The Cash Flow On Total Assets Ratio Is Calculated By Making Your Working Capital Work

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Making Your Working Capital Work

The faster your business expands, the greater the need for working capital. If you don’t have enough working capital – the money needed to keep your business running – your business is doomed. Many companies, which are profitable on paper, are forced to “close their doors” due to the inability to pay off short-term debts as they fall due. However, by implementing good working capital management strategies, your business can flourish; in other words, your assets work for you!

At one point or another, most businesses need to borrow money to finance their growth. The possibility of obtaining a loan is based on the creditworthiness of the company. The two main factors that determine creditworthiness are the existence and extent of collateral and the liquidity of operations. Your company’s balance sheet is used to evaluate both of these factors. On your balance sheet, working capital represents the difference between current assets and current liabilities—the capital you currently have to finance your business. That number, plus key working capital ratios, shows your creditors your ability to pay your bills.

By definition, working capital is a company’s investment in current assets – cash, marketable securities, receivables and inventories. The difference between a company’s current assets and current liabilities is known as net working capital. Current liabilities include payables to suppliers, accrued expenses and the short-term part of loan or leasing repayments. The term “current” is generally defined as those assets or liabilities that will be liquidated during one business cycle, usually a year.

Decisions related to working capital and short-term financing are called Working Capital Management. These decisions include managing the relationship between the company’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that your business can continue to operate and that it has sufficient cash flow to meet short-term debt obligations and upcoming operating expenses.

The true test of a company’s ability to manage its financial affairs rests on how well it manages the conversion of assets into cash that will ultimately pay the bills. The ease with which your company converts its current assets (accounts receivable and inventory) into cash to meet its current liabilities is called “liquidity.” Relative liquidity is calculated in terms of the ratio — ratio of current assets to current liabilities. The rate at which receivables and inventory are converted into cash affects liquidity. All other things being equal, a company with a higher ratio of current assets to current liabilities is more liquid than a company with a lower ratio.

Most business activities affect working capital either by consuming working capital or creating it. A company’s cash goes through a series of stages in the working capital cycle. The working capital cycle begins with the conversion of cash into raw materials, then the conversion of raw materials into product, the conversion of product into sales, the conversion of sales into receivables, and finally the conversion of receivables back into cash.

The primary goal of working capital management is to reduce the length of time it takes for money to go through the working capital cycle. Obviously, the longer it takes for a business to convert its inventory into receivables and then convert its receivables into cash, the greater its cash flow difficulties. Conversely, the shorter the cycle of the company’s working capital, the faster the money and profit from sales on credit are realized.

Correct cash flow forecasting is essential for successful working capital management. In order to understand the magnitude and timing of cash flows, charting cash flow using cash flow forecasting is critical. Cash flow forecasting gives you a clearer picture of your sources of money and the expected date of their arrival. Recognizing these two factors will help you determine “what” you will spend money on and “when” you will need to spend it.

Working capital management includes managing cash, inventory, accounts receivable, accounts payable, and short-term financing. Because the following five working capital processes are interrelated, decisions made within each of the disciplines can affect the other processes and ultimately affect your company’s overall financial performance.

  • Money management: Cash management is the effective management of cash in a business to put cash to work faster and keep cash in revenue-generating applications. The use of banking services, safes and clean accounts enables quick credit of received funds, as well as income from interest on deposited funds. The lockbox service includes collecting, sorting, totaling and recording customer payments in addition to processing and depositing the necessary bank deposits. A clearing account is a pre-arranged, automatic “transfer” – by the bank – of funds from your checking account to a high-interest account.
  • Inventory management: Inventory management is the process of acquiring and maintaining an appropriate assortment of inventory while controlling the costs associated with ordering, warehousing, shipping, and handling. The use of Economic Order Quantity (EOQ) and Just-In-Time (JIT) inventory systems ensures smooth production, sales and/or customer service levels at minimal cost. EOQ is an inventory system that indicates the quantities to order—reflecting customer demand—and minimizes total ordering and holding costs. An EOQ inventory system utilizes the use of sales forecasts and historical reports of customer sales volume. A JIT inventory system relies on suppliers to ship products so that raw materials arrive at the manufacturing plant just in time. A JIT system reduces the amount of warehouse space required and lowers the dollar level of inventory.
  • Claims management: Accounts receivable management allows you, the business owner, to manage the entire credit and collection process intelligently and efficiently. Better insight into a customer’s financial strength, credit history and trends in payment patterns is paramount to reducing your bad debt exposure. While the Comprehensive Collection Process (CCP) greatly improves your cash flow, strengthens penetration into new markets and develops a broader customer base, CCP depends on your ability to quickly and easily make well-informed credit decisions that establish appropriate lines of credit. Your ability to quickly turn your receivables into cash is possible if you implement well-defined collection strategies.
  • Management of payment accounts: Accounts Payable Management (APM) is not simply “paying bills”. APM is a system/process that monitors, controls and optimizes the money a company spends. Whether it is money spent on direct input goods or services, such as raw materials used in the production of a product, or money spent on indirect materials, such as office supplies or miscellaneous costs that are not a direct factor in the finished product , the goal is to have a management system that not only saves money, but also controls costs.
  • Short-term financing: Short-term financing is the process of securing funds for a business for a short period, usually less than a year. The primary sources of short-term financing are business-to-business trade loans, loans from commercial banks or finance companies, receivables factoring, and business credit cards. Trade credit is a spontaneous source of financing because it arises from normal business transactions. In a prearranged contract, suppliers ship goods or provide services to their customers, who in turn pay their suppliers at a later date.

It is wise to invest your effort/time to pre-arrange and establish a revolving credit line with a commercial bank or finance company. In case the need arises to borrow cash, the funds would then be readily available. By arranging a line of credit before you need capital (cash), your company will not experience interruptions in sales or production due to cash shortages.

Factoring is short-term financing obtained by selling or transferring your receivables to a third party – at a discount – in exchange for immediate cash. The discount percentage depends on the age of the claim, the complexity of the collection process and the collectability of the claim.

A business credit card is quick and easy and eliminates pre-authorization. Using your business credit card will also protect you against losses if you may receive damaged goods or not receive goods you have already paid for. Depending on the type of credit card you choose for your business, you can earn bonuses, frequent flyer miles and cash back. However, keep a close eye on your spending and pay off most, if not all, of your debt each month.

To effectively manage working capital, it is wise to measure your progress and control your processes. A good rule of thumb is – – – If you can’t measure it, you can’t control it. Five working capital ratios to help you evaluate and measure your progress are:

  1. Inventory Turnover Ratio (ITR): ITR = cost of goods sold / average value of inventory. ITR shows how quickly you turn inventory. This ratio should be compared to the average within your industry. A low turnover ratio implies weak sales and therefore excess inventory. A high ratio implies either strong selling or ineffective buying.
  2. Receivables turnover ratio (RTR): RTR= Net credit sales / receivables. RTR shows how quickly your customers return payments for products/services provided. A high ratio implies that the company operates on a cash basis or that its credit granting and collection of receivables is efficient. A low ratio implies that the company needs to re-evaluate its credit policy to ensure timely collection of the granted loan that does not bring interest to the company.
  3. Payables Turnover Ratio (PTR): PTR = cost of sales / liabilities. Calculate this ratio to determine how quickly you pay your suppliers. If you consistently outperform industry standards, you may have developed leverage that will make it easier to negotiate discounts or other favorable terms.
  4. Current ratio (CR): CR = Total current assets / Total current liabilities. CR is primarily used to determine a company’s ability to pay off its short-term liabilities (debt and liabilities) with its current assets (cash, inventory, receivables). The higher the current ratio, the more able the company is to pay its obligations.
  5. Quick Ratio (QR): QR = (Total Current Assets – Inventory) / Total Current Liabilities Also known as the “acid test ratio,” QR predicts your current liquidity more accurately than the current ratio because it takes into account the time it takes to turn inventory into cash. The higher the QR, the more liquid the company is.

Working capital management is critical for small businesses because a large portion of their debt is in short-term liabilities versus long-term liabilities. Small businesses can minimize their investment in fixed assets by renting or leasing plant and equipment. However, there is no way to avoid investing in accounts receivable and inventory. Therefore, current assets are especially important for a small business owner. By effectively shortening the working capital cycle, you become less dependent on external financing. In other words, your working capital is really working for you.

Copyright 2008 Terry H. Hill:

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