Ten reasons working capital requirements can increase

2. Reasons for working capital requirement increases

Each of the three working capital components can and should be managed.  Of course, concentrating on only one of the components will likely yield results, but looking at several at a time may provide better outcomes.

In the list below, we will take a look at some reasons why working capital requirements can increase.

  1. Receivables – Problems with Credit Granting:  If a company doesn’t have a process to evaluate the creditworthiness of customers or such process is not adequate, the company will be selling products or services to customers that aren’t able to pay.  This will result in higher accounts receivable balances over time and ultimately receivable write-offs.
  2. Receivables – Billing Problems: If a company doesn’t issue invoices to customers timely, it will have to wait longer to receive payments.  This will result in higher investments in accounts receivable. In addition, if a company doesn’t have good controls to ensure there are no inaccuracies in customer invoices, customers will likely refuse to pay the company until invoice issues are resolved; this, too, can result in higher accounts receivable balances and their aging.
  3. Receivables – Growth of Sales: This is not necessarily a problem; however, when sales increase, it is highly probable that accounts receivable balances will increase as well. (As a separate note, inventory and accounts payable can also increase when sales growth takes place.)
  4. Receivables – Invoice Payment Terms Increase:  If a company decides to extend the payment term to its customers, the accounts receivable balance will increase.
  5. Inventory – Product Mix Changes: If a company decides to replace old products with new products and the new products need new inventory parts, any unused inventory parts for old products will not be used.  This will increase inventory balances (and will likely result in inventory part obsolescence).
  6. Inventory – Sales Forecasting Errors: If a company doesn’t do a good job with forecasting, it may overestimate sales.  When that happens, the company most likely will overproduce inventory which will sit in warehouses longer, and as the result, inventory balance will increase (as well as, the amount of cash invested in inventory).
  7. Inventory – Overproduction to Reduce Overhead Cost: It is possible that a company’s management is compensated based on financial performance.  To achieve lower cost of finished goods (and thus, higher gross margins), the company’s management may decide to produce more finished goods so that the fixed overhead cost is allocated over a larger number of units produced.  This will again result in higher than needed inventory balances, and thus, higher cash investment requirements for inventory.
  8. Accounts Payable – New Payment Terms or Suppliers: If a company chooses to work with new suppliers, the latter can require shorter payment terms.  This will reduce the accounts payable credit that the company has with suppliers.  The same situation will happen if suppliers change their payment terms requiring faster payments.  These situations decrease accounts payable and thus, increase working capital requirements.
  9. Accounts Payable – Taking Advantage of Early Payment Discounts:  If a company decides to pay faster because vendors provide discounts for prompt payments, the accounts payable balance will decrease.  This issue needs to be managed from a trade-off perspective as it may or may not be beneficial to pay bills faster to obtain prompt payment discounts.
  10. Accounts Payable – Incorrect Payments: If a company pays vendors sooner than needed due to errors in the accounting system, etc., the accounts payable balance will decrease.  Periodic reviews of the accounting system and payment terms may help to prevent this issue.
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