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In business money must be paid out to pay for expenses before the receipt of cash from the sale of the firm's goods and services. Consequently, a typical firm's investment in current assets such as inventories, training and accounts receivables exceeds its current liabilities including things like accrued expenses and accounts payable. The change between the current assets and current debts is the company’s working capital. Companies with predictable working capital requirements or permanent working capital, typically will finance it though long-term financing. Seasonal financing demands are better matched with short-term financing, such as a bank loan.
Effective management of a company’s working capital must be to minimize the amount of the firm's money in non-earning assets including receivables and inventories and to maximize the use of "free" credit such as prepayments by clients, accrued wages and accounts payable. These three sources of money are free to the company in that they typically do not carry a specific interest charge. However, companies providing discounts on its products and services to customers paying in advance, will incur an implicit interest charge. Similarly, when a company passes on a supplier’s discount by paying in 60 days versus 10 is an implicit interest charge.
Policies and procedures that reduce the lag between when a product is sold and the receipt of cash from its customers reduce the need for working capital. In a perfect world, every company would like its customers to pay in advance. The firm can also decrease its need for working capital by increasing the time between when it purchases goods and services and when it pay’s cash for them.
What is the perfect amount of working capital for a company? An amount sufficient enough to cover day-to-day operations plus a rainy day fund to cover the unexpected. For example, having immediate access to cash in the way of a line of credit or cash deposits allows the company to take advantage of special discounts to buy inventory or to cover bad debt when a customer does not pay. Working capital is like a roller coaster, too little working capital risks not having enough liquidity. Too much working capital, the company risks not putting its assets to their best use.
Managing working capital requires careful planning and monitoring. Inventory purchases usually will not coincide with the timing of sales. Cash receipts usually do not coincide with the company's need to utilize its cash. Therefore, at any given time a company could find itself with possibly too little or a lot of inventory. So, a company may have excess money sitting idly in its checking account, or it might need additional immediate financing.
The fact that customers have some control over when they pay their bills affects a company's cash management of collections from its accounts receivables. The longer customers take to pay, the longer the company needs to wait between the time when it purchased inventory and the time when it receives cash from the sale. The company can manage this aspect of working capital by setting policies that encourage early payment of accounts receivable.
Every company needs to closely mange the payments of its outstanding commitments. It should make these types of payments on time, along with taking advantage of purchase discounts available from it providers.
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This email is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances.