Impact of Recession on Working Capital Requirements of a Company free essay sample

Impact of Recession on Working Capital Requirements of a Company Working Capital Management is a managerial accounting strategy focusing on maintaining  efficient  levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital. Ratio analysis will lead management to identify areas of focus such as inventory management, cash management, accounts receivable and payable management. Working capital theory prescribes using the optimal amount of net working capital to maximize shareholder wealth. Evidence from multiple countries indicates a negative relationship between the cash conversion cycle or net working capital and firm profitability. We will write a custom essay sample on Impact of Recession on Working Capital Requirements of a Company or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page However, severe economic conditions may force firms to change their inventory, accounts receivable, and/or accounts payable policies, causing the firms to use more/less net working capital. Also, it appears firms in general held more net working capital in order to face new economic challenges. Most businesses like to plan ahead mainly focusing on setting targets and monitoring performance for sales growth, cost control and profit improvement; however the Management of Working Capital is often missed from the plan. In these times of credit crisis, trying to monitor and improve sales and profit performance may be difficult and suddenly Working Capital becomes vital. Yes, it is still important to control costs, but if the business is experiencing falling demand for its products and services, or pressure to lower prices, then â€Å"Cash is King† and the importance of control over working capital (stock levels, customer debts, amounts owed to suppliers and bank facilities) comes into sharp focus. Impact of recession on working capital components: Inventory levels: Reducing stock requires careful analysis to identify slow-moving / surplus items and attempt to turn those into cash. At the same time re-order levels need to be reviewed to see whether certain lines can be reduced or discontinued. Care is needed here to ensure that the business can still react to customer demands without falling short of stock. Accounts Receivable/Debtors: Tightening up on credit control and customer payment terms also needs careful consideration and is unlikely to be resolved overnight. It is important to handle this steadily, systematically and sensitively to avoid losing customers. However there is a point when slow payers may become uneconomical if profit margins are being eroded by the cost of the money outstanding, the time and effort to collect it or both. Accounts Payable/Creditors: Finally the possible impact of slightly relaxing the time taken to settle suppliers’ invoices needs to be considered. Deferring payment for too long may cause undesirable reactions from suppliers – they may perceive you to be a poor credit risk and reduce your permitted order levels, or consider stopping supply. The economic and credit crisis of 2008 has forced many companies into cash flow problems due to non availability of working capital and credit facilities which in turn have led to retrenchment of staff, shrinkage of operations, curtailment of plans for capital expansion into different markets and downsizing. For most of these companies such a curtailment of operations and credit crunch threatens their very existence. To overcome this problem company’s look up to finance professionals who can manage the working capital requirements through planning, obtaining additional facilities and restructuring their operations. Working capital management is one of the cornerstones of business continuity and acts as a hedge against tightening credit and access to additional capital. Companies which manage their working capital optimally during times of recessions come out stronger post the recession period. Measures adopted by companies to improve working capital position: Improve existing working capital processes (eg. standardise, reengineer, automate) Negotiate better terms with buyers and suppliers Improve information systems internally (eg. acquire new technology or pplications) Provide better sales and collections support for foreign operations Provide financing support for operating entities (eg. â€Å"internal bank†) Integrate more transparently with external information systems (e. g. , suppliers, banks) Outsource working capital processes or move to shared services centres Provide financing support for suppliers (i. e. , supply chain financing) Sell or discount receivables using a bank Best Practices to Improve Working Capital Management: Many organizations are currently re-examining their working capital metrics, looking to uncover untapped sources of cash. CFOs, controllers, and treasurers are investigating new procedures and systems to enable a leaner back-office. But they still want access to fast, actionable information about current and future cash flows and working capital requirements. Included in best practices are those that centre on streamlining the accounts payable and accounts receivable function. 1. Centralize and standardize financial transaction processing to drive maximum efficiency and to draw meaningful insights out of underlying data. 2. Use data from an enterprise resource management (ERP) system to inform daily credit and collection activities. . Conduct real-time analysis of cash flow drivers to ensure reliable forecasts and optimize spare cash. 4. Design custom measures of working capital management that are relevant to their business models. 5. Identify and resolve data discrepancies on the front end of the process. Mistakes made in Working Capital Management: Smart companies know that working capital management is a strategic tool that can fund research and development, acquisitions, share buybacks, and higher dividends. Common mistakes companies make when establishing working capital improvement programs: Believing that only the CFO can fix problems in working capital management. Engaging in efforts, such as delaying payment to suppliers or stepping up collection activities, to artificially boost quarterly or year-end metrics. Beating the cash is king drum internally and for Wall Street, but not linking executive compensation to cash flow and comprehensive working capital metrics. Waiting for a business recovery before trying to improve working capital processes. Reducing inventories without improving the overall supply chain process. Conclusion: During the recessionary period, some businesses experienced difficulties in managing their cash flow and working capital and this was sometimes exacerbated because of the difficulties in obtaining support from banks to deal with cash shortfalls. As a consequence, many businesses have made efforts to improve their arrangements for the management of cash and working capital which had somewhat deteriorated over a period of years. Moreover the continuing problems being experienced with the banks coupled with the potential future liquidity problems means that effective cash and working capital management is seen as a managerial priority.