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Chapter 4 WORKING CAPITAL MANAGEMENT (Working capital management involves both setting working

capital policy and carrying out that policy in day-to-day operation)

Finance in the business is like the blood in the body. Just as the body needs proper blood supply to be healthy and fit to work properly so does a business need funds to run successfully and to stand prosperously. It can be rightly said that providing funds to the business as and when needed is the key to success of a business. Nonetheless, the significance of Financial Management is not limited to providing of funds only. In fact, there is a range of other important tasks of Financial Management including the maximization of wealth and maximization of overall value of business. But in this context, we would confine our attention to finance function relating to current assets. Finance is very much concerned with economic as well as the effective utilization of funds. It focuses on the arrangement of funds at the right time in order to carry out the activities and to achieve the determined tasks satisfactorily. Financial management plays an important role because on account of which the liquidity position of a business is affected. The term liquidity means the

. providing unforeseen events or purchasing raw materials for its production. If sufficient funds are available at the right time then only a business can clear its short term debts as well as it can maintain its operations effectively. we generally call the situation as bankruptcy or insolvency. We would like to collect the cash which is owed to us by others.ability of an organization to pay its current liabilities as they come due. If we do not maintain our ready money properly and we fail to do so. Thus the term working capital refers to the excess of the current assets over the current liabilities. This gives rise to know the concept of working capital and working capital requirement of funds for a business. and at the same time we would like to pay the cash whom we owe. The same applies to a business and the task of financial management in terms of working capital is to maintain sufficient funds for its dayto-day requirements while safeguarding the business against the possibility of insolvency. The term working capital is used for day. a business needs certain amount of cash for meeting routine payments. we need to maintain sufficient funds for our cost of living. In the sense. The concept of working capital should be easily understandable to us since it is very much related to our personal lives as well. In other words. It emphasizes the effective utilization as well as effective management of cash.

Management of cash and liquidity involves providing sufficient funds to the business for meeting the requirement of cash at the right time. Current liabilities are those that are to be settled in twelve months period. Current liabilities are: Accounts payable. Just to name a few. inventories. holding the cash entails a precautionary motive in order to meet unforeseen events. payment of taxes. Moreover. unearned revenues and wages payable. They are: Cash. purchases of raw materials and inventory etc. payment of wages. Cash is the king . Cash is the most liquid asset to be presented on the balance sheet commonly as the first item.Current assets can be defined as being those that will be converted in to cash in twelve months period. repayment of bank loans. Receivables. The former case indicates collection of cash payments as soon as they come due for . the cash must be managed properly and be provided for arising contingencies. Management of cash is of great importance for a company. the situation leads to bankruptcy. If adequate cash is not available as and when it is needed. Apart from these. cash management also involves speeding cash inflows and slowing cash outflows. Therefore. It involves several reasons. marketable securities and prepayments.despite the fact that it has its own costs.

credit period. to get more customers and to help customers on whom the fortune of a business is contingent. This is how the two-fold benefit can be obtained. In this manner. credit terms. . While managing receivables. They are the dues from the credit customers. Next in importance comes the receivable. etc so as to manage the receivables in an efficient manner. There are various reasons for credit sales. such as. Credit standard is meant to the classification of customers depending upon the relationships and in terms of risk etc. the payments should be made close to the cut-offdate while utilizing the discounts if any. in the former case the discount is offered for early payment –to generate the revenue quickly. In the latter case the discount is availed – to clear the debts as well as using the facility of discount. It is universal truth that every Business has receivables. to penetrate and establish in the market. So.collection while the latter indicates the payments to be made as close to the cut-off-date as possible – but this should not be taken in isolation – as it is likely to lose the facility of availing the discounts. an organization develops the policies which are beneficial to both the customers as well as to the organization that makes credit sales. to increase sales. Credit policies must have few standards.

it should be understood that making too much credit sales leads to much benefit and make profit on the one hand while it involves the creation of bad debts or risks on the other. whether of trading or of manufacturing. even a little less or more amount of increase or decrease in the costs of inventories gives rise to a radical change in terms of overall amount of investments in the inventories. Thus.The credit period is referred to how long a period should be allowed. the best possible way is to be adopted for receivable is to manage within the accepted level with the establishment of planning as well as controlling measures. . has to carry certain amount of inventories. In the point of fact. The impact of inventory management on working capital is vitally important. it should be noted that having too much or too little inventory becomes a problematic cause in terms of sales and production. Credit terms mean offering discount on early payment or the payment before the cut-off-date. At this juncture. A trading company purchases or sells the finished goods whereas the manufacturing company deals with all types of inventories. of raw materials or of work in process depending upon the type of business. Inventories are classified as inventory of finished goods. A company. Also.

inventory management involves planning and controlling functions with regard to the order of quantity of even single unit and the specific task of inventory management is to answer the questions: when to order the inventory. It is therefore necessary for the process of inventory management to find satisfying answer to the above questions pertaining to various costs of the inventories.Thus. Mention deserves to be made about the overall significance of financial management in a few words. A company can prefer short term investments in them rather than holding large cash.They are regarded to be connected with the cash management. The importance lies in the fact that holding cash does not provide any return. It is appropriate to mention that there are several techniques available for the effective management of Inventories with which the management can be benefited. What may be briefly mentioned in terms of marketable securities is they are involved in the short term investments. Financial management is . on the contrary. how much inventory is needed and if any discounts are likely to be lost by not ordering as per the standard limit of order etc. Marketable securities – categorized as short term investments to earn profit rather than going for long term investments. marketable securities are purchased with a purpose of the generating profits.

Financial management is an integral part of overall management affecting the survival. The operating cycle of working capitals will repeat again and again over the period depending upon the nature of business. If dealt effectively. debtors and finally into cash again. growth and strength of a business. Problems of inadequate Working Capital When working capital is inadequate the company faces the following problems• The growth of company is stagnant. finished products. a financial manager can ward off a large number of problems.distinctive area of business management and the Financial Manager has a key Role in overall business management ensuring the achievement of business objectives and wealth or profit maximization. The sole task of financial management is maximization or optimizing the value of firm. Operating cycle of Working Capital Thus there is complete cycle form cash to cash to cash where in cash gets converted into raw materials. Because the firm to undertake profitable projects for non availability of working capital funds. . work-in-progress. The determination of operating cycle help’s in forecast control and management if working capital.

Thus chances of inventory mishandling. • It is an indication of defective credit policy and slack collection period. Problems of Excessive Working Capital The firm maintains a sound working capital position it should have adequate working capital to run its business operations but excessive working capital position is dangerous to a business enterprises as follows. • The firm loses its reputation when it is not in a position to honor its short term obligations. • Excessive working capital makes management complacent which degenerates into managerial inefficiency.• Inadequate working capital is difficult to implement operating plans and achieve the firms profit target. waste. • It results in unnecessary accumulation of inventories. Consequently higher incidence of bad debts results which adversely affects profits. • Fixed assets are not efficiently utilized for the lack of working capital funds. • Inadequate working capital funds the firm has unable to avail attractive credit opportunities. . theft and losses increase. • Inadequate working capital is difficult to meet day to day commitments.

In view of these features they do not maintain big inventories and have therefore probably the least requirement of working capital. The nature of business is such that they have to maintain a sufficient amount of cash inventories and book debts. The following is the description of the factors. For example. Determinants of Working Capital The total working – capital requirement is determined by a wide variety of factors. It should be noted that these factors affect different enterprises differently. Sale of services rather than commodities. trading and financial firm require a lower investment in . This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits. Public utilities have certain features which have a bearing on their working capital needs.Tendencies of accumulating inventories tend to make speculative profits grow. • Internal Factors :• Nature of Enterprise The working capital requirements of enterprise are basically related to the conduct of business. The two relevant features are• • The cash nature of business (cash sales). The working capital requirements of a firm basically influence by the nature of its firm. which generally influence the working capital requirements of the firms. They have necessarily to invest proportionately large amount in working capital.

In other words. • Sales and Demand Conditions . The variations in business conditions may be in two directions a) upward phase when boom conditions prevail and b) Downswing phase when the economic activity is marked by a decline.working capital but in the case of manufacturing concern have to invest substantially in working capital. the need for working capital is likely to grow to cover the lag between increased sales and receipt of cash as well as to finance purchases of additional material to cater to the expansion of the level of activity. These cycle are covers the time span between the procurement of raw materials and the completion of the manufacturing process leading to the production of finished goods. • Business Cycle The working capital requirements are also determined by the nature of the business cycle. • Production Cycle The working capital requirement is also depends upon the production or manufacturing cycle. there is some time gap before raw materials become finished goods. During the upswing of business activity. Business fluctuations lead to cyclical and seasonal changes which. is turn cause a shift in the working capital position. Funds have to be necessarily tied up during the process of manufacture necessitating unbalanced working capital.

Sales depend on demand conditions mostly firms are experience seasonal and cyclical fluctuations in the demand for their products and services. • Availability of Credit . Similarly. if liberal credit terms are available to firm by its suppliers. which relates to sales and purchases. Credit given to firm by its suppliers. These business variations affect the working capital requirement. The credit policy influences the requirement of working capital in two ways: • • Credit allowed by firm to its customers. the requirements of working capital will be less. it will be expensive during slack periods when the firm has to sustain its working force and physical facilities without adequate production and sales. On the other hand. during periods of peak demand increasing production may be expensive for the firm. • Credit Policy The level of working capital is also determined by credit policy. The credit terms granted to customers have a bearing on the magnitude of working capital by determining the level of books debts. Seasonal fluctuations not only affect working capital requirement but also create production problems for the firm.

This happens very often with raw materials which are in short supply and are controlled to ensure equitable distribution. some raw materials may be available only during certain seasons. There may be some materials which cannot be procured easily either because of their sources are few or they are irregular. A firm will need less working capital if liberal credit terms are available to it. which can get bank credit easily on favorable conditions. It may so happen that a bulk consignment may be available but the firm may be short of funds. • Price Level Changes . • Availability of Raw Material The availability of a continuous basis without interruption would sometimes affect the requirement of working capital.The working capital requirements of a firm are also affected by credit terms granted by its creditors. The procurement of some essential raw materials is difficult because of their sporadic supply. the availability of credit from banks also influences the working capital needs of the firm. Finally. This element of uncertainty would lead to a relatively high level of working capital. will operate with less working capital than a firm without such a facility. Similarly. A firm. The buyer has in such cases very limited options as to the quantum and timing of procurement. while when surplus funds are available the commodities may be in short supply.

as business expands. it requires more working capital in terms of sale or fixed assets. The effect of rising process is that a higher amount of working capital is needed. The implications of changing price levels on working capital position vary from company to company depending on the nature of its operations. • Growth and Expansion Activities It is obvious that.Changes in the price level also affect the requirements of working capital. The management can contribute to a sound working capital position through operating efficiency. That is to say. Efficiency of operations accelerates the pace of cash cycle and improves the working capital turnover. Rising prices necessitate the use of more funds for maintaining an existing level of activity for the same level of current assets. improving co-ordination and a fuller utilization of existing resources. • Operating Efficiency The operating efficiency of the management is also an important determinant of the level of working capital. In the case of growth. with the increase in fixed assets for . and so on. there will be an all round increase in investment. it can ensure the efficient utilization of resources by eliminating waste. Higher cash outlays are required. its standing in the market and other relevant considerations. It releases the pressure on working capital by improving profitability and improving the internal generation of funds. Although the management cannot control the rise in prices.

Depreciation policy is relevant to the planning of working capital. • External Factors :• Business Cycle Fluctuations Business fluctuations lead to cyclical and seasonal change in production and sales and affect the working capital requirement.increasing sales the requirement of working capital will be expanded not only for financing increased volume of raw materials but also to finance maintenance of inventory stock and grant credit to customers. In the second place. • Depreciation Policy Depreciation policy also exerts an influence on the quantum of working capital. These business variations affect specially the temporary working capital requirements of the firm. • Supply Conditions . The effect of depreciation policy on working capital is. the selection of the method of depreciation has important financial implications. indirect in the first place depreciation affects the tax liability and retention of profits. therefore. Most firms experience seasonal and cyclical fluctuation in the demand for their products and services. Depreciation charges do not involve any cash outflows.

• Level of Taxes The amount of taxes to be paid is determined by the prevailing tax regulations the management has no discretion in this respect. which are very important from the point of view of general public. an important aspect of . • Technological Development Changes in technologies may lead to improvements in processing raw materials. Government controls and regulates the prices and supply of some essential products. greater productivity. Tax liability is. If supply is unpredictable and carry the inventory for longer period. very often taxes have to be paid in advance on the basis of the profit of the preceding year.Thus changes in technology affect the requirements of working capital. spares and stores depends on the condition of supply. This policy is followed when the raw material is available only seasonally. minimizing wastages.The inventory of raw materials. All these improvements may enable the firm to reduce investments in inventory . If the supply is prompt and adequate the firm can manage with small inventory hence the firm can manage with small inventory hence the lower requirements of working capital. • Government Policies The policy and decision of government also affect working capital. more speed of production. in a sense. short term liability payable in cash an adequate provision for tax payments is. therefore.

working capital increases. if the firm does not pay dividend but retains the profits. affects working capital to that extent. When profits are relatively small. It is a spontaneous source of finance in the sense that it arises in the normal transactions of the firm without specific negotiations. In planning working capital requirements. the choice is between retention and payment.working capital planning. In the firm should retain profits to preserve cash resources and at the same time. it leads to an increase in the requirement of working capital and vice-versa. The choice must be made after taking into account all the relevant factors. it must pay dividends to satisfy the expectations of investors. Working Capital Financing:• Trade Credit Trade credit represents the credit extended by the supplier of goods and services. • Dividend Policy The payment of dividend consumes cash resources and there by. • Accrued Expenses and Deferred Income . therefore. a basic question to be decided is whether profit will be retained or paid out of shareholders. Provided the firm is considered credit worthy by its suppliers. It is an important source of finance representing 25 percent to 50 percent of short term financing. It tax liability increases. Conversely.

Advance payments made by customers constitute the main item of deferred income. taxes and interest. Thus they represent a spontaneous. .Accrued Expenses:Accrued expenses represent a liability that a firm has to pay for the services which it has already received. interest free sources of financing the most important component of accruals are wages and salaries. Deferred Income:Deferred income represents funds received by the firm for goods and services which it has agreed to supply in future these receipts increase the firm’s liquidity in the form of cash.