ones that have the most invested in working capital and usually need significant overdraft facilities.