As has been mentioned in earlier posts on this blog, 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 if it the business is doing well and more working capital in the form of current assets such as inventory is needed? Then the additional working capital has to be funded somehow.
To understand why that is we need to revisit the accounting equation. Remember that the equation is;
Assets = Equity plus Liabilities
So that means that the more assets the business has (the left side of the equation), the more funding (right side of the equation) that’s needed because the equation must always be in balance. The problem is that additional funding incurs cost and increases risk.
The basic rule when funding assets is to match their term with the term of the corresponding liability. That means that the short-term assets (that is the current assets) are funded by short-term (or current) liabilities and long-term (or capital) assets are funded by long-term liabilities.
So in that case it makes sense that working capital (the total of current assets) will be funded by current liabilities.
In this context there are really only two current liabilities that can be used for funding the current assets; short-term bank borrowing such as an overdraft and accounts payable which represents the credit extended to a business by its suppliers of materials and other basic inputs.
Obviously, the cash flow that the business generates to settle these liabilities comes from either its cash sales or the collection of its accounts receivable from its customers. For the majority of larger businesses cash flow comes from accounts receivable collections.
But what happens if the accounts receivable are not collected from customers in time to pay the operating expenses and the accounts payable when they fall due? Well, that’s often when bankers get to meet the business owner/manager/director for a serious discussion about cash flow.
When we think about a bank overdraft as a means of funding current assets we tend to assume that the inventory (stock) figure is funded by accounts payable (trade creditors) so the bank overdraft is intended to partially fund the accounts receivable (trade debtors) figure.
From that it’s clear that a relatively easy way to fund additional working capital or to reduce reliance on expensive overdraft funding would be to increase the funding from trade creditors, which means negotiating longer credit terms from the suppliers
It’s important that the business doesn’t just take longer to pay without first getting the supplier’s approval – the maxim is to use, don’t abuse, suppliers’ credit.
But there are two potential problems in getting longer credit terms from suppliers which may make it an unattractive option;
1. Suppliers may increase the price of their product to offset the reduction in their own cash flow.
2. Suppliers may refuse to supply more product until they have been paid for previous deliveries.