MANAGEMENT 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 if 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.
a. 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.
b. 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.
Working capital when business grow
y y
Variable
Working capital
Fixed working
Capital
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 Inadequate 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 Redundant or Excessive 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:-
- Excessive working capital may be an indication of excessively liberal credit policy and slack collection from customers resulting in higher incidence of bad debts.
- It may also lead to speculative transactions.
- It may mean unnecessary accumulation of inventories.
- 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.
- It may lead to overall inefficiency in the organization.
f. 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
- Nature
and size of business
- Production
Policy
- Firm’s
credit Policy
- Manufacturing
cycle
- Availability
of credit
- Access
of money market
- Growth
and Expansion of business
- Dividend
policy
- Depreciation
policy
- Operating
efficiency of firm
- Business
fluctuations
- Technological
Developments
- Transport
and communication Developments.
- Import
policy
- 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.
y
Output x
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
a.
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.
y
Time x
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.
Time
c. Aggressive
Approach
A firm may be aggressive in
financing its assets. An aggressive policy is 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.
Permanent
current assets
Fixed assets
Time
d.
Highly Aggressive policy
Under this method, a
part of fixed assets even may be financed from short term 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)
Permanent
current assets
Time
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
Level of
current assets
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.
b.
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.
c.
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.
d.
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.