Virtual University of Pakistan Study forum !
Topic for Discussion: “Working Capital Management Policies”
Working capital management is an ongoing debate between researchers since they have been trying to suggest most suitable policy for efficient management of day to day operations. It has been concluded in pertinent literature that in order to maintain positive working capital, there are costs and benefits attached with different levels of current assets holdings and use of short term and long term financing to fund working capital needs. According to Viscione (1986), the answer to how we can manage working capital requirements effectively, lies in the maturity matching principle in which permanent working capital needs are financed through long term loans and temporary working capital needs are funded through short term loans. However, the approach practiced by the big names like Dell, Amazon, and Wall Mart is contradictory to contemporary approaches of working capital management. All of these companies have been maintaining negative or nearly zero working capital with high market capitalization. It signifies that cash conversion cycle of these companies is also negative.
Reference: Viscione, Jerry A. “How Long Should You Borrow Short Term?” Harvard Business Review (March–April 1986), 20–24.
Generally, negative working capital and negative cash conversion cycle are not assumed beneficial for organization’s financial performance as they indicate operational inefficiency. You are required to identify core strategy employed by the abovementioned companies that are successful even with negative or nearly zero working capital and negative cash conversion cycle.
Negative Cash Cycles
The lower the cash cycle the better it looks for a company’s finances, so a negative cash cycle is very desirable. A negative cash cycle is one in which you don’t pay for your inventory or materials until after you’ve sold the final product associated with them. It means you’re using your working capital as efficiently as possible and have available cash for other things.
Not all companies can achieve a negative cash cycle due to the nature of their products or consumers. For the ones that can, good credit with their suppliers is a must. The longer a supplier allows you go without payment, the easier achieving negative cash cycle will be. The only side of the equation is collecting payment as soon as possible from your customers. A strict payment policy helps you achieve that.
The Definition of Negative Working Capital
Negative Working Capital Can Be A Good Thing for Certain Types of Businesses
Negative working capital can be a way to expand a business on other people's money.
An Example of How Negative Working Capital Might Arise Think back to our Warner Brothers / Wal-Mart example earlier in this lesson. When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all of its accounts payable because fresh, new cash is constantly being generated at levels sufficient to cover whatever bills might be due that day. As long as the transactions are timed right, the company can pay each bill as it comes due, maximizing their efficiency.
Working Capital can be positive or negative, depending on how much of current debt the company is carrying on its balance sheet. In general terms, companies that have a lot of working capital will experience more growth in the near future since they can expand and improve their operations using existing resources. On the other hand, companies with small or negative working capital may lack the funds necessary for growth or future operation. Working Capital also shows if the company has sufficient liquid resources to satisfy short-term liabilities and operational expenses.
Compare to competition
Dell Inc. has Working Capital of 4.11 B. This is much higher than that of the sector, and significantly higher than that of Working Capital industry, The Working Capital for all stocks is over 1000% lower than the firm. To determine improvements in return on invested capital, Dell's asset management team developed a set of internal benchmarks. Metrics included days sales outstanding (DSO), days sales in inventory (DSI), and days payables outstanding (DPO). Add DSO and DSI, then subtract DPO, and you get the chief metric Dell uses to measure its liquidity: cash conversion cycle (CCC). "These were metrics we felt people at the line level could understand and act upon," explains Caswell. The metrics tell a compelling tale. Since booting up its liquidity management program in the fourth quarter of 1996, Dell's cash conversion cycle has gone from an acceptable 40 days to a phenomenal minus-5 days in the fourth quarter of 1997. "Our biggest improvement was in the inventory area, which we drove down from 30-plus days to 13 days," Caswell says. "We analyzed key inventory drivers to identify who was holding inventory and where. It turned out to be us almost exclusively. We realized our vendors could hold most of the inventory instead, and we made the changes necessary to accomplish just that." Reduced inventory levels translate into customer advantages, says Jeffrey Krisel, Dell's former director of asset management and now controller of Dell Financial Services. "If we're carrying inventory 12 days while our competitors and their retailers are carrying inventory for 50 days, consumers are given a choice between 12-day-old technology and 50- day-old technology," Krisel explains.
Amazon's cash conversion cycle is negative, meaning it is generating revenue from customers before it has to pay its suppliers for inventory, among other things. Think of it simply this way. When you buy something on Amazon, you enter your credit card or PayPal info, and, depending on the transaction, Amazon turns that into cash relatively quickly. Amazon, though, doesn't have to pay its suppliers for a much longer time after it has turned its sales into cash. Because of this set-up, Amazon is generating cash from its sales regardless of whether or not each sale is profitable. The negative cash conversion cycle is indicative of a strong management team headed by Jeff Bezos, and illustrates management's efficient use of working capital. More or less, a negative cash conversion cycle is simply an interest free way to finance operations through borrowing from suppliers. Amazon made a $92 million profit last quarter, or about 19 cents per share. That's peanuts compared to other tech giants like Google, which netted $3.93 billion last quarter, or eBay, which made $682 million.
Wal-Mart Stores Inc's Days Sales Outstanding for the three months ended in Oct. 2016 was 4.13. Wal-Mart Stores Inc's Days Inventory for the three months ended in Oct. 2016 was 48.65. Wal-Mart Stores Inc's Days Accounts Payable for the three months ended in Oct. 2016 was 44.84. Therefore, Wal-Mart Stores Inc's Cash Conversion Cycle (CCC) for the three months ended in Oct. 2016 was 7.94.