Lawrence Sports is a manufacturer and distributor of sports equipment and protective gear for baseball, football, basketball, and volleyball. They are a $20 million revenue company that relies heavily on purchases from Mayo Stores. Mayo is the world’s leading retailer and is Lawrence’s principal customer, which contributes 95% of its sales (University of Phoenix, 2012). If Mayo defaults on payments to Lawrence the result will have a trickledown effect, which includes borrowing more money from a bank at a higher interest rate and delaying payments to Lawrence’s other business partners’ Gartner and Murray.
A solid working capital policy that includes a cash conversion cycle will enable the company to develop finances in a successful way, which reduces redefining policy during times of short-term, unexpected, hardship. Lawrence Sports will implement a Cash Conversion Cycle that will allow Lawrence Sports to forecast future sources and uses of cash flow. Emery, Finnerty, & Stowe (2007) summarize that “The cash conversion cycle is the length of time between when a firm pays its accounts payable and when it collects on its accounts receivable.
The cash conversion cycle is equal to the inventory conversion period plus the receivables collection period minus the payables deferral period. ” (p. 659) The Cash Conversion Cycle will provide the means to keep track of average time customers pay bills and will give a view of quarter sales and cash inflow and outflow. For any business to be successful, management must ensure that the business working capital is effective and cash flow is positive to pay expenses. Team C will outline, analyze and determine which policy Lawrence Sports should follow.
The three potential working capital policies that will be considered for the company are maturity matching, long-term conservative approach, and short-term aggressive approach. The policy recommendation will analyze the risk; contingency, performance, and implementation plan measure associated. Lawrence Sports believes that modifying existing working capital policies to reduce future difficulties is vital to keeping the company competitive and profitable. One working capital policy will be selected.
An evaluation of he risk associated with the recommended policy will be discussed along with the contingencies. Performance measures will be discussed and an implementation plan will be included in reference to the new working capital policy for Lawrence Sports. Alternative Working Capital Policies Working capital policies is an organization’s management of current assets and liabilities with the goal of creating a balance between profitability and liquidity so that a firm can maximize the effectiveness of its day to day cash flow management. The two main factors that need to be considered are the risk of the finance used and the cost of finance; either by financing working capital using short or long-term source of finance” (Armah, 2010). The risk and cost associated with working capital are inversely related, the more risky a product the less the cost of borrowing is to the business, however the less risky a policy the more it costs the organization. The three most common types of alternative working capital polices include conservative, aggressive, and maturity matching approaches. Conservative Approach
The conservative approach to working capital as its names suggests notes that working daily capital is financed through long term financing and that short term financing is not commonly utilized. Short term financing is only used in emergencies and is quite restricted for daily financing activities. Emery, Finnerty, & Stowe (2007) note that the conservative approach is utilized “To guard against the risks of a credit shutoff or a sudden cost increase in lending, the conservative approach uses more long-term and less short-term financing than the maturity-matching approach”.
By utilizing the conservative approach, firms rely on long term rather than short term financing which offer a low risk, high cost working capital approach that often results in a risk adverse but less profitable business. Aggressive Approach The aggressive approach differs from the conservative approach because the business relies more on short term rather than long term financing to cover all its daily working capital and even some of its longer term investments.
This allows business to keep their debt expenses lower than the conservative approach to keep profits high; however this is a much riskier approach if the short term loans are not available. Palani & Mohideen (2012) note the advantage with the aggressive approach is that “Firms can reduce their financing costs and/or increase the funds available for expansion projects by minimizing the amount of investment tied up in current assets”.
The aggressive strategy is a low cost high risk approach that can lead to high profitability but will leave a company vulnerable to economic fluctuations as the daily liquidity for operations is low. Maturity Matching Approach The third approach the maturity matching or matching approach is a mix of both the conservative and aggressive approach to working capital management. This means that it uses a combination of both short and long term financing to cover its daily working capital requirements.
Short-Term Financial Decision-Making (1999) notes that a balance in working capital is critical because “Under-investing in working capital, while it may increase the risk of not being able to pay creditors, increases profits through reducing the cost of funds tied up in current assets. Thus too much working capital reduces risk and return: too little working capital increases risk and return. ” A firm that utilizes this approach balances their risk and cost for the use of capital and therefore balances their liquidity and profitability.
Recommendations, Implementation Plan, Risk, Contingencies, and Performance Review Recommendation and Implementation Plan Having reviewed the three alternative working capital policies discussed above, and based on feedback received from the Working Capital Management simulation (University of Phoenix, 2012) Learning Team C is recommending that Lawrence Sporting Goods adopt a short term aggressive approach to solving its current cash flow problems. This plan would call for renegotiated trade terms with all current vendors and suppliers to effect a more positive cash flow situation.
In so doing, Lawrence Sports will seek terms of sale and credit that allow it to leverage its customer relationships by leaning on its best customer for a more aggressive payment schedule, while satisfying its suppliers and building a solid foundation for potential future flexibility needs on their part. Risks As a business owner it is understood that there are inherent risk operations. Understanding the importance of balancing customer satisfaction with maintaining a viable and positive cash flow is vital to success.
In evaluating the risk associated with the alternatives presented it became clear that the short term aggressive approach would present the largest potential for damage to customer relations with Mayo, a major client. However these risks are mitigated in the fact that Lawrence Sports will not be able to pay its bills if the current cash shortage continues. Additional risks include the potential for higher interest cost that reduce cash flow, and bank credit freezes based on reduces cash flow all of which will have a negative impact on operations. Contingencies
As effective as any business plan can be there will always be the potential for things to change based on fluid market conditions. With this in mind Lawrence Sports has developed the following contingencies to supplement the recommended approach if needed. Assuming that the short term cash flow concerns should become a longer term issue for unforeseen reasons, Lawrence Sports is positioning itself for the opportunity to raise additional cash by offering shares in the company to venture capitalist as a means of raising cash for operations. Performance Review
Performance measurement, according to the American Heritage dictionary (1991), is the process of using data and key indicators to evaluate the success of and understand the impact that a plan or policy implementation is having a process. Using defined metrics Lawrence Sports will need to monitor its customer relations metrics to ensure that they are not pushing any relationships beyond their capabilities. It will also be necessary for them to evaluate the effectiveness of the revised trade plan to determine if it is meeting the cash flow requirements and make adjustments in the terms as needed.
Conclusion Working capital management has become one of the most important, yet difficult tasks for managers and executive today. Financial officers, including those at Lawrence Sports, are struggling to identify basic working capital drivers and an appropriate level of working capital ( Nazir & Afza, 2009). After using the Cash Conversion Cycle to forecast Lawrence Sports’ future cash flow, Team C concluded that the most effective working capital approach to take is the aggressive approach and rely heavily on short term financing.
While this approach carries the highest risk, it will also provide Lawrence Sports with the desired outcome of increasing their cash flow by paying off the substantial bank debt. The greatest risk is the damage the more aggressive approach will have on the relationships Lawrence Sports has with Mayo Stores as well as its suppliers Gartner and Murray. However, “effective cash management practices will enable companies to build stronger partnerships with customers and suppliers across the total working capital chain and ultimately translate into improved bottom-line results for all (Ashby, 2012)”. By effectively improving their working capital position through thoughtful consideration of the alternatives and the associated risks, implementation of their plan including contingencies and performance review, Lawrence Sports will strengthen their organization ultimately providing better goods and services which will benefit everyone.
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