Working Capital Management Essay

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Working Capital

George has the sort of basic working capital practises one might expect from a small business. He keeps his inventory levels low during the slower months, but then ramps up inventory a little bit in advance of the busier months. George does seem to understand that the business is a little bit cyclical, and that he does not need to have massive inventories of any given item. So his working capital practices are designed to be able to pay the bank back month to month, more than anything else. These are sound and reasonable practices.

One of the biggest things is that the company basically goes month to month with its working capital. There is not a lot of flexibility with respect to the working capital needs, even though the cash flows appear to fluctuate for the business. The reality is that the business has done well, and George does seem to understand where the cash flow variations are within his business, but he should anticipate that maybe there will be changes in demand conditions. George right now builds his forecasts for this year based on last year, and while this is normal and reasonable practice, it might leave the business vulnerable if there are any changes in the demand conditions on a year over year basis.

The big thing with George is that working capital management is mostly about guarding against risk. The company is not large enough that it will benefit too much from the refined working capital management practices that can generate profits for a company that has economies of scale. However, it does need to ensure that there are no financial crises that the firm will suffer, and that should be the first priority with its working capital management.

b. There are a few potential pitfalls in this working capital management process. The first is that there is an element of subjectivity to his ordering, in particular that his ordering is based on last year plus an adjustment for where he thinks the business is going. Even at that, there is the risk that his inventory turnover is fairly slow -- he argues that six of something is better than twelve, and he is correct in that, but ideally he would be able to pay for a good with the income he earned selling it. Now, that is the optimal working capital practice, the sort of thing that a company like Costco does, and George is unlikely to even achieve that with a low turnover shop, but this is something for him to keep in mind. If there is a downturn in demand, then George will struggle with his inventory management, and there is likely still too much working capital tied up in inventory at this point.

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One thing that is also a pitfall is that he needs to ensure that he has enough revenue for each month's needs. George does recognize this, but his business is fairly highly-leveraged. What that means is that it is especially vulnerable to changes in demand, which would affect his revenue, and therefore become a problem for the company in terms of its working capital. So the big thing for George is not just to anticipate demand but to ensure that he has effectively anticipate revenue, because that is what will be an issue for him. Ideally, there will be enough money in reserve that he can pay the bank back for a few months without any new revenue -- such an approach would significantly reduce the risk that the business faces.

c. I would argue that the most important thing for George is to have a reserve. Right now, the company has a plan for its working capital, but it relies on the company being able to make sales projections. The company has to this point been fine with respect to meeting its obligations, but mainly because it has not had month or two period that were out of line with historical norms. George most certainly is not prepared for a down year, but he should be. Right now, the flow looks a little bit like this:

Jan

Feb

Mar

Apr

May

June

July

Aug

Sept

Oct

Nov

Dec

Inflows

Outflows

Reserve

2000

0

0

The outflows are basically steady, whereas the inflows are more variable. But in this model, the inflows are relatively predictable and there is very little risk, especially when the….....

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