1.1.

Importance of working capital management

Working capital represents the net current assets available for day-to-day operating activities. It
is defined as current assets less current liabilities. Many businesses that appear profitable are
forced to cease trading due to an inability to meet short term obligations when they fall due.
Successful management of working capital is essential to remaining in business.

Working capital management requires great care due to potential interactions between its
components. For example, extending the credit period offered to customers can lead to additional
sales. However, the company’s cash position will fall due to the longer wait for customers to
pay, potentially leading to the need for a bank overdraft. Interest on the overdraft may even
exceed the profit arising from the additional sales, particularly if there is also an increase in the
incidence of bad debts.

Working capital management is central to the effective management of a business because;

1.current assets comprise the majority of the total assets of some companies, 2.shareholder
wealth is more closely related to cash generation than accounting profits, 3.failure to control
working capital and hence to manage liquidity, is a major cause of corporate collapse.

Working capital is an important issue during financial decision making since it is being a part of
investment in asset that requires appropriate financing investment. However, working capital is
always being disregard in financial decision making since it involve investment and financing in
short term period. The crucial part in managing working capital is required maintaining its
liquidity in day-to-day operation to ensure its smooth running and meets its obligation.

A quantity of money can be tied-up inside working capital, so that the firm managing this
effectively could get benefits from improving cash liquidity and may not depend on external
financing. This really is especially essential for small companies while they typically have a
tough time in getting financing from external sources. Furthermore, smaller businesses often
understand the importance of working capital management, which allows a business to better
allocate its resources and to improve its financial management strategies and techniques.
Businesses with more effective working capital management will create much more cash
liquidity and can lead to a higher business valuation.

Management concerning account payable and receivables looks excellent significant driver for
increasing profitability of small businesses. In addition, when companies using low working
capital can publish the best greater return on capital so that shareholders will always et advantage
of high returns for all the amount invested in the business.
Importance of working capital management will assist the company in order to survive in
situations like: crisis, unexpectedly big buy orders, manufacturing issues in the event of
excellent. With enough liquidity, company pays to their suppliers on time, which will also
benefit starting a regular and smooth flow of raw materials; client can receive goods and services
on or before time, as well as ensuring that the manufacture unit remains uninterrupted due to any
kind of financial risks or uncertainty.

The ability to meet short term obligations is a pre requisite to long term solvency. And it is often
a good indication of counterparty’s credit risk. Adequate working capital management will allow
a business to pay on time its short term obligations. This could include payment for a purchase of
raw materials, payment of salaries, and other operating expenses.

The importance of working capital management is reflected in the fact that financial managers
spend most of their time in managing current assets and current liabilities. Adequate working
capital needs to be maintained in order to discharge day-to-day liabilities and protect the business
from adverse effects in times of calamities and emergencies. It aims at protecting the purchasing
power of assets and maximizes the return on investment. The efficiency of the firm to earn
profits depends largely on its ability to manage working capital. Working capital management
has acquired paramount importance in the recent past, especially in view of tight money
conditions prevailing in the economy. Working capital management policies have a crucial effect
on firm’s liquidity and profitability. Thus, working capital plays a crucial role in earning a
reasonable rate of return. Hence, working capital has to be effectively planned, systematically
controlled and optimally utilized.

1.2.Components of working capital

Efficient management of working capital involves effective control over the current assets and
current liabilities, which are the main working capital components.

Working capital components of current assets: current assets are those assets that in the ordinary
course of business, can be or will be turned into cash within an accounting period without
undergoing a diminution in value and without disrupting the operations. Total current assets
consist of cash, marketable securities, inventories, sundry debtors, one year fixed deposits with
banks, and prepaid expenses.

Working capital components of current liabilities: current liabilities are those liabilities intended
to be paid i8n the ordinary course of business within a reasonable period out of the current assets
or revenue of the business. The current liabilities consist of sundry creditors, loans and advances,
bank overdraft, short term borrowings, taxes and proposed dividend.
Let me describe some components briefly;

Cash and cash equivalents: one of the most important working capital components to be
managed by all organizations is cash and cash equivalents. Cash management helps in
determining the optimal size of the firm’s liquid asset balance. It indicates the appropriate types
and amounts of short term investments along with efficient ways of controlling collection and
payout of cash. Good cash management implies the co-relation between maintaining adequate
liquidity with minimum cash in bank. All companies strongly emphasize cash management as it
is the key to maintain the firm’s credit rating, minimize interest cost and avoid insolvency.

Management of inventories: inventories include raw material, work in progress and finished
goods. Where excessive stocks can place a heavy burden on the cash resources of a business,
insufficient stocks can result in reduced sales, delays for customers etc. inventory management
involves the control of assets that are produced to be sold in the normal course of business.

Management of receivables: receivables contribute to a significant portion of the current assets.

For investment into receivables, there are certain costs that any company has to bear, along with
the risk of bad debts associated to it. It is therefore necessary to have a proper control and
management of receivables which helps in taking sound investment decisions in debtors.
Thereby, for effective receivables management one needs to have control of the credits and make
sure clear credit practices are a part of the company policy, which is adopted by all others
associated with the organization.

Management of accounts payable: creditors are a vital part of effective cash management and
have to be managed carefully to enhance the cash position of the business. One has to keep in
mind that purchasing initiates cash outflows and an undefined purchasing function can create
liquidity problems for the company. The trade credit terms are to be defined by companies as
they vary across industries and also among companies.

1.3.Relationship with liquidity and profitability

Experts say that the goal of working capital management should be to enable a firm to maximize
profits of its operations while meeting both short term debt and upcoming operational expenses,
i.e. to preserve liquidity. But increasing profitability would tend to reduce firm’s liquidity and
too much attention on liquidity would tend to affect the profitability. No doubt, every firm tries
to maximize the profitability by preserving the liquidity. However, increasing profits at the cost
of liquidity might cause serious trouble to the firm and this problem might lead to financial
insolvency as well. Thus an effective working capital management would be needed to strike a
balance between the two core objectives of the firm. It is essential that the firms’ liquidity should
be properly balanced. Because excessive liquidity on one hand indicates the accumulation of idle
funds that don’t fetch any profits for the firm and on the other hand, insufficient liquidity might
damage the firms’ goodwill, deteriorates firms’ credit standings and that might lead to forced
liquidation of firm’s assets. Afterwards problems like bankruptcy and insolvency might happen.
To sum up, a company unable to make profits might be termed as a sick company but, a
company having no liquidity might cease to exist.

Theoretically working capital decisions affects both liquidity and profitability. Excess of
investment in working capital may result in low profitability and lower investment may result in
poor liquidity. Management need to trade off between liquidity and profitability to maximize
shareholders wealth. Working capital is the most crucial factor for maintaining liquidity,
survival, solvency and profitability of business. Usually it was observed that if a firm wants to
take a bigger risk for bumper profits and losses, it minimizes the dimension of its working capital
in relation to the revenues it generates. If it is willing to improve its liquidity, that in turn raises
the level of its working capital. Nevertheless, this technique might tend to reduce the sales
volume and consequently, it would affect the profitability.

Liquidity and profitability are two contradictory term, though one cannot be effective without
other. But excess of one may slowdown the other. Management should maintain adequate
liquidity and profitability.

For an example, ACC Ltd being an established company from past few decades is satisfactorily
giving out profits. But the liquidity position of the company was very poor which is not
acceptable. The company was following an aggressive working capital policy to increase
profitability. But a negative working capital all the years with a continuous increase in current
liabilities certainly increases the risk of bankruptcy.

1.4.Determinants of working capital requirement in manufacturing oriented organization

 Nature of the business

The management of working capital is completely different from industry to industry. A simple
comparison of the service industry and manufacturing industry can clarify the point. A service
firm, like an electricity undertaking or a transport corporation, which has a short operating cycle
and which sells on cash basis, has modest working capital requirements. On the other hand, a
manufacturing concern like a machine tools unit, which has a long operating cycle and which
sells on credit, has very substantial working capital requirements. So the nature of the industry is
a factor in determining the working capital requirement.
  Seasonality of industry and production policy

Businesses based on seasons like manufacturing of ACs whose demand peaks in summer and
dips in winter. The requirement of working capital will be more in summer compared to winter if
they are produced in the fashion of their demand. The policy of producing throughout the year
can smoothen the fluctuation of working capital requirement. Another example is that the sugar
industry produces practically all the sugar between December and April and the woolen textile
industry makes its sales generally during the winter. In both these cases the needs of working
capital will be very large during few months. The working capital requirements will gradually
decrease as and when the sales are made. On the other hand, a firm manufacturing a product like
lamps, which have fairly even sales round the year, tends to have stable working capital
requirements.

 Length of period of manufacture

The average length of the period of manufacture, i.e. the time which elapses between the
commencement and end of the manufacturing process is an important factor in determining the
amount of the working capital. If it takes less time to make the finished product, the working
capital required will be less. For an example, a baker requires one night time to bake his daily
quota of bread. His working capital is, therefore, much less than that of a shipbuilding concern
which takes three to five years to build a ship. Between these two cases may fall other business
concerns with varying periods of manufacture requiring different amounts of working capital.

 Volume of business

Generally, the size of the company has a direct relation with the working capital needs. Big
concerns have to keep higher working capital for investment in current assets and for paying
current liabilities.

 The proportion of the cost of raw materials to total cost

Where the cost of raw materials to be used in manufacturing of a product is very large in
proportion to the total cost and its final value, working capital required will also be more. That is
why, in a cotton textile mill or in a sugar mill, huge funds are required for this purpose. A
building contractor also needs huge working capital for this reason. If the importance of
materials is less, as for example in an oxygen company, the needs of working capital will be
naturally not more.

 Need to keep large stocks of raw materials of finished goods

The manufacturing concerns generally have to carry stocks of raw materials and other stores and
also finished goods. The larger the stocks more will be the needs of working capital. In certain
lines of business, eg, where the materials are bulky and have to be purchased in large
quantities,(as in cement manufacturing), stock piling of raw material is used.
  Terms of credit

A company purchasing all raw materials for cash and selling on credit will be requiring more
amount of working capital. The essence of this is that the period which elapses between the
purchase of materials and sale of finished goods and receipt of sales proceeds, will determine the
requirements of working capital.

1.5.Working capital financing policies

There are different approaches to take the decision relating to financing mix of the working
capital as follows;

 Aggressive policy

This policy, as the name suggests, is a high-risk one. Owing to the risk factors, returns are also
higher. To follow this, a business must minimize its current assets or the amount of debt its owed
to. Here there are no debtors-payments are collected in time and are eventually invested in
business. Creditors’ payments are delayed to the maximum. Doing so, sometimes might land up
with possibilities to sell out company assets to clear debts. This type of working capital financing
policy is mostly followed by companies looking for brisk growth.

 Conservative policy

A firm may follow a conservative approach to finance its current assets. In this a firm depends on
the long term sources of funds for financing its requirements. The firm relies more on long term
funds for financing its needs and short term funds are only to emergency situation. In this
strategy, the management finances its permanent current assets and a major part of temporary
current assets with long term sources of funds. Because the strategy relies more on long term
sources of funds, therefore it is less risky.

 Hedging or matching policy

A business firm may follow a financing plan which is based on the principle of matching. It
implies the financing of short term needs with short term sources and financing long term
requirement with long term sources. If the accurate matching is possible, the strategy operates
without any net working capital since all short term requirements are financed with short term
funds. Businesses generally follow this policy when they want their working capital to be less;
thereby utilizing or investing the money elsewhere. Here the current assets of the balance sheet
are matched with the current liabilities and less cash is kept in hand. This in turn, enables the rest
of the finance to be used for expanding business, increasing production scale etc.

A sound working capital financing policy enables a firm to select a working capital loan as per
its needs.