What is Working Capital Management?
Working capital is a balance sheet item, which equals the sum of cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses and other assets that could be converted to cash in less than one year.
Table of Content
- 1 What is Working Capital Management?
- 2 Nature of Working Capital
- 3 Concept of Working Capital
- 4 Need for Working Capital
- 5 Determinants of Working Capital
- 6 Computation of Working Capital
A company’s creditors will often be interested in how much that company has in current assets, since these assets can be easily liquidated in case the company goes bankrupt. In addition, current assets are important to most companies as a source of funds for day-to-day operations.
Nature of Working Capital
Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelationship that exists between them.
The term current assets refers to those assets which in the ordinary course of business can be or will be, converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm.
The major current assets are Cash, Marketable Securities, Accounts Receivables and Inventory. Current liabilities are those liabilities, which are intended at their inception, to be paid in the ordinary course of business, within a year out of the current assets or the earnings of the concern.
The basic current liabilities are Accounts Payable, Bills Payable, Bank Overdraft and outstanding expense. The goal of working capital management is to manage the firm’s 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.
Concept of Working Capital
Working capital refers to that part of a firm‟s capital required for financing short term or current assets such as cash, marketable securities, debtors and inventories. In other words, working capital is the amount of funds necessary to cover the cost of operating the enterprise.
Working capital means the funds (i.e. capital) available and used for day-to-day operations (i.e. working) of an enterprise. It consists broadly of that portion of assets of a business, which are used in or related to its current operations. It refers to funds, which are used during an accounting period to generate a current income of a type, which is consistent with a major purpose of a firms existence.
Every business needs some amount of working capital. It is needed for following purposes:
- For the purchase of raw materials, components and spares.
- To pay wages and salaries.
- To incur day-to-day expenses and overhead costs such as fuel, power, office expenses, etc.
- To provide credit facilities to customers, etc.
The more permanent needs (fixed assets and the fixed element of working capital) should be financed from permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. abank overdraft), which can be drawn on and repaid easily and at short notice.
Need for Working Capital
The prime objective of the company is to obtain maximum profit thought the business. The amount of profit largely depends upon the magnitude of sales. However; the sale does not convert into cash instantaneously.
There is always a time gap between sale of goods and receipt of cash. The time gap between the sales and their actual realisation in cash is technically termed as operating cycle. Additional capital required to have uninterrupted business operations and the amount will be locked up in the current assets.
Regular availability of adequate working capital is inevitable for sustained business operations. If the proper fund is not provided for the purpose, the business operations will be effected. Hence, this part of finance is to be managed well.
The primary objective of working capital management is to ensure that sufficient cash is available. This can be summarised as:
- Meet day-to-day cash flow needs.
- Pay wages and salaries when they fall due.
- Pay creditors to ensure continued supplies of goods and services.
- Pay government taxation and provider of capital dividends.
- Ensure the long-term survival of the business entity.
Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses.
- It helps the business concern in maintaining the goodwill.
- It can arrange loans from banks and others on easy and favourable terms.
- It enables a concern to face business crisis in emergencies such as depression.
- It creates an environment of security, confidence and over all efficiency in a business.
- It helps in maintaining the solvency of the business.
Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress. Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature.
Determinants of Working Capital
There are many factors in the determinants of working capital:
Nature of business
Working capital requirement of a firm influenced by the nature of its business trading and financial firms have a very small investment in fixed assets, but require a large sum of money to be invested in working capital. Retails stores, for example must carry large stock of a veriaty of goods to satisfy varied and continuous demand of their customer.
Market and demand condition
It is difficult to precisely determine the relationship between the volume of sales and working capital need. Current assets will have to be employed before growth takes place. Then it will be necessary to make planning of working capital for a growing firm on a continuous basis.
Technology and manufacturing policy
The manufacturing cycle comprises of the purchase and use of raw material and the production of finished goods. Longer the manufacture cycle, larger will be the firm’s working capital requirement. For example, the manufacturing cycle in the case of a boiler, depending on its size, may range between six to twenty-four months.
On the other hand, the manufacturing cycle of a product such as detergent powder, soap, ice creams, etc. may be few hours.
Credit policy of the firm
It affects the working capital by influencing the level of debtors. The credit term to be guaranteed to customers may depend upon the norm of the industry to which the firm belongs. However, a firm has the flexibility of shaping its credit policy within the constraint of industry norms and practice. The firm should use discretion in granting credit terms to its customers.
The operating efficiency of the firm relates to the optimum utilisation of all its resource at minimum costs. The efficiency in controlling operating cost and utilising fixed and current assets leads to operating efficiency.
The use of working capital is improved and pace of cash conversion cycle is accelerated with operating efficiency. Better utilisation improves profitability and helps the releasing of working capital.
Working Capital Cycle
Working capital cycle shows all the steps starting from cash purchase of raw material, creation of finished product, which is then converted into sale. In case of a credit sale, debtors will also become part of working capital cycle. Receiving money from the debtors is the final part of working capital cycle.
If the debtors are fast and prompt in paying up, the company would need small amount working capital. Otherwise, for purchasing new raw material, we need more amount of working capital.
Manufacturing cycle means the process of converting raw material into finished product. Long manufacturing cycles lead to requirement of large amounts of working capital. The construction of a building complex, for example, could take some years to complete.
Accordingly, the builder would need working capital to meet all the expenses during this period, as the returns will start coming in much later.
There are two main parts of the business cycle, one is boom and other is recession. In boom, companies typically need high amounts of working capital for development of business but in recession, the amount marked as working capital goes down.
Price Level Changes
If there is increasing trend of products prices, we need to store high amount of working capital, because next time, it is precisely that we have to pay more for purchasing raw material or other service expenses. Inflation and deflation are two major factors, which decide the next level of working capital in business.
Effect of External Business Environmental Factors
External business environmental factors like fiscal policy, monetary policy and bank policies, as well as infrastructure have an effect on the working capital required by a firm.
Computation of Working Capital
The two components of Working Capital are current assets and current liabilities. They have a direct bearing on the cash operating cycle. In order to calculate the working capital needs what is required is the holding period of various types of inventories, the credit collection period and the credit payment period.
Working Capital also depends on the budgeted level of activity in terms of production/sales. The calculation of Working Capital is based on the assumption that the production sales are carried on evenly throughout the year and all costs accrue similarly.
As the Working Capital requirements are related to the cost excluding depreciation and not to the sale price, Working Capital is computed with reference to the Cash Cost. The Cash Cost approach is comprehensive and superior to the operating cycle approach based on the holding period of debtors and inventories and payment period of creditors.
Thus, to estimate the Working Capital Requirements of an organisation, we need to estimate the following:
1. Estimation of Current Assets
2. Estimation of Current Liabilities