Summary

Working capital is not only necessary to run a business; it is a resource that will expand and contract with business cycles and must be carefully managed and monitored. The daily, weekly, and monthly needs of business operations are met by cash. Financial managers understand the significance of net working capital (current assets – current liabilities) and various liquidity ratios as they attempt to ensure that bills can be paid. The cash conversion cycle and the cash budget provide additional working capital management tools.

Trade credit is very prevalent in the business world, especially in B2B (business-to-business) transactions. Many business exchanges (sales) could not take place without trade credit and the credit terms that are offered. Like any component of working capital, trade credit must be planned and managed. The creditor (the company granting the credit) does so based on an analysis of creditworthiness and must monitor payments and manage slow-paying accounts. The debtor (accounts payable) needs to make payments on time to keep a clean credit history and to take advantage of discounts.

Cash management is simply making sure you have enough cash to meet expected obligations and for contingencies (unexpected or emergency cash needs). Excess cash should be invested low-risk and highly liquid marketable securities. The cash budget is a critical tool of cash management.

Accounts receivables are monitored by management with tools such as the ratios accounts receivable turnover and average collection period and the aging of receivables. The credit managers’ mantra rings true: “The older the receivable, the greater the likelihood that the account will not be collected.”

Inventory, usually the least liquid of the current assets, presents its own set of management challenges. Finding the optimal level of inventory is probably more of an art than a science. JIT helps to reduce the investment in inventory and lower the costs of storage, but stockout costs can be very damaging to profitability.

Short-term plans of a business are funded with cash, with cash budgets being a critical tool of planning. The cash budget takes into account a target amount of cash, factoring in all the motives for holding cash. A cash budget looks ahead—predicting cash inflows and outflows, allocating for minimum cash balances to be maintained, and helping management determine short-term financing needed. Although it is the last budget prepared, the preparation of the cash budget is an important financial planning exercise of companies small and large.