FACULTY OF BUSINESS AND COMMERCE

DEPARTMENT OF MANAGEMENT
FINANCIAL MANAGEMENT
BBA - SEM 3
Unit: 5
Introduction
Working capital, also known as net working capital (NWC), is the difference between a company’s current
assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and
finished goods, and its current liabilities, such as accounts payable. Net operating working capital is a
measure of a company's liquidity and refers to the difference between operating current assets and operating
current liabilities. In many cases these calculations are the same and are derived from company cash plus
accounts receivable plus inventories, less accounts payable and less accrued expenses.
Working capital is a measure of a company's liquidity, operational efficiency and its short-term financial
health. If a company has substantial positive working capital, then it should have the potential to invest and
grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or
paying back creditors, or even go bankrupt.
 A company has negative working capital if the ratio of current assets to liabilities is less than one.
 Positive working capital indicates that a company can fund its current operations and invest in future
activities and growth.
 High working capital isn't always a good thing. It might indicate that the business has too much
inventory or is not investing its excess cash.

Example of working capital

To illustrate, consider the case of XYZ Corporation. When XYZ first started, it had working capital of only
$10,000, with current assets averaging $50,000 and current liabilities averaging $40,000. In order to
improve its working capital, XYZ decided to keep more cash in reserve and deliberately delay its payments
to suppliers in order to reduce current liabilities. After making these changes, XYZ has current assets
averaging $70,000 and current liabilities averaging $30,000. Its working capital is therefore $40,000.

Factors Affecting the Working Capital:

The firm must estimate its working capital very accurately because excessive working capital results in
unnecessary accumulation of inventory and wastage of capital whereas shortage of working capital affects
the smooth flow of operating cycle and business fails to meet its commitment.So finance manager must
estimate right amount of working capital. The finance manager must keep in mind following factors before
estimating the amount of working capital.
1. Length of Operating Cycle
The amount of working capital directly depends upon the length of operating cycle. Operating cycle refers to
the time period involved in production. It starts right from acquisition of raw material and ends till payment
is received after sale.
The working capital is very important for the smooth flow of operating cycle. If operating cycle is long then
more working capital is required whereas for companies having short operating cycle, the working capital
requirement is less.
2. Nature of Business
The type of business, firm is involved in, is the next consideration while deciding the working capital. In
case of trading concern or retail shop the requirement of working capital is less because length of operating
cycle is small.
The wholesalers as compared to retail shop require more working capital as they have to maintain large
stock and generally sell goods on credit which increases the length of operating cycle. The manufacturing
company requires huge amount of working capital because they have to convert raw material into finished
goods, sell on credit, maintain the inventory of raw material as well as finished goods.
3. Scale of Operation
The firms operating at large scale need to maintain more inventory, debtors, etc. So they generally require
large working capital whereas firms operating at small scale require less working capital.
4. Business Cycle Fluctuation
During boom period the market is flourishing so more demand, more production, more stock, and more
debtors which mean more amount of working capital is required. Whereas during depression period low
demand less inventories to be maintained, less debtors, so less working capital will be required.
5. Seasonal Factor
The working capital requirement is constant for the companies which are selling goods throughout the
season whereas the companies which are selling seasonal goods require huge amount during season as more
demand, more stock has to be maintained and fast supply is needed whereas during off season or slack
season demand is very low so less working capital is needed.
6. Technology and Production Cycle
If a company is using labour intensive technique of production then more working capital is required
because company needs to maintain enough cash flow for making payments to labour whereas if company is
using machine-intensive technique of production then less working capital is required because investment in
machinery is fixed capital requirement and there will be less operative expenses.
In case of production cycle, if production cycle is long then more working capital will be required because it
will take long time for converting raw material into finished goods whereas when production cycle is small
lesser funds are tied up in inventory and raw materials so less working capital is required.
7. Credit Allowed
Credit policy refers to average period for collection of sale proceeds. It depends on number of factors such
as creditworthiness, of clients, industry norms etc. If company is following liberal credit policy then it will
require more working capital whereas if company is following strict or short term credit policy, then it can
manage with less working capital also.
8. Credit Avail
Another factor related to credit policy is how much and for how long period company is getting credit from
its suppliers. If suppliers of raw materials are giving long term credit then company can manage with less
amount of working capital whereas if suppliers are giving only short period credit then company will require
more working capital to make payments to creditors.
9. Inflation
If there is increase or rise in price then the price of raw materials and cost of labour will rise, it will result in
an increase in working capital requirement.

Disadvantages of Redundant or Excessive Working Capital

1. Excessive Working Capital means idle funds which earn no profits for the business and hence the
business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of
inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher
incidence of bad debts.
4. It may result into overall inefficiency in the organisation.

5. When there is excessive working capital, relations with banks and other financial institutions may not be
maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.

Disadvantages or Dangers of Inadequate Working Capital

1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will
lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects
due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies, increases costs and
reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds.
6. The rate of return on investments also falls with the shortage of working capital.

CLASSIFICATION OF WORKING CAPITAL

1. Gross working capital

Gross working capital is the sum of a company’s current assets. These assets represent a company’s short-
term financial resources, which it can convert into cash within a year or less. It includes inventory, debtors,
cash and cash equivalents, marketable securities, and prepaid expenses. Thus, Gross Working Capital =
Trade receivables (debtors) + Inventory + Marketable securities + Cash and cash equivalent. However,
when it comes to the assessment of an organisation’s financial health, gross working capital only presents
half a picture. That’s because it does not take into account the current liabilities that a company is supposed
to mitigate using the short-term financial resources at its disposal. Naturally, gross working capital is always
positive.

2. Net working capital

The only objective difference between gross and net working capital is that the latter takes into account
current liabilities. Resultantly, net working capital can be positive or negative.Such current liabilities include
trade payables or creditors, short-term loans, dividends payable, long-term debts maturing within a year, etc.
One needs to deduct these items from current assets or gross working capital to reach net working
capital. Therefore, Net Working Capital = Current Assets – Current Liabilitie

3. Permanent Working Capital

Permanent working capital is defined as the “amount of current assets required to meet a firm’s long-term
minimum needs”.
It refers to the minimum amount of all current assets that is required at all times to ensure a minimum level
of uninterrupted business operations. Some minimum level of raw materials, working process, bank balance,
finished goods, etc.
A business has to carry all the time irrespective of the level of manufacturing/marketing operations. This
level of working capital is referred to as core working capital or core current assets.
For a growing business the permanent working capital will be rising, for a declining business it will be
decreasing and for a stable business it will be remaining more, or less stay-put.
This part of the working capital being a permanent investment, needs to be financed through long-term
funds. Depending upon the changes in the production and sales, the need for working capital, over and
above the permanent working capital, will fluctuate.

1. Initial Working Capital:

In the initial period of its operation, a firm must need enough money to pay certain expenses before the
business yields cash receipt. In the initial years the banks may not grant loans or overdrafts, sales may have
to be made on credit and it may be necessary to pay the creditors immediately. Therefore the owners
themselves have to provide necessary funds in the initial period, which may be known as initial working
capital.

2. Regular Working Capital:

The firm is always required to keep certain funds with it to continue the regular business operations, which
is called as Regular Working Capital. It is required to maintain regular stock of raw materials and work-in-
progress and also of the finished goods, which must be maintained permanently at a definite level. Regular
working capital is the excess of current assets over current liabilities. It ensures smooth operation of
business.

4. Temporary or Varying Working Capital:

It varies with the volume of operations. If fluctuates with scale of operations.
This is additional working capital required during up seasons over the above the fixed working capital.
During seasons more production/sales take(s) place resulting in larger working capital needs.
The reverse is true during off-seasons. As seasons alternate, temporary working capital moves up and down
like tides. Temporary working capital is defined as the “amount of current assets that varies with seasonal
requirements”.

Temporary working capital can be financed through short term funds, ie. current liabilities. When the level
of temporary working capital moved up, the business might use short-term funds and when the level of
temporary working capital recedes, the business might retire its short-term loans.
1. Seasonal Working Capital:
Some business operations require additional working capital during a particular season. For example, the
groundnut oil producers may have to purchase groundnut in a particular season and have to employ
additional labor for that purpose. These may require additional funds for a temporary period, which may be
called as seasonal working capital.

2. Special Working Capital:

In all enterprises, some unforeseen events do occur like sudden increase in demand, downward movement of
prices of raw materials, strike or natural calamities, when extra funds are needed to tide over such situation.
Such type of extra funds is called as Special working capital.

INVENTORY MANAGEMENT:
Inventories represent investment of a firm’s funds. The manufacturing companies hold inventories in the
form of raw materials, work-in-process and finished goods. The objective of the inventory management
should be the maximization of the value of the firm. The firm should therefore consider: (a) costs, (b) return,
and (c) risk factors in establishing its inventory policy.

Inventory Management tracks inventory from purchase to sale and enables brands to make timely
decisions on what to buy (and how much). It can also help them strategically adjust stock levels based on
trends, seasons, locations, and all manner of economic data.
Nature of Inventories
Inventories are stock of the product a company is manufacturing for sale and components that make up the
product. The various forms in which inventories exist in a manufacturing company are: raw materials, work-
in-process and finished goods.
Raw materials are those basic inputs that are converted into finished product through the manufacturing
process. Raw material inventories are those units which have been purchased and stored for future
productions.
Work-in-process inventories are semi manufactured products. They represent products that need more
work before they become finished products for sale.
Finished goods inventories are those completely manufactured products which are ready for sale. Stocks
of raw materials and work-in-process facilitate production, while stock of finished goods is required for
smooth marketing operations. Thus, inventories serve as a link between the production and consumption of
goods.

Need To Hold Inventories

The question of managing inventories arises only when the company holds inventories. Maintaining
inventories involves tying up of the company’s funds and incurrence of storage and handling costs. If it is
expensive to maintain inventories, why do companies hold inventories? There are three general motives for
holding inventories.
Transactions motive, which emphasizes the need to maintain inventories to facilitate smooth production
and sales operations.
Precautionary motive, which necessitates holding of inventories to guard against the risk of unpredictable
changes in demand and supply forces and other factors.
 Speculative motive, which influences the decision to increase or reduce inventory levels to take advantage
of price fluctuations.

Two types of costs are involved in the inventory maintenance:

• Ordering costs: requisition, placing of order, transportation, receiving, inspecting and storing and clerical
and staff services. Ordering costs are fixed per order. Therefore, they decline as the order size increases.
• Carrying costs: warehousing, handling, clerical and staff services, insurance and taxes. Carrying costs vary
with inventory holding. As order size increases, average inventory holding increases and therefore, the
carrying costs increase.
The firm should minimize the total cost (ordering plus carrying). The economic order quantity
(EOQ) of inventory will occur at a point where the total cost is minimum.

CASH MANAGEMENT
Cash Management refers to the day-to-day administration of managing cash inflows and outflows. It refers
to the proper collection, disbursement, and investment of cash.

Cash is an important current asset when running a business. Cash is always needed to run a business
enterprise.

A reasonable cash balance is always preferred. It should not be less than the demand nor more than the
reasonable demand.

The lower the quantity of cash, then legitimate needs will disturb daily business routines.

Similarly, holding excess cash is unwise because it can undermine the profitability of the organization.

The cash balance is the most unproductive asset of an organization. However, it is important because it is
used to pay liabilities.

Benefits of Holding Cash or Objectives of Cash Management

The following are the main objectives of cash management:

1. Useful in Making Payments According to a Schedule

The main objective of cash management is to ensure that a company's liabilities are paid on the due date.

Payments and purchases may include raw materials, wages, salaries, interest, dividends, taxes, and other
routine payments.

2. No Danger of Insolvency
Sufficient cash holdings will increase the goodwill of the organization and ensure that it can pay creditors
and taxes on the due date. Hence, there is no danger of insolvency under effective cash management.

3. Positive Relationship with Bank

A reasonable cash balance will be helpful in paying customers on the due date. This means that there is no
need to secure bank credit in the form of cash credit, bank overdrafts, and discounting bills.
4. Usefulness of Cash Discount
A reasonable cash balance will benefit large-scale purchases. In particular, payment of large-scale purchases
in cash can be useful in exploiting cash discounts.

5. Good Supplier Relations

A good cash balance is always desirable to ensure that suppliers are paid on the due date. This will increase
the creditability of the firms, which will yield benefits in terms of the organization's future profitability.

6. Helpful in Odd Situations

When a firm has a reasonable cash balance, it can exploit odd and unexpected business situations.

For example, deflation occurs when there is a shortage of currency in circulation. In the context of deflation,
commodities will be cheaper, and so a firm with a sufficient cash balance can benefit by purchasing
commodities and other assets.

RECEIVABLE MANAGEMENT:

Concept: Trade credit happens when a firm sells its products or services on credit and does not receive cash
immediately. It is an essential marketing tool, acting as a bridge for the movement of goods through the
production and distribution stages to customers. A firm grants trade credit to protect its sales from the
competitors and to attract the potential customers to buy its products at favourable terms. Trade credit
creates accounts receivable or trade debtors (also referred to book debts in India) that the firm is expected to
collect in the near future. The customers from whom receivables or book debts have to be collected in the
future are called trade debtors or simply as debtors and represent the firm’s claim or asset. A credit sale has
three characteristics:1 First, it involves an element of risk that should be carefully analyzed. Cash sales are
totally riskless, but not the credit sales, as the cash payments are yet to be received. Second, it is based on
economic value. To the buyer, the economic value in goods or services passes immediately at the time of
sale, while the seller expects an equivalent value to be received later on. Third, it implies futurity. The buyer
will make the cash payment for goods or services received by him, in a future period.

Credit policy variables

The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and

collection effort. These variables are related and have a bearing on the level of sales, bad debt loss, discounts

taken by customers, and collection expenses.

i) Credit standards:

A firm has a wide range of choice in this respect. At one and of the spectrum, it may decide not to extend

credit to any customer, however strong his credit rating may be. At the other end, it may decide to grand

credit to all customers irrespective of their credit rating. Between these two extreme positions lie several

positions, often the more practical ones.

In general, liberal credit standards tend to push sales up by attracting more customers. This is, however,

accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of

collection. Stiff-credit standards have opposite effects. They tend to depress sales, reduce the incidence of

bad debt loss, decrease the investment in receivables, and lower the collection cost.

ii) Credit period:

The credit period refers to the length of time customers are allowed to pay for their purchases. It generally

varies from 15 days to 60 days. When a firm does not extend any credit, the credit period would obviously

be zero. If a firm allows 30 days, say, of credit, with no discount to induce early payments, its credit terms

are stated as “net 30”.

Lengthening of the credit period pushes sales up by inducing existing customers to purchase more and

attracting additional customers. This is, however, accompanied by a larger investment in receivables and a

higher incidence of bad debt loss. Shortening of the credit period would have opposite influences: It tends to

lower sales, decrease investment in receivables, and reduce the incidence of bad debt loss.

iii) Cash discount:

Firms generally offer cash discounts to induce customers to made prompt payments. The percentage

discount and the period during which it is available are reflected in the credit terms. For example, credit

terms of 2/10, net 30 mean that a discount of 2 per cent is offered if the payment is made by the tenth day;

otherwise the full payment is due by the thirtieth day.

Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount

period are lengthened. Such an action tends to enhance sales (because the discount is regarded as price

reduction), reduce the average collection period (as customers pay promptly), and increase the cost of

discount.

iv) Collection Effort:

The collection programmed of the firm, aimed at timely collection of receivables consisting of – monitoring

the state of receivables, dispatch of letters to customers whose due date is approaching, telegraphic and
telephonic advice to customers around the due date, threat of legal action to overdue accounts and legal

action against overdue accounts.

Importance of Receivables Management

Here are some common benefits of receivables management:

Allows evaluation of customer credit ratings

Accounts receivables management may allow you to have an in-depth understanding of the customer's credit
rating. It can help you evaluate the borrowing limit of a customer and their ability to repay the credit
amount. Evaluating customer credit ratings can also be helpful in minimising credit risk. Many finance
managers approve the credit application after analysing the customer credit ratings and gaining full
satisfaction.

Helps firms to minimise the investment in receivables

Receivables management can help you to evaluate if there are enough funds available for making the
investment. It may help you reduce the investment in receivables. You can find the best methods and
strategies that focus on collecting the due account receivables.

With the help of receivables management, you can evaluate the right credit limit and period to avoid
situations like bankruptcy. You can minimise the investment in receivables by collecting accounts receivable
as soon as they become due for payment.

Helps in optimising sales

With the help of receivables management, you can help businesses and firms optimise their sales and
increase the sales volume. Many businesses gain the attention of potential customers by providing them with
different credit facilities. Receivable management can help you understand and monitor the credit facilities a
business is offering to customers.

Reduces risk of bad debts

You can notify customers about due payments. Many professionals use receivable management to charge
interest on delayed payments and ensure the timely collection of payments. It can help you to follow the
necessary steps and reduce the risk of bad debts.

Maintains efficient cash

Maintaining efficient cash can help businesses to remain competitive in the market. Receivables
management can allow you to have a proper track of all the cash flows including both the inflows and
outflows. It may help you to gain a better understanding of the current financial strength of a business and
make decisions accordingly. Before lending any credit to customers, you can analyse the capabilities of the
business and maintain efficient cash. Receivable management can help you maintain steady cash flow within
the organisation.

Lowers cost of credit

Receivable management also helps finance professionals in evaluating the exact lowest cost of credit for
customers. If the previous track record of a customer is poor in accordance with the credit policies, the
company may lower the credit amount. You can collect all the essential information about customers such as
their credit information, requirements and previous due payments. Many businesses limit the credit amount
and credit period to lower the cost of credit.