A company needs to closely monitor its working capital levels in order to keep its cash requirements firmly in check. Lack of attention to the investment in working capital (which is receivables, inventory, and payables) can result in a runaway need for cash, especially when sales are growing. A business can do this most effectively by instituting and enforcing a number of policies. The following working capital policies are sorted by the component of working capital that they most directly affect. Appropriate working capital policies are:
- Do not invest funds in illiquid investment vehicles. Even if a long-term investment opportunity offers the possibility of outsized returns, do not make the investment unless you are sure there are sufficient funds on hand to support all reasonable working capital needs during the period when the funds will be tied up in the investment.
- No investment duration shall exceed the forecasting period. If you are willing to tie up cash in somewhat illiquid investments, then at least keep from making investments that cannot be accessed for periods longer than what the company is currently forecasting. Otherwise, the company may find itself with a large cash requirement and no funds available to offset it.
- All deposited funds must be insured. Only invest cash in accounts that are insured by the FDIC, to guard against the loss of funds due to bank failure. This is a difficult policy to enforce, since a business may have to distribute excess cash among many bank accounts to fit within the insured limit.
Accounts Receivable Policies
- Do not allow payment terms greater than __ days. Do not allow the sales staff to offer terms to customers that exceed a specific number of days without prior approval by a senior manager.
- The maximum credit offered a customer is ___. Use a formula that best fits your industry to arrive at a reasonable maximum amount of credit to offer customers, over which a senior manager must approve the terms.
- Stop customer credit once days outstanding exceed __ days. This policy is designed to keep additional credit from being extended to a customer who is not paying in a timely manner.
- Stop customer credit if a customer check does not clear the bank. This is a prime indicator of impending customer insolvency, and so can be used as a trigger to withhold credit and thereby reduce bad debt.
- Review inventory on hand exceeding __ days of usage. It is exceedingly difficult to adopt rules that will minimize inventory, but consider this policy to bring excessive inventory levels to the attention of management.
- Adopt just-in-time purchasing on qualified raw materials and merchandise. This policy is designed to minimize on-hand inventories by making purchases as late as possible and having items delivered in small quantities.
- Drop shipped inventory is the preferred stocking method. This policy shifts inventory ownership to the company's suppliers, who ship directly to the company's customers on its behalf.
Accounts Payable Policies
- Do not pay accounts payable early. Adopt a monitoring system that highlights any payment made earlier than the due date required by the supplier.
- Require purchase orders for amounts exceeding $___. This policy enforces an examination of larger expenditures before they are actually made.
- Disallow purchases exceeding the department budget. If a manager commits to a specific expenditure level for his department, then do not allow expenditures above that level without approval by a senior manager.
The level of aggressiveness of working capital policies depends to a considerable extent upon the availability of a large, untapped line of credit. If this is available, a company can risk an occasional negative cash situation, since cash can be readily replenished from the line of credit.