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Working Capital Management: A Whsmith Case Study

Essay by   •  January 4, 2012  •  Research Paper  •  2,504 Words (11 Pages)  •  1,999 Views

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Globalisation provides opportunities for companies to enter in new markets, increase profits and growth. Much depends on the company management to develop the capabilities to take advantage of these opportunities and become more successful. One of the most important considerations for management is working capital; efficient working capital management can lead to increased company profitability, growth and shareholder value, making the company more competitive and stronger in the market.

The aim of this assignment is to discuss how companies set their working capital management policies and the main aspects they consider for this. Firstly, different working capital management policies will be examined along with the principal factors involved. Subsequently, the working capital of a particular company in the retail industry will be analysed, comparing its performance through time and with other competitors in the same industry.

2. WORKING CAPITAL MANAGEMENT

2.1. Working capital policies

Working capital management is an important aspect in the approach of a company to generate shareholder value (Shin and Soenen, 1998). Moreover, working capital has a high influence in the profitability of a company due to the fact that the earnings can be significantly increased given a certain amount of working capital (Lazaridis and Tryfonidis, 2006).

According to Smid (2008), working capital can be defined as the capital invested in operating processes to buy, make and sell. In a mathematical approach, net working capital is defined as the difference between current assets and current liabilities (Vijayakumar, 2001). In this way it can be used as an indicator of the profitability of a company and its ability to pay its short term debts (liquidity).

Working capital management is therefore, focused on how to manage the current assets of the company, like cash, inventories and accounts receivables, in order to improve profitability. However, it must be noted that the measures taken could have an adverse effect on the ability to pay the short term debts (Shin and Soenen, 1998).

An efficient working capital management strategy is necessary to find the right balance between profitability and liquidity. It has been shown that some companies that do not manage working capital in an efficient way can go bankrupt even if they have good profits and operations (Chiou, Cheng and Wu, 2006).

Given the importance of working capital in the performance of a company, certain policies can be implemented to control it. There are different policies that a company can adopt such as conservative and aggressive. The conservative policy suggests holding high capital in current assets by keeping higher stocks or increasing cash, which is the opposite of the aggressive policy where current assets are minimised (Weinraub and Visscher, 1998). The aggressive approach is considered risky as keeping low inventories may lead to reduced production and hence profitability, while the conservative sacrifices profitability at the expense of liquidity (Padachi, 2006).

Some companies may adopt one of the policies described above but successful companies go beyond this. They implement their own policies analyzing each one of the factors that affect working capital.

The Cash Conversion Cycle (CCC) is an indicator of the efficiency in capital working management and encloses the main aspects related to this. The CCC is defined as the time gap between the purchases of raw materials (inventories) and the sale of the product (Shin and Soenen, 1998). It is composed for three different factors, accounts payables, accounts receivables and inventory; therefore there are different ways in which this can be managed (Lazaridis and Tryfonidis, 2006). The CCC is given by the sum of receivable days and inventory days less payable days.

A shorter CCC is preferred; moreover, the success of some companies is attributed to their short cash conversion cycle (Verity, 1996). With a smaller CCC the present value of the cash produced by the assets gets higher increasing the value of the company for its shareholders. Additionally, a shorter CCC represents an efficient working capital management and less need of capital from external sources (Shin and Soenen, 1998).

It is suggested that he profitability of a company will increase as the time between production and the sale of the products decrease realising cash and saving costs (Lazaridis and Tryfonidis, 2006). In this way, managing the three aspects of cash conversion cycle will lead to an efficient working capital management.

2.1.1. Receivables management

Accounts receivables or receivables days is the number of days among the date a sale is made and the date the payment for that sale is received (Mathur, 2002). A high level of accounts receivables is not desired since the capital invested on it is not available and cannot be used in other activities like new investments (Dorsman and Gounopoulos, 2008).

Companies tend to establish certain policies that allow them to monitor and control how the clients are meeting their obligations. A simple practice is to limit the time given to their customer to pay the credits granted, the lower the period the better (Lazaridis and Tryfonidis, 2006). Another policy is to offer to their customer discounts for prompt payment. However, this strategy needs to be carefully implemented since giving discounts represent extra costs (Dorsman and Gounopoulos, 2008).

2.1.2. Accounts payables

Accounts payables or payable days are defined as the amount of money that a company must pay for goods or services purchased on credit to its suppliers (Dorsman and Gounopoulos, 2008). A high level of account payables is desired to reduce the CCC. The longer the time that takes for a company to pay their debts the higher the amount of working capital available to generate more profits (Lazaridis and Tryfonidis, 2006).

However, it is suggested that policies used to increase the accounts payables through the delay of payments to creditors are ineffective and prejudicial for the company. Although this parctice is the easiest way to reduce the CCC, it could generate bad reputation and adverse attitudes from the suppliers. Instead, the use of policies that propose to reduce inventories can be more efficient and generate more benefits (Rafuse, 1996).

2.1.3. Inventory management

Inventory or inventory days is the time that a company requires to sell its inventories (Kim and Kim, 2006). As in the case of accounts receivables, a high level in inventories is not appropriate, the capital invested on it is not available to produce cash (Dorsman and Gounopoulos, 2008). In this way, the policies are focused

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