Financial Management

Unit VII: Management of working capital

Gupteswar Patel
Assistant Professor

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Meaning of working capital

● Working Capital is a part of the capital which is needed for meeting

day to day requirement of the business concern.

● For example, payment to creditors, salary paid to workers, purchase

of raw materials etc., normally it consists of recurring in nature.

● It can be easily converted into cash. Hence, it is also known as short-

term capital.

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● According to the definition of Mead, Baker and Malott, “Working

Capital means Current Assets”.

● According to the definition of J.S.Mill, “The sum of the current asset

is the working capital of a business”.

● According to the definition of Weston and Brigham, “Working

Capital refers to a firm’s investment in short-term assets, cash, short-
term securities, accounts receivables and inventories”.

● According to the definition of Bonneville, “Any acquisition of funds

which increases the current assets, increase working capital also for
they are one and the same”.

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Concept of Working Capital

● Working capital can be classified or understood with the help of the
following two important concepts.

● Gross Working Capital:

Gross Working Capital is the general concept which determines the
working capital concept.

● Thus, the gross working capital is the capital invested in total current
assets of the business concern.

● Gross Working Capital is simply called as the total current assets of

the concern.

Gross Working Capital = Current Assets

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● Net Working Capital

Net Working Capital is the specific concept, which, considers both
current assets and current liability of the concern.

● Net Working Capital is the excess of current assets over the current
liability of the concern during a particular period.

● If the current assets exceed the current liabilities it is said to be

positive working capital; it is reverse, it is said to be Negative
working capital.

Net Working Capital = Current Assets – Current Liabilities

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Nature of Working Capital:

1. It is used for purchase of raw materials, payment of wages and
expenses.
2. It changes form constantly to keep the wheels of business moving.
3. Working capital enhances liquidity, solvency, creditworthiness and
reputation of the enterprise.
4. It generates the elements of cost namely: Materials, wages and
expenses.
5. It enables the enterprise to avail the cash discount facilities offered by
its suppliers.
6. It helps improve the morale of business executives and their efficiency
reaches at the highest climax.
7. It facilitates expansion programmes of the enterprise and helps in
maintaining operational efficiency of fixed assets.

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Importance of Working Capital

● Higher return on capital: Firms with lower working capital will post
a higher return on capital. Therefore, shareholders will benefit from a
higher return for every dollar invested in the business.

● Improved credit profile and solvency: 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.

● Higher profitability: According to some researchers, the

management of account payables and receivables is an important
driver of small businesses’ profitability.
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● Higher liquidity: A large amount of cash can be tied up in working

capital, so a company managing it efficiently could benefit from
additional liquidity and be less dependent on external financing.

● This is especially important for smaller businesses as they typically

have limited access to external funding sources. Also, small
businesses often pay their bills in cash from earnings so efficient
working capital management will allow a business to better allocate
its resources and improve their cash management.

● Increased business value: Firms with more efficient working capital

management will generate more free cash flows which will result in
higher business valuation and enterprise value.

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● Favorable financing conditions: A firm with a good relationship

with its trade partners and paying its suppliers on time will benefit
from favorable financing terms such as discount payments from its
suppliers and banking partners.

● Uninterrupted production: A firm paying its suppliers on time will

also benefit from a regular flow of raw materials, ensuring that the
production remains uninterrupted and clients receive their goods on
time.

● Ability to face shocks and peak demand: Efficient working capital

management will help a firm to survive through a crisis or ramp up
production in case of an unexpectedly large order.

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Operating or working capital cycle

● The duration of time required to complete the sequence of events right
from purchase of raw material / goods for cash to the realization of
sales in cash is called the operating cycle, working capital cycle or
cash cycle.

● Working operating cycle = Inventory days + Receivables days –

Payables days.

● In the manufacturing sector inventory days has three components:

(i) raw materials days

(ii) work-in-progress days (the length of the production process), and
(iii) finished goods days.

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Operating cycle= R + W + F + D – C

Where,

R = Raw material storage period

W= Work-in-progress holding period
F= Finished goods storage period
D = Receivables (Debtors) collection period
C = Credit period allowed by suppliers (creditors)

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Various components of operating cycle

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Nature of
Regulator Business
y Size of the
Environm Business
ent

Economic
Credit
Condition
Policy
s

Determinants
of working
capital
Productio Seasonal
n Cycle Variations

Supplier Growth
Terms Rate

Creditwor
Inventory
thiness of
Managem
Customer
ent
s

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Management of cash
● Managing cash is a crucial aspect of financial management, ensuring
a company's liquidity and ability to meet short-term obligations.

● Effective cash management involves optimizing cash flows,

minimizing idle cash, and making strategic decisions to enhance
financial stability.

● Cash management is the process of monitoring, analyzing, and

controlling a company's cash flows to ensure it has the right amount
of cash available at the right time.

● It involves balancing the need for liquidity with the opportunity cost
of holding idle cash.

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● Cash Forecasting: Accurate cash forecasting involves predicting

future cash inflows and outflows. This enables businesses to plan for
periods of surplus or shortage and make informed financial decisions.

● Working Capital Management: Effectively managing working

capital, which includes accounts receivable, accounts payable, and
inventory, is crucial for optimizing cash levels. Streamlining these
components ensures that cash is neither tied up unnecessarily nor
depleted.

● Optimizing Cash Conversion Cycle (CCC): CCC represents the time

it takes to convert resources, such as inventory and accounts
receivable, into cash. A shorter CCC enhances liquidity by speeding
up the cash conversion process.

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● Maintaining Adequate Reserves: Having a safety cushion of cash

reserves helps companies navigate unforeseen expenses, economic
downturns, or disruptions in cash flows.

● Investment of Surplus Cash: While maintaining liquidity is essential,

excess cash should be invested wisely to generate returns. Short-term
investments or money market instruments can provide a balance
between liquidity and earning potential.

● Negotiating Terms with Suppliers and Customers: Extending

payables and optimizing receivables collection periods can positively
impact cash flows. Negotiating favorable terms with both suppliers
and customers is a strategic approach.

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● Cost Management: Efficient cost management is integral to

preserving cash. Identifying areas for cost reduction and
implementing cost-effective practices contribute to maintaining
healthy cash reserves.

● Utilizing Technology: Leveraging financial technology and

automated systems for cash management can enhance accuracy,
speed, and efficiency in monitoring cash positions.

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Management of inventory
● Inventory management is a critical aspect of financial management,
influencing a company's profitability, liquidity, and overall
operational efficiency.

● Effectively managing inventory involves striking a balance between

meeting customer demand and minimizing holding costs.

● Inventory management is the process of overseeing the acquisition,

storage, and utilization of raw materials, work-in-progress, and
finished goods.

● It plays a crucial role in optimizing cash flows, reducing holding

costs, and ensuring timely product availability.

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● Demand Forecasting: Accurate forecasting of product demand is

essential for maintaining optimal inventory levels. Utilizing historical
data, market trends, and other forecasting tools helps in aligning
inventory with expected sales.

● ABC Analysis: Classifying inventory into categories based on

importance allows businesses to prioritize management efforts. "A"
items, representing high-value and high-demand products, require
closer monitoring than "C" items with lower impact.

● Safety Stock: Maintaining a safety stock helps buffer against

unexpected fluctuations in demand or supply chain disruptions. It
ensures that the company can meet customer demands even during
unforeseen circumstances.

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● Just-In-Time (JIT) Inventory: Adopting a JIT approach minimizes

holding costs by receiving goods only as they are needed in the
production process. This strategy reduces the need for extensive
warehousing and helps in efficient cash utilization.

● Economic Order Quantity (EOQ): EOQ is a formula that calculates

the optimal order quantity to minimize total inventory costs,
considering ordering and holding costs. Striking the right balance
with EOQ helps in cost-effective inventory management.

● Technology Integration: Utilizing inventory management software

and technology tools enhances accuracy, real-time tracking, and
efficiency in managing inventory levels. Automation reduces the risk
of errors and facilitates better decision-making.

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● Supplier Relationships: Establishing strong relationships with

suppliers is crucial for timely and cost-effective inventory
replenishment. Negotiating favorable terms, lead times, and quality
standards contributes to efficient inventory management.

● Lifecycle Management: Regularly reviewing and adjusting inventory

levels based on product lifecycle stages helps prevent overstocking
obsolete items. This ensures that the available inventory aligns with
market demand.

● Continuous Monitoring: Regularly monitoring key performance

indicators (KPIs) such as inventory turnover, days sales of inventory
(DSI), and fill rates helps in assessing the effectiveness of inventory
management strategies.

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Management of debtors
● Managing debtors, or accounts receivable, is a crucial aspect of
financial management that directly impacts a company's cash flow
and liquidity.

● Effectively managing debtors involves balancing the need for timely

payment from customers with maintaining positive customer
relationships.

● Debtor management, also known as accounts receivable management,

is the process of overseeing and controlling the credit extended to
customers and ensuring the timely collection of payments.

● It is a critical function in financial management that directly

influences a company's cash flow and working capital.
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● Credit Policies: Establishing clear and well-defined credit policies is

essential for mitigating the risk of bad debts. This includes setting
credit limits for customers based on their creditworthiness and past
payment history.

● Credit Terms: Clearly communicating credit terms, including

payment terms and interest rates for late payments, helps set
expectations with customers. Well-defined credit terms contribute to
timely collections.

● Creditworthiness Assessment: Conducting thorough credit checks on

new customers and regularly reviewing the creditworthiness of
existing customers helps in making informed decisions about credit
limits and terms.

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● Invoicing Practices: Timely and accurate invoicing is crucial for

prompt payment. Clear and detailed invoices reduce the chances of
disputes and facilitate faster processing by customers.

● Payment Terms Negotiation: Flexibility in negotiating payment

terms based on individual customer needs and circumstances can
foster positive relationships while ensuring timely collections.

● Customer Communication: Maintaining open communication with

customers about their outstanding balances, payment due dates, and
any issues with invoices is key to resolving payment delays and
building trust.

● Customer Relationship Management (CRM): Integrating debtor

management with CRM systems helps in maintaining comprehensive
customer profiles, enabling personalized interactions and targeted
collection efforts.
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● Automation and Technology: Utilizing accounting software and

automation tools streamlines the invoicing and collection process.
Automation reduces the risk of errors, speeds up collection cycles,
and improves overall efficiency.

● Aging Analysis: Regularly analyzing the aging of accounts receivable

helps identify overdue payments and take proactive measures to
address potential collection issues. It also provides insights into the
effectiveness of credit policies.

● Debt Collection Strategies: Implementing effective debt collection

strategies, such as offering discounts for early payments or using
third-party collection agencies for overdue accounts, can expedite the
collection process.

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