Working Capital Management: Everything You Need to Know
In this article, we start witht he 1) introduction to working capital management, and continue then with 2) the working capital cycle, 3) approaches to working capital management, 4) significance of adequate working capital, 5) factors for determining the amoung of working capital needed.
INTRODUCTION TO WORKING CAPITAL MANAGEMENT
Any firm, from time to time, employs its short-term assets as well as short-term financing sources to carry out its day to day business. It is this management of such assets as well as liabilities which is described as working capital management. Working capital management is a quintessential part of financial management as a subject. It can also be compared with long-term decision-making the process as both of the domains deal with the analysis of risk and profitability.
1) Definition of Working Capital
Working capital is formally arrived at by subtracting the current liabilities from current assets of a firm on the day the balance sheet is drawn up. Working capital is also represented by a firm’s net investment in current assets necessary to support its everyday business. Working capital frequently changes its form and is sometimes also referred to as circulating capital. According to Gretsenberg:
“circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another.”
2) Types of working capital
Working capital, as mentioned above, can take different forms. For example, it can take the form of cash and then change to inventories and/or receivables and back to cash.
- Gross and Net Working Capital: The total of current assets is known as gross working capital whereas the difference between the current assets and current liabilities is known as the net working capital.
- Permanent Working Capital: This type of working capital is the minimum amount of working capital that must always remain invested. In all cases, some amount of cash, stock and/or account receivables are always locked in. These assets are necessary for the firm to carry out its day to day business. Such funds are drawn from long term sources and are necessary for running and existence of the business.
- Variable Working Capital: Working capital requirements of a business firm might increase or decrease from time to time due to various factors. Such variable funds are drawn from short-term sources and are referred to as variable working capital.
3) Objectives of working capital management
The main objectives of working capital management are:
- Maintaining the working capital operating cycle and to ensure its smooth operation. Maintaining the smooth operation of the operating cycle is essential for the business to function. The operating cycle here refers to the entire life cycle of a business. From the acquisition of the raw material to the smooth production and delivery of the end products – working capital management strives to ensure smoothness, and it is one of the main objectives of the concept.
- Mitigating the cost of capital. Minimizing the cost of capital is another very important objective that working capital management strives to achieve. The cost of capital is the capital that is spent on maintaining the working capital. It needs to be ensured that the costs involved for maintenance of healthy working capital are carefully monitored, negotiated and managed.
- Maximising the return on current asset investments. Maximising the return on current investments is another objective of working capital management. The ROI on currently invested assets should be greater than the weighted average cost of the capital so that wealth maximization is ensured.
THE WORKING CAPITAL CYCLE
The working capital cycle refers to the minimum amount of time which is required to convert net current assets and net current liabilities into cash. From a more simplistic viewpoint, working capital cycle is the amount of time between the payment for goods supplied and the final receipt of cash accumulated from the sale of the same goods. There are mainly the following elements of which the working capital cycle is comprised of:
The cash refers to the funds available for the purchase of goods. Maintaining a healthy level of liquidity with some buffer is always a best practice. It is extremely important to maintain a reserve fund which can be utilized when:
- There is a shortage of cash inflow for some reason. In the absence of reserve cash, the day to day business will get hampered.
- Some new opportunity springs up. In such a case, the absence of reserve cash will pose a hindrance.
- In case of any contingency, absence of a reserve fund can cripple the company and poses a threat to the solvency of the firm.
Creditors and Debtors
- The creditors refer to the accounts payable. It refers to the amount that has to be paid to suppliers for the purchase of goods and /or services.
- Debtors refer to the accounts receivables. It refers to the amount that is collected for providing goods and/or services.
Inventory refers to the stock in hand. Inventories are an integral component of working capital and careful planning, and proper investment is necessary to maintain the inventory in a healthy state of affairs. Management of inventory has two aspects and involves a trade-off between cost and risk factors. Maintaining a sizable inventory has its accompanying costs that include locking of funds, increased maintenance and documentation cost and increased cost of storage. Apart from these things, there is also a chance of damage to the stored goods. On the other hand, maintaining a small inventory can disrupt the business lifecycle and can have serious impacts on the delivery schedule. As a result, it is extremely important to maintain the inventory at optimum levels which can be arrived at after careful analysis and a bit of experimentation.
Properties of a healthy working capital cycle
It is essential for the business to maintain a healthy working capital cycle. The following points are necessary for the smooth functioning of the working capital cycle:
- Sourcing of raw material: Sourcing of raw material is the beginning point for most businesses. It should be ensured that the raw materials that are necessary for producing the desired goods are available at all times. In a healthy working capital cycle, production ideally should never stop because of the shortage of raw materials.
- Production planning: Production planning is another important aspect that needs to be addressed. It should be ensured that all the conditions that are necessary for the production to start are met. A carefully constructed plan needs to be present in order to mitigate the risks and avert unforeseen issues. Proper planning of production is essential for the production of goods or services and is one of the basic principles that must be followed to achieve smooth functioning of the entire production lifecycle.
- Selling: Selling the produced goods as soon as possible is another objective that should be pursued with utmost urgency. Once the goods are produced and are moved into the inventory, the focus should be on selling the goods as soon as possible.
- Payouts and collections: The accounts receivables need to be collected on time in order to maintain the flow of cash. It is also extremely important to ensure timely payouts to the creditors to ensure smooth functioning of the business.
- Liquidity: Maintaining the liquidity along with some room for adjustments is another important aspect that needs to be kept in mind for the smooth functioning of the working capital cycle.
APPROACHES TO WORKING CAPITAL MANAGEMENT
The short-term interest rates are, in most cases, cheaper compared to their long-term counterparts. This is due to the amount of premium which is higher for short term loans. As a result, financing the working capital from long-term sources means more cost. However, the risk factor is higher in case of short term finances. In case of short-term sources, fluctuations in refinancing rates are a major cause for concern, and they pose a major threat to business.
There are mainly three strategies that can be employed in order to manage the working capital. Each of these strategies takes into consideration the risk and profitability factors and has its share of pros and cons. The three strategies are:
- The Conservative Approach: As the name suggests, the conservative strategy involves low risk and low profitability. In this strategy, apart from the permanent working capital, the variable working capital is also financed from the long-term sources. This means an increased cost capital. However, it also means that the risks of interest rate fluctuations are significantly lower.
- The Aggressive Approach: The main goal of this strategy is to maximize profits while taking higher risks. In this approach, the entire variable working capital, some parts or the entire permanent working capital and sometimes the fixed assets are funded from short-term sources. This results in significantly higher risks. The cost capital is significantly decreased in this approach that maximizes the profit.
- The Moderate or the Hedging Approach: This approach involves moderate risks along with moderate profitability. In this approach, the fixed assets and the permanent working capital are financed from long-term sources whereas the variable working capital is sourced from the short-terms sources.
SIGNIFICANCE OF ADEQUATE WORKING CAPITAL
Maintenance of adequate working capital is extremely important because of the following factors:
- Adequate working capital ensures sufficient liquidity that ensures the solvency of the organisation.
- Working capital ensured prompt and on-time payments to the creditors of the organisation that helps to build trust and reputation.
- Lenders base their decisions for approving loans based on the credit history of the organisation. A good credit history can not only help an organisation to get fast approvals but also can result in reduced interest rates.
- Earning of profits is not a sufficient guarantee that the company can pay dividends in cash. Adequate working capital ensures that dividends are regularly paid.
- A firm maintaining adequate working capital can afford to buy raw materials and other accessories as and when needed. This ensures an uninterrupted flow of production. Adequate working capital, therefore, contributes to the fuller utilisation of resources of the enterprise.
FACTORS FOR DETERMINING THE AMOUNT OF WORKING CAPITAL NEEDED
Factoring out the amount of working capital needed for running a business is an extremely important as well as difficult task. However, it is extremely critical for any firm to estimate this figure so that it can operate smoothly and be fully functional. There are several factors that need to be considered before arriving at a more or less accurate figure. The following are some of those factors that determine the amount of liquid cash and assets required for any firm to operate smoothly:
- Nature of business: A trading company requires large working capital. Industrial companies may require lower working capital. A banking company, for example, requires the maximum amount of working capital. Basic and key industries, public utilities, etc. require low working capital because they have a steady demand and continuous cash-inflow to meet current liabilities.
- Size of the business unit: The amount of working capital depends directly upon the volume of business. The greater the size of a business unit, the larger will be the requirements of working capital.
- Terms of purchase and terms of sale: Use of trade credit may lead to lower working capital while cash purchases will demand larger working capital. Similarly, credit sales will require larger working capital while cash sales will require lower working capital.
- Turnover of inventories: If inventories are large and their turnover is slow, we shall require larger capital but if inventories are small and their turnover is quick, we shall require lower working capital.
- Process of manufacture: Long-running and more complex process of production requires larger working capital while simple, short period process of production requires lower working capital.
- Importance of labour: Capital intensive industries e.g. mechanized and automated industries generally require less working capital while labour intensive industries such as small scale and cottage industries require larger working capital.
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