WORKING CAPITAL MANAGEMENT

Working Capital Definition:y The amount of funds, which a company must have to

finance its day-to-day operations. y That proportion of the company s total capital, which is employed in short term operations . y Investment in short term assets like cash, inventories, debtors etc. is called Short-term Funds or Working Capital.

Variants of Working Capital

y Gross Vs. Net Working Capital y Gross Working Capital-Sum total of all current

assets of the firm also known as Current Capital or Circulating Capital . y Net Working Capital-Difference between the current assets and current liabilities.

Fixed Vs Variable Working Capital

y Fixed Working Capital-constant or minimum level, below, which the total investment in current assets does not fall. Also called as Fixed or Constant or Permanent working capital. y Variable Working Capital-The amount of funds needed over and above the Fixed Working Capital to take care of seasonal and other shifts. Also referred to as Fluctuating "or Temporary "Working Capital.

Factors determining Working capital requirements :The working capital needs of a business are influenced by numerous factors. The important ones are discussed in brief as given below: i) Nature of Enterprise The nature and the working capital requirements of an enterprise are interlinked. While a manufacturing industry has a long cycle of operation of the working capital, the same would be short in an enterprise involved in providing services, or in trading concerns. ii) Length of operating Cycle The manufacturing cycle starts with the purchase of raw material and is completed with the production of finished goods. If the manufacturing cycle involves a longer period, the need for working capital would be more. iii)Manufacturing/Production Policy Each enterprise in the manufacturing sector has its own production policy, some follow the policy of uniform production even if the demand varies from time to time, and others may follow the principle of 'demand-based production' in which production is based on the demand during that particular phase of time. Accordingly, the working capital requirements vary for both of them.

Factors determining Working capital requirements contd

iv) Cyclical and seasonal fluctuations The requirement of working capital fluctuates for seasonal business. The working capital needs of such businesses may increase considerably during the busy season and decrease during the slack season. Ice creams and cold drinks have a great demand during summers, while in winters the sales are negligible. v) Market Condition If there is high competition in the chosen product category, then one shall need to offer something like credit, immediate delivery of goods etc. for which the working capital requirement will be high. Otherwise, if there is no competition or less competition in the market then the working capital requirements will be low. vi) Availability of Raw Material If raw material is readily available then one need not maintain a large stock of the same, thereby reducing the working capital investment in raw material stock. On the other hand, if raw material is not readily available then a large inventory/stock needs to be maintained, thereby calling for substantial investment in the same.

Factors determining Working capital requirements contd..

vi)Growth and Expansion Growth and expansion in the volume of business results in enhancement of the working capital requirement. As business grows and expands, it needs a larger amount of working capital. Normally, the need for increased working capital funds precedes growth in business activities. vii)Price Level Changes Generally, rising price level requires a higher investment in the working capital. With increasing prices, the same level of current assets needs enhanced investment. viii)Terms of purchase and sale A firm buying RM on credit and selling goods on cash basis will require less inv. in working capital and vice versa. So amount of working capital depends on credit policy also. At times, business needs to estimate the requirement of working capital in advance for proper control and management. The factors discussed above influence the quantum of working capital in the business.

Working Capital & Operating Cycle

y It may be defined as a particular set of related activities that starts from y 1. 2. 3. 4. 5.

procurement of RM or Trading Goods and ends with the realisation of sales. The total time span is called Working Capital Cycle Period. It consists of sequential of following activities in a repeated manner: Transformation of liquid cash into RM or acquisition of RM or services by spending cash. Putting RM into WIP. Conversion of WIP into FG. Transformation of FG into cash through cash sales or into Debtors /Receivables through credit sales. Conversion of Debtors /Receivables into liquid cash.

Working Capital Cycle

Operating Cycle

Nature of Working Capital

y WCM is concerned with the problems that arise in attempting to manage y

y y y y

the CA and CL & the interrelationship that exists between them. The goal of WCM is to manage firms CA & CL in such a way so that a satisfactory level of WCM is maintained. Otherwise the firm may face bankruptcy or may become insolvent. The CA should be large enough to cover CL in order to ensure a reasonable level of Margin of safety. Each of CA should be efficiently managed to maintain liquidity. Too high or too low is not desirable. The interaction between CA & CL is main theme of WCM. The basic ingredients of the theory of WCM may be said to include its defination,need ,optimum level of CA, the trade off between profitability and risk which is associated with the level of financing mix, strategies and so on.

Significance of Working Capital

y Working capital is like heart of business, as inadequacy of this may lead to financial hazards. y An adequate amount of WC is required for paying off short term debts and running its operating cycle smoothly. y Thus adequate amount of working capital helps a concern to overcome odd financial situations. So stock of WC is often termed as shock absorber of the business

However excessive WC may resulting in y i)Wastage ,damage, theft of huge inventories. y ii)Delay in collection of receivables due to poor credit policy. y iii)Increase of cost of capital and decrease profitability.

Importance of Working Capital contd..

1.

2. 3. 4.

5. 6.

Supply of Raw Material:-WC is needed to maintain a steady flow of RM for a smooth production process in manufacturing concern. In trading concern goods are purchased for reselling. So there WC is also required . Regular payment of operating expenses:-WC is reqd for meeting diff exp like wages of labourers, salaries of the employees,purchase,overhead exp. Solvency:-It means short term loan repayment capacity which depends on the reserve of WC. Increase of Goodwill:-The short term goodwill of the firm largely depends on the amount of WC as adequacy of WC enables the firm to pay his short term obligations. Solving the crisis:-A strong WC base is required to overcome financial crisis and other odd situations. Exploitation of favourable market conditions:-A business concern must have an adequate WC for exploiting business opportunities. Steady flow of WC is required for purchasing high grade RM, paying for efficient workforce, using latest technologies etc.

Importance of Working Capital contd..

7.
Possibility of getting cash discount:-Adequate stock of WC make the company to purchase their stock in cash, so they can get the benefit of cash discount. 8. Increase in efficiency and productivity:-The regular flow of adequate WC makes possible efficient use of resources , reduces wastage, ensures quick recycle of CA etc, which indirectly increases the employees efficiency which results in increased productivity. 9. Increase in Profitability:-A quick rotation of WC and an efficient mgmt of WC helps to reduce cost and increase production which in turn leads to enhancement of profitability. 10. Regular payment of Dividend:-Increased profitability leads to regular payment of dividend, which in turn leads to increase of shareholder value. 11. Research and development:12. High morale of employees:-

Components of Current assets

Current assets of a firm include: y Cash balances y Accounts receivables y Inventories of
y Raw material y Work-in-progress y Finished goods

The two major characteristics of current assets are: y They have a short life span. Cash balances are held only for a week or so; accounts receivables typically are held for a duration of 30-60 days and inventories may be held for 30-100 days. y They are rapidly transformed into other asset forms. Cash is utilised to purchase raw material. Raw material is converted to work-in-progress, which in turn is converted to finished goods. Finished goods are sold for cash or credit, which creates accounts receivables. Accounts receivables are finally realised in cash.

Cash Management
y Cash is the most liquid current asset. It is of vital importance to the daily

operations of business. While the proportion of assets held in the form of cash is very small, its efficient management is crucial to the solvency of the business. Therefore, planning cash and controlling its use are very important tasks. y Cash budgeting is a useful device for this purpose.

Receivables Management
Given a choice, every business would prefer selling its produce on cash basis. However, due to factors like trade policies, prevailing marketing conditions, etc., businesses are compelled to sell their goods on credit. In certain circumstances, a business may deliberately extend credit as a strategy of increasing sales. Extending credit means creating a current asset in the form of Debtors or Accounts Receivable. Investment in this type of current assets needs proper and effective management as it gives rise to costs such as: i. Cost of carrying receivable (payment of interest etc.) ii. Cost of bad debt losses

Receivables Management
y Thus the objective of any management policy pertaining to accounts

receivables would be to ensure that the benefits arising due to the receivables are more than the cost incurred for receivables and the gap between benefit and cost increases resulting in increased profits. An effective control of receivables helps a great deal in properly managing it. Each business should, therefore, try to find out average credit extended to its client using the below given formula:
= Total amount of receivables / Average credit sales per day

Average credit Extended (in days)

y Each business should project expected sales and expected investment in

receivables based on various factors, which influence the working capital requirement. From this it would be possible to find out the average credit days using the above given formula. A business should continuously try to monitor the credit days and see that the average credit offered to clients is not crossing the budgeted period. Otherwise, the requirement of investment in the working capital would increase and, as a result, activities may get squeezed. This may lead to cash crisis.

Inventory Management
y Managing inventory is a juggling act. Excessive stocks can place a heavy burden

on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc. y The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factor would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them. y Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management. y The key issue for a business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up in stocks.

Inventory Management
Factors to be considered when determining optimum stock levels include: y What are the projected sales of each product? y How widely available are raw materials, components etc.? y How long does it take for delivery by suppliers? y Can you remove slow movers from your product range without compromising best sellers? y Remember that stock sitting on shelves for long periods of time ties up money which is not working for you. For better stock control, try the following: y Review the effectiveness of existing purchasing and inventory systems. y Know the stock turn for all major items of inventory. y Apply tight controls to the significant few items and simplify controls for the trivial many. y Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it. y Consider having part of your product outsourced to another manufacturer rather than make it yourself. y Review your security procedures to ensure that no stock "is going out the back door !" y Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.