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INTRODUCTION TO WORKING CAPITAL

Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's

ability to fund operations, reinvest and meet capital requirements and payments. Understanding a

company's cash flow health is essential to making investment decisions. A good way to judge a

company's cash flow prospects is to look at its working capital management (WCM).

WHAT IS WORKING CAPITAL?

Working capital refers to the cash a business requires for day-to-day operations, or, more

specifically, for financing the conversion of raw materials into finished goods, which the

company sells for payment. Among the most important items of working capital are levels of

inventory, accounts receivable, and accounts payable. Analysts look at these items for signs of a

company's efficiency and financial strength.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital gross and net.

GROSS WORKING CAPITAL: It refers to the firms Investment in current assets whichcan be converted into cash within an accounting year(or operating cycle) and include

cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable

and stock (inventory)

NET WORKING CAPITAL: It refers to the difference between Current Assets &Current Liabilities. Current liabilities are those claims of outsiders which are expected to

mature for payment within an Accounting year and include creditors (accounts payable)

,bills payable and outstanding expenses. Net working capital can be positive or negative.A positive net working capital will arise when Current Assets increase current liabilities.

A negative net working capital will occur when Current Liabilities are in excess of

Current Assets.

NATURE OF WORKING CAPITAL

EXCESSIVE AND INADEQUATE WORKING CAPITAL:

A business enterprise should maintain adequate working capital according to the needs of

its business of its business operations. The amount of working capital should neither be

excessive nor adequate. If the working capital is excess of its requirements it means idle funds

adding to the cost of capital is short of its requirements, it will result in production interruptions

and reduction of sales and, in turn, will affect the profitability of the business adversely.

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DEFECIENCIES OF EXCESSIVE WORKING CAPITAL

y EXCESSIVE INVENTORY: Excessive working capital results in unnecessaryaccumulation of large inventory. It increases the chances of misuse, waste, theft etc.

y EXCESSIVE DEBTORS: Excessive working capital will result in liberal credit policywhich, in turn, will result in higher amount tied up in debtors and higher incidence of bad

debts.

y ADVERSE EFFECT ON PROFITABILITY: Excessive working capital means idle fundsin the business which adds to the cost of capital but earns no profits for the firm. Hence it

has a bad effect on profitability of the firm.

y INEFFECIENCY OF MANAGEMENT: Management becomes careless due to excessiveresources at their command. It results in laxity of control on epenses and cash resources.

DEFECIENCIES OF INADEQUATE WORKING CAPITAL:

y DIFFICULTY IN AVALIABILITY OF RAW-MATERIAL: Inadequacy of workingcapital results in non-payment of creditors on time. As a result the credit purchase of

goods on favorable terms becomes increasingly difficult. Also, the firm cannot avail the

cash.

y FULL UTILISATION OF FIXED ASSETS NOT POSSIBLE: Due to the frequentinterruption in supply of raw materials and paucity of stock, the firm cant make full

utilization of its machines etc.

y DIFFICULTY IN THE MAINTAINENCE OF MACHINERY: Due to the shortage ofworking capital, machines are not cared and maintained properly which results in theclosure of production of on many occasions.

y DECRAESE IN CREDIT RATING: Because of inadequacy of working capital, firm isunable to pay its short term obligations on time. It decays the firms relation with its

bankers and it becomes difficult for the firm to borrow in case of need.

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ADVANTAGES OF ADEQUATE WORKING CAPITAL:

AVAILIABILTY OF RAW MATERIAL REGULARLY:Adequacy of working capital makes it possible for a firm to pay the suppliers of raw

material in time. As a result it will continue to receive regular supplies of raw materials and thusthere will be no disruption in production process.

FULL UTILISATION OF FIXED ASSETS:Adequacy of working capital makes it possible for a firm to utilize its fixed assets fully

and continuously. For eg. , if there is inadequate stock of raw material, the machines will not beutilized in full and their productivity will be reduced.

CASH DICOUNT:A firm having the adequate working capital can avail the cash discount by purchasing

the goods for cash or by making the payment before the due date.MEETING UNSEEN CONTINGENCIES:

Adequacy of working capital enables a company to meet the unseen contingenciessuccessfully.

NEED OF WORKING CAPITAL

Along with the fixed capital almost every business requires working capital though the

extent of working capital requirements differ in different businesses. Working capital is needed

for running the day-to-day business activities. When a business is started, working capital is

needed for purchasing raw material. The raw material is then converted into finished goods by

incurring some additional costs on it. Now goods sre sold. Sales do not convert into cash

instantly because there is invariably some credit sales. Thus, there exists a time lag between salesof goods and receipt of cash. During this period, expenses are to be incurred for continuing the

business operations. For this purpose working capital is needed. Therefore, sufficient working

capital is needed which shall be involved from the purchase of raw material to the realization of

cash. The time period which is required to convert raw material into finished goods and then into

cash is known as operating cycle or cash cycle. The need for working capital can also be

explained with the help of operating cycle. Operating cycle of a manufacturing concern involves

five phases:

(i) Conversion of cash into raw material.(ii) Conversion of raw material into work-in-progress.(iii) Conversion of work-in-progress into finished goods.(iv) Conversion of finished goods into debtors by credit sales.(v) Conversion of debtors into cash by realizing cash from them.

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Thus, the operating cycle starts from cash and then again restarts from cash. Need for

working capital depends upon period of operating cycle. Greater the period, more will be the

need of working capital. Period of operating cycle in a manufacturing concern is greater than a

period of operating cycle in a trading concern because in trading units cash is directly converted

into finished goods.

operating cycle (nature of working capital)

CASH

RAW MATERIAL

WORK-IN-

PROGRESS

FINISHED GOODS

DEBTORS & BILLS

RECEIVABLES

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Because of the time involved in a operating cycle, there is a need of working capital in

the form of current assets. Firms have to keep adequate stock of raw-material to avoid risk of

non-avaliabilty of raw materials. Similarly, concerns must have adequate stock of finished goods

to meet the demand in market on continuous basis and to avoid competition which necessitates

the money tied up in debtors and bills receivables. In addition to al these, concerns have to

necessarily keep cash to pay the manufacturing expenses etc. and to meet the contingencies.

PERMANENT AND TEMPORARY WORKING CAPITAL:

Working capital in a business is needed because of operating cycle. But the need for

working capital does not come to an end after the cycle is completed. Since the operating cycle is

continuous process, there remains a need for continuous supply of working capital. However, the

amount of working capital required is not constant throughout the year, but keeps fluctuating. On

the basis of this concept, working capital is classified into two types:

Permanent working capital:The need for working capital or current assets fluctuates from time to time. However, to

carry on day-to-day operations of the business without any obstacles, a certain minimum level ofraw materials, work-in-progress, finished goods and cash must be maintained on a continuous

basis. The amount needed to maintain current assets on this minimum level is called permanentworking capital or regular working capital. The amount involved as permanent working capital

has to be met from long term sources of finance, eg. Capital, debentures, long term loans etc.Temporary working capital

Any amount over and above the permanent level of working capital is called is calledtemporary, fluctuating or variable working capital. Due to seasonal changes level of business

activity is higher than normal during some months of the year and therefore, additional workingcapital will be required along with the permanent working capital it is so because during peak

season demand rises and more stock is to be maintained to meet the demand. Similarly, theamount of debtors increases due to excessive sales. Additional working capital thus needed is

known as temporary working capital because once the season is over; the additional demand willbe no more. Need for temporary working capital should be met from short term of finance, e.g.

Short term loans etc. so that it can be refunded when it is not required.

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FACTORS AFFECTING WORKING CAPITAL

A firm should have neither too much nor too little working capital. The working

capital requirements are determined by a large number of factors but, in general, the following

factors influence the need of working capital needs of an enterprise:

1) NATURE OF THE BUSINESS: working capital requirements of an enterprise arelargely influenced by the nature of the business. For eg. Public utilities such as railways,

transport ,water and electricity etc. have very limited need of working capital becausethey have to invest fairly large amount in fixed assets. Their working capital need is

minimal because they get immediate payment for their services and do not have tomaintain big inventories. On the other extreme are the trading and financial enterprises

which have to invest less amount in fixed assets and a large amount in working capital.This is so because the nature of the business is such that they have to maintain a

sufficient amount of cash, inventories and debtors. Working capital needs of most of themanufacturing enterprise fall between these two extremes, that is between public utilities

and trading concerns.

2) SIZE OF THE BUSINESS: larger the size of business enterprise, greater would be theneed for working capital. The size of a business may be measured in terms of scale of its

business operation.3) GROWTH AND EXPANSION: as business enterprise grows, it is logical to expect that

a larger amount of working capital will be required. Growing industries require more

working capital than those that are static

4) PRODUCTION CYCLE: production cycle means the time span between the purchase ofraw material and its conversion into finished goods. The longer the production cycle thelarger will be the need of working capital because the funds will be tied up for longer

period in work in progress.

5) BUSINESS FLUCTUATIONS: business fluctuations may be in the direction of boomand depression. During boom period the firm will have to operate at full capacity to

meet the increased demand which in turn, leads to increase in level of inventories and

book debts. Hence, the need for working capital in boom conditions is bound to

increase. The depression phase of business fluctuations has exactly an opposite effect on

the level of working capital requirement

6) CREDIT POLICY RELATING TO SALES: if a firm adopts liberal credit policy inrespect of sales, the amount tied up in debtors will also be higher. Obviously, higher

book debts mean more working capital. On the other hand, if the firms follows tight

credit policy, the magnitude of working capital will decrease.

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7) CREDIT POLICY RELATING TO PURCHASE: if a firm purchases more goods oncredit, the requirement for working capital will be less. In other words, if liberal credit

terms are available from the suppliers of goods, the requirement for working capital willbe reduced and vice-versa

8) AVAILABILITY OF RAW-MATERIAL: If the raw material required by the firm isavailable easily on a continuous basis, there will be no need to keep a large inventory ofsuch materials and hence the requirement of working capital will be less. On the other

hand, if the supply of raw material is irregular, the firm will be compelled to keep an

excessive inventory of such material which will result in high level of working capital.

9) AVAILABILITY OF CREDIT FROM BANKS: if the firm can get bank credit facilityin case of need, it will operate with less working capital. On the other hand, if such

facility is not available, it will have to keep large amount of working capital.

10) VOLUME OF PROFIT: The net profit is a source of working capital to the extent it has been earned in cash. Higher net profit would generate more internal funds therebycontributing the working capital pool.

11) LEVEL OF TAXES: full amount of cash profit is not available for working capitalpurposes. Taxes have to be paid out of profits. Higher the amount of taxes less will be the

profits available for working capital.

12) DIVIDEND POLICY: dividend policy is a significant element in determining the level ofworking capital in an enterprise. The payment of dividend reduces the cash and thereby,affects the working capital to that extent. On the contrary, if the company does not paydividend but retains the profit, more would be the contribution of profits towards the

working capital pool.13) DEPRICIATION POLICY: although depreciation does not result in outflow of cash, it

affects the working capital indirectly. In the first place, since the depreciation is

allowable expenditure in calculating net profits, it affects the tax-liability. In the second

place, higher depreciation also means lower disposable profits and ,in turn, a lower

dividend payment. Thus, outgo of cash is restricted to that extent.

14) PRICE LEVEL CHANGES: A change in price level also affects the working capitalrequirements. If the price level is rising, more funds will be required to maintain theexisting level of production

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15) EFFECIENCY OF MANAGEMENT: efficiency of management is also a significantfactor to determine the level of working capital. Management can reduce the need for

working capital by the efficient utilization of resources. It can accelerate the pace of cashcycle and thereby use the same amount working capital again and again very quickly

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MANAGEMENT OF WORKING CAPITAL

Working capital management is concerned with the problems that arise in attempting to

manage the current assets, current liabilities and the inter relationships between them. Its

operational goal is to manage the current assets and current liabilities in such a way that a

satisfactory level of working capital is maintained. The term working capital refers to the net

working capital i.e. current assets minus current liabilities with reference to the management of

working capital, net working capital represents that part of the current assets which are financed

with the long term funds.

The level of NWC has a bearing on the profitability as well as the risk in the sense of theinability of the firm to meet obligations as and when they become due. Therefore, the tradeoff

between profitability and risk is an important element in the evaluation of the level of NWC of

the firm. In general, the higher the NWC the lower the risk, as also the lower is the profitability

and vice-versa. Thus, the NWC measures the degree of risk in the management of working

capital.

Apart from the profitability-risk trade-off, the determination of the finance mix is the

second ingredient of the theory of working capital management. The financing mix refers to the

proportion of current assets to be financed by current liabilities and long term sources. One

approach to determine the financing mix is hedging approach, acc. to which long term fundsshould be used to finance the fixed portion of the current assets and the purely temporary

requirements should be met out of short term funds. This approach is high profit, high risk

financing mix. Acc. to the second approach, namely the conservative approach, the estimate

requirements of the current assets should be financed from long term sources and the short term

funds should be used only in emergency situation.

The conservative approach is a low-profit, low risk combination. Neither of the two is

suitable for efficient working capital management. A trade off between these two extremes

provides a financing plan between these two approaches, and therefore, an acceptable financing

strategy from the view point of the management of working capital.

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CASH MANAGEMENT

Cash management is one of the key areas of working capital management. There are 4 motives

of holding cash

(i)

transaction motive(ii) precautionary motive(iii) speculative motive(iv) compensating motivethe transaction motive refers to the holding of cash to meet anticipated obligations whose

time is not perfectly synchronized with cash receipts.

The cash balances held in reserve for random & unforeseen fluctuations in cash flows are called

as precautionary balances.

The speculative motives indicates the desire of a firm to take advantage of opportunities which

present themselves at unexpected moments and which are typically outside the normal course of

business. The compensating motive means keeping the bank balance sufficient to earn a return

equal to the cost of free service provided by the banks.

The basic objectives of cash management are to reconcile two mutually contradictory and

conflicting tasks: to meet the payment schedule & to minimize funds committed to cash

balances.

Cash budget is probably the most important tol in cash management. It is a device to help

a firm to plan & control the use of cash. The cash position of a firm as it moves from one periodto another period is high lighted by cash budget. A cash budget has normally three parts, namely,

cash collections, cash payments and cash balances. The major sources of cash receipts and

payments are operating and financial. The operating sources are repetitive in nature while the

financial sources are non-recurring.

MANAGEMENT OF RECEIVABLES

It deals with those transactions which deal with the billing of customers who owe money to a

person, company or organization for goods & services that have been provided to the customers

under receivables management, we consider the position of our debtor. Before extending thecredit to him, personal interaction with him is done & information is is collected like the

references, bank account information etc. & if it seems that person is reliable then he could be

extended credit. Then some other factors are also considered like financial position of the debtor,

reputation of the

Debtors in the market, credit paying capacity of the person etc. there should be proper agreement

between the debtor and the company for the repayment terms. But if the debtor fails to pay the

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money then the help of law or muscle power can also be used but the action should be taken

within 3 years of extending credit.

The management of receivables involves crucial decision in three areas: (i) credit policy

(ii) credit terms (iii) collection policies. The credit policies of the firm provides the framework to

determine whether to or not to extend credit to a customers and how must credit to extend. The

two broad dimensions of credit policy decision of a firm are credit standards and credit analysis,

the term credit standards represent the basic criterion for the extension of credit to customers.

The criterion, and therefore, standards can be tight /restrictive or liberal/non-restrictive. The

credit analysis component of credit policies includes obtaining credit information from different

sources and its analysis.

The second decision area in receivables management is the credit terms, the credit terms

specify the repayment terms, comprising credit period,cash discount, if any, and cash discount

period.

The third area involved in the management of receivables is collection policies. It refers

to the procedure followed to collect accounts receivable when they become due. The two

relevant aspects are the degree of efforts to collect the over dues and the type of collection effort.

The framework of analysis of all the three decision areas in receivable management is to

secure a trade-off between the costs & benefits of the measurable effects on the sales volume,

capital cost due to change in accounts receivable, collection costs, and bad debts and so on. The

alterantive will be selected when the benefits exceed the costs.

INVENTORY MANAGEMENT

The term inventory refers to assets which will be sold in future in the normal course of

business operations. The assets which the firm stores as inventory in anticipation of need are raw

materials, work-in-progress, semi-finished goods, and finished goods.

The objective of inventory management consists of two counter balancing parts, namely,

to minimize investments in inventory and to meet the demand for products by efficientproduction and sales operations. In operational terms, the goal of inventory management is to

have a trade-off between costs and benefits at different levels of inventory.

The costs of holding inventory are ordering cost and carrying costs. The major benefits of

holding inventory are in the areas of purchasing, production and sales.

The non-mathematical inventory management techniques illustrated here are

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(i) ABC system

(ii) EOQ

(iii) re-order point

iv)safety stock

ABC system (Always Better Control system)

The first step in inventory control process is classification of different types of

inventories to determine the type and degree of control required for each. The ABC system is a

widely used classification technique to identify various items of inventory for purposes of

inventory control. This technique is based on the assumption that a firm should not exercise thesame degree of control on all items of inventory. It should rather keep a more rigorous control

on items that are (i) more costly (ii) slowest turning while items that are less expensive should be

given less control effort.

On the basis of the cost involved, the various inventory items are, according to

this system, categorized into three items (1) A (2) B (3) C. the items included in group A

involved the largest investment. Therefore, inventory control should be most rigourous

and intensive and the most sophisticated inventory control techniques should be applied

to these items. C group consists of items of inventory, which involve relatively small

investments alyhough the number of items is fairly large. These items deserve minimumattention. B group stands mid way. It deserves less attention than A but more than C.

employing less sophisticated techniques can control it.

The task of inventory management is to properly classify all the inventory items into one

of these three groups. The typical breakdown of inventory items is shown in following table:

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Group No. of Items Inventory Value

(%)

A 15 70

B 30 20

C 55 10

---- ----

100

Some points

stand out from above table. While group A is the least important than in terms of the no. of

items, it is by far the most important in terms of investments involved. With only 15% of the

number, it accounts for as much as 70% of the total value of inventory. The firm should direct

most of its inventory control efforts to the items included in this group. The items comprising Bgroup accounts for 20% of the investment in inventory. They deserve less attention than A, but,

more than C, which involves only 10% of the total value although number wise its share is as

high as 55%.

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ECONOMIC ORDER QUANTITY

After various inventory items are classified on the basis of the ABC analysis, the management

becomes aware of the type of control that would be appropriate for each of the three categories

of the inventory items. The A group of items wants the maximum attention and the most rigorous

control. A key inventory problem particularly in respect of the group A items relates to the

determination of the size or quantity in which inventory will be acquired. In other words, while

purchasing raw material or finished goods, the question to be answered are : how much inventory

should be bought in one lot under one order on each replenishment? Should the quantity to be

purchased be large or small? Or, should the requirement of materials during a given period of

time (say, six months or one year) be acquired in a lot or should it be acquired in installments or

in several small lots? Such inventory problems are called order quantity problems.

The determination of the appropriate quantity to be purchased in each lot to replenish stock as a

solution to the order quantity problem necessitates resolution of conflicting goals. Buying in

large quantities implies a higher inventory level which will assure (1) smooth production / sale

operations (2) lower ordering or set up costs. But it involve higher carrying cost. On the other

hand small orders will reduce the carrying cost of inventory by reducing the average inventory

level but the ordering cost will improve as there is likelihood of interruption in the operationsdue to stock-outs. A firm should place neither too large nor too small orders. On the basis of

trade-off between benefits derived from the avaliabilty of inventory and the cost of carrying that

level of inventory, the appropriate or optimum level of the order to be placed should be

determined. The optimum level ofinventory is popularly referred as economic order

quantity(EOQ). It is also known as economic lot size. The EOQ may be defined as that level of

inventory order that minimizes the total cost associated with inventory management.

RE-ORDER POINT

The EOQ technique determines the size of an order to acquire inventory so as to minimize the

carrying as well as the ordering costs. In other words, the EOQ provides an answer to the

question: how much inventory should be ordered in one lot? Another important question

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pertaunung to efficient inventory management is : when should the order to procure inventory be

placed? This aspect of inventory management is covered under the order point problem.

The reorder point is stated in terms of the level of inventory at which an order should be placed

for replenishing the current stock of inventory. In other words, reorder point may be defined as

that level of inventory when fresh order should be placed with the suppliers for procuringadditional inventory equal to the economic order quantity. Although some sophisticated re-order

point formulae are available, it is based on following assumptions:

Constant daily usage of inventory & fixed lead time.

In other words, the formulae assume condition of certainty. The re-order point = lead time in

days x average daily usage of inventory.

The term lead-time refers to the time normally taken in receiving the delivery of inventory afterplacing orders with the suppliers. It covers the time span from the point when a decision to place

an order for the procurement of inventory is made to the actual receipt of the inventory by the

firm. Another way of saying it is that the lead time consists of the number of days required by the

suppliers to receive and process the orders as well as the number of days during which the goods

will be in transit from the supplier. The lead time may also be called as the procurement time of

inventory.

The average usage means the quantity of inventory-consumed daily. We can, therefore, define

re-order point as that inventory level, which should be equal to the consumption during the lead-

time.