FinMan

WORKING CAPITAL MANAGEMENT

What is working capital management?

Working capital management is a business tool that helps companies effectively make use of
current assets, helping companies to maintain sufficient cash flow to meet short term goals and
obligations. By effectively managing working capital, companies can free up cash that would
otherwise be trapped on their balance sheets. As a result, they may be able to reduce the need
for external borrowing, expand their businesses, fund mergers or acquisitions, or invest in R&D.

 Working capital management (WCM) is also known as short term financial management
and is mainly concerned with the decisions relating to current assets and current
liabilities

Working capital is essential to the health of every business, but managing it effectively is
something of a balancing act. Companies need to have enough cash available to cover both
planned and unexpected costs, while also making the best use of the funds available. This is
achieved by the effective management of accounts payable, accounts receivable, inventory and
cash.

Nature of Working Capital

Working capital management is concerned with the problems that arise in attempting to manage
the current assets, the current liabilities and the interrelations that exist between them.

Current assets refer to those assets which in the ordinary course of business can be, or will be,
converted into cash within one year without undergoing a diminution in value and without
disrupting the operations of the firm.

Examples- cash, marketable securities, accounts receivable and inventory.

Current liabilities are those liabilities which are intended, at their inception, to be paid in the
ordinary course of business, within a year, out of the current assets or the earnings of the
concern.

Examples- accounts payable, bills payable, bank overdraft and outstanding expense

Objective of Working Capital Management

 The goal of working capital management is to manage the firm’s current assets and
liabilities in such a way that a satisfactory level of working capital is maintained.
 The interaction between current assets and current liabilities is, therefore the main
theme of the theory of the working capital management
Concepts and Definitions of Working Capital

There are two concepts of working capital:

Gross working capital- means the total current assets; refers to the firm’s investments in all the
current assets taken together. Thus it total of investments in all the current assets. Also called
as total working capital

Net working capital- it refers to the excess of total current assets over current liabilities which
can be defined in two way so

 The difference between current assets and current liabilities.

 The portion of current assets which is financed with long term funds

Factors Influencing Working Capital Requirement :

Different factors which will affect the working capital requirement of a firm are :

 Nature of Business – for service / trading firm, lower to modest working capital is
required; while for manufacturing concern, substantial WC is required.
 Seasonality of operations – firms which have marked seasonality in their operations
usually have high fluctuations in working capital requirement.
 Production policy – adequate production policy may reduce the sharp fluctuations in WC
requirement, even in seasonal firms.
 Market conditions – degree of competition in market place has a strong influence on WC
requirement. If competition is strong, higher amount of WC required, otherwise if
competition is weak low level of WC will suffice.
 Supply conditions – if supply of raw materials, spares, other goods, is prompt, adequate
and predictable, the firm can manage with small inventory (or working capital)

Working Capital Policy

The working capital management need not necessarily have a target of increasing the wealth of
the shareholders, but it helps in attaining the objective by providing sufficient liquidity to the firm.
Thus, efficient WCM is important from the point of view of both the liquidity and profitability. Poor
and inefficient WCM means that funds are unnecessarily tied up in idle assets. Keeping these
views in mind, working capital policy is framed.

Liquidity versus Profitability- A Risk Return Trade-off

An important aspect of a working capital policy is to maintain and provide sufficient liquidity to
the firm. The decision on how much working capital is maintained involves a trade-off i.e.,
having a large net working capital may reduce the liquidity-risk faced by the firm, but it can have
a negative effect on the cash flows. Therefore, the net effect on the value of the firm should be
used to determine the optimal amount of working capital.

Types of Working Capital Needs:

 For any business, two kinds of working capital
may be required.

 Permanent WC – this refers to

minimum amount of investment in
current assets which is required at all
times to carry out minimum level of
business operations
 Temporary WC – apart from PWC, the
firm may also require additional
working capital in order to meet the
requirement arising out of fluctuations
in sales volume. This extra working
capital needed to support the
increased volume of sales is called as TWC

Strategies

Hedging Approach/ Matching Approach

 According to this approach, the maturity of the sources of the funds should match the
nature of the assets to be financed. For the purpose of analysis, the current assets can
be broadly classified into two classes of those which are required in a certain amount for
a given level of operation and, hence, do not vary over time of those which fluctuate over
time.
  The Hedging approach suggests that long term funds should be used to finance the
fixed portion of current assets requirements in a manner similar to the financing of fixed
assets.
 The purely temporary requirements, that is, the seasonal variations over and above the
permanent financing needs should be appropriately financed with short term funds.
 This approach, therefore, divides the requirements of total funds into permanent and
seasonal components, each being financed by a different source.

Conservative Approach

 This approach suggests that the estimated requirement of total funds should be met
from long term sources; the use of short term funds should be restricted to only
emergency situations or when there is an unexpected outflow of funds.

Aggressive approach

 A working capital policy is called an aggressive policy if the firm decides to finance a part
of the permanent working capital by short term sources. The aggressive policy seeks to
minimize excess liquidity while meeting the short term requirements. The firm may
accept even greater risk of insolvency in order to save cost of long term financing and
thus in order to earn greater return.
 The trade-off between risk and profitability depends largely on the financial manager’s
attitude towards risk, yet while doing so he must take care of the following factor
(Flexibility of the mix, Cost of financing, Risk attached with financing mix)