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

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

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

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. So, the payments should be made close to the cut-offdate while utilizing the discounts if any. In this manner, 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. This is how the two-fold benefit can be obtained. Next in importance comes the receivable. It is universal truth that every Business has receivables. They are the dues from the credit customers. There are various reasons for credit sales, such as, to penetrate and establish in the market, to increase sales, to get more customers and to help customers on whom the fortune of a business is contingent. While managing receivables, an organization develops the policies which are beneficial to both the customers as well as to the organization that makes credit sales. Credit policies must have few standards, credit period, credit terms, etc so as to manage the receivables in an efficient manner. Credit standard is meant to the classification of customers depending upon the relationships and in terms of risk etc.

The credit period is referred to how long a period should be allowed. Credit terms mean offering discount on early payment or the payment before the cut-off-date. In the point of fact, 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. Thus, 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. The impact of inventory management on working capital is vitally important. A company, whether of trading or of manufacturing, has to carry certain amount of inventories. Inventories are classified as inventory of finished goods, of raw materials or of work in process depending upon the type of business. A trading company purchases or sells the finished goods whereas the manufacturing company deals with all types of inventories. At this juncture, it should be noted that having too much or too little inventory becomes a problematic cause in terms of sales and production. Also, 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, 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, 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. 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. It is appropriate to mention that there are several techniques available for the effective management of Inventories with which the management can be benefited. Marketable securities categorized as short term investments to earn profit rather than going for long term investments- They are regarded to be connected with the cash management. What may be briefly mentioned in terms of marketable securities is they are involved in the short term investments. A company can prefer short term investments in them rather than holding large cash. The importance lies in the fact that holding cash does not provide any return, on the contrary, marketable securities are purchased with a purpose of the generating profits. Mention deserves to be made about the overall significance of financial management in a few words. Financial management is

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. Financial management is an integral part of overall management affecting the survival, growth and strength of a business. The sole task of financial management is maximization or optimizing the value of firm. If dealt effectively, a financial manager can ward off a large number of problems.

Operating cycle of Working Capital

Thus there is complete cycle form cash to cash to cash where in cash gets converted into raw materials, work-in-progress, finished products, debtors and finally into cash again. The operating cycle of working capitals will repeat again and again over the period depending upon the nature of business. The determination of operating cycle helps in forecast control and management if working capital.

Problems of inadequate Working Capital

When working capital is inadequate the company faces the following problems The growth of company is stagnant. Because the firm to undertake profitable projects for non availability of working capital funds.

 Inadequate working capital is difficult to implement operating plans and achieve the firms profit target. Inadequate working capital is difficult to meet day to day commitments. 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. The firm loses its reputation when it is not in a position to honor its short term obligations.

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. It results in unnecessary accumulation of inventories. Thus chances of inventory mishandling, waste, theft and losses increase. It is an indication of defective credit policy and slack collection period. Consequently higher incidence of bad debts results which adversely affects profits. Excessive working capital makes management complacent which degenerates into managerial inefficiency.

Tendencies of accumulating inventories tend to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits.

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. The following is the description of the factors, which generally influence the working capital requirements of the firms.

Internal Factors : Nature of Enterprise

The working capital requirements of enterprise are basically related to the conduct of business. Public utilities have certain features which have a bearing on their working capital needs. The two relevant features are The cash nature of business (cash sales). Sale of services rather than commodities.

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. They have necessarily to invest proportionately large amount in working capital. The working capital requirements of a firm basically influence by the nature of its firm. For example, trading and financial firm require a lower investment in

working capital but in the case of manufacturing concern have to invest substantially in working capital.

Production Cycle
The working capital requirement is also depends upon the production or manufacturing cycle. 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. Funds have to be necessarily tied up during the process of manufacture necessitating unbalanced working capital. In other words, there is some time gap before raw materials become finished goods.

Business Cycle
The working capital requirements are also determined by the nature of the business cycle. Business fluctuations lead to cyclical and seasonal changes which, is turn cause a shift in the working capital position. 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. During the upswing of business activity, 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.

Sales and Demand Conditions

Sales depend on demand conditions mostly firms are experience seasonal and cyclical fluctuations in the demand for their products and services. These business variations affect the working capital requirement. Seasonal fluctuations not only affect working capital requirement but also create production problems for the firm, during periods of peak demand increasing production may be expensive for the firm. Similarly, it will be expensive during slack periods when the firm has to sustain its working force and physical facilities without adequate production and sales.

Credit Policy
The level of working capital is also determined by credit policy, which relates to sales and purchases. The credit policy influences the requirement of working capital in two ways: Credit allowed by firm to its customers. Credit given to firm by its suppliers.

The credit terms granted to customers have a bearing on the magnitude of working capital by determining the level of books debts. On the other hand, if liberal credit terms are available to firm by its suppliers, the requirements of working capital will be less.

Availability of Credit

The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm will need less working capital if liberal credit terms are available to it. Similarly, the availability of credit from banks also influences the working capital needs of the firm. A firm, which can get bank credit easily on favorable conditions, will operate with less working capital than a firm without such a facility.

Availability of Raw Material

The availability of a continuous basis without interruption would sometimes affect the requirement of working capital. There may be some materials which cannot be procured easily either because of their sources are few or they are irregular. The procurement of some essential raw materials is difficult because of their sporadic supply. This happens very often with raw materials which are in short supply and are controlled to ensure equitable distribution. The buyer has in such cases very limited options as to the quantum and timing of procurement. It may so happen that a bulk consignment may be available but the firm may be short of funds, while when surplus funds are available the commodities may be in short supply. This element of uncertainty would lead to a relatively high level of working capital. Finally, some raw materials may be available only during certain seasons.

Price Level Changes

Changes in the price level also affect the requirements of working capital. Rising prices necessitate the use of more funds for maintaining an existing level of activity for the same level of current assets. Higher cash outlays are required. 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, its standing in the market and other relevant considerations.

Operating Efficiency
The operating efficiency of the management is also an important determinant of the level of working capital. The management can contribute to a sound working capital position through operating efficiency. Although the management cannot control the rise in prices, it can ensure the efficient utilization of resources by eliminating waste, improving co-ordination and a fuller utilization of existing resources, and so on. Efficiency of operations accelerates the pace of cash cycle and improves the working capital turnover. It releases the pressure on working capital by improving profitability and improving the internal generation of funds.

Growth and Expansion Activities

It is obvious that, as business expands, it requires more working capital in terms of sale or fixed assets. In the case of growth, there will be an all round increase in investment. That is to say, with the increase in fixed assets for

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.

Depreciation Policy
Depreciation policy also exerts an influence on the quantum of working capital. Depreciation charges do not involve any cash outflows. The effect of depreciation policy on working capital is, therefore, indirect in the first place depreciation affects the tax liability and retention of profits. In the second place, the selection of the method of depreciation has important financial implications. 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. Most firms experience seasonal and cyclical fluctuation in the demand for their products and services. These business variations affect specially the temporary working capital requirements of the firm.

Supply Conditions

The inventory of raw materials, spares and stores depends on the condition of supply. 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. If supply is unpredictable and carry the inventory for longer period. This policy is followed when the raw material is available only seasonally.

Technological Development
Changes in technologies may lead to improvements in processing raw materials, minimizing wastages, greater productivity, more speed of production. All these improvements may enable the firm to reduce investments in inventory .Thus changes in technology affect the requirements of working capital.

Government Policies
The policy and decision of government also affect working capital. Government controls and regulates the prices and supply of some essential products, which are very important from the point of view of general public.

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, very often taxes have to be paid in advance on the basis of the profit of the preceding year. Tax liability is, in a sense, short term liability payable in cash an adequate provision for tax payments is, therefore, an important aspect of

working capital planning. It tax liability increases, it leads to an increase in the requirement of working capital and vice-versa.

Dividend Policy
The payment of dividend consumes cash resources and there by, affects working capital to that extent. Conversely, if the firm does not pay dividend but retains the profits, working capital increases. In planning working capital requirements, therefore, a basic question to be decided is whether profit will be retained or paid out of shareholders. In the firm should retain profits to preserve cash resources and at the same time, it must pay dividends to satisfy the expectations of investors. When profits are relatively small, the choice is between retention and payment. The choice must be made after taking into account all the relevant factors.

Working Capital Financing: Trade Credit

Trade credit represents the credit extended by the supplier of goods and services. It is a spontaneous source of finance in the sense that it arises in the normal transactions of the firm without specific negotiations. 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.

Accrued Expenses and Deferred Income

Accrued Expenses:Accrued expenses represent a liability that a firm has to pay for the services which it has already received. Thus they represent a spontaneous, interest free sources of financing the most important component of accruals are wages and salaries, taxes and interest.

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 firms liquidity in the form of cash. Advance payments made by customers constitute the main item of deferred income.