Recommendation for the Course of Action
If I choose option 1 (factoring), I will have a total benefit of $24,147.94. This amount is almost three times the benefit of option 2 (discounting) equivalent to $15,340.93 difference. If this would be the firm’s annual savings and the only issue that will affect my decision, there is no second thought of choosing option 1. However, strict imposition of 30-day period would discourage potential and current customers that would affect my long-term profitability. This is on top of my firm’s inflexibility in streamlining strategic actions/ responses to the detriment of long-term opportunities because we will loose control of our customer credit leveraging. On the other hand, shareholders and other creditors basically want short-term profitability recurring in the form of cash and not merely graphical projections of increasing customer base in the fate of apparently aggravating cash conversion period. Therefore, there is a need for further considerations of other factors.
Freezing the financial aspect (as the computed benefits delimit the variables to my decision-making), opportunities for option 1 are higher conversion period, predictability of inventory level, and less risk on overdraft repayment. As a result, planning for the financial and operational aspect of the business would be more efficient. This will have positive effects in reducing lost opportunity for an investment endeavor, cost of warehousing and its consequent use to finance other investment, and security in financing permanent current assets. In effect, investors and creditors will increase their trust to the future operations of the company since its survival and business opportunities are easily observable including their increased confidence in its performance since only customers with relatively higher liquidity stayed transitions with the firm.
On the other hand, the three main opportunities suggested risk-aversion of the firm to the detriment of future possibilities of bigger returns. We may be dropping considerable amount of customers who relatively lack liquidity but are also bulk, repeat and strategic buyers. They could be seasonal customers who purchase in bulk and so payment is of minimal consideration. In addition, they could also be small but frequent buyers whose return in reselling/ consuming our products is intermittent and so requires contingent financial structuring. Lastly, they can be really bad debtors but have large access to end-users through their ocular presence in malls, billboards, etc. It could also be a situation of large customer with large bargaining power who wanted our policy to be customized as to give way to their own financial restructuring. These customers are causing us financial headache but also provide or marginally/ discretely providing strategic support in the value chain particularly in marketing.
Further, the factoring firm may not accept or undermine strategic and tactical plans in favor of operational ones. In this view, our firm, particularly the contingent actions of our sales and marketing teams to key customers, would lose its flexibility considering the fact that factor firm who will handle our key customer financial leveraging is seemingly “cash-based” rather customer-based. We can be a one-time news maker in this industry who is unforgiving and craving for an aspect that is usually referred by customers as really “the root of all evils”. What is more important to us, tangible (cash) or intangible (reputation) resources? As a result, our future is blurred as to gain above average returns to the detriment not only of shareholders and creditors’ incentive to invest in our firm but also the managerial incentive for more challenging and high paying job. And most importantly, our conservative customer base would limit our incentive intensifying value-added activities like product modifications and additional service to justify our harsh credit contract. However, with the stance of eliminating those who cannot pay within 50-day period, it is questionable that our firm would still permit pro-customer pursuits rather than strict asset management.
In comparison, opportunities in option 2 are the mitigated problem against low conversion period particularly the 40% of the debtors and maintained (have prospect to increase due to incentive) level of inventory. However, planning for financial and operational aspects would be more complex and the need for contingencies including its subsequent costs is necessary due to relatively ambiguous policy. The existence of 60% of bad debtors would injure the capability of the firm to invest in other profitable ventures including increase in the cost of warehousing and there is the necessity to allocate contingent financing for permanent current assets (due to the unreliability of overdrafts). In effect, shareholders and creditors would require me to explain further more intricate computations of risks. Their trust is not instantly given for the new strategy since it has trade-offs between predictability (lower risk) and profitability (higher risk) of the firm.
The relative ambiguity of option 2, on the other hand, has its long-term advantages. Old customers including the bad but strategic debtors will be retained, therefore, increasing the opportunity for bigger projects and larger profits. The fact that there is an incentive in the 30-day bracket would minimize ambiguity of future returns (from raw data to 40:60 ratios). As a result, the problem of financing permanent current assets can have relative ease in anticipation and leveraging. This would necessitate the firm’s managers and employees to continuously react and foresee the trends in order to maneuver possible adjustments like increasing the incentive from the 30-day bracket or coming up with disciplinary policy to hold deliveries when bad debts exceed the tolerable level. In this respect, the organization must perform beyond the expectations of shareholders and creditors in order to obtain their trust in our capability to collect in a determined period (although customer would translate this as approximate) including our dexterity to finance crucial permanent current assets. In effect, this will necessitate the resources and capabilities of a factoring firm but with the culture and mind-set of our company.
One of the most important issues of option 2 is that it increases our capacity to be flexible. Due to the challenging situation, we can test our professional extents without being too timid to financial drawbacks. Our movement towards risks and higher profitability would not be possible without our flexibility concretized by our culture, experience and intra-/ inter-departmental relationship among managers and employees. There is a treasured history of negotiation culminated between sales and marketing department and manufacturing, purchasing/ warehouse division and supplier/ customer markets, and sales and marketing and finance particularly accounts receivable unit. Are we willing to loose this relationship and adapt to new environment with outside parties? If this will be the case, then we would turn to formality and strictly business type started not by department managers rather from the small unit of account receivables. This would likely loose motivation of our collections department and undermines their informal communication and bargaining to customers.
According to the abovementioned scenarios, my selected strategy would be option 2. I would rather explain the shareholders and creditors how we can have a profitable tomorrow with our heads up rather than disclose the details of how we can improve our finances by hiding in the middle of our secured zones. The fact that we have a net benefit of 8,807.01 from the venture, although sub-optimal compared to option 1, the reduced number of bad debtors to only 60% and a more challenging environment for the organization particularly the sales and marketing and finance departments would be enough to express the improved situation from the previous performance. Strategic leadership is crucial and it depends on my ability and credibility including provisions of benefits for employees to convert this ambiguous and difficult situation into everybody’s legacy. This option is not at all aggressive stance as to lead to increased risk, overtrading and liquidity problems due to higher profitability because there is a reduction (less ambiguity) of bad debtors due to a minimal incentive of 1% (which could be encouraging in the coming periods), contingency plans for disciplinary actions, investors’ trust, and forecasted on-time payments. These can be our justification to our refused position against short-term, static and inflexible money-based decision in option 1.
The Balanced Strategy: Hybrid of Option 1 and Option 2
The subjective solution to option 2’s relatively risky stance of having a strategic leader and the firm being endowed with motivated employees can be set aside for a more objective (financial-based) approach to credit facility problem by integrating and polishing the flaws of the two options. The first phase is to identify the main problem which is the rising of collection period for sales to 50 days from the policy of 30 days. The symptom of such problem is the 1.5% increase in annual bad debts. In addition, there is a need to minimize the use of bank overdrafts by customers to limit the risk of loosing financing for permanent current assets.
Due to this, the factor service is limited to implement the following: the advance payment of 60% of debtors and interest rate at 15% level (as to offset impact of revision to the original offer). On the other hand, my strategy will be limited to only one: incentive of 1% or higher depending on the circumstances for 30-day bracket. As observed, the provision of the factor service to lead our collection platform is removed to support our flexible and collaborative incentive system. Also, its absorption of the 60% represents the bad debtors that is estimated in option 2 while the 15% annual interest represents its consultancy services and lost control of our internal operations. The additional burden in interest is justified by the absence of 2% sales commission that would then offset the administrative savings of $18,000. And even though we did not opt from the assurance of all customers to pay within 30 days, we are basically endowed with flexibility to allow us to apply the history of customer relationship and learning experience. On the other hand, overdraft payments and maintenance of workable bad debts would still remain a challenge involving company effort and negotiation with the factoring firm, creditors, shareholders, and customers.
This model is not a perfect and risk-free alternative. However, it embodies the possible advantages of factoring service and internal capabilities towards the attainment of short-term financial and long-term profitable health. If strategic leadership and motivated workforce would emerge in the picture, the minimized operational difficulties have their corresponding resolution. In effect, the need of liquidity does not eclipse the need for organizational challenges and prospects of the future of the firm. Liquidity is important to the firm as well as future opportunities that they are reinforcing factors for the firm to consider.
Optimizing a Firm’s Working Capital Position
Although a firm uses formal capital budgeting process wherein a minimum requirement of $2M should be approved by the Chief Operating Officer (CFO) and should show 12% rate of return, few proposals have received careful attention. Of course, nothing is lost from the firm while its capital structure remained untarnished. And so being, the numerical evaluation continues to be enjoyed by few engineers, accountants and technical people. There is also a departmental chronic habit to spend less in the first three quarters of the year and accelerate spending 25%-50% for the last quarter. This is referred as capital budgeting being out of control (Copeland & Ostrowski, 1993).
Although analytical tools like net present value (NPV) are helpful, the greatest obstacle to minimize the need for working/ physical capital to be able to enhance free cash flows is not guaranteed. This is when capital efficiency comes into the picture. The strategy requires managers to understand the demand of capital and its implementation of particular projects which in effect entails involvement from specific units. The teamwork would identify and manage resources and capabilities that provide value to the firm. In this process, inefficiencies will be eradicated so that operational expenditures can be an optimal reflection of capital spending. As a result, capital requirements are reduced between 10% and 25% without change in revenues or quality of products/ services provided to customers. A specific example of this activity is the measurement of capacity utilization of cable wires of telecommunications company and the size of transformers of an electric firm. By locating inefficiencies and value-adding activities, deferral or elimination of projects that can be a deceptive action (due to savings) can be re-analyzed to locate possible opportunities that are kept untapped (Copeland & Ostrowski, 1993).
Second, the optimization of working capital can also be attained when a firm uses appropriate accounting procedures to guide decision-making. An innovative measurement of corporate performance, economic value added (EVA) is defined as the difference between a company’s net operating income after taxes and its cost of capital of both equity and debt. It challenges the conventional accounting earnings for both security analysis and performance evaluation for the firm. EVA has the capability to show the wealth created by the firm during a period as accounting earnings can do but differs with the latter as it also measures the opportunity cost accrued by shareholders in investing to a specific firm activity (equity capital). Providing a clear grasp of equity capital, accounting distortions can be prevented. For example, the management proposes to establish a research and development facility. The current GAAP would impede this engagement as it will not include the wealth that can arise (reflected in the equity side). This could transform the opportunity to a risky strategy and would not receive approval (Chen & Dodd, 2001).
EVA is also applauded by its ability to reflect a more appropriate stock price and even result to higher stock returns (as in the case of Coca Cola’s 200% stock gain between 1987 and 1993 using EVA as performance measure and decision benchmark). In this foregoing, it is a clear indication that accounting practice has an impact to optimize the working capital, that without an efficient and relatively accurate performance measure, decision-making both in short- and long-term basis can be crippled. As a result, the firm would tend to be in risky position and would rather prefer to set aside/ ignore a value-adding venture just because of numerical impediments and distortions of accounting for earnings. Using a more accurate measurement of economic reality, EVA concretizes decision-making for the firm to be able to take relatively farther steps towards higher returns with enough liquidity left at home (Chen & Dodd, 2001).
The company’s working capital should not always be a source of risk. There is a need to balance this cognition to the reverse side of the venture which is opportunity. Our attack to the problem of optimization is two-edged that focus on activities to minimize the requirement of capital outlay (financial relaxation) and clearer understanding of firm standing for a particular venture (financial opportunity). With this in mind, the firm can optimize its working capital in the sense that it does not impede the prospects for the firm to think big and think in a futuristic manner. It also equips the company with efficiency and relative accounting accuracy bringing confidence to shareholders, creditors and employees including secured continuous improvement in supplier and customer relationships. Thus, the two-edged blade harvests a lot from the working capital indeed.
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