Essay Example on Minimizing Working Capital

Minimizing Working Capital is an undertaking that is done so as to ensure that there is enough liquidity in terms of cash to meet the companys operations without holding it in excess. The reason for minimizing liquidity arises from the fact excess liquidity tends to reduce companys investment prospects because funds that could have been used in investment are held for no use, it also increases efficiency in operations, shortens the period of converting cash. Additionally, when minimizing working capital, the company with excess whose cash inflow does not balance off its cash outflows doesnt operate a healthy business. Working capital is defined simply as the difference between current assets and current liabilities and it is defined as the capital that a firm needs in order to undertake its daily operations (Sharma, 2009). Just as examined in the second paragraph, a company that has excess working capital minimizes investment prospects therefore raising the need to minimize working capital.

Minimizing working capital for a firm comes with numerous challenges that may even hamper or affect the daily operations of the business if it is not fully and carefully done. Some of the challenges that a firm encounters when minimizing working capital include; lack of accurate information about the operation needs, time constraints, lack of formal structure of operating, and bureaucratic system. The challenge that arises from the lack of proper information begs the question of undertaking a transaction that will end up being wrong (Sagner, 2010). With regards to the issue of bureaucracy, some firms have numerous stakeholders that need to be consulted before settling on a certain decision, some of the stakeholders may agree while others may refuse to support some decisions that would have minimized working capital. On the same note, time constraints may be another major challenge that may arise when minimizing working capital in a company.

The act of minimizing funds has to be done in a manner that allows for the company to continue operating without delaying of hampering any operation, sometimes therefore; it may not be the case since the operations of the company may not allow for a decision of minimizing operating capital due to ongoing operations. Minimizing working capital will enable a firm to free up funds for investment in an event that most of the funds are held up in the firms current liabilities and current assets; one of the major challenges that arises in as far as liquidating unnecessary current assets is the issue of current liabilities (Sherman, 2011).

when a firm has more current liabilities as compared to current assets it is always prudence to liquidate assets so as to meet and perhaps cover all current liabilities, however, it has to be done while having in mind the time constraint that the liabilities have. For instance, if current liabilities can be covered by current assets that are to be liquidated in the future, then waiting for the liabilities to mature will be the only option however in the even that liability mismatches the current assets, then the only option is to liquidate or to seek for increased working capital (Downes, 2014). Minimizing working capital for large firms can be tricky owing to the numerous operations that span different regions; however for small firms it is always very easy to come up with the required level of capital without having to incur an extra cost.

XYZ Company

Sells 2/10, net 30.

Total sales $ 1000,000

30% on discount to be paid on date 10th

70% of customers pay 45 days after their purchases

Q1. Days outstanding sale

DSO (Days Sale Outstanding) ratio = accounts receivable/ average sales per day * number of days

= 2/10*1,000,000/30 = $ 3,333.

Q2. Average amount of receivables

Average receivables = average amount of accounts receivables* Days/Credit sales

= $1000, 000 * 45 days/ 30% of 1000000

= $150,000

Q3. Percentage cost of trade credit for discount customers

% cost of trade credit discount = (1 + discount/1-discount) 365 days/days after discount period -1

= (1+ 0.02/0.98) 365/20-1

43%

Q4. Percentage cost of trade credit for customers who do not take trade credit but pays in 45 days.

% cost of trade credit discount = (1 + discount/1-discount) 365 days/days after discount period -1

= (1+0.02/0.98) 365/40 1

= 21%

Q5. All non-discount customers to pay on 30th

If all non-discount customers were to pay on 30th the account receivable will reduce the current amount that the company expects in the account receivable. Since the discount payment period is for discount is 45 days after purchase, reducing that to 30th will reduce the accounts receivable. Additionally, the working capital will be minimized because funds that could have been held in accounts receivable will be freed up due to reduced repayment periods (Downes, 2014). Additionally, the customer turnover will likely to go up, leading to increased sales thus increased revenue and profitability for the firm.

References

Sharma, D. (2009). Working capital management: A conceptual approach. Mumbai, IND: Himalaya Publishing House.

Sagner, J. (2010). Essentials of working capital management. Hoboken, NJ: John Wiley & Sons.

Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: Amacom.

Downes, J., & Goodman, J. E. (2014). Dictionary of finance and investment terms (9th ed.). Hauppague, NY: Barron's.