WORKING CAPITAL MANAGEMENT

Introduction:
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very
essential to maintain the smooth running of a business. No business can run
successfully with out an adequate amount of working capital.

Working capital refers to that part of firm’s capital which is required for financing
short term or current assets such as cash, marketable securities, debtors, and
inventories. In other words working capital is the amount of funds necessary to
cover the cost of operating the enterprise.

Meaning:

Working capital means the funds (i.e.; capital) available and used for day to day
operations (i.e.; working) of an enterprise. It consists broadly of that portion of
assets of a business which are used in or related to its current operations. It refers
to funds which are used during an accounting period to generate a current income
of a type which is consistent with major purpose of a firm existence.

Objectives of working capital:

Every business needs some amount of working capital. It is needed for following
purposes-

• For the purchase of raw materials, components and spares.

• To pay wages and salaries.
• To incur day to day expenses and overhead costs such as fuel, power, and office
expenses etc.
• To provide credit facilities to customers etc.

Factors that determine working capital:

The working capital requirement of a concern depend upon a large number of

factors such as
? Size of business
? Nature of character of business.
? Seasonal variations working capital cycle
? Operating efficiency
? Profit level.
? Other factors.

Sources of working capital:

The working capital requirements should be met both from short term as well as
long term sources of funds.

? Financing of working capital through short term sources of funds has the benefits
of lower cost and establishing close relationship with banks.

? Financing of working capital through long term sources provides the benefits of
reduces risk and increases liquidity

Types of working capital:

Working capital an be divided into two categories-

Permanent working capital:

It refers to that minimum amount of investment in all current assets which is

required at all times to carry out minimum level of business activities.

Temporary working capital:

The amount of such working capital keeps on fluctuating from time to time on the
basis of business activities.
Advantages of working capital:

• It helps the business concern in maintaining the goodwill.

• It can arrange loans from banks and others on easy and favorable terms.
• It enables a concern to face business crisis in emergencies such as depression.
• It creates an environment of security, confidence, and over all efficiency in a
business.
• It helps in maintaining solvency of the business.

Disadvantages of working capital:

• Rate of return on investments also fall with the shortage of working capital.
• Excess working capital may result into over all inefficiency in organization.
• Excess working capital means idle funds which earn no profits.
• Inadequate working capital can not pay its short term liabilities in time.

Management of working capital:

A firm must have adequate working capital, i.e.; as much as needed the firm. It
should be neither excessive nor inadequate. Both situations are dangerous.
Excessive working capital means the firm has idle funds which earn no profits for
the firm. Inadequate working capital means the firm does not have sufficient funds
for running its operations. It will be interesting to understand the relationship
between working capital, risk and return. The basic objective of working capital
management is to manage firms current assets and current liabilities in such a way
that the satisfactory level of working capital is maintained, i.e.; neither inadequate
nor excessive. Working capital some times is referred to as “circulating capital”.
Operating cycle can be said to be t the heart of the need for working capital. The
flow begins with conversion of cash into raw materials which are, in turn
transformed into work-in-progress and then to finished goods. With the sale finished
goods turn into accounts receivable, presuming goods are sold as credit. Collection
of receivables brings back the cycle to cash.
The company has been effective in carrying working capital cycle with low working
capital limits. It may also be observed that the PBT in absolute terms has been
increasing as a year to year basis as could be seen from the above table although
profit percentage turnover may be lower but in absolute terms it is increasing. In
order to further increase profit margins, SSL can increase their margins by
extending credit to good customers and also by paying the creditors in advance to
get better rates.

WORKING CAPITAL AND RATIO ANALYSIS

Ratio Analysis is one of the important techniques that can be used to check the
efficiency with which working capital is being managed by a firm. The most
important ratios for working capital management are as follows

Net Working Capital:

There are two concepts of working capital namely gross working capital and net
working capital. Net working capital is the difference between current assets and
current liabilities. An analysis of the net working capital will be very help full for
knowing the operational efficiency of the company. The following table provides the
data relating to the net working capital of SSL.

NET WORKING CAPITAL = CURRENT ASSETS-CURRENT LIABILITIS

YEAR CURRENT ASSETS CURRENT LIABILITIES NET WORKING CAPITAL

2005 246755108 184541063 62214045
2006 289394416 169342603 120051813
2007 337982290 187602877 150379413
2008 36344554 217973661 145471893

Graph

INFERENCE:

From the above table it can be inferred that the proportion of net working capital
had increased from the year 2005 to2007 and decreed in the year 2008 compare
with 2007.

Working capital turnover ratio:

This is also known as sales to working capital ratio and usually represented in times.
This establishes the relationship of sales to net working capital. This ratio indicates
-heather or not working capital has been effectively utilized in making sales. In case
if a company can achieve higher volume of sales with relatively small amount of
working capital, it is an indication of the operating efficiency of the company. It is
calculated as follows-

YEAR NET SALES(RS) WORKING CAPITAL(RS) RATIO

2005 429128296 62214045 6.89
2006 622181610 120051813 5.2
2007 668215791 150379413 4.4
2008 655229319 145471893 4.5

INTERPRETATION:

From the above table we can conclude that working capital ratio is decreasing. In
the year 2005 it is 6.89 times it decreased to 4.4 times in the year 2007. And it is
increasing 4.5 times in the year 2008.
CURRENT ASSETS TO TOTAL ASSETS RATIO:

Current assets play an important role in day-to-day functioning of an organization.

So, every firm should maintain adequate current assets so as to meet the daily
requirements of business. If the proportion of current assets in total assets exceeds
then the required limit, there will be some idle investments on such assets. At the
time, the proportion of current assets in total should not less than requirements. So,
every firm should maintain the adequate quantity of current assets. But during the
situations of peak demand, should employ more current assets and vice-versa.
Particularly in case of production organizations, there is heavy importance to the
current assets than fixed assets. This kind of analysis will enable the managers to
understand the working capital position of the firm. Data relating to the proportion
of working capital in total assets is depicted as follows-

This ratio establishes the relationship between the current assets and total assets.

YEAR CURRENT ASSETS(RS) TOTAL ASSETS(RS) RATIO

%
2005 217973661 390012770 55.88
2006 187602877 327640705 57.25
2007 169342603 475995664 35.57
2008 184541063 491935181 37.51

INFERENCE:
From the above table it can be inferred that the proportion of current assets to total
assets had decreased 55.88 in the year 2005. In the year 2005 it had increased to
57.25, again in the year 2007 it has decreased 35.57%, again in the year 2008
increase in 37.51
Current assets to sales ratio:
The current assets are used for the purpose of generating sales. A ratio of current
assets to sales reveals that how best the assets are applied in business for turnover.
As per the above said ratio, a low proportion of current assets in relation to sales
indicates better turnover of the company and vice-versa, which will show positive
impact on profitability. The data relating to this aspect is provided as follows and it
is calculated as follows.

YEAR CURRENT ASSETS(RS) NET SALES(RS) RATIO

%
2005 246755108 429128296 57.5
2006 289394416 622181610 46.5
2007 337982290 668215791 50.5
2008 363445554 655229319 55.4

INFERENCE:
From the above table it can be inferred that the proportion of current assets to sales
had increased to 57.5% in the year 2005. In the year 2006 it had decreased 46.5%.
In the years 2007 it had increased to 50.5% and in the year 2008 had increased
55.4%.

Current assets to fixed assets ratio:

Total assets in any business contain both fixed and current assets. For properly
functioning of the organization in terms of production and marketing it is necessary
to maintain a properly balance between them. If the proportion of fixed assets
increases, it will be a negative impact on the firm’s liquidity and if current assets
increase, production increases and which causes impact on the demand for the
product. In view of effective management of funds and to invest on both fixed and
current assets, it is necessary to take the decision as soon as possible. Data relating
to the ratio between current assets to fixed assets is depicted as follows.
YEAR CURRENT ASSETS(RS) FIXED ASSETS(RS) RATIO
%
2005 246755108 167454219 14.13
2006 289394416 184597059 15.67
2007 337982290 138013376 24.4
2008 363445554 202084725 18.0

INFERENCE:
From the above table it can be inferred that the proportion of current assets to fixed
assets had decreased 14.13% in the year 2005. In the year 2006 it had increased to
15.67%. In the year 2007 it had increased 24.4%it had decrease in year 2008 in
18.0%.

New

Meaning of Working Capital Management Working capital means current assets such as cash,
accounts receivables and inventory etc. The management of working capital or current assets is
as important as or rather more, important than the management of fixed assets because the fate of
most of the businesses very largely depends upon the manner in which their working capital is
manged.

The problem of working capital management. Involves the problem of decision making
regarding investment in various current assets with an objective of maintaining the liquidity of
funds of the firm to meet its obligations promptly and efficiently.

The management of working capital encompasses the following problems:-

(i) To decide upon the optimal level of investment in various current assets, i.e., determining the
size of working capital.

(ii) To decide upon the optimal mix of short term funds in relation to long term capital, and

(iii) To locate the appropriate means of short term financing.

The study of working capital management is incomplete unless we have an over-all look on the
management of current liabilities. Determining the appropriate levels of current assets and
current liabilities of level of working capital involves fundamental decisions regarding firm's
liquidity and the composition of firm's debts.
. Sources of Additional Working Capital
Sources of additional working capital include the following:
• Existing cash reserves
• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the
financial resources of the business. This is called overtrading. Early warning signs include:
• Pressure on existing cash
• Exceptional cash generating activities e.g. offering high discounts for early cash payment
• Bank overdraft exceeds authorized limit
• Seeking greater overdrafts or lines of credit
• Part-paying suppliers or other creditors
• Paying bills in cash to secure additional supplies
• Management pre-occupation with surviving rather than managing
• Frequent short-term emergency requests to the bank (to help pay wages, pending receipt
of a cheque).

1. Working Capital Cycle

Cash flows in a cycle into, around and out of a business. It is the business's life blood and every
manager's primary task is to help keep it flowing and to use the cashflow to generate profits. If a
business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't
generate surpluses, the business will eventually run out of cash and expire. Click here for more
information about the vital distinction between profits and cashflow.
The faster a business expands, the more cash it will need for working capital and investment. The
cheapest and best sources of cash exist as working capital right within business. Good
management of working capital will generate cash will help improve profits and reduce risks.
Bear in mind that the cost of providing credit to customers and holding stocks can represent a
substantial proportion of a firm's total profits.
There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-
progress) and Receivables (debtors owing you money). The main sources of cash are Payables
(your creditors) and Equity and Loans.
Each component of working capital (namely inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY. When it comes to managing working capital -
TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies
due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory
levels relative to sales), the business will generate more cash or it will need to borrow less money
to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll
have additional free money available to support additional sales growth or investment. Similarly,
if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund future sales.

New

Working capital is one of the most difficult financial concepts to understand for the small-
business owner. In fact, the term means a lot of different things to a lot of different people. By
definition, working capital is the amount by which current assets exceed current liabilities.
However, if you simply run this calculation each period to try to analyze working capital, you
won't accomplish much in figuring out what your working capital needs are and how to meet
them.
A useful tool for the small-business owner is the operating cycle. The operating cycle analyzes
the accounts receivable, inventory and accounts payable cycles in terms of days. In other words,
accounts receivable are analyzed by the average number of days it takes to collect an account.
Inventory is analyzed by the average number of days it takes to turn over the sale of a product
(from the point it comes in your door to the point it is converted to cash or an account
receivable). Accounts payable are analyzed by the average number of days it takes to pay a
supplier invoice.
Most businesses cannot finance the operating cycle (accounts receivable days + inventory days)
with accounts payable financing alone. Consequently, working capital financing is needed. This
shortfall is typically covered by the net profits generated internally or by externally borrowed
funds or by a combination of the two.

Most businesses need short-term working capital at some point in their operations. For instance,
retailers must find working capital to fund seasonal inventory buildup between September and
November for Christmas sales. But even a business that is not seasonal occasionally experiences
peak months when orders are unusually high. This creates a need for working capital to fund the
resulting inventory and accounts receivable buildup.
Some small businesses have enough cash reserves to fund seasonal working capital needs.
However, this is very rare for a new business. If your new venture experiences a need for short-
term working capital during its first few years of operation, you will have several potential
sources of funding. The important thing is to plan ahead. If you get caught off guard, you might
miss out on the one big order that could have put your business over the hump.
Here are the five most common sources of short-term working capital financing:
• Equity: If your business is in its first year of operation and has not yet become profitable,
then you might have to rely on equity funds for short-term working capital needs. These
funds might be injected from your own personal resources or from a family member,
friend or third-party investor.
 • Trade Creditors: If you have a particularly good relationship established with your trade
creditors, you might be able to solicit their help in providing short-term working capital.
If you have paid on time in the past, a trade creditor may be willing to extend terms to
enable you to meet a big order. For instance, if you receive a big order that you can
fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier
if 30-day terms are normally given. The trade creditor will want proof of the order and
may want to file a lien on it as security, but if it enables you to proceed, that shouldn't be
a problem.
• Factoring: Factoring is another resource for short-term working capital financing. Once
you have filled an order, a factoring company buys your account receivable and then
handles the collection. This type of financing is more expensive than conventional bank
financing but is often used by new businesses.
• Line of credit: Lines of credit are not often given by banks to new businesses. However,
if your new business is well-capitalized by equity and you have good collateral, your
business might qualify for one. A line of credit allows you to borrow funds for short-term
needs when they arise. The funds are repaid once you collect the accounts receivable that
resulted from the short-term sales peak. Lines of credit typically are made for one year at
a time and are expected to be paid off for 30 to 60 consecutive days sometime during the
year to ensure that the funds are used for short-term needs only.
• Short-term loan: While your new business may not qualify for a line of credit from a
bank, you might have success in obtaining a one-time short-term loan (less than a year) to
finance your temporary working capital needs. If you have established a good banking
relationship with a banker, he or she might be willing to provide a short-term note for one
order or for a seasonal inventory and/or accounts receivable buildup.
In addition to analyzing the average number of days it takes to make a product (inventory days)
and collect on an account (account receivable days) vs. the number of days financed by accounts
payable, the operating cycle analysis provides one other important analysis.
From the operating cycle, a computation can be made of the dollars required to support one day
of accounts receivable and inventory and the dollars provided by a day of accounts payable.
Working capital has a direct impact on cash flow in a business. Since cash flow is the name of
the game for all business owners, a good understanding of working capital is imperative to make
any venture successful.
Factors affecting working capital
requirements
(1) Availability of Credit: The amount of credit that a firm can obtain, as also the length of the
credit period significantly affects the working capital requirement. The greater the prospects of
getting credit, the smaller will be its requirement of working capital because it can easily
purchase raw materials and other requirements on credit.
Creditworthiness can also the interpreted to mean that the firm can function smoothly even with
a smaller amount of working capital if it is assured that it can obtain loans from the bank
immediately and easily. The firm does not need then to keep a wide margin of safety.
(2) Growth and Expansion: The working capital requirements increase with growth and
expansion of business. Hence planning of the working capital requirements and its procurement
must go hand in hand with the planning of the growth and expansion of the firm. The
implementation of the production plan that aims at the growth or expansion of the unit
necessitates more of fixed capital and working capital both.
Even the expansion of the volume of sales increases the requirements of working capital. Of
course, it is difficult to establish a quantitative relationship between them. An important point to
be noted is that the requirements of working capital emerge before the growth or expansion
actually takes place.
(3) Profit and its Distribution: The net profit of a firm is a good index of the resources
available to it to meet its capital requirements. But, from the viewpoint of working capital
requirement, it is the profit in the form of cash which is important, and not the net profit. The
profit available in the form of cash is called cash profit and it can be assessed by adding or
deducting non-cash items from the net profit of the firm. The larger the amount of cash profit,
the greater will be the possibility of acquiring working capital.
But, in fact the entire amount of cash profit may not be available to meet working capital needs.
The portion of cash profit which is available for this purpose depends on the profit distribution
policy. The policies with regard to distribution of dividends, ploughing back of profit and tax
payments will determine the portion of cash profit which the firm can use to meet its working
capital needs. Even depreciation policy can influence the amount of cash available, as
depreciation of capital assets is deductible item of expenditure and it reduces tax liability.
(4) Price Level Fluctuations: A general statement may be made that with price rise, a firm will
require more funds to purchase its current assets. In other words, the requirements of working
capital will increase with the rise in prices. But all firms may not be affected equally. The prices
of all current assets never go up to the same extent. Price of some current assets rise less rapidly
than those of the others. Hence for the firms which use such current assets, the working capital
need will increase by a smaller amount. Besides, if it is possible to pass on the burden of high
prices of raw materials to the customers by raising the prices of final product, then also there will
be no increase in working capital requirements.
(5) Operating Efficiency: If a firm is efficient, it can use its resources economically, and
thereby it can reduce cost and earn more profit. Thus, the working capital requirement can be
reduced by more efficient use of the current assets.
There are a number of factors which determine the amount of working capital requirements in
business. Therefore, it is not possible to give general principles applicable to all enterprises
equally. It is desirable to analyze the factors in the context of each particular unit. We may point
out some basic factors influencing working capital requirements.
(1) Nature and Volume of Business: The nature and volume of business is an important factor
in deciding the amount of working capital. For example, the amount of working capital is
generally more in trading concerns and in service units as compared to the manufacturing units.
The retail trading units have also to invest large funds in working capital. In some manufacturing
units also, the working capital holds a significant place. On the other hand, public utilities require
less working capital. Other manufacturing units need more working capital as compared to
public utilities.
The relation between the volume of business and the requirement of working capital is more
direct and clear. The bigger the size of the units, the more will be the requirement of working
capital.
(2) Length of Manufacturing Cycle: The time that elapses from the purchase and use of raw
materials to the production of finished goods is called manufacturing cycle. The longer the
period a manufacturing cycle takes, the larger is the amount of working capital required, because
the funds get locked up in production process for a longer period of time.
It is in view of this that, when alternative methods of production are available, the method with
the shortest manufacturing cycle should be chosen (assuming other factors to be equal). Once a
choice is made, care is taken to see that the manufacturing cycle is completed within a specified
period. Any delay in production is bound to increase the requirement of working capital.
(3) Business Fluctuations: Business fluctuations are of two types: seasonal fluctuations which
arise out of seasonal changes in demand for the product and cyclical fluctuations which occur
due to ups and downs of economic activities in the country as a whole.
If demand for the product is seasonal, production will have to be increased during the season,
and it will have to be reduced during the off-season. Correspondingly, there will be fluctuations
in the requirement of working capital. The business unit will have to face some other problems in
addition to this one. It has to bear extra expenses to increase production when product demand
increases. It has to bear, costs even to maintain work force and physical facilities during slack
season. For this reason, many units prefer to continue production even during slack season and
increase the level of their inventories.
The cyclical fluctuations are made up of periods of prosperity and depression. The sales and
prices increase during prosperity necessitating more working capital in the form of inventories
and book-debts. If new investment is made in fixed capital to meet additional demand for the
product, then also there will be an increase in working capital requirement. Generally, business
units adopt the policy to borrow funds on a large scale to increase investment in working capital.
As against this, the requirement of working capital gets reduced during depression and therefore
they adopt the policy of reducing their short term debts.
(4) Production Policy: The production policy of business is also an important determinant of
working capital requirement. If the policy of Constant Production is adopted, there are two
possible effects. If demand for the product is regular and constant, this policy helps in reducing
working capital requirement to the lowest possible level. But if demand for the product is
seasonal, this policy raises the level of inventory during off season and thereby increases the
working capital requirement. If the cost of maintaining inventory is considerably high, the policy
of varying production according to demand is preferred. If the unit produces varied products, it
can reduce the requirement of working capital by adjusting the structure of production to the
changes in demand.
(5) Credit Policy: In the present-day circumstances, almost all units have to sell goods on credit.
The nature of credit policy is an important consideration in deciding the amount of working
capital requirement. The larger the volume of credit sales, the greater will be the requirement of
working capital. Also, the longer the period the collection of payment takes, the greater will be
the requirement of working capital.
Generally, the credit policy of an individual firm depends on the norms of the industry to which
the firm belongs. Yet it is possible to pursue different credit policies for different customers in
accordance with their creditworthiness. To ignore creditworthiness of the individual customers
can be dangerous to the firm. In addition, it is necessary that the firm should be prompt in
collection of payments. Any slackness in this respect will increase the requirement of working
capital and will increase the chance of bad debts.
Factors determining working capital requirements
• Size of business
• Stage of development
• Time of production
• Rate of stock turnover ratio
• Buying and selling terms
• Seasonal consumption
• Seasonal product
• profit level
• growth and expansion
• production cycle
• general nature of business
• business cycle