Literature Review:
The size and composition of working capital can vary between industries (Atrill P, 2006). For some types of business, the investment in working capital can be substantial. For example, a manufacturer will invest heavily in raw materials, work-in-progress and finished good and it will often sell its goods on credit, thereby generating trade debtors. A retailer, on the other hand, will hold only one form of stock (finished goods) and will usually sell goods for cash. Working capital represents a net investment in short-term assets. These assets are continually flowing into and out of a business and are essential for day-to-day operation. Further Atrill P, 2006 believe that the various elements of working capital are interrelated and can be seen as part of a short-term cycle.
According to Richard pike and Bill Neale "working capital refers to current assets less current liabilities - hence its alternative name of net current asset. Current assets include cash, marketable securities, debtors, and stocks. Current liabilities are obligations that are expected to be repaid within the year". Long term investment and financing decisions give rise to future cash flows which, when discounted by an appropriate cost of capital, determine the market value of a company. However, such long term decision will only result in the expected benefits for a company if attention is also paid to short term decision regarding current assets and liabilities. Current assets and liabilities, that are assets and liabilities with maturities of less than one year, need to be carefully managed. Net working capital is the term given to the difference between current assets and current liabilities.
Watson D and Head A, 2007 argued that "maintaining adequate working capital is not just important in the short term. Adequate liquidity is needed to ensure the survival of the business in the long term". Even a profitable company may fail without adequate cash flow to meet its liabilities. It can be argue as according to ACCA paper 2.4, 2005, "an excessively conservative approach to working capital management resulting in high-level of cash holdings will harm profits because the opportunity make a return on the assets tied up as cash will have been missed".
Therefore, in short, working capital is money used to pay short-term obligations such as creditors, to purchase stock, for paying wages etc - costs that are used to make and sell your product or deliver your service and will ultimately be recovered from sales. Basically working capital represents the funds that are required to operate a business on a day to day basis.
The management of working capital is an essential part of a business's short-term planning process. It is necessary for managers to decide how much of each element should be held. Watson D and Head A, 2007 have noted that there are costs associated with holding both too much and too little of each element. Managers must be aware of these costs in order to manage effectively. They must also be aware that there may be other, more profitable uses for the funds of the business. Hence the potential benefits must be weighed against the likely costs in order to achieve the optimum investment.
Level/scale of working capital
According to Meade, N & Gormley, F. 2006 the working capital needs of a particular business are likely to change over time as a result of change in the commercial environment. This means that working capital decisions are rarely one-off decisions. Managers must try to identify changes in an attempt to ensure the level of investment in working capital is appropriate. In addition to changes in the external environment, changes arising within the business such as changes in production methods (resulting, perhaps, in a need to hold less stock) and changes in the level of risk that managers are prepared to take could alter the required level of investment in working capital. Peter Atril, 2006 has also tried to explain the level of working capital in total investment.
Several factors motivate an understanding of the basics of investment analysis. First, the professional manager - regardless of functional speciality - benefits from a practical knowledge of the important elements of analysing and selecting capital projects. Second, a well-executed analysis often requires estimates best provided by those with functional area expertise and experience. For example, from the view point of working capital, the analyst may call on the marketer to estimate sales levels at various prices and trade discounts which affect debtors (customers) or the production specialist which affect creditors of raw material and up to some extent stocks and accountant to estimate variable costs of production, cash management and receivables. (Steven S et al, 1997)
The level of working capital required is also affected by the following factors:
The credit policy of suppliers. The less credit the company is allowed to take, the lower the level of payables and the higher the net investment in working capital (ACCA- F9, 2007/08). The investment of a business in working capital can be expressed in terms of time taken to move from cash ready for investment back to cash again. As Alan Pizzey, 1998 stated in his book that the working capital cycle starts with an order to supplier of raw material, which is delivered and waits in stock until requisitioned for use in the factory. This cost is combined with labour and overheads as work in progress during the production process, and then becomes finished goods stock awaiting sale. Once, sold the stock is transformed into a debtor and when the credit period has elapsed the debtor is changed into cash. Somewhere in this cycle, the supplier (a trade creditor) is paid for the material. A good manager will be able to reduce the time lag by increasing the velocity of circulation in the cycle, and making the funds invested work harder. The cash budget is a useful tool in this exercise.
The consequences of insufficient working capital:
The disadvantages suffered by a business which does not have sufficient working capital underline its importance. According to White, G et al 2001 operations may be prejudiced and growth stunted if there is not enough investment to finance stock and debtors. The major disadvantages are as follows:
Overtrading:
A company which tries to finance a certain volume of trade with insufficient working capital is said to be overtrading. Soufani, K. 2000 explains that expansion means more funds tied up in stock and debtors, and without capital available in the business this can only be accomplished by taking longer to pay trade creditors or by increasing the overdraft up to and even beyond the agreed limit. The working capital ratio may fall below 1:1, and the acid test ratio and debt to equity ratio will show signs of financial distress. If the trade creditors and/or the bank and/or the Inland Revenue withdraw their support, liquidation may be the result. Good working capital management means that the business will always have a reserve of liquid resources for use if the payment situation deteriorates. An overtrading business often needs only the slightest upset to its expected cash receipts to overbalance the fragile structure of other people's money which it is using to finance its operation.
Major parameters of working capital:
Inventory:
Another name of stocks is inventory. Inventory, or stock, may be classified into the following:
In most cases, finished goods will convert most rapidly into cash, but where customer tastes change rapidly, such as in the fashion trade, this stock can also be the most risky. Inventory is the least liquid of current assets. It is therefore vital to manage it in such a way that it can be converted from raw material to work in progress and finished goods as quickly as possible. (Pike R, Neale B, 1999). The form of inventory level varies from one firm to another. For a construction firm it may consist of bricks, timber and unsold houses, while for a retailer it is goods bought in for sale but as yet unsold. The level of inventory held is determined by factors such as the predictability of sales and production (more instability may call for more safety stocks), the length of time it takes to produce and the nature of the product. On the last point, note that a dairy company is likely to have low stock levels relative to sales because of the danger of deterioration, whereas a jeweller will have large inventories to offer greater choice to the customer. Manufacturers with lengthy production cycles such as shipbuilders will have proportionately higher inventories than, say, a fast food chain (Arnold G, 2005). Further, significant amounts of working capital can be invested in stocks of raw material, work in progress and finished goods. Stocks of raw material and work in progress can act as a buffer between different stages of the production process, ensuring its smooth operation. Stocks of finished goods allow the sales department to satisfy customer demand without unreasonable delay and potential loss of sales. These benefits of holding stock must be weighed against any costs incurred, however, if optimal stock levels are to be determined.
Investments which may be incurred in holding stocks include:
Firms have the difficult task of balancing the costs of holding inventories against the costs which arise from having low inventory levels. The cost of holding inventories include the lost interest on the money tied up in stocks as well as additional storage cost (for e.g. rent, secure and temperature-controlled warehouses), insurance cost and the risk of obsolescence.
The cost of holding low stocks levels fall into two categories.
Furthermore, other costs, such as lost sales or the opportunity cost of tying up funds will not be directly recorded by the accounting system. This lack of information concerning the cost of holding particular levels of stock makes the management of stock more difficult. (Atrill P, 2006)
Stock is carried for two reasons:
Inventory control is an important topic for both production management and financial management, which should work closely to establish an inventory policy that meets customer requirement while operating at optimum stock levels.
Overstocking results in the following:
Under stocking reduces the working capital required, but can lead to out of stock situation with orders unfulfilled, idle machines and underemployed workers. In the past, carrying higher than necessary stocks has been a way of compensation for inefficient production and distribution or poor forecasting. But in today's highly competitive global markets, with Japanese and other overseas businesses operating efficient production schedules and minimal stock levels, European companies have been forced to examine their inventory management processed more closely (Pike R, Neale B, 1999). P.L. Primrose, 1992 noted that "despite the almost universal belief to the contrary, inventory reduction should not be a major objective for investing in advanced manufacturing technology because the financial benefits from it can be relatively small compared with other benefits. High inventory levels are only a symptom of other problems;" if these problems are not first identified and solved, inventory reductions can be counterproductive. Further, according to Martin Smith and Chris Poole, 2007 "it may seem obvious that if you do not have products on the shelf, then business will be lost. What is not obvious, however, is the extent to which this can destroy value for retailers and manufacturers. For the manufacturer, 46 per cent of the time the shopper will either substitute for another brand or not buy at all, according to recent research for ECR (Efficient Consumer Response) Europe. For the retailer, the biggest risks are that products are not bought at all, or that the shopper will buy the product from a competing store. When they have no stock, this happens 30 per cent of the time."
In addition to counter this, and to maintain level of investment in stock, one approach is to design and operate the supply chain "from the shelf back", delivering whatever it takes to win with the consumer. Martin Smith and Chris Poole, 2007 noted that "it was Procter & Gamble that embraced this approach five years ago. As early as 2004, it was attributing some $1bn in annual sales growth to its new approach. However, while the returns are great, the difficulties involved are significant. Designing the supply chain from the shelf back requires flexibility and responsiveness, which increase probability with the need to reduce cost. In the UK, Tesco responded to different consumers' needs by supplementing its regular supermarkets with Tesco Extra and Metro stores, addressing different ends of the market. The manufacturers themselves supported this move by providing more product options and different pack sizes, but this undermined their cost reduction efforts, which were based on simplification and standardisation."
Now the question arises that with this complexity and competing demands, how can we match P&G's success? According to Martin Smith and Chris Poole, 2007, the answer is that there are three factors. One, "make the supply chain a key part of your business strategy, focused on delivering top line growth. Two, integrate supply chain management with sales and marketing. Three, build joint Tbusiness plans with your supply chain partners."
Trade Receivables:
According to Myers and Brealey (2000), accounts receivable or debtors are one of the important current assets. When one company sells goods to another company or a government agency, it does not usually expect to be paid immediately. These unpaid bills, or trade credit, make up the bulk of accounts receivable. Companies also sell goods on credit to the final consumers. This consumer credit makes up the remainder of accounts receivable.
Economic conditions, product pricing, product quality, and the firm's credit policies are the chief influences on the level of a firm's accounts receivable. All but the last of these influences are largely beyond the control of the financial manger. As with other current assets, however, the manager can vary the level of receivables in keeping with the trade-off between profitability and risk. Lowering credit standard may stimulate demand, which, in turn, should lead to higher sales and profits. But there is a cost to carrying the additional receivables, as well, as a greater risk of bad debt losses. The policy variables we consider include the quality of the trade accounts accepted. The length of the credit period, the cash discount (if any) for early payment, and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of credit sales that result in bad debt losses (James C. and John M, 2005)
Selling goods or services on credit results in cost that incurred by a business. This cost includes credit administration cost, bad debts and opportunities forgone in using the funds for more profitable purpose. When a company grants credit to its customers it incurs the risk of non-payments. Credit management, or more precisely credit risk management, refers to the systems, procedures and control which company has in place to ensure the efficient collection of customer payment and minimise the risk of non-payment. Selling goods on credit enables to increase sales resulting from the opportunity for customers to delay payment. Credit sales are a widespread, and appear to be the norm outside, the retail trade. When business offers to sell its goods or services on credit, it must have clear polices concerning
Credit risk management will form a key part of a company's overall risk management strategy. Weak credit risk management is a primary cause of many business (particularly) small business failures. Many small businesses, for e.g. neither have neither resources nor expertise to operate sound credit risk management system. (McMenamin J. 1999. Peter A. and Eddie M - 2001).
According to Yu-Chung Tsao & Gwo-Ji Sheen-2007, the traditional EOQ model tacitly assumes that payment must be made to the supplier immediately after the retailer receives the items. However, such an assumption is not necessarily what happens in the real world. Further he added that in practice, the supplier may often allow the retailer to have forward financing in order to increase demand or decrease inventory.
According to Huei Ho C et al, (2008) Suppliers often offer trade credit as a marketing strategy to increase sales and reduce on hand stock level. This means that the vendor allows the buyer a credit period for settling the amount owed during which no interest on the amount owed is charged. Gray D and Sharp K, 2007 said that an increase in customers is only good business if those customers pay. A numbers of researchers over the years have already dealt with the inventory model under the situation. Haley and Higgins-1973, Chapman et al.-1984, Goyal-1985, Daellenbach-1986 and Rachamadugu-1989 have examined the effect of the credit period on the optimal inventory policy from the retailer's point of view. Huang and Chung-2003 discussed replenishment and payment policies to minimize the total cost of cash discounts and payment delays.
Huang 2003 considered a scenario where not only does the supplier offer a credit period to the retailer, but also that where the retailer offers a credit period to his customer. Huang 2007 considered where the supplier would offer the retailer a partial permissible delay in payments for an order smaller than a predetermined quantity. The above approach on trade credit is based with the assumption that the supplier offers the buyer a ''one-part'' trade credit, i.e., the supplier offers a specified period without interest charge to the buyer that is to be paid off within a permissible delay period. As a result, with no incentive for making early payments, and earning interest through the accumulated revenue received during the credit period, the buyer postpones payment up to the last moment of the permissible period allowed by the supplier. Therefore, from the supplier's perspective, offering trade credit leads to delayed cash inflow and increases the risk of cash flow shortage and bad debt. To accelerate cash inflow and reduce the risk of a cash crisis and bad debt, the supplier may provide a cash discount to encourage the buyer to pay for goods quickly. In other words, the supplier offers a ''two-part'' trade credit to the buyer to balance the trade off between delayed payment and cash discount. For example, under a contract, the supplier agrees to a 2% discount deducted from the buyer's purchasing price if payment is made within 10 days. Otherwise, full payment is required within 30 days after the delivery (Huei Ho C et al, 2008).
While a jump in orders is good news, it comes with the added pressure of an increased level of debtors and time spent chasing payment, rather than developing the business. A high level of debtors could also mean an increased late payment that leads to lengthy cash conversion cycle, if you are not on top of recouping invoices. Depending on the sector, debtor days can range from 60 to 90, rather than the 30 days companies will have budgeted for. (Gray D and Sharp K, 2007). This has an impact on working capital. The solution is to release cash from where it is being most tied up - in this case, the invoices.
Over the years invoice finance has become a mainstream financial option for companies across a range of sectors, providing useful funding options for companies of all sizes. The main advantage of invoice finance is that companies can get paid a high percentage of the value of the sales invoice within 24 hours - typically 80 to 90 per cent. The two main product lines in invoice finance are "factoring" and "invoice discounting", both offering funding against invoices. The main difference between the two products is that factoring provides a fully outsourced credit control function, while with invoice discounting the company retains control of the credit ledger. Another advantage to invoice finance is that unlike traditional financing methods, available funds grow in line with your sales. (Gray D and Sharp K, 2007).
That avoids the time-consuming and often expensive renegotiation period you may experience with other types of funding. By using a factor, instant advice is available on the quality of your new customers so you can avoid bad debts and focus your business growth in the right direction. Invoice finance also fits with all stages of business life, from start-ups to more established and larger companies (Gray D and Sharp K, 2007).
Liquid/cash:
According to Meade, N & Gormley, F. 2006 Cash management is concerned with optimising the short term funding requirements of a company and as such is a financial activity of importance to the treasuries of companies operating in either a national or international environment. One technique used for cash management by companies is cash concentration (sweeping), this involves the transfer of funds between accounts in order to concentrate funds at a central point. Typically, for a multinational company, the central points are treasury controlled bank accounts denominated in the currencies in which the company does business. Funds are transferred to these treasury bank accounts from the bank accounts of the individual businesses of the multinational company. The concentration of cash in this manner results in reduced need for external debt, reductions in the cost of borrowing, increased returns in cases where there is excess cash and lower transaction costs.
The literature on cash (balance) management has developed sporadically over more than a century. Edgeworth (1888) is one of the earliest writers on cash management, he formulates a game in which a bank's resources are allocated to maximise profits and minimise penalties from having too few liquid assets. Later the paradigm of inventory control was introduced. Baumol (1952) formulated the cash management problem using this approach. Baumol's cash manager converted interest-bearing assets into cash at regular intervals to meet a deterministic demand for cash. Miller and Orr (1966) considered conversion between the same two assets, cash and a balance in an interest-bearing deposit account, where the demand for cash was stochastic (random). Further developments, considering more general cost structures and more general specifications for the stochastic behaviour of the cash flow, were made by Girgis (1968), Eppen and Fama (1969), Elton and Gruber (1974). A general assumption was that net cash flows were assumed to be independent and identically distributed; this assumption was relaxed by, among others, Hinderer and Waldman (2001). By definition, cash current asset and liability as a maturity of less than one year.( Myddelton D R, 2000 ) However, in practice the line between current and noncurrent has blurred in recent years. Marketable securities and debt are particularly susceptible to arbitrary classification. For this reason, working capital ratios should be used with caution. (White G, Sondhi A, Fried D, 2001) Short term liquidity analysis compares the firm's cash resources with its cash obligations. ( Keown A J et al, 2001 ) Conceptually, the ratios differ in whether levels (amount shown on the balance sheet) or flows (cash inflows and outflows) are used to gauge the relationship as below:
That exclude inventory and prepaid expenses from cash resources. "Recognizing that the conversion of inventory to cash is certain both in terms of timing and amount, and that prepaid expenses reflect past cash outflows rather than expected inflows. The included assets are "quick assets" because they can be quickly converted to cash". Finally, according to Myers and Brealey, 2000, the Cash Ratio, defined as
Cash Ratio = Cash +Marketable Securities / Current Liabilities
The most conservative of these measures of cash resources, as only actual cash and securities easily convertible to cash are used to measure cash resources. White G, Sondhi A, Fried D, 2001 the use of either the current or quick ratio implicitly assumes that the current assets will be converted to cash. In reality, however, firms do not actually liquidate their current assets to pay their current liabilities. Minimum levels of inventories and receivables are always needed to maintain operations. If all current assets are liquidated, the firm has effectively ceased operations. The process of generating inventories, collecting receivables, and paying suppliers is ongoing. These ratios therefore measure the margin of safety provided by the cash resources relative to obligations rather than expected cash flows. Liquidity analysis, moreover, is not independent of activity analysis. Poor receivables or inventory turnover limits the usefulness of the current and quick ratios. Obsolete inventory or uncollectible receivables are unlikely to be sources of cash. Thus, levels and changes in short term liquidity ratios over time should be examined in conjunction with turnover ratios.
The cash flow from operation ratio, measure liquidity by comparing actual cash flows (instead of current and potential cash resources) with current liabilities
Cash flow from operations ratio =
Cash flow from operations / current liabilities
This ratio avoids the issues of actual convertibility to cash, turnover, and the need for minimum levels of working capital (cash) to maintain operations. An important limitation of liquidity ratios is the absence of an economic or real world interpretation of those measures. Unlike the cash cycle liquidity measure, which reflects the number of days cash is tied up in the firm's operating cycle, there is no intuitive meaning to a current ratio of 1:5. For some companies that ratio would be high, for others dangerously low.
Policies of working capital:
Working capital policies:
Finance textbooks typically begin their working capital sections with a discussion of the risk and return tradeoffs inherent in alternative working capital policies. High risk, high returns working capital investment and financing strategies are referred to as aggressive; lower risk and return strategies are called moderate or matching; still lower risk and return is called conservative (Moyer et al, Pinches, Brigham and Gapenski, Gitman). According to Denzil Watson and Antony Head (2007) working capital is so important; a company will need to formulate clear policies concerning the various components of working capital. Key policies areas relate to the level of investment in working capital for a given level of operations and the extent to which working capital is financed from short term funds such as bank overdraft.
The predictive power of financial ratios has been a recurring subject of analysis, and researchers have also focused on grouping ratios into useful classifications (Chen and Shimerda, 1981). Another area of research has focused on the issue of using regression analysis versus traditional financial ratios for analysis and prediction, (Frecka and Lee, 1983). An interesting paper by Nunn, 1981 examined why firms have different levels of working capital. His paper dealt with the strategic determinants of working capital (cash, short term securities, accounts receivable, and inventory) on a product line basis. He used factor analysis to test 166 variables against the working capital policies of over 1700 businesses, or product lines, from 1971 to 1978. His final multiple regression model contained 19 variables pertaining to production, sales, accounting, competitive position, and industry factors. His model was used to explain why working capital levels differ between firms both within and across industries. Some earlier work by Gupta 1969 and Gupta and Huefner 1972 examined the differences in financial ratio averages between industries. The conclusion of both studies was that differences do exist in ratio means amongst industry groups. Pinches, Mingo and Caruthers 1973used factor analysis to develop seven classifications of ratios, and found that the classifications were stable over the 1951-1969 time periods. Johnson 1970 extended this work by finding cross-sectional stability of ratio groupings for both retailers and primary manufacturers. Similarly, Gombola and Ketz 1983 examined the stability of financial ratio patterns between manufacturing and retail firms and found them to be very stable over time, although the structure of the ratio patterns varied. Much of recent working capital literature focuses on special subsets of business. Ferconio and Lane 1991, Kincaid 1993, looked at the healthcare industry. Belt and Smith 1991 examined Australian companies; Kim, Rowland, and Kim 1992 investigated Japanese manufacturers in the United States; and Burns and Walker 1991 studied small businesses. However, these studies did not address the issue of differences in aggressive / conservative working capital policies.
Aggressive asset management results in capital being minimized in current assets versus long-term investments. This has the expectation of higher profitability but greater liquidity risk. As an alternative, a more conservative policy places a greater proportion of capital in liquid assets, but at the sacrifice of some profitability. To measure the degree of aggressiveness the current asset to total asset ratio is used, with a lower ratio meaning a relatively more aggressive policy (Herbert J & Visscher S, 1998).
Aggressive financing policies utilize higher levels of normally lower cost short-term debt and less long-term capital. Although lowering capital costs, this increases the risk of a short-term liquidity problem. A more conservative policy uses higher cost capital but postpones the principal repayment of debt, or avoids it entirely by using equity. The total current liability to total asset ratio is used to measure the degree of aggressive financing policy, with a high ratio being relatively more aggressive (Herbert J & Visscher S, 1998). Further Watson D and Head A (2007) noted that working capital policies of a company can be characterised as aggressive, moderate or conservative only by comparing them with the working capital policies of similar companies. He argued that there are no absolute benchmarks of what may be regarded as aggressive or otherwise, but these characterisations are useful for analysing the ways in which individual companies approach the operational problem of working capital management. All three approaches shown in following figure:
Besley S & Brigham E, (2000) has stated in their book that under the conditions of certainty, when sales, cost, lead times, payment periods, and so on are known for sure, all firms would hold only minimal levels of current assets. Any larger amounts would increase the need of external funding without a corresponding increase in profits, while any smaller holding s would involve late payments to labour and suppliers and lost sales due to inventory shortages and an overly restrictive credit policy. However, the situation changes when uncertainty occurs. Here the firm requires some minimum amount of cash and inventories based on expected payments, expected sales, expected order lead times, and so on, plus additional amounts, or safety stocks, which enable it to deal with departures from the expected values.
As noted above that key policy areas of working capital policy relates to the level of investment in working capital for a given level of operations and the extent to which working capital is financed from short term funds such as bank overdraft, short term bank loan, and trade credit.
Cash conversion cycle:
When managing cash, it is important to be aware of the operating cash cycle of the business. This may be defined as the time period between the outlay of cash necessary for the purchase of stocks and the ultimate receipt of cash from the sale of the goods. The operating cash cycle of a business that purchase goods on credit for subsequent resale on credit, is shown diagrammatically in figure below
The diagram shows that payment for goods acquired on credit occurs some time after the goods have been purchased and, therefore, no immediate cash outflow arises from the purchase. Similarly, cash receipts from debtors will occur sometime after the sale is made and so there will be no immediate cash inflow as a result of the sale. The operating cash cycle is the time period between the payment made to the creditor for goods supplied, and the receipt of cash from the debtor.
Myers and Brealey (2000) said that the operating cash cycle is important because it has a significant influence on the financing requirements of the business. The longer the cash cycle the greater the financing requirements of the business and the greater the financial risks. For this reason, a business is likely to want to reduce the operating cash cycle to the minimum possible period. The business that buys and sells on credit, the operating cash cycle can be calculated from the financial statements by the use of certain ratios, as follows:
Average stock turnover period (Plus) Average settlement period for debtors (Minus) Average payment period for creditors (Equals) operating cash cycle.
The CCC metric can be used to help measure liquidity level and organisational valuation. The measurement of liquidity assesses the firm's ability to cover obligations with cash flows (Gallinger, 1997; Lancaster et al., 1998). Corporate liquidity can be examined from two distinct ways: static or dynamic views. The static view is based on balance sheet data at a given point in time. This usually involves using traditional ratios - such as the current ratio and quick ratio - to assess the firm's ability to meet obligations through the liquidation of assets. While this approach is commonly used to measure corporate liquidity level, many authors suggest that the static nature of these financial ratios discourage their ability to measure liquidity adequately (Soenen, 1993; Emery, 1984). Other studies suggest that a second approach - a dynamic view - should be utilized to capture ongoing liquidity from the firm's operations (Hager, 1976; Kamath, 1989; Richards and Laughlin, 1980; Emery, 1984). As a dynamic measure of the time it takes a firm to go from cash outflow to cash inflow, the cash to cash cycle was first introduced by Gitman (1974) and further refined by Gitman and Sachdeva (1982). Other researchers have also used the cash conversion cycle to measure liquidity level in experimental studies of corporate performance (Lancaster and Stevens, 1996). By reflecting the net time interval between actual cash expenditures for the purchase of productive resources and the ultimate collection of receipts from product sales, the CCC provides a valid alternative for measuring corporate liquidity and depicting a company's average liquidity position. Further, firms can use the cash conversion cycle to evaluate changes in working capital and thereby assist in the monitoring and control of its components. Since it is important to invest available resources to yield the greatest economic benefit, a proper mix must be achieved between the amount of resources deployed to working capital and the amount deployed to capital investments. Therefore, a company's optimum liquidity position, the minimum level of liquidity necessary to support a given level of business activity, must be identified and regularly assessed (Schilling, 1996). The optimum position liquidity level for a firm is an on-going trade-off between financial decisions to shorten the CCC (which decreases minimum liquidity required) and operational decisions (which can lengthen the cash conversion cycle and therefore, increase minimum liquidity required). To determine minimum liquidity, a useful starting point would be the calculation of cash turnover, which entails a measure of the number of times cash cycles during the year for a firm. Cash turnover can be calculated by dividing the number of days in the year by the cash conversion cycle. Then, taking the cash turnover and dividing it into the annual cash expenditures can obtain the minimum liquidity required. Obviously, a direct relationship exists between the length of the CCC and the minimum liquidity required. If the cash conversion cycle lengthens, the minimum liquidity required increases. Conversely, if the cash conversion cycle shortens, the minimum liquidity required decreases (Schilling, 1996). Also, longer the CCC, the greater need for a company to obtain external finances. (Soenen, 1993; Moss and Stine, 1993). While an analysis of the cash conversion cycle hardly resolves the problem of finding management to deal with it more effectively. (Skomorowsky, 1988).
Cash transmission:
According to Farris, T & Hutchison, P 2002 a business will normally wish to benefit from receipts from customers at the earliest opportunity. The benefit is immediate where payment is made in cash. However, when payment is by cheque there is normally a delay of three to four working days before the cheque is cleared through the banking system. The business must therefore wait for this period before it can benefit from the amount paid in. In the case of a business that receives large amounts in the form of cheques, the opportunity cost of this delay can be very significant.
To avoid this delay, a business could require payments to be made in cash. However, Hinderer, K. & Waldman, H 2001 argued that this is not usually practical for a number of reasons. Another option is to ask for payment to be made by standing order or by direct debit from the customer's bank account. This should ensure that the amount owing is always transferred on the day that has been agreed. It is also possible for funds to be directly transferred to a business bank account. As a result of developments in computer technology, a customer can pay for items by using a debit card which results in his or her account being instantly debited and the business bank account being instantly credited with the specified amount. This method of payment is widely used by large retail business and may well extend to other types of business.
BIBLOGRAPHY
