WORKING CAPITAL MANAGEMENT

Definition of working capital Gross Working Capital = the firms investment in current asset. Net working capital = current assets less its current liabilities. Parts of Working Capital In principle, the working capital need can be separated into two parts: A fixed part, and A fluctuating part The fixed part is probably defined in amount as the minimum working capital requirement for the year. It is widely advocated that the firm should be funded in the way shown in the diagram below:

The more permanent needs (fixed assets and the fixed element of working capital) should be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short notice.

Working Capital Ratio (Current Ratio)

Current Assets ________________ Current Liabilities

Indicates if a firm has enough short-term assets to cover its immediate liabilities. Things to remember If the ratio is less than one then they have negative working capital.

A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash

Types of Working Capital

Management of working capital Management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management: Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management Inventory includes all types of stocks. For effective working capital management, inventory needs to be managed effectively. The level of inventory should be such that the total cost of ordering and holding inventories is the least. Simultaneously, stock out costs should be minimised. Business, therefore, should fix the minimum safety stock level, re-order level and ordering quantity so that the inventory costs is reduced and its management becomes efficient. Debtors management Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on Capital. Short term financing Identify the appropriate source of financing, given the cash conversion cycle, the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

Significance of Working Capital Management 1) 2) 3) 4) In a typical manufacturing firm, current assets exceed one half of total assets. Current liabilities are the principal source of external financing for small firms. Requires continuous day -to day managerial supervision. Working capital management affects the companys risk, return and share price.

In working capital management, we analyze following three points The need for working capital

After studying the nature of production, we can estimate the need for working capital. If company produces products at large scale and continues producing goods, then company needs high amount of working capital. Optimum level of Working capital in business Have you achieved the optimum level of working capital which has invested in current assets? Because high amount of working capital will decrease the return on investment and low amount of working capital will increase the risk of business. So, it is very important decision to get optimum level of working capital where both profitability and risk will be balanced. For achieving optimum level of working capital, finance manager should also study the factors which affect the requirement of working capital and different elements of current assets. If he will manage cash, debtor and inventory, then working capital will automatically optimize. Main Working capital policies of businesses Policies are the guidelines which are helpful to direct business. Finance manager can also make working capital policies. a) Liquidity policy Under this policy, finance manager will increase the amount of liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays its dues at maturity. But finance manger should not forget that the excess cash will not produce and earning and return on investment will decrease. So liquidity policy should be optimized. b) Profitability policy Under this policy, finance manger will keep low amount of cash in business and try to invest maximum amount of cash and bank balance. It is sure that profit of business will increase due to increasing of investment in proper way but risk of business will also increase because liquidity of business will decrease and it can create bankruptcy position of business. So, profitability policy should make after seeing liquidity policy and after this both policies will helpful for proper management of working capital. Questions: 1. What are the different types of Working Capital? 2. What you mean by Working capital ratio? 3. What is the significance of Working Capital Management? Source : www.authorstream.com Compiled By Latha R 09487360611 lathafca@yahoo.co.in