SINCE 2020 and the onslaught of the pandemic, companies have faced major challenges in managing working capital. The problem is compounded in the case of small and medium-sized enterprises (SMEs). Most SMEs have suffered from reduced cash flow and disruptions in supply chains. The closures have affected consumer mobility and demand has plummeted. Despite efforts to open up the economy and the proclamation of the new president on his no-lockdown policy, working capital issues continue to surface.
Let’s get back to basics. As defined, working capital is the difference between a company’s current assets and its current liabilities. The essence of working capital management is to ensure that the business has the appropriate resources for its day-to-day operations while keeping the resources productively invested.
Components of current assets include cash, accounts receivable and inventory. Current liabilities include accounts payable, short-term borrowings and accrued liabilities. The company’s working capital policy will relate to the levels that must be maintained in each of the components. A second policy asks how working capital should be funded.
The first element is the level of liquidity and the quantity of it to continue to respond to liquidity problems. The business needs enough cash for its ordinary business needs and its unforeseen needs. Cash performs four important functions: transaction, precaution, compensatory balance for loans/services, and speculation. The objective of cash management is to fulfill these functions, without having useless cash surpluses.
As we know, this is the first casualty of the pandemic crisis: cash flow. Given its importance, the cash management strategy is essential. The company should determine how much capital is needed for large transactions, how long it can be maintained, and contingency measures to find cash in case of an emergency.
Liquidity must be maintained as it helps to cope with financial difficulties and strengthens the solvency of the company. But too much cash reflects poor resource allocation because it is generally unremunerative. Cash is like inventory with two opposite behavioral costs – holding cost and ordering costs. At the margin, ordering costs are reduced when larger orders are placed, but carrying costs increase. The economic solution is to order the necessary cash so that the marginal reduction in the cost of ordering equals the marginal cost of ownership.
Cash budgeting becomes an important exercise. Ideally, the cash budget should show positive cash flow with more money coming in than going out. The money could have been used to overstock actual inventory despite less demand. Allowing long payment terms to customers can lead to a shortage of cash. Overspending on customers and over-dealing with new business prospects can have the same effect.
In a context of crisis, we tend to be mistaken about the overstocking of liquidity despite its cost. A sharp increase in cash is not surprising given the errors in demand forecasting. At this point, it is best to err on the side of caution due to greater volatility in the environment. Measures to reduce cash outflows through careful management of variable costs are also warranted.
The company needs to improve the receivables process. The organization needs to generate faster cash flow from receivables and technology can be a major support. Digital payments, online deliveries and internet/smartphone transactions have been a boost to speed up the process. In many cases, the use of digital solutions can save lives. In fact, this is now the new normal.
The inventory audit should help determine appropriate supply issues and avoid shortages. Changes in the supply chain will impact delivery methods and timing. While just-in-time models are attractive in normal times, the likelihood of shortages and missing key inputs will lead to lost sales. Changes in the logistics configuration will require a precautionary attitude in the constitution of stocks, as the order taking time adapts to the new reality.
Boutonniere of The Economist makes this comment about inventory cycles that apply, in general, to all components of working capital. He wrote: “Just-in-time production assumes a largely frictionless world – of open borders, predictable demand and low transportation costs. This can no longer be invoked. Inventory is a form of insurance against unexpected delays. The trade-off between efficiency and self-assurance, between just-in-time and just-in-case, has clearly shifted towards the latter.
A major challenge is to make alternative financing options available to ensure a steady flow of working capital. Prudent management of short-term funding preserves liquidity in an environment of uncertainty. The business should explore the right financing instruments – regular lines of credit, revolving credit agreement, secured loans, discounting receivables, factoring, inventory financing and, yes, even trade credits. A good environmental scan should reveal the company’s access and availability to banking services, the level of interest rates, inflation in the economy, and the level of competitiveness within its industry.
Accounts Payable is one source of funds, but note how expensive trade credit can be, especially if discounts are offered. The company must correctly calculate the cost of not taking such discounts on commercial debt. Advance planning will help meet credit needs beyond the ordinary. Relationships with suppliers must be protected.
In sum, working capital management requires a balance between the levels involved in the main components cited – cash, receivables, inventory, payables and financing options. In all components, the trade-offs are between ordering and holding costs. Nowadays, working capital management requires a more conservative attitude that promotes the philosophy of just in case.
The opinions expressed here are his own and do not necessarily reflect the opinion of his office as well as that of FINEX.
Benel Dela Paz Lagua previously served as executive vice president and chief development officer at the Development Bank of the Philippines. He is an active member of FINEX and an advocate for risk-based lending for SMEs. Today, he is an independent administrator in progressive banks and in some NGOs.