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Controlling working capital - Coggle Diagram
Controlling working capital
A reduction in working capital can be achieved either by speeding up the cycle of inventory and trade receivables or by lengthening the cycle of trade payables
A higher level of working capital represents a large commitment of finance and a significant opportunity cost
Efficiency savings generated through the efficient management of trade receivables, inventory, cash and trade payables can reduce the bank overdraft and interest charges as well as increasing cash balances that can be reinvested elsewhere in the business
Reducing inventory levels
The cost of holding inventory includes pruchaing goods, storing, insuring and managing them once they are in inventory
For most business, carrying inventory involves a major working capital investment and uses large amounts of finance that could be used elsewhere in the business
Inventory levels need to be tightly controlled while retaining the capacity to meet future demand
Advantages
Carrying low inventory reduces carrying costs of storage
Frees up money tied up in invnetories
Reduces the risk of deterioration, obsolescence and theft
Disadvantages
Reducing inventories risks the possibility of stock outs and dissatisfied customers
Bulk purchase discounts may not be available
A higher risk of loss of production time
Tighter credit control
A strategy employed by businesses ensure customers pay promptly so that cash is received by businesses as quick as possible
Efficient collection of income releases funds which can be reinvested in the business as a source of short term finance
Increase gas sales and decrease bad debt written off
Settlement discounts may be offered to encourage prompt payment, the higher the level of trade receivables, the larger the commitment of finance and the more cost for the company in terms of opportunity cost in interest and the greater risk of losses through bad debts
Businesses with too much credit could experience cash flow problems
Those not offering enough credit would risk losing customers with detrimental consequences on sales and profitability
Advanatages
Frees up cash
Creates savings in opportunity cost in interest
Reduces the cost of credit control and the risk of losses through bad debt
Disadvanatages
Tigether credit control risks losing the competitive edge over businesses providing credit, thus resulting in a potential loss of customers
Loss of customers could result in reduced sales and reduced profit
Delaying payment to trade payabales
The company risks losing its credit status with its suppliers and this could result in supplies being stopped
The company could risk the possibility of not being able to buy on credit in the future and/or lose the benefit of any settlement discount offered by the supplier for early payment
The annual effective cost of refusing early payment discounts can be calculated and compared with the cost of financing working capital to help make financing decisions in the short term
Advantages
Delaying payment helps cash retention that can be used for other purposes
Often viewed as free credit and a cheap form of sort term finance
Disadvanatages
May be repetitional cost from loss of goodwill that could damage the company's credit stats
Potential loss of suppliers due to breach of credit and default if their suppliers aren't paid on time
Suppliers may increase prices in future
Loss of benefits from suppliers who provide incentives such as settlement discounts
Sale of redundant assets
Businesses can raise funds by selling off their unused assets
Cn be used as a one off source of finance to free up cash for other business needs
The future operating capability of the business should be considered
Advanatages
Raises finance from assets that are no longer needed
No interest charges or dilution of control
Disadvantages
Businesses do not always have surplus assets available
One off source of finance
May not be easy to find potential buyers