WORKING CAPITAL MANAGEMENT

INTRODUCTION
Many companies still underestimate the importance of working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing these components, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a companys enterprise value by reducing capital employed and thus increasing asset productivity. High working capital ratios often mean that too much money is tied up in receivables and inventories. Typically, the knee-jerk reaction to this problem is to apply the big squeeze by aggressively collecting receivables, ruthlessly delaying payments to suppliers and cutting inventories across the board. But that only attacks the symptoms of working capital issues, not the root causes. A more effective approach is to fundamentally rethink and streamline key processes across the value chain. This will not only free up cash but lead to significant cost reductions at the same time. Many Companies that are profitable on paper are forced to cease trading due to an inability to meet short-term debts when they fall due. In order to remain in business it is essential that a Company successfully manages its working capital. Too often however, this is an area which is ignored. This article will look at the items which comprise working capital, and using live examples will consider the level of working capital required by businesses operating in different industries. We will also look at the problems faced by small businesses before reviewing some of the ways in which a Company can improve its management of working capital

DEFINITION
The definition of working capital is fairly simple, it is the difference between a Companies current assets and its current liabilities. Of more importance is its function which is primarily to support the day-to-day financial operations of a Company, including the purchase of stock, the payment of salaries, wages and other business expenses, and the financing of credit sales. As the cycle indicates, working capital comprises a number of different items and its management is difficult since these are often linked. Hence altering one item may impact adversely upon other areas of the business. For example, a reduction in the level of stock will see a fall in storage costs and reduce the danger of goods becoming obsolete. It will also reduce the level of resources that a Company has tied up in stock. However, such an action may damage a Companies relationship with its customers as they are forced to wait for new stock to be delivered, or worse still may result in lost sales as customers go elsewhere. Extending the credit period might attract new customers and lead to an increase in turnover. However, in order to finance this new credit facility a Company might require a bank overdraft. This might result in the profit arising from additional sales actually being less than the cost of the overdraft. Management must ensure that a business has sufficient working capital. Too little working capital will result in cash flow problems highlighted by a Company exceeding its agreed overdraft limit, failing to pay suppliers on time, and being unable to claim discounts for prompt payment. In the long run, a business with insufficient working capital will be unable to meet its current obligations and will be forced to cease trading even if it remains profitable on paper. On the other hand, if a Company ties up too much of its resources in working capital it will earn a lower than expected rate of return on capital employed. Again this is not a desirable situation.

Executive Summary
Working capital (also known as net working capital) is a financial metric that measures a companys operating liquidity.

Working capital is defined as current assets minus current liabilities. A positive position means that a company is able to support its dayto-day operationsi.e., to serve both maturing short-term debt and upcoming operational expenses. One of the metrics shortcomings, however, is that current assets often cannot be liquidated in the short term. High working capital positions often indicate that there is too much money tied up in accounts receivable and inventory, rather than short-term liquidity. All companies should therefore focus on the tight management of working capital. Inventory, accounts receivable, and accounts payable are of specific importance since they can be influenced most directly by operational management. Companies that improve their working capital management are able to free up cash and thus can, for example, reduce their dependence on outside funding, or finance additional growth projects.

If done right, working capital management generates cash for growth together with streamlined processes along the value chain and lower costs. Management of current assets needs to seek an answer to the following question:1. Why should you invest in current assets? 2. How much should be invested in each type of current assets ? 3. What should be the proportion of short term and long-term funds to finance the current assets ?

4. What sources of funds should be used to finance current assets ?

CONCEPT OF WORKING CAPITAL

The term working capital refers to the amount of capital which is readily available to a company. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and Company commitments for which cash will soon be required (Current Liabilities). Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business". Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business". Thus:
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

In a company's balance sheet components of working capital are reported under the following headings: Current Assets: Liquid Assets (cash and bank deposits) Inventory Debtors and Receivables Current Liabilities: Bank Overdraft Creditors and Payables Other Short Term Liabilities There are two definitions of working capital (1) Gross working capital (2) Net working capital

Gross working capital refers to working capital as the total of current assets, whereas the net working capital refers to working capital as excess of current assets over current liabilities. In other words net working capital refers to current assets financed by long term funds. Accordingly, Gross working capital = Total current assets Net working capital = Current assets Current liabilities The Net working capital position of the firm is an important consideration, as this will determine the firms profitability and risk. Here the profitability refers to profits after expenses and risk refers to the probability that a firm will become technically insolvent where it will be unable to meet obligations when they become due for payment. A finance manager has to make an appropriate financing mix, which will limit the risk and increase the profitability. Financing mix refers to the proportion of current assets financed by current liabilities and long term funds. There are two approaches which determine the financing mix (1) Aggressive approach (2) Conservative approach. According to aggressive approach the long term funds are used to finance only the core or fixed portion of current assets (e.g., minimum level of finished goods inventory, raw material etc) and the other portion i.e. temporary and seasonal requirements are financed by short term funds. This is of high risk and high profit financing mix.

According to conservative approach the total current assets are financed from long term sources and short term sources are used only in emergency situation i.e. when there is an unexpected cash outflow. This is of low-risk and low-profit financing mix. As we observed two methods of financing mix, one method is of high risk high profit and other is of risk low profit. A finance manager has to trade off between these two extremes.

The Importance Management

of

Good

Working

Capital

From a company's point of view, excess working capital means operating inefficiencies. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum balance of each of the working capital components. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible, thereby maximizing the interest earned. However, such cash may more appropriately be "invested" in other assets or in reducing other liabilities. Working capital management takes place on two levels: * Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management * The individual components of working capital can be effectively

managed by using various techniques and strategies When considering these techniques and strategies, companies need to recognize that each department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to department. For example, some departments have significant inventory levels; others have little if any inventory. Furthermore, working capital management is not an end in itself. It is an integral part of the department's overall management. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance.

OPERATING CYCLE
The objective of financial management is to maximize the shareholders wealth. So it is needed to generate sufficient profits. The profits generated depend mainly on sales volume. When the goods are being sold on credit as is the normal practice of business firms today to cope with increased competition the sale of goods cannot be converted into cash instantly because of time lag between sales and realization of cash. As there is a time lag between sales and realization of receivables there is a need for sufficient working capital to deal with the problem which arises due to lack of immediate realization of cash against goods sold. The operating cycle is the length of time required for conversion of non-cash assets into cash. This operating cycle refers to the time taken for the conversion of cash into raw material, raw materials into work-in-progress, work-in-progress into finished goods, finished into receivables into cash and this cycle repeats.

The operating cycle length differs from firm to firm. If a firm has lengthy production process or a firm has liberal credit policy the length of operating cycle will be more. On the other hand, if a firm does not extent credit or the firm is not a manufacturing concern i.e. where cash will be converted into inventory directly then the length of operating cycle will be reduced to a greater extent. The length of operating cycle can be calculated by calculating periods of raw material storage, work in process, finished gods storage and debtors collection period. 1. Raw materials storage period = Average stock of raw materials and stores/ Average daily consumption of raw material and stores 2. Work in process period = Average work in process inventory /Average cost of production per day 3. Finished goods storage period = Average finished goods inventory / Average cost of goods sold per day 4. Debtors collection period = Average book debts / Average credit sales per day Length of operating cycle = 1+2+ 3+4

CA SH

RAW M A TER I AL

R EC EI VABL E

A CCO U NT

PRO G RE SS

W O RK I N

GOODS

FI NI SH E D

FINISHED GOODS

WORK IN RAW PROGRESS MATERIAL

OPERATING CYCLE AND WORKING CAPITAL ANALYSIS

The operating cycle of a firm begins with the acquisition of the raw materials and store and with the collections of receivables. It is the sum of four periods, namely

a. Raw Materials & Store Period:This is the time for which raw materials and stores are kept in inventory. Average stock of raw material & store Average daily consumption of raw material & stores

b. Work in progress period:This is the required to transform raw material into finished goods. Average Work-in-Progress inventory Average cost of production per day

c. Finished goods storage period:This is the time for which finished goods remain in inventory before sale. Average Finished Goods inventory Average Cost of Production per day

d. Debtor Collection Period:This is the time required for collecting the receivable arising from credit sales. Average Book Debts Average credit sales per day

e. Creditors Payment period:This is purchasing raw material on credit & deferred the payment

Average creditors Total credit purchase

WORKING CAPITAL MANAGEMENT

INTRODUCTION DEFINITION EXECUTIVE SUMMARY CONCEPT OF WORKING CAPITAL IMPORTANCE OF GOOD WORKING CAPITAL APPROCHES OF WORKING CAPITAL OPERATING CYCLE OPERATING CYCLE & WORKING CAPITAL ANALYSIS