Chapter One

Overview of Working Capital Management

INTRODUCTION

The uses of funds of a concern can be divided into two parts namely long-term funds and short-
term funds. The long -term investment may be termed as 'fixed investment.' A major part of the
long-term funds is invested in the fixed assets. These fixed assets are retained in the business to
earn profits during the life of the fixed assets. To run the business operations short-term assets
are also required.

Meaning and Terminology of Working Capital:-

Working Capital,
Capital, is the amount of capital that a business has available to meet the day-to-day
cash requirements of its operations, sometimes called gross working capital, simply refers to
current assets used in operations.

It refers to that part of the firm’s capital, which is required for Financing Short-Term or Current
Assets such as Cash, Marketable Securities, Debtors and Inventories. Working Capital is also
known as Revolving or circulating capital or short-term capital

Net Working Capitalis the difference between resources in cash or readily convertible into cash
(Current Assets) and organizational commitments for which cash will soon be required (Current
Liabilities) or it refers to the amount of current assets that exceeds current liabilities (i.e. CA –
CL)

Net Operating Working Capitalis defined as current assets minus non-interest-bearing current
liabilities. More specifically, net operating working capital is often expressed as cash and
marketable securities, accounts receivable, and inventories, less account payable and accruals.

Meaning of Working Capital Management

Working Capital Management is concerned with the problems that arise in attempting to manage
the current assets, current liabilities and the interrelationship that exists between them.

Working Capital Management means the deployment of current assets and current liabilities
efficiently so as to maximize short-term liquidity. It entails short term decisions – generally,
relating to the next one year period which is “reversible”

Two Steps Involved in the Working Capital Management:

 Forecasting the amount of working capital

 Determining the sources of working capital

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It is important to management working capital because that working capital is the life blood of
the business and fixed assets (long term assets) can be purchased on lease/hire purchase but
current assets cannot be.

Significance of Working Capital Management

Funds are needed in every business for carrying on day-to-day operations. Working capital funds
are regarded as the life blood of a business firm. A firm can exist and survive without making
profit but cannot survive without working capital funds. If a firm is not earning profit it may be
termed as 'sick', but, not having working capital may cause its bankruptcy. Thus, each firm must
decide how to balance the amount of working capital it holds, against the risk of failure.

Working capital has acquired a great significance and sound position in the recent past for the
twin objects of profitability and liquidity. In period of rising capital costs and scare funds, the
working capital is one of the most important areas requiring management review. It is rightly
observed that, "Constant management review is required to maintain appropriate levels in the
various working capital accounts. Mainly the success of a concern depends upon proper
management of working capital so "working capital management has been looked upon as the
driving seat of financial manager.

It consumes a great deal of time to increase profitability as well as to maintain proper liquidity at
minimum risk. There are many aspects of working capital management which make it an
important function of the finance manager. In fact we need to know when to look for working
capital funds, how to use them and how measure, plan and control them.

Objectives of Working Capital Management:

Management: - Some of the main objectives of managing
working capital of a firm are;

 To deciding optimum level of investment in various WC assets

 To decide optimal mix of short term and long term capital
 To decide appropriate means of short term financing

Working capital financing strategies/Policies

There are two source from which fund can be raised for current assets investment or working
capital investment.

1. Short term source which is current liabilities , and

2. Long term source such as share capital and long term borrowings.

The real question is; what portion of current asset should be financed by short term debt and
what portion by long term debt? Decision on such question will determine the financing mix for
working capital investment. This decision will involve tradeoff between profitability and risks.

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There are three working capital financing policies.

1. Maturity Matching Policy

The maturity matching, or “self-liquidating,” approach calls for matching asset and liability
maturities. All of the fixed assets plus the permanent current assets are financed with long-term
capital, but temporary current assets are financed with short-term debt. Inventory expected to be
sold in 30 days would be financed with a 30-day bank loan; a machine expected to last for 5
years would be financed with a 5-year loan; a 20-year building would be financed with a 20-year
mortgage bond; and so forth. Actually, two factors prevent an exact maturity matching:

(1) There is uncertainty about the lives of assets. For example, a firm might finance inventories
with a 30-day bank loan, expecting to sell the inventories and use the cash to retire the loan. But
if sales are slow, the cash would not be forthcoming, and the firm might not be able to pay off
the loan when it matures.

(2) Some common equity must be used, and common equity has no maturity. Still, when a firm
attempts to match asset and liability maturities, this is defined as a moderate current assets
financing policy.

Any ways, this policy minimize the risk that the firm will be unable to payout its maturing
obligations and this working capital investment expected profitability and risk level fall between
the other two policies.

2. Aggressive Policy
For a relatively aggressive firm that finances all of its fixed assets with long-term capital and part
of its permanent current assets with short-term, non spontaneous credit. Note that we used the
term “relatively” because there can be different degrees of aggressiveness. For example, if all of
the permanent current assets and part of the fixed assets were financed with short-term credit;
this would be a highly aggressive, extremely non conservative position, and the firm would be
very much subject to dangers from rising interest rates as well as to loan renewal problems.
However, short-term debt is often cheaper than long-term debt, and some firms are willing to
sacrifice safety for the chance of higher profits.

Thus, aggressive working capital investment policy the company holds a relatively small portion
of its total asset in the form of current asset. As a result, this policy yield a higher expected
profitability and a higher risk that the firm will unable to meet its short term obligation when
due.

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3. Conservative Policy
In this approach permanent capital is being used to finance all permanent asset requirements and
also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-
term, non spontaneous credit to meet its peak requirements, but it also meets a part of its
seasonal needs by “storing liquidity” in the form of marketable securities.

Thus, conservative working capital investment policy holds a relatively large portion of its total
asset in the form of current asset This policy result a lower expected profitability as measured by
the rate of return on total asset, because the rate of return on current asset investment normally
assumed to be less than the rate of return on fixed asset investment.

Characteristics of Working Capital

While managing the working capital, two characteristics of current assets should be kept in mind
that is

I. Short life span:

span: which means each constituent of current asset has comparatively very
short life span. Investment remains in a particular form of current asset for a short period.
and
II. Swift (rapid) transformation into other form of current asset ; the life span of current
assets depends upon the time required in the activities of procurement; production, sales
and collection and degree of synchronization (organization) among them.
III. Circular movement:
movement: At one given time both the current assets and current liabilities
exist in the business. The current assets and current liabilities are flowing round in a
business like an electric current. However, "The working capital plays the same role in
the business as the role of heart in human body. Working capital funds are generated and
these funds are circulated in the business. As and when this circulation stops, the business
becomes lifeless. It is because of this reason that he working capital is known as the
circulating capital as it circulates in the business just like blood in the human body."
Working Capital Cycle makes it clear that the amount of cash is obtained mainly from
issue of shares, borrowing and operations. Cash funds are used to purchase fixed assets,
raw materials and used to pay to creditors. The raw materials are processed; wages and
overhead expenses are paid which in result produce finished goods for sale. The sale of
goods may be for cash or credit. In the former case, cash is directly received while in
later case cash is collected from debtors. Funds are also generated from operation and
sale of fixed assets. A portion of profit is used for payment of interest, tax and dividends
while remaining is retained in the business. This cycle continues throughout the life of
the business firm.

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A circular movement nature and a very short life span of current assets results into swift
transformation into other form of current assets for a running business. These characteristics
have certain implications:

(i) Decision regarding management of the working capital had to be taken frequently
and on a repeat basis.
(ii) The various components of the working capital are closely related and
mismanagement of any one component adversely affects the other components
too.

Other characteristics:

 Permanency: Although it is just a kind of short term capital, working capital is

needed by business forever and always.

 Fluctuation: Working capital still fluctuates every now and then even it is
something permanent

 Less risky: investments in current asset such as working capital comes with less
risk for it is just for short term.

 No need for special accounting system: since working capital is short term asset
that will last for a year only, there will be ant need for adoption of special
accounting system.

Difference between the Working Capital Management and the Fixed Assets Management

In fact management of working capital is similar to that of fixed assets management in the sense
that in both cases a firm analyses their effects on its profitability and risk. However, fixed assets
management and working capital management differ in three important ways.

Firstly,
Firstly, in managing fixed assets time is very important. Consequently, discounting and
compounding aspects of time element play a significant role in capital budgeting and a minor
one in the working capital management.

Secondly, large holdings of current assets specially cash, strengthen a firm's liquidity position
(and reduce risks), but they also reduce overall profitability.

Thirdly,
Thirdly, the level of fixed as well as current assets depends upon the expected sales, but it is
only current assets, which can be adjusted with sales fluctuations in the short-run.

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CONSEQUENCES OF UNDER ASSESSMENT OF WORKING CAPITAL

 Growth may be stunted. It may become difficult for the enterprise to undertake projects
due to non-availability of working capital.
 Implementation of operating plan may become difficult and consequently the profit goals
may not be achieved.
 Cash crisis may emerge due to scarcity of working funds.
 Optimum capacity utilization of fixed assets may not be achieved due to non-availability
of the working capital
 The business may fail to honor its commitment in time, thereby adversely affecting its
credibility. This situation may lead to business closure.
 The business may be compelled to buy raw materials on credit and sell finished goods on
cash. In the process it may end up with increasing cost of purchases and reducing selling
prices by offering discounts. Both these situations would affect profitability adversely.
 Non-availability of stocks due to non-availability of funds may result in production
stoppage.

CONSEQUENCES OF OVER ASSESSMENT OF WORKING CAPITAL

 Excess of working capital may result in unnecessary accumulation of inventories.

 It may lead to offer too liberal credit terms to buyers and very poor recovery system and
cash management.
 It may make management complacent leading to its inefficiency.
 Over-investment in working capital makes capital less productive and may reduce return
on investment.

Working capital is very essential for success of a business and, therefore needs efficient
management and control. Each of the components of the working capital needs proper
management to optimize profit.

Financing Strategy Working Capital

Now let us understand the means to finance the working capital. Working capital or current
assets are hose assets, which unlike fixed assets change their forms rapidly. Due to this nature,
they need to be financed through short-term funds. Short-term funds are also called current
liabilities. The following are the major sources of raising short-term funds:

i. Supplier’s Credit

At times, business gets raw material on credit from the suppliers. The cost of raw material is paid
after some time, i.e. upon completion of the credit period. Thus, without having an outflow of
cash the business is in a position to use raw material and continue the activities. The credit given
by the suppliers of raw materials is for a short period and is considered current liabilities. These

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funds should be used for creating current assets like stock of raw material, stock work in process,
stock finished goods, etc…

ii. Bank Loan For Working Capital

This is a major source for raising short-term funds. Banks extend loans to businesses to help
them create necessary current assets so as to achieve there required business level. The loans are
available for creating the following current assets:

 Stock of raw materials

 Stock of work in process
 Stock of finished goods
 Debtors

Banks give short-term loans against these assets, keeping some security margin. The advances
given by banks against current assets are short-term in nature and banks have the right to ask for
immediate repayment if they consider doing so. Thus bank loans for creation of current assets are
also current liabilities.

Factors Influencing Working Capital Requirement

Numerous factors can influence the size and need of working capital in a concern. So no set rule
or formula can be framed. It is rightly observed that, "There is no precise way to determine the
exact amount of gross or net working capital for every enterprise. The data and problem of each
company should be analyzed to determine the amount of working capital. Briefly, the optimum
level of current assets depends upon following determinants.

Price level change:

change: With the increase in price level more and more working capital will be
needed for the same magnitude of current assets. The effect of rising prices will be different for
different enterprises.

Circulation of working capital:

capital: Less working capital will be needed with the increase in
circulation of working capital and vice-versa. Circulation means time required to complete one
cycle i.e. from cash to material, from material to work-in-progress, form work-in-progress to
finished goods, from finished goods to accounts receivable and from accounts receivable to cash.

Volume of sale:
sale: This is directly indicated with working capital requirement, with the increase in
sales more working capital is needed for finished goods and debtors, its vice versa is also true.

Liquidity and profitability:

profitability: There is a negative relationship between liquidity and profitability.
When working capital in relation to sales is increased it will reduce risk and profitability on one
side and will increase liquidity on the other side.

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Management ability:
ability: Proper co-ordination in production and distribution of goods may reduce
the requirement of working capital, as minimum funds will be invested in absolute inventory,
non-recoverable debts, etc.

External Environment:
Environment: With development of financial institutions, means of communication,
transport facility, etc., needs of working capital is reduced because it can be available as and
when needed.

Change in Technology:
Technology: Technological developments related to the production process have a
sharp impact on the need for working capital.

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