WORKING CAPITAL MANAGEMENT

Working Capital Management

Working Capital Management or Short Term Management is concerned with decisions relating to current assets and current liabilities. Short term financial decisions typically involve cash flows within a year or within the operating cycle of the firm.

Working Capital Management

Two concepts of Working Capital a) Gross Working Capital: It is the total of all current
assets. b) Net Working Capital: It is the difference between current assets and current liabilities.
Management

of Working Capital refers to the management of current assets as well as current liabilities. Major thrust is on management of current assets because current liabilities arise in the context of current assets.
2010 BSE Institute Limited 3

Working Capital Management

Importance of Working Capital Management
in CAs represents a substantial portion of total investments. Investments in CAs and level of CLs have to to be geared quickly to changes in sales. FA investment and long-term investments are also responsive to variation in sales but the relationships is not as direct as it is in the case of working capital components.
Investments

Working Capital Management

Components of Current Assets
Inventories

Raw Materials and Components Work-in-Process Finished Goods Others Trade Debtors Loans and Advances Cash and Bank Balances
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Working Capital Management

Components of Current Liabilities
Sundry

Creditors Trade Advances Short term Borrowings Commercial Banks Others Provisions

Working Capital Management

Current Assets Characteristics
Current

assets have a short life span. Cash balances may be held idle for a week or two. Account receivables may have a life span of 30 to 90 days. Inventories may be held for 1 to 60 days. Life Span depends upon the time required in procurement, production, sales and collection and also the degree of synchronization among them.
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Working Capital Management

Current Assets Characteristics
Each

current assets is swiftly transformed into other asset forms. Cash is used for acquiring raw materials. Raw materials are transformed into finished goods involving several stages of work-in-process. Finished goods are generally sold on credit. Credit sales become account receivables. Account receivables on realization generate cash.

Working Capital Management

Current Assets Characteristics
Decisions

relating to working capital management are repetitive and frequent. The difference between profit and present value is insignificant. Efficient management of one component cannot be taken without simultaneous consideration of other component. In case of large accumulation of finished goods inventory, the company may have to provide liberal credit terms or show laxity in credit collection. The firm may have to offer generous discounts in case of a liquidity crunch.
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Working Capital Management

Factors Influencing Requirements.
Nature

Working

Capital

of Business. Seasonality of Operations. Production Policy. Market Conditions. Conditions of Supply.

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Working Capital Management

Nature of Business

A service firm like an electricity undertaking or a transport corporation has a short operating cycle and which sells predominantly on cash basis has modest working capital requirements. A manufacturing concern like a machine tool/steel unit has a long operating cycle. They sell largely on credit and have very substantial working capital requirements.

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Working Capital Management

Seasonality of Operations
Firms

which have marked seasonality in their operations have highly fluctuating working capital requirements. Sale of ceiling fan reaches a peak during summer months and drops sharply during winter. Working Capital requirements are likely to increase considerably in summer months and decrease significantly during winter. A lamp manufacturing company will have fairly even sales round the year and tend to have stable 12 working capital requirements.

Working Capital Management

Production Policy
Firms

marked by pronounced seasonal fluctuations in sales may pursue a production policy which may reduce the sharp variations in working capital requirements. A manufacturer of ceiling fans may maintain steady production throughout the year rather than intensify the production activity during the peak season. Such a production policy may reduce the fluctuations in working capital requirements.
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Working Capital Management

Market Conditions
Degree

of competition prevailing in the market place has an important bearing on working capital needs. When competition is tough, large inventory of finished goods is required to promptly serve customers who may or may not be inclined to wait because other manufacturers are ready to meet their needs. Generous credit terms may have to be offered to attract customers in a highly competitive market. Working capital requirements tend to be high because of greater investments in finished goods 14

Working Capital Management

Market Conditions
When

market is strong and competition weak, a firm can manage with a smaller inventory of finished goods because customers can be served with some delay. A firm can insist on cash payment and avoid lockup of funds in accounts receivable and can also ask for advance payment partial or total.

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Working Capital Management

Supply Conditions
Inventory

of raw materials, spares and stores depends on the conditions of supply. If supply is prompt and adequate, the company can manage with small inventory. If supply is unpredictable and scant, then the firm will have to acquire stocks as and when they are available and carry larger inventory, on an average. This is to ensure continuity of production process. A similar policy has to be adopted if the raw materials are available only seasonally.
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Working Capital Management

Level of Current Assets
Under

a flexible or a conservative policy the investment in current assets is high. The firm maintains a huge balance of cash and marketable securities, carries large amount of inventories and grants generous credit terms to customers which leads to a high level of debtors. Under a restrictive or aggressive policy the investments in current assets is low. The firm keeps a small balance of cash and marketable securities, manages with small amounts of inventories and offers stiff terms of credit which leads to a low level of debtors.
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Working Capital Management

Level of Current Assets
A

flexible policy results in fewer production stoppages, ensures quick deliveries to customers and stimulates sales because liberal credit is granted to customers. However the benefits come with higher costs of investments in current assets. A restrictive policy results in frequent production stoppages, delayed deliveries to customers and loss of sales. The firm may have to bear indirect costs like loss of goodwill, sales etc when its investment in current 18 assets is low.

Working Capital Management

Level of Current Assets
The

company needs to maintain an optimum level of current assets. This involves a trade-off between costs that rise with current assets (carrying costs) and costs that fall with current assets (shortage costs). Carrying costs are mainly in the nature of the cost of financing a higher level of current assets. Shortage costs are mainly in the form of disruption in production schedule, loss of sales and loss of customer goodwill.
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Working Capital Management

Financing of Current Assets
The

firm must determine how the current assets should be financed. What mix of long-term capital and short-term debt should the firm employ to support its current assets. Fixed assets generally grow at constant rate which reflects the secular rate of growth in sales. Current assets are also expected to display the same long term growth rate however they show a lot of short term fluctuations due to seasonal patterns in sales and/or purchases.
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Working Capital Management

Financing of Current Assets
Investment

in current assets may be broken into

two parts: Permanent current assets : They represents what the firm requires even at the bottom of its sales cycle. Temporary current assets : They represent a variable component that moves in line with seasonal fluctuations.

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Working Capital Management

Financing of Current Assets
Strategy A: Long-term financing is used to meet F.A requirements as well as peak W.C requirements. When the W.C requirements is less than its peak level, the surplus is invested in liquid assets. B. Strategy B: Long-term financing is used to meet F.A requirements, permanent W.C requirements and a portion of the fluctuating W.C requirements. During seasonal upswings, short-term financing is used and during seasonal downswings the surplus is invested in liquid assets. C. Strategy C: Long-term financing is used to meet F.A requirements and permanent W.C requirements. Shot term financing is used to met fluctuating WC requirements. 22
A.

Working Capital Management

The Matching Principle
The

maturity of sources of finance should match the maturity of the assets being financed. Fixed Assets and Permanent Current Assets should be supported by long-term sources of finance. Fluctuating Current Assets should be supported by short-term sources of finance. This will reduce periodic refinance of assets which is not only risky but highly inconvenient.

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Working Capital Management

The Operating Cycle
The a) b)

c)
d)

investment in working capital is influenced by four key events. Purchase of raw materials. Payment for raw materials. Sale of finished goods. Collection of cash for sales.

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Thank you

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