Average Number Of Days To Collect Accounts Receivable Formula 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 firms choose their operating cycle? How do firms choose their cash flow cycle? What is the effect of the firm’s operating cycle on the amount and frequency of investment in receivables and inventory? How do seasonal and cyclical trends affect the firm’s operating cycle, cash-flow cycle and investment in current assets? These strategic policy questions refer to the coordination of available capital and the effective management of working capital designed to maximize the productive capacity of the business.

In this study, we will review relevant and existing academic literature on effective working capital management and provide operational guidance for small businesses. The shorter the capitalization cycle, the smaller the firm’s investment in inventories and receivables and hence the lower the firm’s financing needs. Although the elimination of cash balances is, for the most part, judgmental, some analytical principles can be used to assist in the effective formulation of better judgments and to improve cash flow management.

As you know, relationships with money are working capital. Working capital is not money 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 current resources and uses of cash, respectively. Clearly, a firm’s ability to meet its financial obligations (debts due within a year) depends on its ability to manage its current assets and liabilities, effectively and efficiently.

Effective management of working capital requires formulation of a working capital policy and periodic management of cash flow, inventory, accounts receivable, surplus and accounts payable. And because poor working capital management can seriously damage a business’s creditworthiness and restrict its access to finance and capital markets, every effort should be made to reduce the risk of business failure.

The importance of paying bills cannot be overemphasized. Additionally, anything that negatively affects a firm’s financial position reduces its ability to borrow and withstand unexpected financial difficulties. The firm must maintain its ability to respond to unexpected costs and investment opportunities. Financial flexibility comes from a company’s leverage and cash holdings.

In fact, the proper management of working capital includes an effective cash conversion cycle, an effective operating cycle, the determination of the appropriate level of accruals, inventory, and account payments and methods of financing subsidiaries. Working capital policy affects a firm’s balance sheet, cash ratio (current and quick assets) and debt levels. Crucial to the effective management of a firm’s capital is a good understanding of the cash conversion cycle, or how long it takes for a firm to convert capital invested in operations into cash receipts.

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

As you know, the conversion cycle is divided into three parts: the average payment period, the average collection period and the average number of years. A firm’s operating cycle is the length of time from procurement of raw materials to collection of payment for products sold on account. The operating cycle is therefore the sum of the inventory conversion time (the time between when raw materials are received in inventory and the product is sold) and the receivables conversion time (the time between sales and receipt collection). Note that the operations of a retail business include purchasing (buying merchandise), selling (selling products to customers), and collecting (receiving money from customers).

Other Operating Instructions:

There is accumulated evidence showing that working capital management begins with an assessment of the operating cycle and maximizing the cash flow from the firm’s operations. Managers must know, understand and anticipate the impact of cash flow on the firm’s operations and its ability to increase the profit-generating capacity of the business. Effective financial management is critical to business success. It’s all about cash flow.

One of the best ways to increase liquidity is to accelerate the collection of incoming payments by reducing the age of accounts receivable using the right mix of incentives and penalties. The firm should evaluate current payment systems and identify effective ways to expedite the collection of accounts receivable.

There is strong evidence to suggest improving payment systems and moving to electronic alternatives will increase liquidity and better manage incurred costs. Cash flow is critical to the success of every business and effective cash management is the key to cash flow. In fact, a thorough cash flow analysis and assessment of investment strategies and policies are required to ensure that the firm has the appropriate resources needed to increase the company’s liquidity, and to increase cash flow management.

A firm increases cash flow control in its operating cycle by streamlining and improving the way it manages cash receipts, makes cash outflows and shortens the age of accounts receivable. The firm needs digital records, electronic banking, strong internal controls and agile accounting systems for quick reconciliation of bank statements with timely access to bank accounts, customer records; and streamlining cash flow, accounts payable, and accounting systems to increase efficiency.

Best business practices include monthly cash flow analysis to determine the net cash balance (the difference between total cash inflows and total cash outflows). The objective is to increase or periodically eliminate the financial balance; Monitoring customer balances to manage account receivables (money owed by the firm from customers); and proper pre-qualification procedures before extending credit to customers are essential to reducing the incidence of bad credit.

A tracking system that monitors money received and sends automatic reminders, invoices and reports is a useful tool. Some firms use assets by selling receivables to brokerage firms to ensure stable cash flow; Slow cash flow: Wise cash management dictates that the company retains cash for as long as possible. Increase cash flow control by making on-time payments while using all the accommodations that fit the financial benefit calculus. Finally, borrow long-term and borrow short-term with large expenses by setting aside a small amount of money to finance expected large expenses. Always remember that long-term liabilities become current liabilities in the accounting period in which they accrue.

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