Working capital management

Working capital management involves handling the short-term assets and liabilities of a firm.
It focuses on the management of current assets like cash, bank balances, inventories,
receivables (debtors and bills), and marketable securities. Effective management of working
capital is crucial for any business for two main reasons: ensuring that there is enough
working capital to support the optimum use of fixed assets and avoiding the unnecessary
blockage of funds. Poorly managed working capital can lead to insufficient liquidity or the
wastage of scarce resources.

Key Aspects of Working Capital Management:

1. Level of Current Assets: Financial managers must decide the amount of money to
invest in each type of current asset. This decision impacts the firm's liquidity and
profitability.
2. Nature and Types of Working Capital:
o Gross Working Capital: Total investment in current assets.
o Net Working Capital: The excess of current assets over current liabilities.
3. Operating Cycle: The time period between the procurement of goods or raw
materials and the realization of sales revenue. The operating cycle duration affects the
amount of working capital needed.
4. Factors Influencing Working Capital Needs:
o Nature of Business: Retail and trading firms usually require less working
capital compared to manufacturing firms which need substantial working
capital for raw materials, labor, and overheads.
o Business Cycle Fluctuations: Different phases like boom and recession affect
working capital needs. During a boom, more funds are blocked in inventories
and receivables, whereas during a recession, these needs decrease.
o Seasonal Operations: Firms dealing with seasonal products require varying
levels of working capital throughout the year.
o Market Competitiveness: Firms in competitive markets may need to offer
credit to customers and maintain larger inventories, increasing working capital
needs.
o Credit Policy: The terms on which a firm buys and sells goods influence its
working capital requirements.
o Supply Conditions: The time taken by suppliers to deliver goods affects the
inventory levels and thus the working capital.

WORKING CAPITAL POLICY AND MANAGEMENT

Determining the working capital requirement involves considering various factors. The
financial manager must establish a well-defined working capital policy and a self-sufficient
capital management system. If goods are received shortly after placing an order, maintaining
high inventory levels may not be necessary. Conversely, larger inventories might be essential
for imported goods. Often, shopkeepers procure goods from wholesalers only when there is
demand, minimizing the need to keep all items in stock.

NEED FOR ADEQUATE WORKING CAPITAL

Adequate working capital is crucial for day-to-day operations. A firm must maintain a sound
working capital position to avoid adverse business impacts. The financial manager must
ensure that the firm has sufficient working capital to optimize the use of fixed assets. The
objective of financial management, maximizing shareholder wealth, cannot be achieved
without optimized operations.

Excessive Working Capital

 Unnecessary Accumulation of Inventories: Leads to waste, theft, and damage.

 Delays in Collection of Receivables: Results in overly liberal credit terms.
 Adverse Influence on Management Performance: Can negatively impact
managerial decisions.

Inadequate Working Capital

 Suboptimal Use of Fixed Assets: Fixed assets may not be fully utilized.
 Stagnant Firm Growth: Growth may stagnate.
 Interruptions in Production Schedule: Can lower profitability.
 Missed Opportunities: Firm may miss out on beneficial opportunities.
 Affected Goodwill: Firm's market reputation may suffer if liabilities are not met on
time.

WORKING CAPITAL PLANNING AND MANAGEMENT

Managing working capital well is important for keeping a business running smoothly and
making money. When a business's sales go up, it needs more working capital (money for
daily operations). The financial manager needs to make sure this money is available quickly.

Liquidity-Profitability Trade-Off

When managing working capital, it's important to balance having enough cash and making a
profit. If a business keeps too much cash or inventory, it can avoid problems like running out
of stock or not being able to pay bills. But, this can also mean the business isn't making as
much profit. On the other hand, if a business reduces cash and inventory to increase profits, it
risks running out of money or stock. Additionally, using current liabilities versus long-term
debt involves a risk-return trade-off. Greater reliance on short-term debt for financing current
assets increases liquidity risk, while long-term debt reduces this risk but can decrease
profitability.

Risk-Return Trade-Off

Balancing liquidity and profitability is crucial. Keeping more cash reduces the risk of running
out of money but can lower profits because the money isn't being used to make more money.
Increasing investments in assets that can generate more profit can increase profits but also
increases the risk of running out of money. The financial manager needs to find the right
balance to manage working capital effectively.

The importance of working capital management can be expressed in these points:

 1. The level of current assets changes often, depending on actual and forecasted sales.
Decisions to adjust current assets to the desired levels should be made promptly and
frequently.
2. Changing levels of current assets may require periodic reviews of financing patterns.
Financing needs for working capital should be reviewed regularly.
3. Poor working capital management can lead to lost sales and decreased profits.
4. Poor working capital management can also cause insolvency if the firm cannot meet
its liabilities and commitments.
5. Current assets usually make up a large part of the firm's total assets, involving
significant investment in current assets. There is a clear link between sales growth and
current asset levels. Sales growth requires adequate working capital, so the financial
manager must quickly provide and arrange additional working capital.

Types of Working Capital Needs

1 Permanent Working Capital: There is always a minimum level of working capital which is
continuously required by a firm in order to maintain its activities. Every firm must have a
minimum of cash, stock and other current assets in order to meet its business requirements
irte-spective of the level of operations. Even during slack season, every firm maintains some
current assets. This amount of working capital is constantly and regularly required in the
same way as fixed assets are required. So, it may also be called fixed working capital.

2. Temporary Working Capital: Over and above the permanent working capital, the
firm may also require additional working capital in order to meet the requirements
arising out of fluctuations in sales volume. This extra working capital needed to
support the increased volume of sales is known as temporary or fluctuations working
capital.

For example, in case of spurt in sales, more stock must be maintained in order to meet
the demand. This additional inventory may become excess when the normal sales
level reappears after some time.

Financing of Current Assets

Another important aspect of working capital management is deciding the pattern of financing
current assets. The firm must decide about the sources of funds whether to Break down
working capital needs into permanent and temporary components over time provides a useful
by product in terms of financing choice.

Permanent Component

The permanent component is predictable as it is linked to expected changes in sales or the

cost of goods sold over time.

Temporary Component

The temporary component is also predictable in general as it follows the same pattern every
year.
Thus, the two components of working capital need to be financed accordingly, and the
different sources of funds can be grouped as follows:

Long-Term Sources

These provide funds for a relatively longer period. Under this category, the main sources are:

 Share Capital
 Retained Earnings
 Debentures
 Long-Term Borrowing

Short-Term Sources

These usually provide funds for a short period, say up to one year or so. In this category, the
main sources are:

 Bank Credit
 Public Deposit
 Commercial Papers
 Factoring

Transactionary Sources

Spontaneous sources of finance are funds that a business gets through its normal operations,
like credit from suppliers and unpaid wages or expenses. When a firm delays payments, it can
use these funds at no cost.

For example, when a company buys inventory, suppliers often provide trade credit
automatically, based on the company’s purchase and expected sales. Additionally, unpaid
wages, accrued expenses, interest, and taxes also act as spontaneous financing.

There are different approaches to deciding the financing mix of the working capital as
follows:

Hedging Approach (Matching Approach)

The Hedging Approach to working capital financing divides total working capital needs into
two parts: permanent working capital and temporary working capital. Here's how it works in
simple terms:

1. Match Duration: The idea is to match the duration of assets and the period of
financing.
o Permanent Working Capital: Needs long-term financing (like fixed assets).
Use long-term sources like loans or equity.
o Temporary Working Capital: Needs short-term financing. Use short-term
sources like short-term loans.
 2. Example:
o If a company needs more inventory for a short season, it should use a short-
term loan. When the season ends and inventory is sold, the loan is repaid.
o Using long-term funds for short-term needs would leave the company with
extra cash it doesn't need, lowering profits.
3. Benefit: This approach ensures the company has the right amount of funds at the right
time without excess liquidity.
4. Challenge: Exact matching of asset duration and financing period is difficult due to
uncertainties.

Conservative Approach

The Conservative Approach to financing working capital focuses on

minimizing risk.

1. Low Risk: The finance manager avoids risk by using long-term sources to cover
all working capital needs. Short-term sources are only used for emergencies or
unexpected situations.

2. Long-Term Financing: Most or all working capital is financed with long-term funds,
reducing the risk of insolvency (being unable to pay debts).
3. Idle Funds: If there are no temporary working capital needs, the excess long-term
funds can be invested in marketable securities to earn extra income.
4. Small Use of Short-Term Funds: Only a small amount of short-term funds is used to
meet peak working capital needs, and liquidity is stored during off-peak times.

Aggressive Approach

An aggressive working capital policy means a company uses short-term funds to cover some
of its long-term financial needs. This approach increases short-term borrowing compared to a
more cautious strategy. The idea is to avoid having too much cash sitting idle while still
being able to pay immediate bills. However, it also means there's a higher risk of running out
of cash when it's needed. The goal is to save money on long-term loans and potentially make
more profit, even though it raises the risk of financial problems.

Hedging Approach vs. Conservative Approach

Hedging Approach

Advantages:

1. The cost of financing is reduced.

2. The investment in net working capital is nil or minimum.

Disadvantages:

1. Frequent efforts are required to arrange funds.

2. The risk is increased as the firm is vulnerable to sudden shocks.
Conservative Approach

Advantages:

1. It is less risky, and the firm is able to absorb shocks.

2. The firm does not face frequent financing problems.

Disadvantages:

1. The cost of financing is definitely higher.

2. Large investment is blocked in temporary working capital.