Working Capital Policy
Working capital management involves the relationship between a firms short term assets and short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivables and payables, and cash. Working capital management policies are implemented to assure the safety of organizational assets, provide required liquidity for operations, obtain the best banking relationships, and attain reasonable return on all funds. Aggressive capital management results in capital being minimize in current assets versus long-term investment. This has the expectation of higher profitability but greater liquidity risks. As an alternative, a more conservative policy places a greater proportion of capital in liquid assets, but at the sacrifice of some profitability.
To measure the degree of aggressiveness the current asset to total asset ratio is used with a lower ration, meaning a relatively more aggressive policy must be integrated in an effort to prepare for adequate financial planning procedures (Weinraub, et al, 1998). Cash budgeting involves planning for the inflows of cash into the business so there is cash available to meet operational expenditures. Proper cash management allows for smooth, uninterrupted operations of the business. Poor cash management can result in costly business operations and delays. Therefore, making projections of cash flow in and out of the business should be constructed and monitored on a regular basis.
One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Unfortunately, Lawrence Sports was unable to foresee the financial difficulties currently plaguing the organization due to a poor working capital policy. A poor working capital policy generally leads to financial distress on a company, increased borrowing, and late payments to creditors- all of which result in a lower credit rating. A lower credit rating means banks could charge a higher interest rate, which could cost an organization a significant amount of money, which in turn could ultimately prevent the company from alleviating some of the risk associated with cash deficit such as; bankruptcy. (About.com, 2008).
Cash budgeting involves a detailed statement of cash inflows and outflow incorporating both revenue and capital items. A cash budget is one of the most important planning tools that an organization can use. It displays the cash effect of all plans made within the budgetary process. Cash budgeting can give management an indication of the potential problems that could arise and allows them the opportunity to take action to avoid such problems (NetTom, n.d.). The purpose of cash budgeting is to determine an organizations future ability to pay debts as well as operational expenses. Organizations can manage cash in virtually all areas of operations that involve the use of cash. The goal is to receive cash as soon as possible while at the same time waiting to pay out cash as long as possible (Studyfinance.com, 2008).
Currently Lawrence Sports is facing a severe cash deficit. In order for the company to generate a positive cash inflow the company was placed in a position to negotiate loan terms to alleviate some of their current cash flow issues. Lawrence Sports poor cash budgeting practices, was a hindrance to the company meaning that the company was unable to acquire a loan that would not place the company deeper in debt. Generally a company with poor cash management would have difficulty obtaining a loan with a low interest rate. One of the key objectives of Lawrence Sports is to negotiate with lenders for a short-term loan with a low interest rate. Due to the fact that the company has a huge cash deficit, the interest rate on the loan could be astronomical and the term of the loan would not necessarily assist in the company’s short-term cash flow problems.
Lawrence Sports problems began in the first quarter of April, their total cash inflows was zero and their total cash outflow was $400,000 leaving the company with an ending cash balance of $50,000 after all operating expenses and miscellaneous expenditures, which ultimately placed the company under severe financial distress. Inevitably the company had to borrow additional funding in order to maintain a $50,000 cash balance and to cover additional expenses for the day-to-day operations. However, borrowing from the bank with a minimum cash balance has enabled a high interest payments on the bank loan. Therefore, if Lawrence Sports wants to keep its head above water, they would have to negotiate better loan-terms with lower interest rates and develop additional ways to receive additional funding such as; increase sales prices, eliminate product discounts, etc. Lawrence Sports did not prepare for the unforeseeable financial hardships, nor was a strategic plan integrated to forecast the financial difficulties of the future. The companies weaknesses include:
? Lack of financial planning
? Borrowing high interest loans
? Failure to properly manage cash inflow
? Short-term loan deferment
Working Capital Policy: Cash Balance Requirements
Loans can include covenants that require minimum values for liquidity measures the company must maintain, such as a minimum current ratio (current assets/current liabilities). Liquidity should be sufficient to prevent running out of cash. Due to uncertainty involved in estimating sales and costs, cash flows can vary from their forecast values. Maintaining a minimum cash balance at the end of each month provides a buffer against running out of cash (Ogden et al, 2001). Lawrence Sports may have a policy already in place that ensures that the minimum cash balance is maintained at all times. If the closing cash balance revealed at 5 above is less than the required minimum there will be a cash deficit and the organization will need a recourse to some short-term financing. Should the closing cash balance be greater than the required minimum then there will be a cash surplus available for investing in suitable short-term liquid investments (McMenamin, 1999).
All businesses require capital, that is, money invested in plant, machinery, inventories, accounts receivable and all the other assets it takes to run a business efficiently. Typically, these assets are not purchased all at once but obtained gradually over time. When long-term financing more than covers the cumulative capital requirement, the firm has surplus cash available. Thus the amount of long-term financing raised, given the capital requirement, determines whether the firm is a short-term borrower or lender (Brealey et al, 2005).