The perfect world does not requires or concentrates about current assets or current liabilities because there would not be uncertainty, no transaction costs, information search costs, scheduling costs or production and technology constraints. The unit cost of production would not vary with the quantity produced. Capital, Labour and products markets shall be perfectly competitive and would reflect all available information. Thus in such an environment, there would be no advantage for investing in short term assets. Whereas, the world in which we live is not perfect. It is characterized by considerable amount of uncertainty regarding the demand, market price, quality and availability of own products and those of suppliers. There are transaction costs for purchasing or selling goods or securities. Information is costly to obtain and is not equally distributed. There are spreads between the borrowing and lending rates for investments and financing of equal risk. Similarly each organization is faced with its own limits on the production capacity and technology it can employ. There are fixed as well as variable costs associated with producing goods. In other words, the markets in which real firms operate are not perfectly competitive.
These real world facts introduce problems and require the necessity of working capital. The most important areas in the day to day management of the firm, is the management of working capital. Working capital management is the functional area of finance that covers all the current accounts of the firm. It is concerned with management of the level of individual current assets as well as the management of total working capital. Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
For example, an organization may be faced with an uncertainty regarding availability of sufficient quantity of crucial inputs in future at reasonable price. This may necessitate the holding of inventory ie., current assets. Similarly an organization may be faced with an uncertainty regarding the level of its future cash inflows and insufficient amount of cash may incur substantial costs. This may necessitate the holding of a reserve of short – term marketable securities, again a short term capital asset. The unpredictable and uncertain global market plays a vital role in working capital. Though the globalization of economy and free trading of products envisages the continuous availability of products but how much its cost effective and quality based varies concern to concerns.
Working capital refers to the funds invested in current assets, ie., investment in stocks, sundry debtors, cash and other current assets. Current assets are essential to use fixed assets profitably. The term current assets refers to those assets which in the ordinary course of business can be converted into cash within one year without undergoing diminish in value and without disrupting the operations of the firm. The current assets are cash, marketable securities, accounts receivable and inventory. Current liabilities are those which are to be paid within a year out of the current assets or earnings of the concern. The current liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses.
The financial manager plays a vital role in management of working capital. The financial management of any business organization involves the three following vital functions:
1. Management of Long Term Assets
2. Management of Long Term Capital
3. Management of Short Term Assets and Liabilities
In most of the organizations the first & second one which refers to Capital Budgeting and Capital Structure respectively will be maintained and cope up with organization growth. The third one which refers to Working Capital Management requires more skills for sustaining and steady growth rate for any organization.
The working capital management includes decisions
i. How much stock/inventory to be hold
ii. How much cash/bank balance should be maintained
iii. How much the firm should provide credit to its customers
iv. How much the firm should enjoy credit from its suppliers
v. What should be the composition of current assets
vi. What should be the composition of current liabilities
For eg., a machine cannot be used without raw material. The investment on the purchase of raw material is identified as working capital. It is obvious that a certain amount of funds is always tied up in a raw material inventories, work in progress, finished goods, consumable stores, sundry debtors and day to day cash requirements. However the businessman also enjoys credit facilities from his suppliers who may supply raw material on credit. Similarly, a businessman may not pay immediately for various expenses. For instance, the labourers are pain only periodically. Therefore, a certain amount of funds is automatically available to finance the current assets requirements. However, the requirements for current assets are usually greater than the amount of funds payable through current liabilities. The satisfactory level of working capital is the main object of working capital management. Any organization which fails to maintain satisfactory level of working capital may be forced to bankruptcy. The current assets should always be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Thus the interaction between current assets and current liabilities is the main aim of working capital management.
The basic objective of financial management is to maximize shareholders wealth. This objective can be achieved when the company earns sufficient profits. The amount of profits largely depends on the magnitude of sales. But, sales do not convert into cash instantly. There is time lag between the sale of goods and the receipt of cash. Working capital is required to purchase the materials, pay wages and other expenses in order to sustain sales activity the time lag. The time gap between the sale of goods and realization of cash is called operating cycle. What operating cycle stands for?
a. Conversion of cash into raw materials
b. Conversion of raw materials to finished goods
c. Conversion of finished goods into receivables
d. Conversion of receivables into cash
Where is Working Capital Analysis Most Critical?
On the one hand, working capital is always significant. This is especially true from the lender's or creditor's perspective, where the main concern is defensiveness: can the company meet its short-term obligations, such as paying vendor bills?
But from the perspective of equity valuation and the company's growth prospects, working capital is more critical to some businesses than to others. At the risk of oversimplifying, we could say that the models of these businesses are asset or capital intensive rather than service or people intensive. Examples of service intensive companies include H&R Block, which provides personal tax services, and Manpower, which provides employment services. In asset intensive sectors, firms such as telecom and pharmaceutical companies invest heavily in fixed assets for the long term, whereas others invest capital primarily to build and/or buy inventory. It is the latter type of business - the type that is capital intensive with a focus on inventory rather than fixed assets - that deserves the greatest attention when it comes to working capital analysis. These businesses tend to involve retail, consumer goods and technology hardware, especially if they are low-cost producers or distributors.
2. Concepts & Definitions of Working Capital
There are two concepts of working capital
1. Gross Working Capital : It represents the total current assets and is also referred to as circulating capital because current capital as current assets, are circulating in nature.
2. Net Working Capital : It is a measure of liquidity and it can be defined in two ways.
a. The most usually implied definition of net working capital is that it represents the difference between current assets and current liabilities. Some people also define it as excess of current assets over the current liabilities.
b. It is that portion of the firm’s current assets, which is financed by long term funds.
Nett working capital as a measure of liquidity is generally not very useful to compare the performance of different units due to difference in scales of operation, efficiency, and creditability in the market etc., between the different firms. However it is a very useful measure for internal control purposes. It can also be used to compare the liquidity position of the same unit over a period of time. This will help in maintaining the acceptable level of net working capital.
Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.
A few key performance ratios of a working capital management system are the working capital ratio, inventory turnover and the collection ratio. Ratio analysis will lead management to identify areas of focus such as inventory management, cash management, accounts receivable and payable management.
3. Objectives of Working Capital Management
The main objective is to ensure the maintenance of satisfactory level of working capital in such a way that it is neither inadequate nor excessive. It should not only be sufficient to cover the current liabilities but ensure a reasonable margin of safety also.
i. To minimize the amount of capital employed in financing the current assets. This also leads to an improvement in the “Return of Capital Employed”.
ii. To manage the current assets in such a way that the marginal return on investment in these assets is not less than the cost of capital acquired to finance them. This will ensure the maximization of the value of the business unit.
iii. To maintain the proper balance between the amount of current assets and the current liabilities in such a way that the firm is always able to meet its financial obligations, whenever due. This will ensure the smooth working of the unit without any production held ups due to paucity of funds.
4. Types of Working Capital
A. Permanent Working Capital
B. Temporary Working Capital
Permanent Working Capital:
The operating cycle is a continuous feature in almost all the going concerns and therefore creates the need for working capital and their efficient management. However the magnitude of working capital required will not be constant, but will fluctuate. At any time, there is always a minimum level of current assets which is constantly and continuously required by a business unit to carry on its operations. This minimum amount of current assets, which is required on a continuous and uninterrupted basis is after referred to as fixed or permanent working capital. This type of working capital should be financed (along with other fixed assets) out of long term funds of the unit. However in practice, a portion of these requirements also is met through short term borrowings from banks and suppliers credit.
For eg., In a manufacturing unit, basic raw materials required for production has to be available at all times and this has to be financed without any disturbance.
Temporary Working Capital
Any amount over and above the permanent level of working capital is variable, temporary or fluctuating working capital. This type of working capital is generally financed from short term sources of finance such as bank credit because this amount is not permanently required and is usually paid back during off season or after the contingency. As the name implies, the level of fluctuating working capital keeps on fluctuating depending on the needs of the unit unlike the permanent working capital which remains constant over a period of time.
5. Determinants of Working Capital
Working capital management is an indispensable functional area of management. However the total working capital requirements of the firm are influenced by the large number of factors. It may however be added that these factors affect differently to the different units and these keep varying from time to time. In general, the determinants of working capital which are common to all organizations can be summarized as under:
a. Nature and Size of Business
b. Production Cycle
c. Business Cycle
d. Production Policy
e. Credit Policy
f. Growth & Expansion
g. Proper availability of raw materials
h. Profit level
j. Operating Efficiency
6. Estimating of working capital requirements
The amount of the different constituents of the working capital such as debtors, cash, inventories, creditors, etc are estimated separately and the total amount of working capital requirement is worked out accordingly.
Percent Sales method is the most simple and widely used method in combination with other scientific methods. A ratio is determined for estimating the future working capital requirements. This is generally based on the past experience of the management as this ratio varies from industry to industry and unit to unit with in the same industry.
Operating Cycle method points towards the length of time considered necessary to complete the following cycle of events:
a. Purchase of raw materials by converting cash
b. Storage of raw materials including for buffer stock and safety margin
c. Conversion of raw materials into work in progress
d. Conversion of work in progress into finished goods
e. Conversion of finished goods into debtors and bills receivable
f. Conversion of debtors into cash
Cash Conversion Cycle is a measure of working capital efficiency, often giving valuable clues about the underlying health of a business. The cycle measures the average number of days that working capital is invested in the operating cycle. It starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO). This is because a company "invests" its cash to acquire/build inventory, but does not collect cash until the inventory is sold and the accounts receivable are finally collected.
The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity.
Speculation: Economist Keynes described this reason for holding cash as creating the ability for a firm to take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount that is greater than the carrying costs of holding the inventory.
Precaution: Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for.
Transaction: Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.
Receivable are essentially loans extended to customers that consume working capital; therefore, greater levels of DIO and DSO consume more working capital. However, days payable outstanding (DPO), which essentially represent loans from vendors to the company, are subtracted to help offset working capital needs. In summary, the cash conversion cycle is measured in days and equals DIO + DSO – DPO:
7. Sources of Working Capital
The working capital necessary and what constitutes working capital have been analyzed in depth. Now we look out what are the ways we can generate working capital.
a. Trade Credits
b. Bank Credit
c. Current provisions and non-bank short term borrowings: and
d. Long term sources ie., equity share capital, preference share capital and other long term borrowings.
Short term source of funds are generally available at comparatively lower costs but theoretically these funds can be called back any moment and therefore it is more appropriate to meet at least two thirds of the permanent working capital requirements from the long term sources. The advantages of long term sources is, it reduces risk as there is no need to repay the loans at frequent intervals and funds can be employed gainfully and it increases liquidity.
Traditional analysis of working capital is defensive; it asks, "Can the company meet its short-term cash obligations?" But working capital accounts also tell you about the operational efficiency of the company. The length of the cash conversion cycle (DSO+DIO-DPO) tells you how much working capital is tied up in ongoing operations. And trends in each of the days-outstanding numbers may foretell improvements or declines in the health of the business.
Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital. Thus the importance of adequate of working capital in commercial undertakings can never be over emphasized. The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over capitalization. Over Capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return a situation which implies a less than optimal use of resources. Insolvency risk is there in the case of under capitalization of working capital. Hence working capital management plays a pivotal role in growth or to sustain in market for any organization.