Working Capital Policies FIN/571 April 1, 2013 Jim Ciaramella | | | | Introduction Lawrence Sports is a 20 million dollar company that manufactures sports equipment. Mayo is a major customer of Lawrence Sport’s and has defaulted on 80% of the payments for goods and services for the weeks of March 17-23, and March 24-30 and Lawrence can’t expect any money from mayo until weeks April 14-20. Lawrence has borrowed money from the bank and has deferred payment to Gartner to manage the week of March 24-30 but the outstanding loan and the interest burden have gone up consequently (University of Phoenix, 2010).
Team C is responsible for working capital management for the company and has come up with an alternate working capital solution and a plan to manage Lawrence’s cash position in the forthcoming weeks. This paper will discuss the risk and contingencies associated with the alternate working capital solution. Performance measures will be discussed to show it will be used to evaluate and implement Team C recommendations for Lawrence Sports. Working Capital Policies Team C will look at the following policies for working capital to see which one could be considered appropriate for Lawrence Sports.
These policies are characterized by a combination of risk and return, and can have from a conservative to an aggressive profile. The three types of working capital policies most recommended and used are: Aggressive Policy, Average Policy, and Conservative Policy. The aggressive policy working capital management focuses on maintaining current assets amounts at minimum levels, which is reflected in the total asset turnover higher, with a higher margin. This policy emphasizes the aspect of returns on risk-return decision. This policy is the highest risk policy but with more funds to reinvest in the company or usiness. According to Kulkarni (2011) “ it is a high risk arrangement though, because, should your creditor come asking for money, and for some reason, you don’t have enough money to pay them off, you might end up having to sell a costly asset to pay off your debt to them. ” (Kulkarni, A. 2011 , Working Capital Policy, ¶9). The matching policy working capital management leaves a person with cash available to reinvest in his company or business. This policy entails a medium level risk and with this policy the business assets matched business liabilities.
According to Kulkarni (2011) “this policy works in an arrangement where the current assets of the business are used perfect to match the current liabilities. It is a medium risk proposition and requires a good amount of attention. ” (Kulkarni, A. 2011 , Working Capital Policy, ¶6). A conservative policy working capital management focuses on maintaining a high liquidity, as well as other accounts assets, as inventories and accounts receivable, which is very expensive, because they remain idle resources that eventually become unproductive, with slow rotation of assets due to the large investment in current assets.
This policy emphasizes the minimization of risk, as opposed to maximizing yields that is not risk to be sure liquidity. A conservative policy may be best for people who want to keep low risks. According to Kulkarni (2011) “This is the policy with the lowest risk, but it reduces the money used in increasing the production” (Kulkarni, A. 2011 , Working Capital Policy, ¶11). Recommended Policy The working capital policy recommended for Lawrence Sports is the matching policy, more commonly referred to as the moderate approach.
The working capital is funded by short and long term borrowing, equity financing or a combination of them. It is vital for the company to balance the risk and return of financing. The moderate approach falls in between the two other polices described above and is the most balanced. This enables Lawrence Sports to balance its risk and returns. Furthermore, it finances short term debt with temporary assets while permanent and fixed assets are financed by long term debt and equity sources (Zeepedia, n. d. ).
A moderate approach gives Lawrence Sports the ability to maintain the relationships necessary to continue business, balance the working capital to still create a profit, and repay what is owed to the bank. Figure 1. Different Policies Regarding the Level of Investment in Working Capital demonstrates how the Moderate Approach compares with the others in terms of the level of investment in working capital (Watson ; Head, 2012, p. 72). Risk It is important for a company to choose the best working capital policy, one that features a level of risk the company can handle.
Team C decisions about working capital management are being driven by the intrinsically related priority of risk management. Team C’s aim is to minimize the risk of insolvency while maximizing the return on the assists (Dixon, 1991). Teams C choose the matching working capital policy because it entails a medium level of risk and it will also leave Lawrence Sports with more cash to reinvest in the business. Lawrence Sports will keep low levels of working capital so that they can employ the funds more productively elsewhere like purchasing more goods or more machinery.
It is a relatively amount of risk balanced by a relatively moderate amount of expected return. The best level of working capital would be the one in which a balance is achieved between risk and efficiency which also requires continuous monitoring to maintain proper level in various components of working capital, i. e. , cash receivables, inventory and payables, etc. Contingencies A contingency is an unexpected event or situation that affects the financial health, professional image, or market share of a company. It is usually a negative event, but can also be an unexpected windfall such as a huge order.
Anything that unexpectedly disrupts a company’s expected operation can harm the company even if the disruption is because of a windfall (Duff, 2013). In the case of Lawrence Sports there should be a contingency plan in place in the event product is damaged or lost either in transit or by some unforeseen event. Another contingency plan Lawrence Sports should consider is a cash reserve to cover accounts receivable loses if Mayo defaults on invoice credits. In this case vendor defaults affect bottom line but in turn Lawrence would not have to borrow money from Gartner and avoid high interest rates.
For Lawrence to recover from such an incident Lawrence Sports needs to use its working capital to cover the costs so that funds are not continuously incurred on the bank loan. In order for Lawrence Sports to raise the capital to cover a contingency plan Mayo would have to relinquish all sales to Lawrence Sports, payments to Gartner will have to be stretched out further and Murray would lose working capital and halt operations because Lawrence Sports payments would be differed even longer. These hefty decisions are all apart of risk management and can negatively affect business relations.
Performance Measures Ensuring the survival of Lawrence Sports depends heavily on the ability to measure the performance of the recommended policy. Understanding what working capital entails enables one to review the data efficiently and make the appropriate decisions. Working capital is financed through accounts receivable, accounts payable, and inventory. Performance indicators as described by Luhring (2012) to determine days of working capital (DWC) are days sales outstanding in accounts receivable (DSO), day sales outstanding in inventory (DSI), and days sales outstanding in accounts payable (DPO).
The equation is DWC = DSO + DSI – DPO” (para. 7). Last, determining working capital requires DWC multiplied by daily sales (Luhring, 2012, para. 33). Evaluating and calculating the indicators allows Lawrence Sports to optimize its working capital and work to balance its liabilities and assets. These indicators can help track performance on a weekly and monthly base. Benchmarking annually can further aid in improving performance as well as creating new ideas or tools to assist in growing the company (Broxton & Bowbray, 2011).
Implementation Plan Lawrence currently uses a combination of current assets in the form of cash from receivables along with trade credit from vendors and a line of credit from the bank to fund operations. The firm’s largest customer, Mayo Stores, provides a major portion of the receivables Lawrence uses to fund current operations. Additionally, based on the scenario whenever Lawrence must become more aggressive with Mayo to receive payment the retailer retaliates by ordering less in subsequent months.
Further the unexpected challenge to replace a portion of the goods due to damage in transit did not help Lawrence’s position. In the short term now that the relationship with the distributor has been severed Lawrence will need to establish a new relationship with a different logistical partner. The finance team will need to review all trade agreements with vendors and customers with an eye on shortening the cash conversion period. Even reducing the conversion period a few days will result in a cost savings in paying down the line of credit.
In addition to negotiating better terms with both vendors and customers, Lawrence could consider alternative funding sources such as issuing commercial paper or establishing a receivables funding relationship with a private source to better leverage current assets. Conclusion The purpose of a working capital management program is to ensure there are enough liquid assets to finance the day to day operations of the firm. “Net working capital consists of current assets minus current liabilities. (Emery, Finnerty, & Stowe , 2007, pg 639) The three recognized capital management philosophies consider an aggressive approach, a conservative approach, and a maturity matching approach. After comparing the approaches to the challenges Lawrence Sporting Goods has experienced in the simulation, Team C, elected to recommend Lawrence manage its working capital using the maturity matching approach. This method allows the firm to use assets from current activities to finance current operation while using long term funding to finance both long term assets and permanent current assets.
Lawrence is a strong profitable company that will make a greater effort to hedge their relationships with both vendors and customers to maintain their current assets at a level to fund operations. By effective management of inventory levels, accounts receivable, and the cost of credit the firm will be able to improve their own net present value without sacrificing relationships or profitability. References Arjun, K. (2011). Managing a multicultural workforce. Working Capital Policy. Retrieved from http://www. buzzle. com/articles/working-capital-policy. html Broxton, A. , & Bowbray, P. L. (2011).
Improving working capital and cash flow intelligence. APQC. Retrieved from http://www. protiviti. com/en-US/Documents/White-Papers/Risk-Sol utions/APQC-Protiviti-Working-Capital-Management-Study. pdf Duff, V. (2013). What is a business contingency plan. Retrieved from http://smallbusiness. chron. com/business-contingency-plan-1081. html Emery, D. R. , Finnerty, J. D. , & Stowe, J. D. (2007). 2007 (3rd ed. ). Upper Saddle River, New Jersey: Prentice Hall. Luhring SurvivalWare. (2012). Days of working capital. Retrieved from http://www. survivalware. com/articles/days_of_working_capital. php Satish, M. (2022).
Working capital management and control: Principles and practice, New Age International Publishers Reprint 2003 Watson, D. & Head, A. (2012). Corporate finance principles and practices (5th ed. ). New York, NY: Financial Times Prentice Hall. University of Phoenix (2010) . Lawrence Sports Simulation retrieved 3/29/2013 from University of Phoenix, FIN/571: Economics website. Zeepedia. (n. d. ). Working capital management. Retrieved from http://www. zeepedia. com/read. php? working_capital_management_risk_profitability_and_liquidity_working_capital_policies_conservative_aggressive_moderate_corporate_finance&b=22&c=26
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