Working Capital Management

Introduction
Capital required for a business can be classified under two main categories viz.
1)Fixed capital
2)Working capital.
•Every business needs funds for two purposes for its establishment and to carry out its day-
to-day operations.
•Long-term funds are required to create production facilities through purchase of fixed assets
such as plant and machinery, land, Building etc.
•Investments in these assets represent that part of firm’s capital which is blocked on
permanent basis and is called fixed capital.
A major portion of the capital funds used for investing in purchase of fixed assets for
permanent or long-term purposes, for the purpose of diversification, expansion of business,
renovation or modernization of plant and machinery and research and development
• Funds are also needed for short-term purposes for purchase of raw
materials, payment of wages and other day-to-day expenses etc.
• These funds are known as working capital which is also known as
Revolving or circulating capital or short term capital.

Meaning of Working Capital

Working capital is the capital available for conducting the day-
to-day operations of an organization; normally the excess of
current assets over current liabilities.

Working Capital Management

Working capital management is the management of all aspects
of both current assets and current liabilities, to minimize the
risk of insolvency while maximizing the return on assets.
Working Capital
Concepts of Working Capital
There are two concepts of working capital namely gross concepts
and net concepts:

1. Gross Working Capital

2. Net Working Capital

The concept of gross working capital refers to the total value of current
assets. In other words, gross working capital is the total amount available for
financing of current assets.
Gross Working Capital = Total Current Assets

The concept of net working capital refers to the capital required for running
day-to-day operations of a business. It may be expressed as excess of current
assets over current liabilities.
Net Working Capital = Current Assets-Current Liabilities
Objectives of Working Capital Management
The objectives of working capital management are
1. Profitability
2. Liquidity.
• The objective of profitability supports the primary financial management
objective, which is shareholder wealth maximization.
The key objective is profitability. Funds tied up in working capital tend to earn
little, or no, return. Hence, a company with a high level of working capital may
fail to achieve the return on capital employed (Operating profit ÷ (Total equity
and long-term liabilities)) expected by its investors.

• The objective of liquidity ensures that liabilities can be met as they fall due.
A business with insufficient working capital will be unable to meet obligations
as they fall due, leading to late payments to employees, suppliers and other
providers of credit. Late payments can result in lost employee loyalty, lost
supplier discounts and a damaged credit rating. Non-payment (default) can lead
to the compulsory liquidation of assets to repay creditors.
When determining the appropriate level of working capital there
is a trade-off between liquidity and profitability:
 Trade-off between two objectives
1. It depends on the particular circumstances of an
organization.
2. Liquidity may be more important objective when short-
term finance is hard to find.
3. Profitability may become a more important objective when
cash management has become too conservative.
4. Both objectives are important and neither can be neglected.
 Questions for Discussion
1. Identify the objectives of working capital management and
discuss the conflict that may arise between them.
2. Discuss whether profitability or liquidity is the primary
objective of working capital management.
3. Outline the advantages to a company of taking steps to
improve its working capital management, giving examples
of steps that might be taken.
4. What differences would there be in working capital
policies for a manufacturing company and a food retailer?
 Steps to achieve the objectives of working capital
management
1. Credit management
2. Inventory management
3. Other actions

Credit Management
i. The fundamental objective of the company is to maximize the wealth of its
shareholders and good working capital management helps to achieve this
by minimizing the cost of investing in current assets.
ii. Good credit management, for example, aims to minimize the risk of bad
debts and expedite the prompt payment of money due from debtors in
accordance with agreed terms of trade.
iii. Taking steps to optimize the level and age of debtors will minimize the cost
of financing them, leading to an increase in the returns available to
shareholders.
Inventory Management
i. Good inventory management, for example using techniques such as the
economic order quantity model(EOQ), ABC analysis, inventory rotation
and buffer inventory management can minimize the costs of holding and
ordering inventory.
ii. The application of just-in-time methods of inventory procurement and
manufacture can reduce the cost of investing in inventory. Taking steps to
improve inventory management can therefore reduce costs and increase
shareholder wealth.