UNIT 1

Working Capital: Meaning, Concept & Nature

Meaning:

In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day
operations of a concern.

This is related to short-term assets and short-term sources of financing. Hence it deals with both,
assets and liabilities—in the sense of managing working capital it is the excess of current assets
over current liabilities. In this article we will discuss about the various aspects of working
capital.

Concept of Working Capital:

The funds invested in current assets are termed as working capital. It is the fund that is needed to
run the day-to-day operations. It circulates in the business like the blood circulates in a living
body. Generally, working capital refers to the current assets of a company that are changed from
one form to another in the ordinary course of business, i.e. from cash to inventory, inventory to
work in progress (WIP), WIP to finished goods, finished goods to receivables and from
receivables to cash.

There are two concepts in respect of working capital:

(i) Gross working capital and

(ii) Networking capital.

Gross Working Capital:

The sum total of all current assets of a business concern is termed as gross working capital. So,

Gross working capital = Stock + Debtors + Receivables + Cash.

Net Working Capital:

The difference between current assets and current liabilities of a business concern is termed as
the Net working capital.

Hence,

Net Working Capital = Stock + Debtors + Receivables + Cash – Creditors – Payables.

Nature of Working Capital:

The nature of working capital is as discussed be

i. It is used for purchase of raw materials, payment of wages and expenses.

ii. It changes form constantly to keep the wheels of business moving.

iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the
enterprise.

iv. It generates the elements of cost namely: Materials, wages and expenses.

v. It enables the enterprise to avail the cash discount facilities offered by its suppliers.

vi. It helps improve the morale of business executives and their efficiency reaches at the highest
climax.

vii. It facilitates expansion programmes of the enterprise and helps in maintaining operational
efficiency of fixed assets.

Need for Working Capital:

Working capital plays a vital role in business. This capital remains blocked in raw materials,
work in progress, finished products and with customers.

The needs for working capital are as given below:

i. Adequate working capital is needed to maintain a regular supply of raw materials, which in
turn facilitates smoother running of production process.

ii. Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.

iii. Working capital is needed for the efficient use of fixed assets.

iv. In order to enhance goodwill a healthy level of working capital is needed. It is necessary to
build a good reputation and to make payments to creditors in time.

v. Working capital helps avoid the possibility of under-capitalization.

vi. It is needed to pick up stock of raw materials even during economic depression.

vii. Working capital is needed in order to pay fair rate of dividend and interest in time, which
increases the confidence of the investors in the firm.
Importance of Working Capital:

It is said that working capital is the lifeblood of a business. Every business needs funds in order
to run its day-to-day activities.

The importance of working capital can be better understood by the following:

i. It helps measure profitability of an enterprise. In its absence, there would be neither production
nor profit.

ii. Without adequate working capital an entity cannot meet its short-term liabilities in time.

iii. A firm having a healthy working capital position can get loans easily from the market due to
its high reputation or goodwill.

iv. Sufficient working capital helps maintain an uninterrupted flow of production by supplying
raw materials and payment of wages.

v. Sound working capital helps maintain optimum level of investment in current assets.

vi. It enhances liquidity, solvency, credit worthiness and reputation of enterprise.

vii. It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise
run successfully during periods of crisis.

Classification of Working Capital

Working capital may be classified as follows:

(1) On the basis of concept Working capital may be classified as:

(i) Gross working capital.

(ii) Net working capital. 

These terms have been discussed above.

(2) On the basis of periodicity of requirement:

(i) Permanent (or Fixed) Working Capital:

This capital is permanently locked up in the current assets to carry out the business smoothly.
This investment in current assets is of the permanent nature and will increase as the size of
business expands.

Permanent working capital is that minimum amount of investment in raw materials, work-in-
process inventory, finished goods, stores and spares, accounts receivable and cash balance which
a firm is required to have in order to carry on a desirable level of business activity.
Such an amount cannot be reduced if the firm wants to carry on the business operations without
interruption. It is that minimum amount which is absolutely essential throughout the year on a
continuous basis for maintaining the circulation of current assets.

Minimum cash is required for making payment of wages, salaries, and other expenses; minimum
stock is required to maintain regular supplies and minimum investment in debtors is essential on
account of credit sales according to the period of credit allowed to the customers. Since the
requirement of permanent or hard core working capital is on a permanent basis, such working
capital should be financed out of long-term funds.

Characteristics of permanent working capital:

(1) The size of permanent working capital grows with the growth of business.

(2) It keeps on changing its form from one current asset to another.

(3) As long as the firm is a going concern, working capital cannot be substantially reduced.

(a) Regular Working Capital:

It is the minimum amount of liquid capital needed to keep up the circulation of the capital from
cash to inventories, to receivable and again to cash. This would include sufficient minimum bank
balance to discount all bills, maintain adequate supply of raw materials etc.

(b) Reserve Margin or Cushion Working Capital:

It is the excess over the needs or regular working capital that should be kept in reserve for
contingencies that may arise at any time. These contingencies include rising prices, strikes,
special operations such as experiments with new products etc.

(ii) Variable Working Capital:

Variable working capital requires changes with the increase or decrease in the volume of
production or business.

Variable working capital can be classified as:

(a) Seasonal Working Capital:

The working capital required to meet the seasonal needs of the industry or business is known as
seasonal working capital. For example, if an enterprise is marketing woolen garments, it needs
more money for that purpose during winter months than in summer season. Similar is the case
with a factory/business engaged in the production or marketing or coolers, refrigerators or air-
conditioners. They are all Seasonal products.
(b) Special Working Capital:

Special working capital is that part of the variable working capital which is meant for meeting
the special business operations such as extensive marketing campaigns, experiments with
products or methods of production, etc.

The distinction between fixed and variable working capital is of great significance particularly in
raising the funds for an enterprise. Fixed working capital should be raised in the same way as
fixed capital is procured. Variable working capital is procured out of short-term borrowings from
the bank or from the public.

Factors Affecting Requirements for Working Capital:

In addition to the investment in a fixed asset, it is sometimes necessary to carry additional cash,
receivables or inventories. This investment in working capital is treated as a cash outflow at the
time it occurs.

The working capital needs of a firm are influenced by the following factors:

(1) Nature of Business:

A machine tool manufacturing concern which has a long operating cycle and sells largely on
credit has a very substantial working capital requirement.

On the other hand a service firm, such as an electricity undertaking or a transport corporation
with a short operating cycle and sales predominantly on cash basis, has a modest working capital
requirement.

(2) Seasonality of Operations:

A firm manufacturing seasonal products such as fans, coolers, woolen clothes etc., has a highly
fluctuating working capital requirement.

On the other hand, a firm manufacturing electric bulbs or tube-lights or televisions has fairly
even sales round the year and hence a stable working capital need.

(3) Conditions of Supply:

If the raw inventory required for production is easily available throughout the year, the firm can
manage with a small capital being involved in inventory. However, if the raw material supply is
scant and unpredictable, then, to ensure continuity of production, the firm has to keep a good
stock of inventory which will involve large working capital.

(4) Marketing Conditions:

If the market is strong and competition is weak, the firm can manage with smaller inventory of
finished goods as customers can be served after a delay. In this situation, the firm can insist on
cash selling or even can ask for advance payment. This will avoid lock up of funds in accounts
receivable.

On the other hand, if many firms are making the same product (like T.V., Refrigerators, etc.) and
the competition is high, the firm has to keep a larger inventory of finished goods so that its
product is not out of stock at any time. In this situation, the working capital needs tend to be
high.

Approaches to Working Capital Financing

There are basically three approaches to financing working capital. These are: the Hedging
approach, the Conservative approach and the Aggressive approach.

1. Hedging Approach:  The hedging approach is also known as the matching approach.
Under this approach, the funds for acquiring fixed assets and permanent current should be
acquired with long term funds and for temporary working capital short term funds should
be used.
2. Conservative Approach: This approach suggests that in addition to fixed assets and
permanent current assets, even a part of variable current assets should be financed from
long-term sources. The short-term sources are used only to meet the peak seasonal
requirements. During the off season, the surplus fund is kept invested in marketable
securities. Surplus current asset enable the firm to absorb sudden variation in sales,
production plans, and procurement time without destructing production plans.
Additionally the higher liquidity level reduces the risk of insolvency. But lower risk
translates into lower returns. Large investment in current asset lead to higher interest and
carrying cost and encouragement for efficiency. But conservative policy will enable the
firm to absorb day to day risk. It assures continuous flow of operation and illuminates
worry about recurring obligation. Under this strategy, long term financing covers more
than the total requirement of capital. The excess cash is invested in short-term marketable
securities and in need these securities are sold off in the market to meet the urgent
requirement of working capital.
3. Aggressive Approach: This approach depends more on short-term funds. More short-
term funds are used particularly for variable current assets and a part of even permanent
current assets, the funds are raised from short term sources. Under this approach current
assets are maintained just to meet the current liabilities without keeping cushions for the
variation in working capital needs. The companies working capital is financed by long-
term source of capital and seasonal variation are met through short-term borrowing.
Adoption of this strategy will minimize the investment in net working capital and
ultimately it lowers the cost financing working capital needs. The main drawback of this
strategy is that it necessitates frequent financing and also increase, as the firm is variable
to sudden shocks.
Sources of Working Capital:

(1) Funds from business operations.

(2) Other incomes such as from dividends, transfer fees, donations, interest from investments
made in other companies, etc.

(3) Sale of non-current assets such as useless and obsolete plant and machinery.

(4) Long-term borrowings.

(5) Issue of additional equity capital or preference share capital.

Uses of Working Capital:

1. Loss from business operations would decrease the working capital.

2. The purchase of non-current assets generally causes a decrease in current assets or increase in
current liabilities. Therefore, it should appear as the use of funds.

3. The retirement of long-term liabilities such as payment to preference shareholders and

debenture holders involves the use of cash.

4. Dividend to shareholders.

5. Interest to lenders.
UNIT 2

Cash Management
Definition: Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid
resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound
cash flow position in the organization.

Receivables Cash Management

Any amount which the company has earned however not yet received, i.e. its outstanding and is
expected to be received in future, is known as receivables.

An organization must manage its receivables to maintain the surplus cash inflow. It helps the
firm to fulfil its immediate cash requirements.

The cash receivables must be planned in such a way that the organization can realise its debts
quickly and should allow a short credit period to the debtors.

Payables Cash Management

The payables refer to the payment which is unpaid by the organization and is to be paid off
shortly.

The organization should plan its cash outflow in such a manner that it can acquire an extended
credit period from the creditors.

This helps the firm to retain its cash resources for a longer duration to meet the short term
requirements and sudden expenses. Even the organization can invest this cash in a profitable
opportunity for that particular credit period to generate additional income.

Objectives of Cash Management

Why do we need to manage cash flow in the organization? What is the use of cash management
in the business?

 Fulfil Working Capital Requirement: The organization needs to maintain ample liquid
cash to meet its routine expenses which possible only through effective cash
management.
 Planning Capital Expenditure: It helps in planning the capital expenditure and
determining the ratio of debt and equity to acquire finance for this purpose.
  Handling Unorganized Costs: There are times when the company encounters
unexpected circumstances like the breakdown of machinery. These are unforeseen
expenses to cope up with; cash surplus is a lifesaver in such conditions.
 Initiates Investment: The other aim of cash management is to invest the idle funds in the
right opportunity and the correct proportion.
 Better Utilization of Funds: It ensures the optimum utilization of the available funds by
creating a proper balance between the cash in hand and investment.
 Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a
profit out of the money available.

Cash Management Models

Cash management requires a practical approach and a strong base to determine the requirement
of cash by the organization to meet its daily expenses. For this purpose, some models were
designed to determine the level of money on different parameters.

The two most important models are discussed in detail below:

The Baumol’s EOQ Model

Based on the Economic Order Quantity (EOQ), in the year 1952, William J. Baumol gave the
Baumol’s EOQ model, which influences the cash management of the company.

This model emphasizes on maintaining the optimum cash balance in a year to meet the business
expenses on the one hand and grab the profitable investment opportunities on the other side.

The following formula of the Baumol’s EOQ Model determines the level of cash which is to be
maintained by the organization:

Where,
‘C’ is the optimum cash balance;
‘F’ is the fixed transaction cost;
‘T’ is the total cash requirement for that period;
‘i’ is the rate of interest during the period

The Miller – Orr’ Model

According to Merton H. Miller and Daniel Orr, Baumol’s model only determines the cash
withdrawal; however, cash is the most uncertain element of the business.
There may be times when the organization will have surplus cash, thus discouraging
withdrawals; instead, it may require to make investments. Therefore, the company needs to
decide the return point or the level of money to be maintained, instead of determining the
withdrawal amount.

This model emphasizes on withdrawing the cash only if the available fund is below the return
point of money whereas investing the surplus amount exceeding this level.

Where,
‘Z’ is the spread of cash;
‘UL’ is the upper limit or maximum level
‘LL’ is the lower limit or the minimum level
‘RP’ is the Return Point of cash

We can see that the above graph indicates a lower limit which is the minimum cash a business
requires to function. Adding up the spread of cash (Z) to this lower limit gives us the return point
or the average cash requirement.

However, the company should not invest the sum until it reaches the upper limit to ensure
maximum return on investment. This upper limit is derived by adding the lower limit to the three
times of spread (Z). The movement of cash is generally seen across the lower limit and the upper
limit.

Let us now discuss the formula of the Miller – Orr’ model to find out the return point of cash and
the spread across the minimum level and the maximum level:

Where,
‘Return Point’ is the point at which money is to be invested or withdrawn;
‘Minimum Level’ is the minimum cash required for business sustainability;
‘Z’ is the spread across the minimum level and the maximum level;
‘T’ is the transaction cost per transfer;
‘V’ is the variance of daily cash flow per annum;
‘i’ is the daily interest rate

Functions of Cash Management

Cash management is required by all kinds of organizations irrespective of their size, type and
location. Following are the multiple managerial functions related to cash management:

 Investing Idle Cash: The company needs to look for various short term investment
alternatives to utilize surplus funds.

 Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is
an essential function of the business.
 Planning of Cash: Cash management is all about planning and decision making in terms
of maintaining sufficient cash in hand and making wise investments.
 Managing Cash Flows: Maintaining the proper flow of cash in the organization through
cost-cutting and profit generation from investments is necessary to attain a positive cash
flow.
 Optimizing Cash Level: The organization should continuously function to maintain the
required level of liquidity and cash for business operations.

Cash Management Strategies

Cash management involves decision making at every step. It is not an immediate solution but a
strategical approach to financial problems. Following are the strategies of cash management:

Business Line of Credit: The organization should opt for a business line of credit at an initial
stage to meet the urgent cash requirements and unexpected expenses.

Money Market Fund: While carrying on a business, the surplus fund should be invested in the
money market funds. These are readily convertible into cash whenever required and yield a
considerable profit over the period.

Lockbox Account: This facility provided by the banks enable the companies to get their
payments mailed to its post office box. This lockbox is managed by the banks to avoid manual
deposit of cash regularly.

Sweep Account: The organizations should avail the facility of sweep accounts which is a mix of
savings and fixed deposit account. Thus, the minimum balance of the savings account is
automatically maintained, and the excess sum is transferred to the fixed deposit account.

Cash Deposits (CDs): If the company has a sound financial position and can predict the
expenses well along with availing of a lengthy period, it can invest the surplus cash in the cash
deposits. These CDs yield good interest, but early withdrawals are liable to penalties.
Cash Flow Management Techniques

Managing cash flow is a contemplative process and requires a lot of analytical thinking. The
various techniques or tools used by the managers to practice cash flow management are as
follows:

 Accelerating Collection of Accounts Receivable: One of the best ways to improve cash
inflow and increase liquid cash by collecting the debts and dues from the debtors readily.
 Stretching of Accounts Payable: On the other hand, the company should try to extend
the payment of dues by acquiring an extended credit period from the creditors.
 Cost Cutting: The company must look for the ways of reducing its operating cost to
main a good cash flow in the business and improve profitability.
 Regular Cash Flow Monitoring: Keeping an eye on the cash inflow and outflow,
prioritizing the expenses and reducing the debts to be recovered, makes the
organization’s financial position sound.
 Wisely Using Banking Services: The services such as a business line of credit, cash
deposits, lockbox account and sweep account should be used efficiently and intelligently.
 Upgrading with Technology: Digitalization makes it convenient for the organizations to
maintain the financial database and spreadsheets to be assessed from anywhere anytime.

Limitations of Cash Management

Cash management is an inevitable part of business organizations. However, it has a few

shortcomings which make it unsuitable for small organizations; these are as follows:

Cash management is a very time consuming and skilful activity which is required to be
performed regularly.

As it requires financial expertise, the company may need to hire consultants or other experts to
perform the task by paying administrative and consultation charges.

Small business entities which are managed solely, face problems such as lack of skills,
knowledge, time and risk-taking ability to practice cash management.

Cash Concentration

Cash Concentration is a corporate treasury management strategy involving the transfer of all
funds from different accounts to a single, centralised account to increase cash management
efficiency and reduce fees.

There are numerous advantages to concentrating all available funds into a single account.
Businesses improve their investment potential as well as the visibility and availability of their
funds, they gain more control over deposits from diverse locations and can easily ensure that no
funds are lying in bank accounts that don’t generate interest. Cash concentration also reduces
bank service charges to those of the central account and makes it simpler to monitor cash flows.