WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT Meaning of Working Capital: According to DrVarma and Argawal (1993) the term working capital is commonly used for the capital required for day to day working in a business concern such as purchasing raw material, for meeting day to day expenditure on salaries, wages, rents rates, advertising etc.However, there are much disagreement among various financial authorities (Financiers, accountants, businessmen and economists) as to the exact meaning of the term working capital. There are two concepts of working capital that is Gross working capital and Net working capital. According to one school of thought(gross concept of working capital) supported by distinguished authorities like Baker,Mead,Mallot and Field, Mill, the working capital refers the firm’s total investment in current assets.(e.g.cash, short term securities, bills receivable) According to the other school of thought (Net concept) supported by authorities like Lincoln,Stevens,Doris and Saliers the working capital refers to the difference between current assets and current liabilities.(Working capital = Current Assets – Current Liabilities) Determinants of working capitalinclude: Nature of business- the more the ratio of raw materials in the total cost the more working capital. Seasonal variations-seasonal industries require more working capital to stock the raw materials during season. Credit policy - affects the working capital by influencing the level of debtors. Availability of credit from suppliers - a firm will need less working capital liberal credit terms are available to it from the suppliers. Growth and expansion of business - growing concerns require more working capital. Price level changes - rising price levels requires more working capital to maintain the same level of current assets. Analysis of working capital Analysis of working capital can be done through ratio analysis, fund flow analysis, budgeting analysis. 1)Ratio analysis: It helps management in checking upon the efficiency with which working capital is being used in the business. 2) Funds flow analysis of working capital: is the study of the sources of funds and their application in the business. The analysis shows how the funds in the business have been procured and how they have been employed. By the use of this method , changes in the working capital between the two dates can be very easily analysed by studying the changes in each type of current assets and current liabilities as well as the sources from which working capital has been obtained. 3)Budgeting analysis: The analysis is made by preparing working capital budget to compare the budgeted figures with those of actual performance. This analysis may be studied through scatter charts. The implications of working capital(research) WORKING CAPITAL MANAGEMENT Management of working capital means decision making regarding investment in current assets with an objective of maintaining the liquidity of the funds of the firm to meet its obligations. The management of working capital involves the following: Management of cash balances: Cash is the money which a firm can disburse immediately without any restriction. The term cash includes currency and cheques held by the firm and balances in its bank accounts. Sometimes near cash items, such as marketable securities or bank term deposits are also included in cash. Cash management is concerned with the managing of: cash flows into and out of the firm,cashflows within the firm,and cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Management of accounts receivables: The financial management in managing the receivables is concerned with maintaining the receivables at the optimum level and review the credit policy and procedures accordingly. Management of inventory: Theobjective of inventory management is to avoid overinvestment and underinvestment in inventories and to provide the right quantity of goods of right quality at proper time and at proper value. The management of current assets is as important as or rather more important than the management of fixed assets because the fate of most of the businesses very largely depends upon the manner in which their working capital is managed. Basically, the management of working capital encompasses the following: -To decide upon the optimal level of investment in various current assets i.e. determining the size of working capital. -To decide upon the optimal mix of short term funds in relation to long term capital. -To locate appropriate means of short term financing. NBWorking capital management is incomplete unless we have an overall look on the management of current liabilities. Determining appropriate levels of current assets and current liabilities involves fundamental decisions regarding firm’s liquidity and the composition of firm’s debts. Importance of working capital management The importance of working capital management can be viewed from the following facts: 1)There is a positive correlation between the sales and the current assets i.e. an increase in sale of the product requires a corresponding increase in current assets. It is therefore indispensable to manage the current assets properly and efficiently. 2) More than half of the total capital of the firm is generally invested in current assets hence the need for attention too. 3) Working capital needs are more often financed through outside sources, so it is necessary to utilize them in the best way possible. 4)Fixed assets can be acquired even on lease but current assets cannot so be acquired. 5) The operations of the firm are viewed as a total and not in segments. Hence an overall look is necessary. 6)It is more important for small units which do not have easy access to long term capital markets. DIFFERENT APPROACHES TO MANAGING WORKING CAPITAL 1) Hedging or matching approach The firm can adopt a financial plan which matches the expected life of assets with the expected life of the source raised to finance theassets. Thus, a ten year loan may be raised to finance a plant with an expected life of ten years; stock of goods to be sold in forty days may be financed with a forty day commercial paper or bank loan. Using long term financing for short term assets is expensive as funds will not be utilized for the full period. Similarly financing long term assets with short term financing is costly as well as inconvenient, as arrangements for the new short term financing will have to be made on a continuing basis. Thus, when the firm follows a hedging approach, long term financing will be used to finance fixed assets and permanent current assets and short term financing to finance temporary or variable assets. The following diagram illustrates the matching plan over time. The firm’s fixed assets and permanent current assets are financed with long term funds and as the level of these assets increases, the long term financing also increases. The temporary or variable current assets are financed with the short term funds and as their levels increases, the level of short term financing also increases. Under a matching plan, no short term financing will be used if the firm has a fixed current assets need only. However, it should be realized that exact matching is not possible because of the uncertainty about the expected lives of assets. Advantages Optimum Level of Funds (Liquidity): The funds remain on the balance sheet only till they are in use. As soon as they are not needed, they are paid. This is how the interest cost is optimized in this strategy. Interest is paid only for the amount and time for which money is used. There are no unutilized cash lying idle with the business. Savings on Interest Costs:When short term requirements are not funded with long term finances, the firm saves interest rate difference between long term and short term interest rates. No risk of refinancing and interest rate fluctuations during refinancing: Since the fundamental principal of finance is followed here i.e. long term asset to long term finance and short term assets to short term finance. Disadvantages of Matching Maturity Approach Difficult to implement: It is one of the best strategies or ideal strategy but it is very difficult to implement. Exactly matching maturity of assets with their source of finance is practically not possible. There is quite a lot of uncertainty on current asset’s side. One cannot exactly predict at what time, the debtor will pay or what time the sales will occur. Risks still persists: After adopting this strategy and planning everything in accordance with it, if the assets are not realized on time, it will not be possible to extend the loan due dates unreasonably. In that situation, the strategy moves either towards conservative or aggressive approach. Once that happens, the analytics and risks of those strategies will apply. The risks which are avoided with this strategy again come into play.  2) Conservative approach The financing policy of the firm is said to be conservative when it depends more on long term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long term financing. In the periods when the firm has no need for temporary current assets, the idle long term funds can be invested in the tradable securities to conserve liquidity. The conservative financing policy can be illustrated as follows: Note that when the firm has no temporary current assets e.g. at (a) and (b), the released long term funds can be invested in marketable securities to build up the liquidity position of the firm. The conservative plan relies heavily on long term financing and, therefore, the firm has less risk of facing the problem of shortage of funds. Advantages of Conservative Strategy of Working Capital Financing Smooth operations with no stoppages:In this strategy, the level of working capital and current assets (inventory, accounts receivables and most importantly liquid cash or bank balance) is high. Higher level of inventory absorbs the sudden spurt in product sales, production plans, any abnormal delay in procurement time etc. This achieves higher level of customer satisfaction and smooth operations of the company. Higher levels of accounts receivables are due to relaxed credit terms which in turn attracts more customer and thereby higher sales and higher sales means higher profits in normal circumstances. Insolvency Risk: Most important part and highly relevant to financing strategy is the higher levels of cash and working capital. Higher working capital avoids the risk of refinancing which exists in case it is financed by short term sources of finance. Not only the risk of refinancing but also the risk of adverse change in the interest rate while getting the short term loans renewed are avoided. This is how the insolvency risk is avoided as at any time company has sufficient capital to pay off any liability. Disadvantages of Conservative Strategy of Working Capital Financing Higher Interest Cost: This strategy employs long term sources of finance and hence there are all the chances that the rate of interest will be high. The theory of term premium says that the long term funds have higher interest rate compared to short term funds as risk perception and uncertainty is high in case of longer terms. Idle Funds: Long term loans cannot be paid off when wished and if paid cannot be easily availed back. As we noted in the diagram, the long term funds remain unutilized in the times when seasonal spurt in activity is not there. Idle funds have opportunity cost of interest attached to it. Higher Carrying Cost: Higher level of inventory and debtors implies higher carrying and holding cost which has direct impact on profitability. Inefficient Working Capital Management: If the margins of the firm are low for a particular year, a reasonable part of it will be attributed to working capital management. In such a situation, conservative approach of financing may be called with other name of ‘inefficient working capital management’.  3) Aggressive approach An aggressive approach is said to be followed by the firm when it uses more short term financing than warranted by the matching plan. Under an aggressive policy, the firm finances a part of its permanent current assets with short term financing. Some extremely aggressive firms may even finance a part of their fixed assets with short term financing. The relatively large use of short term financing makes the firm more risky. The aggressive financing is illustrated below: Advantages of Aggressive Approach Advantages of Aggressive Approach Lower Financing Cost, High Profitability: In this strategy, the cost of interest is low because of the maximum usage of short term finances. There are two reasons of this. Firstly, the rate of interest is cheaper and secondly, in the off seasons, the loan can be repaid and hence, no idle funds. Highly Efficient Working Capital Management: The task of working capital manager is to smoothly run the operating cycle of the company with lowest level of working capital. Precisely, that is what this strategy is all about. Disadvantages of Aggressive approach Insolvency Risk: This strategy faces high level of insolvency risk because the permanent assets are financed by the short term financing sources. To maintain those permanent assets, the firm would need repeated refinancing and renewals. It is not necessary that all the time the refinancing is smooth. For any reason, if the financial institution rejects the renewal, the firm will not be in a position to maintain those permanent assets and will have to forcibly sell them. If failed in realizing those assets, the option left is liquidation. Liquidating the permanent working capital is very difficult as it consists of accounts receivables and inventory. Lost Opportunities and Unexpected Shocks: Since, there are no cushions or margin in this strategy of financing, sudden big contracts of sales are not possible to execute. On the other hand, if there are other uncertainties like delay in abnormal raw material acquisition, machinery break downs etc, the firm will disturb the business operating cycle and therefore will face sustainability problems. 7 | Page