INFORME DE EVALUACIÓN A LOS OFERENTES

At the shorter end of the time scale, there is another concept which is important to the financial structure of the firm. Working capital is defined as current assets less current liabilities, and represents a measure of the ability of the company to pay its way.

 Current assets are those assets of the business that can be converted into cash in the short term – usually within one year, in the normal course of business. These include cash held in bank accounts, moneys owed to the business (by trade debtors – basically customers who have been allowed credit in order to purchase the business's products), and any stocks of finished or part-finished goods. Current assets are important to businesses because they are the assets that, once converted into cash, can be used to fund day-to-day operations and pay ongoing expenses.

 Current liabilities are the debts or obligations of the business which are due to be paid in the short term – again, usually within one year, in the normal course of business. These include the bills that are due to suppliers (mostly trade creditors – those other businesses from whom materials and other supplies, such as energy, have been purchased to use in the production of its own goods and services), interest payments which have to be met and loans repaid.

It is usual to consider working capital in the context of a cycle of business activities. When a business begins to operate, cash will initially be provided by the proprietor or shareholders. This cash is then used to purchase fixed assets (machinery, etc.), with part being held to buy stocks of materials and to pay employees' wages.

This finances the setting up of the business to produce goods/services to sell to customers for cash, which sooner or later is received back by the business and used to purchase further materials, pay wages, etc. and so the process is repeated.

Figure 6.2: The Working Capital Cycle

Problems arise when, at any given time in the cycle, there is insufficient cash to pay creditors, who could have the business placed in liquidation if payment of debts is not received. One solution would be for the business to borrow to overcome the cash shortage, but this can be costly in terms of interest payments, even if a bank is prepared to grant a loan. A more appropriate response would be to strike a balance between assets and liabilities such that there is sufficient working capital and liabilities are always covered. Working capital requirements can fluctuate because of seasonal business variations, interruption to normal trading conditions, or external influences, such as changes in interest or tax rates. Unless the business has sufficient working capital available to cope with these fluctuations, expensive loans become necessary; otherwise insolvency may result. On the other hand, the situation may arise where a business has too much working capital tied up in idle stocks or with large debtors which could lose interest and therefore reduce profits. Irrespective of the method used for financing fixed and current assets, it is extremely important to ensure that there is sufficient working capital at all times and that this is not excessive. If working capital is in short supply, the fixed assets cannot be employed as effectively as is required to earn maximum profits. Conversely, if the working capital is too high, too much money is being locked up in stocks and other current assets. Possibly, the excessive working capital will have been built up at the sacrifice of fixed assets. If this is so, there will be a tendency for low efficiency to persist, with the inevitable running down of profits.

The management of working capital is an extremely important function in a business. It is mainly a balancing process between the cost of holding current assets and the risks

associated with holding very small or zero amounts of them. The issues involved in respect of the different current assets are as follows.

(a) Management of stocks which may include raw materials, work-in-progress (both in a manufacturing business) and finished goods. We have considered the costs of holding and of not holding stocks in a previous chapter, but we repeat them briefly here.

 The cost of holding stocks are:

(i) Financing costs – the cost of producing funds to acquire the stock held (ii) Storage costs

(iii) Insurance costs

(iv) Cost of losses as a result of theft, damage, etc. (v) Obsolescence cost and deterioration costs.

Expenses incurred with suppliers/employees

Goods/services produced

Cash from debtors

Debtors

Stock

Cash to creditors Cash

These costs can be considerable, and estimates suggest they can be between 20% and 100% per annum of the value of the stock held.

 The cost of holding very low (or zero) stocks:

(i) Cost of loss of customer goodwill if stocks not available

(ii) Ordering costs – low stock levels are usually associated with higher ordering costs than bulk purchases

(iii) Cost of production hold-ups owing to insufficient stocks.

The organisation will set the balance which achieves the minimum total cost, and arrive at optimal stock levels.

(b) Management of debtors requires identification and balancing of the following costs:  Costs of allowing credit:

(i) Financing costs

(ii) Cost of maintaining debtors' accounting records (iii) Cost of collecting the debts

(iv) Cost of bad debts written off

(v) Cost of obtaining a credit reference

(vi) Inflation cost – outstanding debts in periods of high inflation will lose value in terms of purchasing power.

 Cost of refusing credit:

(i) Loss of customer goodwill

(ii) Security costs owing to increased cash collection.

Again, the organisation will attempt to balance the two categories of costs – although this is not an easy task, as costs are often difficult to quantify. It is normal practice to establish credit limits for individual debtors.

(c) Management of cash. Again, two categories of cost need to be balanced:  Costs of holding cash:

(i) Loss of interest if cash were invested

(ii) Loss of purchasing power during times of high inflation (iii) Security and insurance costs.

 Costs of not holding cash:

(i) Cost of inability to meet bills as they fall due

(ii) Cost of lost opportunities for special-offer purchases

(iii) Cost of borrowing to obtain cash to meet unexpected demands.

Once again, the organisation must balance these costs to arrive at an optimal level of cash to hold. The technique of cash budgeting is of great help in cash management. It is quite possible for a firm to go out of business because of working capital problems. The business may have a good product, effective production systems and so on, but be unable to manage its short-term working capital cycle.