Management of Working Capital

After reading this lesson you will be able to: -

Understand Concept, need and determinants of working capital
Understand the concept of operating cycle
Computation of operating cycle

I will start this lesson with a question:

Why should managers be familiar with working capital management?

When we work in any organization, we find that most of the time managers are concerned with
working capital management.

What I mean is: -

# Ensuring that enough cash exists to pay bills;
# Ensuring that enough inventory exists to make and sell products;
# Ensuring that any excess cash is invested in interest-bearing securities;
# Ensuring that accounts receivable are at a level that maximizes earnings,
# Ensuring that short-term borrowings such as salaries payable and trade credit are used efficiently and
at the lowest cost possible.

What is Working capital management?

You see, working capital management involves the relationship between a firm's short-term
assets and its short-term liabilities. The basic goal of working capital management is to ensure that a
firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-
term debt and upcoming operational expenses. The management of working capital involves
managing inventories, accounts receivable, accounts payable and cash

This Topic extends the discussion to the management of the firms working capital needed. There is a
trade-off between the risk of having too little working capital on hand and the reduced profitability that
results from having excess working capital.

What is Working capital?

You can understand working capital in two different but interlinked senses. In the first sense, working
capital refers to gross working capital and in second sense it is understood in terms of net working
capital. We can explain both in following paragraphs: -

CONCEPTS OF WORKING CAPITAL

GROSS WORKING CAPITAL

It refers to the firms investment in current assets. Current assets are the assets, which can be converted
into cash within an accounting year or within an operating cycle. You can include here cash, short-term
securities, debtors (accounts receivable & book debts), bills receivable and stock.

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NET WORKING CAPITAL

But the net working capital refers to the difference between current assets and current liabilities.
Current liabilities are those claims of outsider, which are expected to mature for payment within an
accounting year & include creditors, bills payable & the outstanding expenses. In other words you can
say that this is the excess of current assets over current liabilities.

CURRENT ASSETS constitute the following:

a. Inventories: Inventories represent raw materials and components, work-in-progress and

finished goods.
b. Trade Debtors: Trade Debtors comprise credit sales to customers.
c. Prepaid Expenses: These are those expenses, which have been paid for goods and services
whose benefits have yet to be received.
d. Loan and Advances: They represent loans and advances given by the firm to other firms for a
short period of time.
e. Investment: These assets comprise short-term surplus funds invested in government securities,
shares and short-terms bonds.
f. Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for
meeting operational requirements. One thing you can see here is that this current asset is purely
liquid but non-productive.

Current liabilities form part of working capital that represents obligations which the firm has to clear to
the outside parties in a short-period, generally within a year.

CURRENT LIABILITIES comprise the following:

I. Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms
usually for a period of one to two months.
II. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the
firms current accounts with banks
III. Short-term Loans: Short-terms borrowings by the firm from banks and others form part of
current liabilities as short-term loans.
IV. Provisions: These include provisions for taxation, proposed dividends and contingencies.

Working capital
Current assets Current liabilities
Cash Accounts payable
Accounts receivable Notes payable
Notes receivable Accrued expenses
Marketable securities Taxes payable
Inventory
Prepaid expenses
Total current assets Total current liabilities

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Net working capital is current assets minus current liabilities.
Gross working capital concept focuses on two aspects:

1. How to optimize investment in current assets?

2. How should current assets be financed?

The planning should be done keeping in mind two danger points i.e. excessive and inadequate
investment in current assets. Investment in current assets needs to be adequate as it affects the
profitability, solvency and liquidity. Why this issue comes up because it ultimately affects the
objectives of financial management.

Danger points to be kept in mind while planning

1. Excessive investment (Profitability)

a. It results in unnecessary accumulation of inventories. Thus, chances of inventory is handling,

waste, theft & losses increase.
b. It is an indication of defective credit policy & slack collection period.
c. Excessive WC makes management complacent, which degenerates into managerial
inefficiency.
d. Tendencies of accumulating inventories tend to make speculative profits grow.

2. Inadequate investment (Liquidity)

a. It stagnates growth.
b. It becomes difficult to implement operating plans and achieve the firms operating profit target.
c. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day
commitments.
d. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firms
profitability would deteriorate.
e. Paucity of WC funds render the firm unable to avail attractive credit opportunities.
f. The firm loses its reputation when it is not in a position to honour its short-term obligations.

Kinds of Working Capital

Permanent working capital:

1. This component represents the value of the current assets required on a continuing basis over
the entire year, and for several years. Permanent working capital is the minimum amount of
current assets, which is needed to conduct a business even during the dullest season of the year.
The minimum level of current assets is called as permanent current asset.

2. Permanent or fixed working capital as this part is permanently blocked in current assets. This
amount varies from year to year, depending upon the growth of the company and the stage of
the business cycle in which it operates. It is the amount of funds required to produce the goods

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 and services, which are necessary to satisfy demand at a particular point of time. It represents
the current assets, which are required on a continuing basis over the entire year. It is maintained
as the medium as to continue the operations at any time.

Characteristics of Permanent working capital

It is classified on the basis of the time period

It constantly changes from one asset to another and continues to remain in the business
process.
Its size increase with the growth of business operations.

2. Temporary working capital:

Contrary to the above you will find that temporary working capital represents a certain amount
of fluctuations in the total current assets during a short period. These fluctuations are increased
or decreased and are generally cyclical in nature. Additional current assets are required at
different times during the operating year. Variable working capital is the amount of additional
current asset that are required to meet the seasonal needs of a firm, so is also called as the
seasonal working capital. For example: additional inventory will be required for meeting the
demand during the period of high sales When the peak period is over variable working capital
starts decreasing or very little during the normal period. It is temporarily invested in current
assets.

Say for an example a shopkeeper invests more money during winter season because he/ she
require keeping more amount of stock of woolen cloths. The same happens in a sugar factory
how: the factory manager buys more quantity of sugarcane during the harvesting season and
then continuously stops for some time.

Characteristics of Temporary working capital

It is not always gainfully employed, though it may change from one asset to another asset,
as permanent working capital does.
It is particularly suited to business of a seasonal or cyclical nature.

Determinants of Working Capital

We can explain the determinants of working capital as follows:

Nature of business

The working capital requirements of an enterprise are basically related to the conduct of the business.
Public utility undertakings like Electricity, Water supply, Railways, etc. need very limited working
capital because they offer cash sales only and supply services, not products and as such no funds are
ties up in inventories and receivables. But at the same time have to invest fewer amounts in fixed
assets. The manufacturing concerns on the other hand require sizable working capital along with fixed
investments, as they have to build up the inventories.

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Terms of sales and purchases

Credit sales granted by the concerns too its customers as well as credit terms granted by the suppliers
also affect the working capital. If the credit terms of the purchases are more favorable and at the same
time those of sales less liberal, less cash will be invested in the inventory. With more favorable credit
terms, working capital requirements can be reduced.

Manufacturing cycle

The length of manufacturing cycle influences the quantum of working capital needed. Manufacturing
process always involves a time lag between the time when raw materials are fed into the production
line and finished goods are finally turned out by it. The length of the period of manufacture in turn
depends on the nature of product as well as production technology used by a concern. Shorter the
manufacturing cycle - lesser the working capital required.

Rapidity of turnover

If the inventory turnover is high, the working capital requirements will be low. With a better inventory
control, a firm is able to reduce its working capital requirements. When a firm has to carry on a large
slow moving stock, it needs a larger working capital as against another whose turnover is rapid. A firm
should determine the minimum level of stock, which it will have to maintain throughout the period of
its operation.

Business cycle

Cyclical changes in the economy also influence quantum of working capital. In a period of boom i.e.,
when the business ism prosperous, there is s need of larger amount of working capital due to increases
in sales, rise in price etc and vice-a-versa during period of depression.

Changes in technology

Changes in technology may lead to improvements in processing of raw materials, savings in wastage,
greater productivity, and more speedy production. All these improvements may enable the firm to
reduce investments in inventory.

Seasonal variation

The inventory of raw materials, spares and stores depends on the condition of supply. If the supply is
prompt and adequate the firm can manage with small inventory. However, if the supply were
unpredictable and scant then the firm, to ensure the continuity of production, would have to acquire
stocks as and when they are available and carry larger inventory on an average.

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Market conditions

The degree of competition prevailing in the market place has an important bearing on working capital
needs. When competition is keen, a larger inventory of finished goods is required to promptly serve
customers who may not be inclined to wait because other manufacturers are ready to meet their needs.

Seasonality of operation

Firms, which have marked seasonality in their operations usually, have highly fluctuating working
requirements. Let us take an example to illustrate this point. Consider firm manufacturing fans. The
sale of fans reaches a peak during the summer months and drops sharply during the winter period. The
working capital need of such a firm is likely to increase considerably in summer months and decrease
significantly during winter season.

Dividend policy

It has a dominant influence on the working capital position of a firm. If the firm is following a
conservative dividend policy, the need for working capital can be met with retained earnings.

Working capital cycle

Larger the working capital cycle, more is the requirement of working capital.

Prepared by: Dr. Sarbesh Mishra

Sr. Associate Professor, Finance Area
NICMAR CISC, Hyderabad 500 084. (A.P)
E-mail sarbeshmishra@nicmar.ac.in
Off 040 6451 0763 (Direct)