Accrual Basis Net Income Vs Net Operating Cash Flow Effective Working Capital Management and Optimal Synchronization of Cash Flows

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Effective Working Capital Management and Optimal Synchronization of Cash Flows

How do companies choose their operating cycles? How do companies choose their cash conversion cycle? What effect does a firm’s operating cycle have on the size and duration of investments in receivables and inventories? How do seasonal and cyclical trends affect a company’s operating cycle, cash conversion cycle, and investment in current assets? These strategic policy questions relate to optimal cash flow synchronization and effective working capital management designed to maximize the asset generation potential of the enterprise.

In this review, we will examine some relevant and existing academic literature on effective working capital management and provide some operational guidance to small business enterprises. The shorter the cash conversion cycle, the smaller the firm’s inventories and investment receivables, and consequently the lower the firm’s financing needs. Although determining cash balances is largely judgmental, certain analytical rules can be applied to effectively formulate better decisions and optimize cash flow management.

As you know, the correlation of cash is net working capital. Net working capital is not cash but the difference between current assets (what the firm currently owns) and current liabilities (what the firm currently owes). Current assets and current liabilities are the firm’s immediate sources and uses of cash. Clearly, a company’s ability to meet its current financial obligations (bills due within a year) depends on its ability to manage its current assets and liabilities efficiently and effectively.

Effective working capital management requires formulation of optimal working capital strategy and periodic management of cash flow, inventory, accounts receivable, accruals and accounts payable. And since poor working capital management can seriously damage a firm’s creditworthiness and limit its access to money and capital markets, every effort must be made to minimize business default risk.

The importance of liquidity cannot be overstated. Additionally, anything that adversely affects a firm’s financial flexibility reduces its ability to borrow and withstand unexpected financial difficulties. A firm must maintain the ability to react to unexpected costs and investment opportunities. Financial flexibility is derived from the company’s use of leverage as well as cash holdings.

In practice, optimal working capital management includes effective cash conversion cycle, effective operating cycle, adequate accruals, inventory and accounts payable and attendant funding options. Working capital strategy affects the firm’s balance sheet, financial ratios (current and quick assets) and possibly credit rating. Critical to an efficient firm’s working capital management is a good understanding of its cash conversion cycle, or the time it takes for a firm to convert cash invested in operations into cash received.

The cash conversion cycle captures the time elapsed from the beginning of the production process to the sale of finished goods to the collection of cash. Typically, a firm purchases raw materials and manufactures products. These products go into inventory and are then sold on account. Once products have been sold, often on credit, the firm waits to receive payment, at which point the process begins again. Understanding the cash conversion cycle and accounts receivable aging is critical to successful working capital management.

As you know, the cash conversion cycle is divided into three parts: average payment period, average collection period and average age of inventory. A firm’s operating cycle is the period from receipt of raw materials to collection of payment for products sold on account. The operating cycle is therefore the sum of the inventory conversion period (the average time between when raw materials are received in inventory and when the product is sold) and the receivables conversion period (the average time between the sale and collection of the receipt). Note that the operations of a merchandising enterprise include purchasing (the purchase of merchandise), sales (the sale of products to customers), and collection (the receipt of cash from customers).

Some operational guidance:

Empirical evidence is accumulating that suggests that effective working capital management begins with assessing the operating cycle and optimizing cash flows from a firm’s operations. Management must know, understand, and predict the impact of cash flow on the company’s operations and its ability to increase the profit-generating potential of the enterprise. Effective cash management is critical to business success. It’s all about cash flow.

One of the best ways to increase cash availability is to speed up the receipt of incoming payments by reducing the age of accounts receivable using the right mix of incentives and penalties. A firm must evaluate current payment processes and identify effective alternatives to expedite accounts receivable collection.

There is strong evidence to suggest that improving payment processes and moving to electronic options will maximize liquidity and better manage receivables. Liquidity is critical to the success of every business venture and effective cash management is at the core of liquidity. In practice, careful analysis of cash flow and evaluation of investment policies and strategies is necessary to ensure that the firm has the right tools to increase the firm’s liquidity and optimize cash flow management.

By rationalizing cash flow management throughout its operating cycle and improving methods of managing the flow of cash receipts, a firm makes outflows cash payments and shortens the age of accounts receivable. A firm needs digital records, electronic banking, strong internal controls and agile accounting systems to quickly reconcile bank statements with timely access to bank accounts, customer records; and synchronizing cash flow, accounts payable and accounting systems for increased efficiency.

Best industry practices include analyzing monthly cash flows to determine the cash balance (the difference between gross cash inflows and gross cash inflows). The objective is a growing or positive periodic ending cash balance; monitoring customer balances to manage accounts receivable (money owed to the firm by customers); And proper pre-qualification process is required before extending credit to customers to reduce the incidence of bad loans.

A tracking system that monitors outstanding receivables and sends automated reminders, invoices, and statements is a useful tool. Some companies use factoring by selling their receivables to factoring companies to ensure steady cash flow; Minimizing cash disbursements: Prudent cash flow management determines that the firm holds cash for as long as possible. Optimize cash flow management by paying on time using all facilities consistent with financial benefit calculations. Finally, take out a large loan and pay less and over time, leaving a small amount aside for larger anticipated expenses. Always remember that long-term liabilities become current liabilities in the accounting period in which they mature.

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