BUS FPX 4070 Assessment 7 Minimizing Working Capital

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Capella University

BUS-FPX4070 Foundations in Finance

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Working Capital

Working capital refers to the difference between a company’s current assets and current liabilities. According to Investopedia, it is defined as “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 (NWC) serves as an important metric for evaluating a company’s ability to invest, grow, and maintain liquidity. It indicates the company’s operational efficiency and short-term financial health (Fernando, 2021). A positive working capital means a company can meet its short-term obligations, invest in growth, and maintain smooth operations.

Importance of Minimizing Working Capital

Minimizing working capital is crucial for ensuring that a company manages its finances effectively, pays off debts promptly, and receives payments from customers in a timely manner. A key strategy to reduce working capital is revising the accounts receivable policy, such as switching to Net 30 terms, which reduces outstanding balances past 30 days and minimizes possible discounts. This adjustment can improve income and liquidity, thereby reducing working capital. According to the CFA Journal, “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 ensuring a quick recovery track record from the company” (CFA Journal, n.d.). Moreover, reducing working capital helps lower the cash conversion cycle, meaning a company can quickly turn its assets into cash and extend the time for paying expenses. As a result, cash flow improves, which in turn increases profitability by enhancing liquidity, reducing expenses, and avoiding unnecessary borrowing (Wolf, 2015).

Challenges in Minimizing Working Capital

Despite the benefits of minimizing working capital, several challenges exist, particularly for smaller companies. Lower working capital can raise concerns among investors, stakeholders, and employees about a company’s financial stability. Large companies can usually sustain lower working capital for longer periods, while smaller companies face more immediate risks. Smaller firms might struggle to pay employees, replenish inventory, or maintain operations due to insufficient liquidity. When faced with slow-paying customers, smaller businesses may resort to strategies like raising prices, laying off employees, delaying payments to vendors, or seeking credit. However, these measures often come with drawbacks. Raising prices may drive customers to competitors, while layoffs could reduce product quality. Slow payment to vendors may damage relationships, potentially forcing the company to work with less reliable suppliers. Furthermore, past due receivables may negatively impact a company’s ability to obtain financing or lead to higher interest rates on loans. Larger companies can withstand past due receivables better than smaller ones due to their ability to absorb such impacts over longer periods.

XYZ Inc. Case Analysis

XYZ Inc. provides products on terms of 2/10, net 30, with annual sales of $1,000,000. Of its customers, 30% take discounts and pay within 10 days, while 70% pay on average 45 days after purchase. To calculate the days’ sales outstanding (DSO), the formula is based on the outstanding receivables and the average payment period. For the 70% of customers who pay after 45 days, the DSO is calculated as follows:
[ \frac{700,000}{\frac{1,000,000}{45}} = 31.5 \text{ days}. ]
For the 30% of customers who take the discount, the DSO is:
[ \frac{29,400}{\frac{1,000,000}{10}} = 2.94 \text{ days}. ]
Thus, the total DSO is approximately 31.5 days for 70% of customers and 2.94 days for 30%, indicating a significant gap in payment timelines. When calculating the average amount of receivables, for the customers who pay in 45 days, the average is $15,555.56, and for the discount takers, it is $2,940.

BUS FPX 4070 Assessment 7 Minimizing Working Capital

Next, the percentage cost of trade credit for customers who take the discount is calculated as:
[ \frac{30,000}{0.02} = 600.00 \text{ or 2%}. ]
For those who do not take the discount and pay in 45 days, the cost is:
[ \left(\frac{2\%}{100\%- 2\%}\right) \times \frac{365}{45} = 16.58\%. ]
If XYZ Inc. implements a policy that requires non-discount customers to pay within 30 days, the impact on receivables would be as follows:
[ \frac{700,000}{30} = 23,333.34, ] which results in an increase of $7,777.78 or a 49.48% improvement in receivables collection by shortening the payment period.

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