by Prasanna Dhungel
Working Capital Management is an extremely important tool that every business owner must know by heart. It consists of three parts –
- Accounts Receivable (A/R) – what you lend or sold to others and are waiting for payment
- Inventory – what you have bought from others and have in stock to process further or manufactured products you have in stock to sell
- Accounts Payable (A/P) – what you need to pay others
The first and second parts are a drain on your cash. It is cash that you would have in your pocket that is now in others’ pocket. Your customers may be buying your products but you could go bankrupt if they don’t pay you on time and you don’t manage your working capital.
Let us take a simple example to hammer this concept. For example, Mr. Ram Thapa, owns a biscuit factory in Patan. He buys wheat from the farmer to manufacture biscuits, pays his workers to make biscuits out of wheat, keeps manufactured biscuits in his store and sells the biscuits to wholesalers in Kalimati.
Assume the following,
To start, Mr. Thapa has Rs 2,000 in Cash in the bank and Rs 2,000 worth of biscuits (Inventory) in store. He needs to pay the wheat farmer Rs 2,500 that is Account Payable.
He buys 50kg of wheat for cash from the farmer for Rs 20/kg. So he pays Rs 1,000.
He pays his worker Rs 500/day in Cash for 2 days to make biscuits. So he pays Rs 1,000.
He stores the manufactured biscuit in store. This makes the biscuits in store worth Rs 2,000 + Rs 2,000 = Rs. 4,000. However, he has no cash left in the bank now. A wholeseller, Mrs. Pasang Tamang, buys Rs 2,000 worth of biscuits from him for Rs 3,000 on credit and agrees to pay him the amount in 7 days. This reduces the biscuits in stock to Rs 2,000. Yes he made a profit of Rs 1,000 but he has Rs 0 in his pocket. This increases his A/R to Rs 3,000.
Do you see what the problem is? He has sold biscuits but has no cash in hand. He has A/R of Rs. 3000 and you would think he made a profit of Rs 1000 by selling the Rs 2000 worth of biscuit for Rs 3000. But he has no cash in hand. Now see what types of problems he can have with zero cash in his pocket –
- Let us say Mr. Hari Magar wants to buy biscuits worth Rs 10,000 from Mr. Ram. He wants Mr. Ram to manufacture and deliver the biscuits next month. Mr. Ram will have to buy wheat and employ people to do the work. Yet he has no cash to pay for the wheat or the people. So he has tells Mr. Magar that he cannot do the project for lack of cash and loses a big business opportunity. If he had collected the Rs 2,000 from Mr. Tamang, he would have cash to do this project. => Danger of giving your vendors your goods on credit rather than collecting cash.
- Mrs. Tamang tells Mr. Thapa that he will only pay Rs. 800 out of the Rs 3000 of biscuits as most of them were stale. Mr. Thapa couldn’t do anything about it as some of the biscuits he had in stock may have gotten stale. They were in the warehouse for 1 month. => Danger of having inventory on stock. You want to sell your inventory as soon as possible.
- Imagine what would have happened if Mr. Thapa had to clear the Rs 2500 in payable to the farmer first. He couldn’t have manufactured anything. He had Rs 2000 in the bank. If he had paid the farmer all of the money, he would still be down Rs. 500. And, he couldn’t have purchased the wheat of Rs. 1000 and paid his worker the Rs. 1000 to make the extra biscuit. He would be bankrupt.
Even if Mr. Thapa receives all Rs. 3000 from Mrs. Tamang but decides to clear the Rs. 2,500 account payable to the wheat farmer, he will be left with Rs. 500 cash on hand and no balance in the bank (because he used that to make the biscuits that he sold to Mrs. Tamang). With that money he won’t be able to produce enough biscuit to make a decent profit. Hence, for Mr. Thapa, working capital management, or when to clear account receivable, inventory and account payable is critical for smooth operation of his business.
Account Receivable (what others owe you) and Inventory are a drain on your cash. They can bleed your business to death. Account Payable (what you owe others) saves you cash. So you always want to maximize your account payable and reduce your account receivable and inventory.
Maximize Account Payable (but know that it’s a liability that you eventually have to clear)
Minimize Account Receivable and Inventory
[Account Payable] – [Account Receivable + Inventory]
Maximizing A/P can be tricky and is a sensitive matter. You don’t want to annoy your suppliers with too long A/P payment. They may stop supplying you in the future or may provide you inferior quality goods. Likewise, you don’t want to rely too much on one supplier as s/he may increase prices or stop supplying thereby impacting your production.