An Assignment on “Working Capital Policy, Chapter 14”

Course Title: Working Capital Management

Submitted To:
Md. Alamgir Hossen
Assistant Professor
Institute of Business Administration
Jahangirnagar University

Submitted By:
Sanjid Mahmud
201803067
WMBA, 19th Batch
Institute of Business Administration
Jahangirnagar University

Date: 23/10/2020
Working capital is the amount of the firm’s current assets: cash, accounts receivable, marketable
securities, inventory and prepaid expenses. The concept of working capital was first developed by Karl
Marx. There are two concepts of working capital, gross working capital and net working capital. Gross
working capital is the capital invested in total current assets of the firm.

Gross working Capital = Total Current Assets

The main constituents of current assets are inventories that include raw material, work in progress, stores
and spares and finished goods; account receivable, cash on hand and cash at bank, loan and advances etc.
Net working capital is a narrow term, refers to the excess of current assets over current liabilities. Current
liabilities are those which are to be paid within a short period of time normally one accounting year or
normal operating cycle whichever is shorter.

Net Working Capital = Current Assets – Current Liabilities.

The effective management of working capital is significant because of its relationship with the regular
business operation. It has been realized that inadequate working capital is the major reason for business
failure. Management of working capital assumes considerable importance of the firm. It aims at protecting
the purchasing power of assets and maximizing the return on investment. To avoid interruption in the
production schedule and maintain sales, a concern requires funds to finance inventories and receivables.
It has been found that the largest portion of financial manager’s time is utilized in the management of
working capital.

No business can run successfully without an appropriate amount of working capital. The main advantages
of maintaining the adequate amount of working capital are as follows:

 Solvency and easy loan to the business: Adequate working capital helps in maintaining
appropriate liquidity of the firm. This enables the firm in making payment to its short term
creditors in time. This increases the credit standing of the firm and hence, it becomes simple for
a firm to obtain the loan from banks and other financial institution on favorable terms.
 Getting benefit of cash discount: Sufficient working capital also enables a firm to avail cash
discount by making prompt payment on its purchase and reduces cost of production.
 Ability to face unfavorable condition: Proper working capital helps the firm to face business crisis
such as inflation. During such period, company more depends on its working capital strength.

Factors That Affect Working Capital Needs

 Working capital needs are not the same for every company. The factors that can affect working
capital needs can be endogenous or exogenous.
 Endogenous factors include a company’s size, structure, and strategy.
 Exogenous factors include the access and availability of banking services, level of interest rates,
type of industry and products or services sold, macroeconomic conditions, and the size, number,
and strategy of the company’s competitors.

There are certain policies that must be followed while calculating and managing working capital. The most
commonly followed working capital policies are given below:

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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 it’s 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 policy is mostly followed by companies looking
for brisk growth.

Conservative policy

Businesses with low-risk appetite are mostly inclined towards such a policy. In this policy, credit limits are
pre-set to a specific amount. Also, such policies refrain doing business on credit with any debtor who
defaults. Generally, a conservative working capital policy is followed to keep the company assets and
liabilities in sync with each other, with the assets value on the higher side, in case of sudden exigencies.

Matching policy

This one is a hybrid between a working capital management policy and a working capital financing policy.
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. sound working capital financing policy enables a firm
to select a working capital loan as per its needs.

Short Term Sources of Working Capital Finance

Factoring - Credit management is a professional activity and involves a huge amount of effort. So many
companies find it simple to transfer it to an external agency whereby the external agency is supposed to
maintain records and accounts and put in efforts for collection. This process is called factoring. It is a
conventional source of short term funding. Factoring facility arrangements incline to be restrictive and
entering into a complete - turnover factoring facility can lead to belligerent chasing of outstanding invoices
from clients, and it controls the loss of a company’s credit function. The factor financial institution that
purchases the accounts receivable for cash, put in efforts to collect all the billings, and charges a fee for
rendering this service. Factoring agreements could be bifurcated under two ways

A) If the risk of bad debts is transferred to factor agencies, then it is known as non-recourse factoring
agreement and other are known as recourse factoring agreement.

B) If any advance payment is received by company from the factor, it is known as advance factoring
agreement; if no money is receivable currently then it is maturity factoring agreement.

Securitization - It is another prevailing arrangement used by company to sell its accounts receivable with
the creation of special purpose equity (SPE), usually a subsidiary or a trust, the SPE buys a pool of accounts
receivable from the company and then sells related securities, typically debt such as bonds or commercial
paper, that are collateralized by the receivables.

Installment Credit - Installment credit is a method of finance to pay for goods or services over a period
through the fixed number of payments of principal and interest in routine or regular payments.

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Asset-Based Lending - A lender providing an asset-based loan considers mainly to the value of the assets
ensuring the loan for repayments of the obligation. It is different from conventional loan in that the
borrower’s capacity to repay the borrowed funds from operating incomes is unpredictable. These are
provided against inventory, accounts receivable and equipment’s.

Invoice Discounting - Invoice Discounting is a source of asset based finance which enables a concern to
release cash tied up in an invoice and unlike factoring authorizes a client to retain control of the
administration of its account receivables.

Trade Finance - An exporter needs an importer to pay in advance for goods shipped. Naturally, the
importer naturally wants to minimize risk by demanding the exporter to document that the goods have
been delivered or shipped. The importer’s bank facilitates by issuing a letter of credit to the exporter (or
the exporter’s bank) providing for payment upon presentation of required documents, such as a bill of
lading. The exporter’s bank may also provide a loan to the exporter on the ground of the export contract

Long Term Sources of Working Capital Finance

Shares Capital - Shares capital refers to the owner’s funds of a company that can be obtained by issuing
shares to shareholders for cash or an equivalent item of capital value. Share capital consists of the nominal
values of all shares allotted (Example: The sum of their “par values”). Share capital can simply be defined
as the part of capital (cash or an equivalent item of capital value) that company receives from shareholders
or investors for its shares.

Debenture - It is one of the long term sources of raising the loan capital of the company. A debenture is a
written document or certificate that either creates a debt or recognizes it and it is a debt without collateral
security. In corporate finance, the term is applied for a medium to long-term debt instrument used by
large companies to raise funds. A debenture is same as a certificate of loan which is attached with the fact
that the company will be liable to pay a pre-decided amount with interest and although the funds raised
by the debentures is a part of the company’s capital structure. Debentures can freely be transferred by
the debenture holder.

Determinants of Working Capital Requirements / Factors Influencing Working Capital Requirements

Working capital requirements of a firm depend upon number of factors. Every factor is important because
all such factors are of different importance and influence of individual factor fluctuates for a firm over
period of time. There are some important factors that determine the working capital requirements, these
are as follows:

Basic nature of the business: The working capital requirements of a concern basically rely upon the nature
of the business. Trading and financial firms need good quantum of working capital because they require
more investment in current assets as compared to fixed assets. Trading concerns have to carry large stock,
more receivables and liquid cash. Manufacturing concerns also require huge amount of working capital
for the purchase of raw materials, maintaining the stock of inventories, financing the receivables and
meeting operating expenses.

Business cycle fluctuations: Various phases of business cycle i.e. recession, boom, recovery etc. also
determine the working capital requirement. In case of boom conditions, inflationary pressure exists and
business operations expand. As a result, the overall requirement for cash, inventories etc. increases,
consequently more and more funds blocked in these current assets. In case of recession phase, there is

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usually dullness in business operations and there would be opposite impact on the level of working capital
requirement. There will be a fall in inventories and receivables.

Size of the business: The size of the business has also an important determinant of working capital
requirements. The working capital requirements would be different between two firms doing same types
of business. A firm with larger scale of operations or routine business will require more working capital
than a firm with smaller scale of operations.

Working capital management involves balancing movements related to five main items – cash, trade
receivables, trade payables, short-term financing, and inventory – to make sure a business possesses
adequate resources to operate efficiently. The levels of cash should be enough to deal with ordinary or
small unexpected needs, but not so high to determine an inefficient allocation of capital. Commercial
credit should be used properly to balance the need to maintain sales and healthy business relationships
with the need to limit exposure to customers with low creditworthiness.

Managing short-term debt and accounts payable should allow the company to achieve enough liquidity
for ordinary operations and unexpected needs, without an excessive increase in financial risk. Inventory
management should make sure there are enough products to sell and materials for its production
processes while avoiding excessive accumulation and obsolescent.

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