1 .Chapter Introduction
2 .Meaning, Need & Types of Working Capital
3. Inadequacy of Working Capital
4. Determinants of Working Capital
5. Efficiency Criteria
1 .Chapter Introduction:
To operate profitably, every organization requires effective financial management. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets, diversification and expansion of business, renovation or modernization of plant and machinery, and research & development. Funds are also required for short-term purposes, that is, for current operations of the business. For example, payment of wages, meeting routine expenses, etc.
Working capital refers to a firm's investment in short-term assets, viz. Cash, short-term securities, debtors, inventory, etc. In other words, Working capital is the investment needed for carrying out day to day operations of the business. The management of working capital is equally important as the management of long-term financial investment.
2 .Meaning, Need & Types of Working Capital:
Q. Write a short note on Working Capital (June 99)
Working Capital refers to investment in current assets. This is also known as gross concept of working capital. There is another concept of working capital known as net working capital. Net working capital is the difference between current assets and current liabilities.
Working Capital = Current Assets – Current Liabilities
Net working capital is a qualitative concept, which indicates the liquidity position of the firm, and the extent to which working capital needs may be financed by permanent sources of funds. In other words we can say total current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operation cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also not goods for the business. Therefore it is necessary for the management to take a prompt and timely action to improve the imbalance of the liquidity of the business.
Working Capital refers to investment in current assets. This is also known as gross concept of working capital. There is another concept of working capital known as net working capital. Net working capital is the difference between current assets and current liabilities.
Working Capital = Current Assets – Current Liabilities
Net working capital is a qualitative concept, which indicates the liquidity position of the firm, and the extent to which working capital needs may be financed by permanent sources of funds. In other words we can say total current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operation cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also not goods for the business. Therefore it is necessary for the management to take a prompt and timely action to improve the imbalance of the liquidity of the business.
Kinds of Working Capital
Ordinarily, working capital is classified into two categories:
- Fixed or Permanent Working Capital; and
- Fluctuating or Variable Working Capital.
The need for current assets is associated with the operating cycle which, as we know is a continuous process. As such, the need for current assets is felt constantly. The magnitude of investment in current assets however may not always be the same. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Nevertheless, there is always a certain minimum level of current assets, which is essential for the firm to carryon, its business irrespective of the level of operations. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. This minimum level of investment in current assets is permanently locked up in business and is therefore referred to as permanent or fixed or regular working capital. It is permanent in the same way as investment in the firm's fixed assets is.
Fluctuating Working Capital
Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate. The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in the price level may lead to an increase in the amount of funds invested in stock of raw materials as well as finished goods. Additional doses of working capital may be required to face cut throat competition in the market or other contingencies like strikes and lockouts. Any special advertising campaigns organized for increasing sales or other promotional activities may have to be financed by additional working capital. The extra working capital needed to support the changing business activities is called the fluctuating (variable, seasonal, temporary or special working capital.
Importance of Working Capital Management
Because of its close relationship with day to day operations of a business, a study of working capital and its management is of major importance to internal, as well as external analysts. It is being increasingly realised that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not lose sight of the fact that management of working capital is an integral part of the overall financial management and, ultimately, of the overall corporate management. Working capital management thus throws a challenge and should be a welcome opportunity for a financial manager who is ready to playa pivotal role in his organisation.
Neglect of management of working capital may result in technical insolvency and even liquidation of a business unit. With receivables and inventories tending to grow and with increasing 'demand for bank credit in the wake of strict regulation of credit in India by the Central Bank, managers need to develop a long-term perspective for managing working capital. Inefficient working capital management may cause either inadequate or excessive working capital, which is dangerous.
A firm may have to face the following adverse consequences from inadequate working capital:
- Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds.
- Implementation of operating plans may become difficult and consequently the firm's profit goals may not be achieved.
- Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments.
- Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering the rate of return on investments in the process.
- Attractive credit opportunities may have to be lost due to paucity of working capital.
- The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm is likely to face tight credit terms.
On the other hand, excessive working capital may pose the following dangers:
- Excess of working capital may result in unnecessary accumulation of inventories increasing the chances of inventory mishandling, waste, and theft.
- It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables causing a higher incidence of bad debts has an adverse effect on profits.
- Excessive working capital may make management complacent, leading eventually to managerial inefficiency.
- It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal dividend policy, which becomes difficult to maintain when the firm is unable to make speculative profits.
3. Inadequacy of Working Capital:
Q. What would be the adverse consequences of inadequate working capital. (Dec. 01)
In fact inadequacy or mismanagement of working capital is the leading course of business failures. So its necessary to have an effective financial management.
A firm may have to face the following adverse consequences from inadequate working capital:
- Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds.
- Implementation of operating plans may become difficult and consequently the firm's profit goals may not be achieved.
- Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments.
- Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering the rate of return on investments in the process.
- Attractive credit opportunities may have to be lost due to paucity of working capital.
- The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm is likely to face tight credit terms.
- Post Payment: When there exists lesser working capital in the organization it cannot pay cash on due dates.
4. Determinants of Working Capital:
Q. What are the factors that a finance manager would take into consideration while determining the working capital requirements of his firm? (June 01, June 03)
The working capital requirements of a corporate differ from company to company. There are no rules or formulas to determine the working capital requirements of a firm. The management has to consider a number of factors to determine the level of working capital. The following are some important factors:
Nature & Size of Business
The working capital of a firm basically depends upon the nature of its business. Trading & financial firms generally have low investment in fixed assets, but require a large investment in working capital. In contrary to this, public utilities have limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products.
The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale operations will need more working capital than a small firm.
Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories.
Seasonal Variation
Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially the temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firm's investment in inventory and receivables or book debts & vice versa.
Production Policy
If a firm follows steady production policy, even when demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs & risks. Firms whose physical facilities can be utilized for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season and other products during off-season. Thus, production policies may differ from firm to firm. Accordingly, the need for working capital will also vary.
Turnover of Circulating Capital
The speed with which the operating cycle completes its round plays a decisive role in influencing the working capital needs.
Credit Policy
The credit policy of the firm affects the size of working capital by influencing the level of book debts. A long collection period will generally mean tying of larger funds in book debts.
Growth & Expansion Activities
The working capital need increases with the growth & expansion of a company. Although, is difficult to determine the relationship between the growth in the volume of business & the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, one can retain profits in business for providing working capital, fast growing need more working capital.
Operating Efficiency
Operating efficiency means optimum utilization of resources. The firm can minimize its need for working capital by efficiently controlling its operating costs.
Price Level Changes
Generally, rising prices requires a higher investment in working capital. With increasing prices the same levels of current assets need enhanced investment. The effects of increasing price level may, however, be felt differently by differently firms due to variations in individual prices. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit.
Other Factors
Some other factors like management ability, import policy, asset structure, banking facilities, etc., also influence the requirements of working capital.
5. Efficiency Criteria:
Q. How would you judge the efficiency of the management of working capital in a business enterprise? Explain with the help of hypothetical data. How can computers help? (June 99)
Working capital refers to a firm's investment in short term assets, viz. Cash, short-term securities, inventories, accounts receivables, etc. Improved profitability of a firm, to a great extent, depends on its efficiency in managing working capital. Some of the parameters for judging the efficiency in managing working capital are:
- Whether there is enough assurance for the creditors about the ability of the company to meet its short-term commitments on time. Hence, a reliable index is whether a company can settle the bills on due dates. The finance department has to plan in advance to maintain sufficient liquidity to meet maturing liabilities.
- Whether maximum possible inventory turnover is achieved. The adverse effect of ineffective inventory management may not be offset even by the most efficient management of other components of working capital.
- Whether reasonable credit is extended to customers. This powerful instrument to promote sales should not be misused. The other side of the same coin is receiving credit. Both depend upon a company's strength as a seller and as a buyer.
- Whether adequate credit is obtained from suppliers. It depends upon the company's position in relation to its suppliers and the nature of supply market, i.e., whether there is a single supplier or a large number of suppliers. With coordination of efforts buyers can be in a position to negotiate competitive credit terms even if there is a single supplier and his ability to control the market. At times the supplier imposes the credit terms as 100% advance, i.e., negative trade credit.
- Whether there are adequate safeguards to ensure that neither overtrading nor undertrading takes place.
Current Ratio (CR)
CR = Current Assets/Current Liabilities
It indicates the ability of a company to manage the current affairs of business. It is useful to study the trend of working capital over a period of time.
Quick Ratio (QR)
QR = Liquid Assets/Current Liabilities
Where liquid assets include Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term Investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.
Current liabilities include Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Cash to Current Assets: If cash alone is a major item of current assets then it may be a good indicator of the profitability of the organization as cash by itself does not earn any profit, the proportion should usually be kept low.
Sales to Cash Ratio
Sales to Cash Ratio = Sales/Average cash balance during the period.
Cash should be turned over as many times as possible, in order to achieve maximum sales with minimum cash on hand.
Average Collection Period
(Debtors/Credit Sales) x 365
This ratio explains how many days of credit a company is allowing to its customers to settle their bills.
Average Payment Period
Average payment period = (Creditors/Credit purchases) x 365
It indicates how many days of credit is being enjoyed by the company from its suppliers.
Inventory Turnover Ratio (ITR)
ITR = Sales/Average Inventory
It shows how many times inventory has turned over to achieve the sales. Inventory should be maintained at a level which balances production facilities and sales needs.
Working Capital to Sales: It signifies that for any amount of sales a relative amount of working capital is needed. If any increase in sales is contemplated it has to be seen that working capital is adequate. Therefore, this ratio helps management in maintaining working capital, which is adequate for the planned growth in sales.
Working Capital to Net Worth
Working Capital/Net worth
This ratio shows the relationship between working capital and the funds belonging to the owners. If this ratio is not carefully watched, it may lead to overtrading & undertrading. Efficient working capital management should, therefore, avoid both overtrading and under trading.