June 8, 2015
Traditionally, investors, creditors and bankers have considered working capital as a critical element to watch, as important as the financial position portrayed in the balance sheet and the profitability shown in the income statement. Working capital is a measure of the company’s efficiency and short term financial health. It refers to that part of the company’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. It is a company’s surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources. Funds thus, invested in current assets keep revolving and are constantly converted into cash and this cash flow is again used in exchange for other current assets. That is why working capital is also known as revolving or circulating capital or short-term capital.
Illustration to calculate working capital:
Components of the balance sheet: (Rs)
Current portion- long term debt
Total current assets
Total current liabilities
WC = CA- CL
Net working capital is defined as the excess of current assets over current liabilities. Working capital mentioned in the balance sheet is an indication of the company’s current solvency in repaying its creditors. That is why when companies indicate shortage of working capital they in fact imply scarcity of cash resources.
• Nature of business: generally working capital is higher in manufacturing compared to service based organizations
• Volume of sales: higher the sale, higher the working capital required
• Seasonality: peak seasons for sales need more working capital
• Length of operating and cash cycle: longer the operating and cash cycle, more is the requirement of working capital
A) Matching or hedging approach: This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets.
Example: A fixed asset which is expected to provide cash flow for 5 years should be financed by approx 5 years long-term debts. Assuming the company needs to have additional inventories for 2 months, it will then seek short term 2 months bank credit to match it.
B) Conservative approach: it is conservative because the company prefers to have more cash on hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower return”.
C) Aggressive approach: The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.
Working capital can be categorized on basis of Concept (gross working capital and net working capital) and basis of time (Permanent/ fixed WC and temporary/variable WC). The two major components of Working Capital are Current Assets and Current Liabilities. One of the major aspects of an effective working capital management is to have regular analysis of the company’s currents assets and liabilities. This helps to take into account unforeseen events such as changes in the market conditions and competitor activities. Furthermore, steps taken to increase sales income and collecting accounts receivable also improves a company’s working capital.
For every business entity adequate amount of working capital is required to run the operations. It needs to be seen that there is neither excess nor shortage of working capital. Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the company operations. Inadequate working capital has its disadvantages where the company is not capable to pay off its short term liabilities in time, difficulty in exploring favorable market situations, day to day liquidity worsens and ROA and ROI fall sharply. On the other hand, one should keep in mind that excess of working capital also leads to wrong indications like idle funds, poor ROI, unnecessary purchase and accumulation of inventories over required level due to low rate of return on investments, all of which leads to fall in the market value of shares and credit worthiness of the company.
The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying-up funds in its working capital without earning any return on it. This is also one of the essential parameters to be recorded in working capital management.
Working Capital Management (WCM) refers to all the strategies adopted by the company to manage the relationship between its short term assets and short term liabilities with the objective to ensure that it continues with its operations and meet its debt obligations when they fall due. In other words, it refers to all aspects of administration of current assets and current liabilities. Efficient management of working capital is a fundamental part of the overall corporate strategy. The WC policies of different companies have an impact on the profitability, liquidity and structural health of the organization. Although investing in good long-term capital projects receives more emphasis than the day-to-day work associated with managing working capital, companies that do not handle this financial aspect (working capital) well will not attract the capital necessary to fund those highly visible ventures; in other words, you must get through the short run to get to the long run.
Often the interrelationships among the working capital components create real challenges for the financial managers. Inventory is purchased from suppliers, sale of which generates accounts receivable and collected in cash from customers to pay off those suppliers. Working capital has to be managed because the firm cannot always control how quickly the customers will buy, and once they have made purchases, exactly when they will pay. That is why; controlling the “cash-to-cash” cycle is paramount.
The different components of working capital management of any organization are:
• Cash and Cash equivalents
• Debtors / accounts receivables
• Creditors / accounts payable
One of the most important working capital components to be managed by all organizations is cash and cash equivalents. Cash management helps in determining the optimal size of the firm’s liquid asset balance. It indicates the appropriate types and amounts of short-term investments alongwith efficient ways of controlling collection and payout of cash. Good cash management implies the co-relation between maintaining adequate liquidity with minimum cash in bank. All companies strongly emphasize on cash management as it is the key to maintain the firm’s credit rating, minimize interest cost and avoid insolvency.
Inventories include raw material, WIP (work in progress) and finished goods. Where excessive stocks can place a heavy burden on the cash resources of a business, insufficient stocks can result in reduced sales, delays for customers etc. Inventory management involves the control of assets that are produced to be sold in the normal course of business.
o Regularly review the effectiveness of existing purchase and inventory systems
o Keep a track of stocks for all major items of inventory
o Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long
o Outsourcing should also be a part of the strategy where part of the production can be done through another manufacturer
o A close check needs to be kept on the security procedures as well
Receivables contribute to a significant portion of the current assets. For investments into receivables there are certain costs (opportunity cost and time value) that any company has to bear, alongwith the risk of bad debts associated to it. It is, therefore necessary to have a proper control and management of receivables which helps in taking sound investment decisions in debtors. Thereby, for effective receivables management one needs to have control of the credits and make sure clear credit practices are a part of the company policy, which is adopted by all others associated with the organization. One has to be vigilant enough when accepting new accounts, especially larger ones. Thereby, the principle lies in establishing appropriate credit limits for every customer and stick to them.
o Process and maintain records efficiently by regularly coordinating and communicating with credit managers’ and treasury in-charges
o Prepare performance measurement reports
o Control accuracy and security of accounts receivable records.
o Captive finance subsidiary can be used to centralize accounts receivable functions and provide financing for company’s sales
Creditors are a vital part of effective cash management and have to be managed carefully to enhance the cash position of the business. One has to keep in mind that purchasing initiates cash outflows and an undefined purchasing function can create liquidity problems for the company. The trade credit terms are to be defined by companies as they vary across industries and also among companies.
o Trade credit and the cost of alternative forms of short-term financing are to be defined
o The disbursement float which is the amount paid but not credited to the payers account needs to be controlled
o Inventory management system should be in place
o Appropriate methods need to be adopted for customer-to-business payment through e-commerce
o Company has to centralize the financial function with regards to the number, size and location of vendors
Every component of working capital (namely inventory, receivables and payables) has two dimensions TIME and MONEY, in managing working capital. By making the money move faster around the cycle, one can reduce the amount of money tied up. This helps the business generate more cash or it will need to borrow less money to fund its working capital. Consequently, it would either reduce the cost of interest or have free funds to support additional sales growth or investments of the company. Similarly, if one can negotiate on better terms with suppliers i.e. get an increased credit limit or longer credit; it will effectively create additional cash to help fund future sales.
Hence to conclude, Working capital in lay men terms can be compared to the blood vessels in any human body which makes the body function properly and thus make maximum utilization of the human or company assets.
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