Management of Working Capital

                    

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 CHAPTER I

MANAGAMENT OF WORKING CAPITAL

                     Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the inter relationship that exists between them. The goal of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.  This is so because of the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy

Concepts of Working Capital

                   Working capital 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.  Funds invested in current assets keep revolving fast and are being constantly converted into cash and this cash flow out again in exchange for other current assets. Hence it is also known as revolving or circulating capital or short – term capital

        In the words of Shubin “Working capital is the amount of funds necessary to cover the cost of operating the enterprise”

                   There are two concepts of working capital:

(A)      Balance Sheet Concept

(B)       Operating Cycle or Circular Flow Concept

Balance Sheet Concept

(a)      Gross working capital refers to the amount of funds invested in current assets current assets are the assets which can be converted into cash within an accounting year and include cash, short- term securities, debtors, bills receivables and stock.

(b)       Net Working Capital refers to the difference between current assets and current liabilities

              Net Working Capital indicates: -

i.                    The liquidity position of the firm

ii.                  The working capital that should be financed by using permanent source of funds.

                        The net working capital may be a negative or a positive. When the current asset exceeds current liabilities, the net working capital is said to be positive. But when the current liabilities are more than current assets, the net working capital becomes negative

Operating cycle OR Circular Flow Concept of Working Capital

                     The working capital is also known as circulating capital because it regularly and continuously; circulates or converts from one form to another. The circular flow in a newly set-up undertaking begins with conversion of cash into raw materials which are in turn transformed into work-in-progress and then into finished goods. With the sale of finished goods, the finished goods turn into accounts receivables. Collection of the receivables brings back the cycle to cash. The cash received or profit from such operation is used to pay taxes and declare dividends.  The amount left in hand is put into this circulation again. Thus through the process in a firm, the values are changed from one form to another

                                                Cash

                            Debtors’                    raw materials                                           

   

       

                      Sales                                     work in progress

                       

                                          Finished goods

Classification of working capital

      

              From the point of view of the period for which capital is required, working capital can be divided into two categories viz, permanent working capital and temporary working capital.

1. Permanent Working Capital - There is always a minimum level of current assets always required by a firm, to carry on its operations. The minimum level of current assets always known as permanent working capital. It is also called core working capital, regular working capital or fixed working capital. Normally fixed working capital is fixed in nature. But it should be noted that as the business grows, the amount of permanent working capital would also increase.   

                    The permanent working capital can further be classified as regular working capital and reserve working capital regular working capital required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on. Reserve working capital is the excess amount over the requirement for regular working capital, which may be provided for contingencies that may arise at unstated periods such as strikes, rise in prices, depression, etc.

2. Temporary or variable working capital- Temporary or variable working capital is the amount of working capital, which is required to meet the seasonal demands and some special exigencies. Variable working capital can be further classified as seasonal working capital and special working capital most of the enterprises have to provide additional working capital to meet the seasonal and special needs.  The capital required to meet the seasonal needs of the enterprise is called seasonal working capital. Special working capital a is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research etc.

 

Importance of Adequate Working Capital

                        Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business.  The main advantages of maintaining adequate amount of working capital are as follows:

a.              Solvency of the business – Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

b.             Goodwill – sufficient working capital enables a business concerns to make prompt payments and hence helps in creating and maintaining goodwill

c.              Cash discounts – Adequate working capital also enable to take advantage of cash discounts by making payments in time.

d.             Easy Loans - A concern having adequate working capital, high solvency and good credit standing can arrange loans from bank and others on easy and favorable terms.

e.              Regular supply of raw materials   - Sufficient working capital ensures regular supply of raw materials and continuous production.

f.              Exploitation of favorable Market Condition  - Only concerns with adequate working capital can exploit favorable market   conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices

g.             Ability to face crisis - Adequate working capital enables concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital Regular payment of salaries, wages and other day to day commitments

Disadvantages of Redundant or Excessive working capital

                 The management is to ensure that the firm has adequate working capital to run its business operations smoothly.  Inadequate working capital results in inefficiency and consequently decreased profitability.  The following are the disadvantages of inadequate working capital:-

 

a.              As the firm is found unable to honor its short-term obligations in time it loses some of its credit worthiness.

b.              The firm finds it difficult to grow profitable projects are not undertaken due to inadequacy of working capital

c.              Fixed assets are not fully and efficiently utilized because of inadequacy of working capital. It decreases firm’s profitability.

d.             There may be interruptions in production the result is that the profit targets are not met

Disadvantages of Inadequate working capital

                               Excessive working capital has also to be avoided. Excessive working capital means idle funds earning no profit for the firm. It also lowers profitability. The following are the disadvantages of excessive working capital:-

1. Excessive working capital may be an indication of excessively liberal credit policy and slack collection from customers resulting in higher incidence of bad debts.
2. It may also lead to speculative transactions.
3. It may mean unnecessary accumulation of inventories.
4. Excessive working capital means idle funds which earn no profit for the business and hence the business cannot earn a proper rate of return on its investment.
5. It may lead to overall inefficiency in the organization.
6. Due to low rate of return on investments, the value of shares may also fall.

Factors Determining the Working Capital Requirements

                      The working capital requirements of a concern depend up on a large number of factors such as nature and size of business, the length of production cycle etc. The determinants of working capital requirements are classified into two- External factors and internal factors

                                

                                Determinants of working capital

 

                     Internal Factors                                             External Factors

1. Nature and size of business
2. Production Policy
3. Firm’s credit Policy
4. Manufacturing cycle
5. Availability of credit
6. Access of money market
7. Growth and Expansion of business
8. Dividend policy
9. Depreciation policy
10. Operating efficiency of firm

1. Business fluctuations
2. Technological Developments
3. Transport and communication Developments.
4. Import policy
5. Taxation Policy

A. Internal Factors

a. Nature and size of Business   - The working capital requirements of a firm basically depends upon the nature of its business.  Public utility undertakings like electricity, water supply and railways need very limited working capital. On the other hand trading and financial firms require a huge amount working capital.

b. Production Policy      - The requirements of working capital depends upon the production policy.  The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep production steady by accumulating inventories it will require higher working capital.

c. Firm’s credit policy    - A concern that purchases its requirement on credit and sells its products or services on cash requires lesser amount of working capital .On the other hand, a concern buying its requirement for cash and allowing credit to its customers shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

d. Manufacturing cycle - The manufacturing cycle starts with the purchase and use of raw materials and completes with the production of finished goods. Longer the manufacturing cycle larger will be the firm’s working capital requirements.

e. Availability of credit - A firm will need less working capital if liberal credit terms are available to it. Similarly the availability of credit from banks also influences the working capital needs of the firm.  Firms, which can get credit easily on favorable conditions, need only less working capital.

f. Access to money market - The working capital requirements of a firm are conditioned by the firm access to different sources of money market.  Thus the firm with readily available credit from banks and trade credit facilities at liberal terms will be able to function with less working capital than a firm without such facilities.

g. Growth and Expansion of Business   - The working capital needs of the firm increases as it grows in terms of sales or fixed assets. It is usually found in actual practice that a growing firm requires additional funds to acquire additional fixed assets so as to sustain growing production and sales. Besides, additional current assets will be needed to support increased scale of operation.

h. Profit Margin and Dividend Policy   - A high net profit margin reduces the working capital requirements of the firm because it contributes towards the working capital pool. Distribution of high proportion of profits in the form of cash dividend results in a drain of cash resources and thus reduces companies working capital to that extend. The company, which follows a conservative dividend policy, will have a strengthened working capital position.

i. Operating efficiency of a firm   - Operating efficiency of the firm results in                 optimum utilization of resources at minimum cost.  If a firm successfully controls operating costs it will be able to improve net profit margin which will in turn release greater funds for working capital purposes.

 j Depreciation Policy  -  Depreciation is an indirect way of     retaining profits and preserving the firm’s working capital position.

B.  External factors

a. Business fluctuations   - There may be fluctuations in the demand of products and services because of changes in economic conditions. In the event of economic prosperity the demand increases and to cope with the increased demand core working capital is needed.  In the case of recession or depression in an economy the working capital needs will be reduced.

b. Technological Developments - If the firm adopts new manufacturing process and new equipment, which enable the company to reduce the operation cycle, the permanent working capital requirements of the firm will decrease.

c. Transport and communication developments  - Where the means of transport and communication in a country are not well developed, industries may need additional funds to maintain big inventory of raw materials and other accessories which could otherwise not be needed where the transport and communication system are highly developed.

d. Import Policy   - Import policy of the govt. may also have its bearing on the level of working capital of the enterprise since they have to arrange funds for importing goods at specified times.

e. Taxation Policy - If heavy tax is imposed by govt., it will result in the borrowing of additional funds to meet their working capital needs.   When a liberal taxation policy is followed the pressure on working capital is minimized.

                 

Current Asset and Fixed Asset

                  A firm needs fixed and current assets to support a particular level of output. However to support the same level of output, the firm can have different levels of current assets.

              The level of current assets can be measured by relating current assets to fixed assets.  Dividing current assets by fixed assets gives   CA   ratio.                                    

                                                                                                FA                                                                                        Assuming a constant level of fixed assets,                                                                       

                                                              

If CA ratio is higher then it indicates a conservative current asset Policy.          

    FA

If CA ratio is lower it shows an aggressive current asset policy

    FA

             Conservative policy implies greater liquidity and lower risk as more amounts is invested in current asset.

              Aggressive policy indicates higher risk and poor liquidity.  The current asset policy of the most firms may fall between these two policies i.e., average policy.                           

 

                                                             

 

                     

 If in the conservative policy high level of current assets are maintained, but in aggressive policy the level of current assets will be minimum.

 

 

 

 FINANCING CURRENT ASSETS

                    The firm must find out the sources of funds to finance its current assets.  It can adopt different financing policies.  There are three types of financing:   -

             - Long term financing

             - Short term financing

- Spontaneous financing

                         

                               The important sources of long term financing are shares, debenture, preference shares, retained earnings and debt from financial institutions.

 

                               Short term financing refers to those sources of short-term credit that the firm must arrange in advance.  These sources include short-term bank loans, commercial papers, factoring receivables, and public deposits.

                                                                                                 

                            Spontaneous financing refers to the automatic sources of financing. The major sources of such financing are trade credit available and outstanding expenses. This source of finances is cost free. Therefore; a firm would like to finance its current assets with spontaneous sources as much as possible. Every firm is expected to utilize spontaneous sources the fullest extend.  Thus the real choice of financing current asset is between short term and long-term sources.

               The following are the policies or approaches of financing working capital.

a.      Matching approach / Hedging approach

b.      Conservative Approach

c.       Aggressive Approach

d.      Highly aggressive approach

1. Matching / Hedging Approach  

                             

                           The firm can adopt a financial plan, which involves the matching of the expected life of assets with the expected life of the sources of funds raised to finance assets.

          For e.g.: - A ten-year loan may be raised to finance a plant with an expected life of ten year.

        The above figure is used to illustrate the matching plan overtime.  The firm’s fixed assets and permanent current assets are financed with long-term funds and as the level of these assets increases, the long term financing level also increases.  The temporary or variable current assets are financed with short-term funds and as their level increases, the level of short term financing also increases.

 b.       Conservative Approach

             

                     The financing policy of the firm is said to be conservative when it depends more on long-term funds for financing needs.  Under a conservative plan, the firm finances its permanent assets and a part of temporary current assets with long term financing. Thus the conservative plan depends heavily on long term financing and therefore it is less risky. Short term financing is used only for a part of temporary current assets.  When in the periods when the firm has no temporary current assets, it stores liquidity by investing surplus funds into marketable securities.

 

2. Aggressive Approach 

               A firm may be aggressive in financing its assets. An aggressive policy said to be followed by the firm, when it uses more short term financing than warranted by the matching plan.  Under an aggressive policy, the firm financing a part of its permanent current assets with short term financing.  Some extremely aggressive firms may even finance a part of their fixed assets with short term financing.  The relatively more use of short term financing makes the firm more risky.

 

3. Highly Aggressive policy

                            

                       Under this method, a part of fixed assets even may be financed from short term a source that is very much risky.  Thus long-term sources are used to acquire the major part of fixed assets and the short-term sources are used to acquire a minor part of fixed assets plus whole of current assets (i.e. both permanent and temporary current assets)

 

 Liquidity Vs Profitability: - Risk-   Return trade – off

                A larger investment in current assets under certainty would mean a low rate of return on investment for the firm.  On the other hand, smaller investment in current assets will lead to interrupted production and sales because of frequent stock outs and inability to pay to creditors in time due to restrictive policy

                                The two important aims of the working capital management are: -

Profitability and solvency

                                Solvency in the technical sense refers to the firm’s continuos ability to meet maturing obligations.  To ensure solvency, the firm should be very liquid, which means larger current assets holdings. Thus a liquid firm has less risk of insolvency, that is, it will hardly experience a cash shortage or stock outs.

                                 To have higher profitability the firm may sacrifice solvency and maintain a relatively low level of current assets. When the firm does so, its profitability will improve as less funds are tied up in idle current assets.  But in such situations, its solvency would be threatened and the firm would be exposed to greater risk of cash shortage and stock outs.

                                  The management should try to maintain a trade off between profitability and liquidity.  The working capital should be neither excessive nor inadequate

The Cost Trade Off

                    The different way of looking into the risk return trade off is in terms of the cost of maintaining a particular level of current assets.  There are two types of costs involved.  The cost of liquidity and the cost of illiquidity

                  If the firm’s level of current assets is very high it has excessive liquidity, its return on assets will be low, as funds tied up in idle cash and stock earn nothing and high levels of debtors reduce profitability. Thus the cost of liquidity increases with the level of current assets. Cost of liquidity means the cost of holding excessive current assets

                       The cost of illiquidity is the cost of holding insufficient current assets.  Insufficient current assets will be lead to insolvency of the firm.

                        In determining the optimum level of current assets, the firm should balance the cost of liquidity and cost of illiquidity

                    

             

              The figure shows that the cost of liquidity increases with the level of current assets, but cost of illiquidity decreases with the level of current assets.  The firm should maintain its current assets at that level where the sum of these two costs is minimized.  The minimum cost point indicates the optimum level of current assets.

Principles of Working Capital Management / Policy   

             In managing working capital the finance manager must bear in mind certain fundamental principles, which serve as useful guidelines.  These principles are: -

a. Principle of Risk Variation: -

         There is an inverse relationship between risk of insolvency and profitability. When a firm maintains large investment in current assets with less dependence on short-term borrowings increases liquidity, reduces risk and there by reduces the opportunity for gain or loss. On the other hand less investment in current assets with greater dependence on short-term borrowings increases risk reduces liquidity and increases profitability.  A conservative management prefers to minimize risk by maintaining a   higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital.  However the goal of the management should be to establish a trade off between profitability and risk.

3. Principle of cost of capital: - 

   

           Working capital can be raised from various source of finance. Each source has its own cost and risk. Generally higher the risk, (risk to the company not to the financing institution) lower is the cost and lower the risk higher is the cost.  A sound working capital management should always try to achieve a proper balance between these two.

4. Principle of Equity Position

                      This principle is concerned with planning the total investment in current assets.  According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position.  Every rupee invested in the current assets should contribute to the net worth of a firm.

4. Principle of Maturity of Payment / Principle of suitability

                    This principle is concerned with planning the sources of finance for working capital.  According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. This stipulates that each asset should be offset with a financing instrument of the same approximate maturity.  Thus temporary or seasonal working capital would be financed by short-term borrowings and permanent working capital with long-term sources.

                     To sum up, working capital management should be considered as an integral part of overall corporate management.  In the words of Louis Brand   “ we need to know when to look for working capital funds, how to use then and how to measure, plan and control there”. To achieve the above-mentioned objectives of working capital management, the financial manager has to perform the following basis functions.

-    Estimating the working capital requirements

-    Financing of working capital needs, and

-    Analysis and control of working capital. 

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