BUS FPX 4070 Assessment 7 Minimizing Working Capital
Phillip March 9, 2024 No Comments

BUS FPX 4070 Assessment 7 Minimizing Working Capital

BUS FPX 4070 Assessment 7 Minimizing Working Capital

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Capella university

BUS-FPX4070 Foundations in Finance

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Date

Working Capital

Working capital is equal to current assets. To be able to stay in business, your current assets need to be higher than your current liabilities. Investopedia says, “working capital, also known as net working capital (NWC), is the difference between a company’s current assets – such as cash, accounts receivable / customers’ unpaid bills, and inventories of raw materials and finished goods – and its current liabilities, such as accounts payable and debts.” Net working capital is a measurement of the company’s ability to invest and grow based on liquidity, operational efficiency, and short-term financial health. (Fernando, 2021).

Importance of Minimizing Working Capital

Why is it important to minimize working capital? Working capital is a reflection on how a company can manage their finances. Able to pay their debts and receive payments from their customers in a timely manner. Reworking the accounts receivable policy to state Net 30 would minimizing the possible discounts and the outstanding balances past 30 days. This can increase the income to help reduce the working capital. “The reduction in working capital means that organizations are able to maintain and duly manage their resources in the sense that they are able to settle their debts in time while ensuing a quick recovery track record from the company.” (CFA Journal n.d.) Cash conversion cycle is the average time for incoming cash to be realized and the average payables to go out.

Reduced working capital suggests that a company can reduce its cash conversion cycle while having current assets available to cover expenses. Cash flow improves when customers pay within terms and the company can delay expenses for longer periods of time. Increase in cash and reduction in expenses. (CFA Journal, n.d.). Any company that is able to generate sales and receive payments from customer and still be able to delay expenses for as long as possible can operate on a reduced working capital and increase the value for shareholder, investors, and creditors. The increase in assets helps to reduce the need for further debt or credit. Managing or maximizing the inventory, reduction in expenses, improving the turn-around for receivables, and increase the terms on payable accounts. (Wolf, 2015).

Challenges in Minimizing Working Capital

What are the challenges in minimizing working capital? Lower working capital can have this effect on a company’s financial records and how they are viewed by stakeholder, investors, bankers, and employees. Larger companies having lower working capital can sustain for longer periods than the small companies. Lower working capital for larger companies can lead to loss of current supplier which in turn forces them to go to a new supplier that may have inferior product or higher prices. The effect on the smaller company is more significant and detrimental. They are not able to pay employees, restock or build up their inventory to continue supplying other companies Smaller companies that are being forced to work with lower working capital due to slow paying customers have options to help to sustain the lower working capital they are forced to endure. These companies can raise prices, terminate or lay-off employees, slow pay their vendors, or apply for credit.

  1. Raising prices can cause the customer to seek out other suppliers for better pricing
  2. Terminating or laying-off employees can mean reduced quality of product, over worked employees can lead to inferior product being produced.
  3. Slow paying vendors can create a C.O.D. payment term or terminating the relationship.
  4. Past due receivables are a negative factor for lenders and banks when small companies apply for loans. They are deemed to be a credit risk or given loans at much higher interest rates.
  5. A larger competitor will be better able to withstand the past due receivables on their books for a larger period.

XYZ Inc. Case Analysis

XYZ Inc. sells on terms of 2/10, net 30. Total sales for the year are $1,000,000. Consider that 30 percent of the customers take discounts and pay on the 10th day, while the other 70 percent pay, on average, 45 days after their purchases.

  1. What is the days’ sale outstanding?

Receivables / Annual sales / average days 70% of customers pay within 45 days ( \frac{700,000}{(\frac{1,000,000}{45})} = 31.5 ) days

30% of customers are 2/10, net 30 (30,000 \times 0.02 = 600.00) (30,000 – 600 = 29,400) ( \frac{29,400}{(\frac{1,000,000}{10})} = \frac{29,400}{10,000} = 2.94) days

  1. Determine the average amount of receivables.

(\frac{700,000}{45} = 15,555.56) (\frac{29,400}{10} = 2,940)

  1. For the customers who take the discount, what is the percentage cost of trade credit?

(\frac{30,000}{0.02} = \$600.00 = 2\%)

BUS FPX 4070 Assessment 7 Minimizing Working Capital

  1. For the customers who do not take the discount and pay in 45 days, what is the percentage cost of trade credit?

( \frac{2\%}{(100\%- 2\%)} \times \frac{365}{45}) (= \frac{2\%}{98\%} \times 8.12) (= 2.0408 \times 8.12 = 16.58\%)

  1. What would happen to XYZ’s accounts receivable if it created a new collection policy that required all non-discount customers to pay on the 30th day?

Receivables / average days ( \frac{700,000}{30} = 23,333.34)

That would be an increase in receivables collection of $23,333.34 – 15,555.56 = \$7,777.78. Approximately 49.48% increase to change the collection policy from 45 days to net 30 days. Increase in receivables at a shorter net due date would be a great improvement on reducing working capital.

References

Carlson, R. (2020, January 3). The balance. Small business. The cost of trade credit (accounts payable). Retrieved from https://www.thebalancesmb.com/the-cost-of-tradecredit-accounts-payable-392835

CFA Journal. (n.d.). How does reduction of working capital help the company improve their cash flows? Retrieved from https://www.cfajournal.org/reduction-working-capital-helpcompany-improve-their-cash-flows/

Fernando, J. (2021, October 27). Investopedia. Working capital. What is working capital? Retrieved from https://www.investopedia.com/terms/w/workingcapital.asp

Helper, S. Ph.D., Nicholson, J. R., Noonan, R., & Callen, J. (n.d.). U.S. Department of commerce. The economic benefits of reducing supplier working capital costs. Retrieved from https://www.sba.gov/sites/default/files/aboutsbaarticle/The_Economic_Benefits_of_Reduc ing_Supplier_Working_Capital_Costs.pdf

Wolf, R. (2015, September 2). Strategic Finance.

Free up cash: manage working capital. Retrieved from https://sfmagazine.com/post-entry/september-2015-free-up-cash-manageworking-capital

BUS FPX 4070 Assessment 7 Minimizing Working Capital