1.2. Operating cycle of the enterprise and its relationship to current assets

Movement of current assets during cycle goes through four basic stages consistently changing its forms.

Management of current assets of an enterprise is due to the specific design of its operating cycle. Operating cycle is a period of total turnover of entire amount of current assets in which there is a change of their individual species. He characterizes the period between the acquisition of inventory and receiving cash from sales generated from these products.

The most important characteristic of an operational cycle, significantly influencing the volume, structure and utilization of current assets is its duration. It includes the period time from the moment of spending money to purchase input inventories of assets to the receipt of money from the debtors for products sold to them.

Duration of operating cycle is calculated as follows:

OC = AI + CP, (1.1.3)

where OC – operating cycle, days; AI – age of inventories, days; CP – collection period, days.

The age of Inventory shows the number of days that inventory is held prior to being sold.

In the process of current assets management within the operating cycle there are distinguished two major components:

1. Production cycle of enterprise;

2. Financial cycle (or series of cash flow) of enterprise.

The production cycle of the company characterizes the period of total turnover of the material elements of current assets used to maintain the production process, starting from receipt of raw materials and semi finished products on enterprise and ending by the point of the shipment manufactured finished products to customers.

The duration of the production cycle of enterprise is determined by the following formula:

PC = RM + WIP + FP, (1.1.4)

where PC – production cycle, days; RM – raw materials and semi-finished goods average turnover, days; WIP – work in progress average turnover, days; FP – finished products stock average turnover, days.

Financial cycle (cash flow) of enterprise is a period of time between the beginning of payment to suppliers of raw materials received from them, and materials (satisfaction of accounts payable) and the beginning of cash receipts from customers for goods supplied to them (collection of receivables).

The financial cycle (cash flow) of an enterprise is determined by the following formula:

CF = PC + CP – CAP, (1.1.5)

where CF – cash flow, days; PC – production cycle, days; CP – collection period, days; CAP – current accounts payable satisfaction, days.

1.3. Strategies of financing current assets

An important role in organizing circulation of funds of enterprise plays working capital providing property and operational independence, which determine the financial sustainability of the enterprise. Initially, the formation of equity capital is carried out at the time of creation of a company. It provides fixed and current assets necessary to carry out commercial activities in the amount determined by the constituent documents.

Under conditions of complete economic independence, when businesses have broad powers at the disposal of their own property, at their turnover may be other personal funds, for example, temporarily unused funds of cash in the form of depreciation, bonus, stock maintenance and other specific sources of working capital are profitable investments of temporarily free financial resources.

In addition to its own sources of financing working capital of the enterprise funds are available equated to its own. These are stable liabilities which do not belong to the organization, but are constantly in circulation and used for the current financing. To sustainable liabilities relate:²

• Minimum turning wages payable arising due to timing differences in calculating the date of payment;

• Budget debt for payment of taxes, charge of which occurs prior to payment;

• Minimum debt reserve to cover future expenses and payments;

• Debts to suppliers of goods and services, payment term for which is yet to come;

• Due to advances to customers and a partial payment for products. Stable liabilities are a source for coverage of working capital only in the amount of increase, i.e. difference between the value of the end and beginning of the period. This source of funds is also called the proposed accounts payable.

In the turnover of the company, apart from its own and similar financial resources, there are also borrowed funds that are based on short-term loans from banks and other creditors. The literature also refers to as “long-term liabilities.”

Policy of current assets financing reflects the overall philosophy of company financial management from the standpoint of a reasonable ratio between the level of profitability and risk of financing activities. Depending on the choice of sources to cover the fixed and variable parts of the working capital economists such as E. Brigham, J. Van Horn, V. Teryokhin, G. Polyak, A. Horin and others identify the following models for financing working capital:

1. Aggressive;

2. Conservative;

3. Moderate (compromise, optimum, coherent).

In the economic literature is also found the concept of “ideal” model of financing of current assets, which leads to the equality of current assets and short-term liabilities.

The choice of a financing strategy boils down to release of the corresponding shares of the capital that is considered as a source of coating of current assets.

Conservative approach to the formation of current assets includes not only the satisfaction of current needs in all types of current assets, ensuring the normal course of operations, but also the creation of high amount of reserves for unforeseen difficulties. This approach ensures the minimization of commercial and financial risks, but also adversely affects the efficiency of current assets - their turnover and the level of profitability.

Conservative model assumes that the range of current assets is also covered by long-term liabilities (debt capital). In this case, there are no short-term liabilities, and therefore there is no risk of loss of liquidity. Net working capital is equal to current assets. This model is an artificial one.

It is believed that from the liquidity position conservative strategy is the least risky and at the same time it is accompanied by relatively low current returns, as the enterprise is forced to bear the additional cost of maintaining surplus inventory. Conservative model, in principle, is economically infeasible and from the point of view that in this case, the enterprise refuses from accounts payable, in some sense being a free source of funding.

An aggressive approach to the formation of current assets is to minimize all forms of insurance reserves for certain types of assets. In the absence of failures during the operating activities such an approach to the formation of current assets provides the highest level of efficiency.

Aggressive model means that the long-term capital is a source of coverage of noncurrent assets and system part of current assets, i.e. their minimum necessary to carry out economic activities. In this case net working capital is exactly equal to this minimum. Varying part of current assets fully covered by current liabilities. It is considered that from the liquidity position this strategy is risky because permanent sources of funding in this case are sufficient only to cover the minimum current assets, but in peak season the company might not find free resources to finance the additional requirements in industrial stocks. In other words, there will be a relatively high current income (as the costs of maintaining the current inventory is minimal) and a high risk of potential losses from business interruption and possible non-receipt of income during the rapid increase in demand for products.

Moderate approach to the formation of current assets is aimed at ensuring the full satisfaction of current needs in all their forms and the establishment of normal insurance reserves. With this approach the average ratio between the level of risk and level of effectiveness of current assets is provided.

This model is most realistic. In this case, non-current assets, the system part of current assets and approximately half of varying part of current assets are financed by long-term sources. Net working capital is equal in volume to the sum of the system part of current assets and half of varying part.

In certain moments of time the company might have excess current assets, which negatively affects the profits, though it is considered as payment for the maintenance of liquidity risk at the proper level.