Chapter two

Overview of Working Capital Management

Learning Objectives:
After completing this chapter, you will be able to:
 Understand the concept of working capital
 Distinguish between permanent and temporary working capital
 Identify the components of working capital
 Understand the need and determinants of working capital
 Identify the three current asset financing strategies

2. Introduction
Every running business needs working capital. Even a business which is fully equipped with all
types of fixed assets required is bound to collapse without (i) adequate supply of raw materials
for processing; (ii) cash to pay for wages, power and other costs; (iii) creating a stock of finished
goods to feed the market demand regularly; and, (iv) the ability to grant credit to its customers.
All these require working capital. Working capital is thus like the lifeblood of a business. The
business will not be able to carry on day-to-day activities without the availability of adequate
working capital.
Since current assets typically earn a lower return than long-term fixed assets, an overly strong
liquidity position could lower firm profitability. An effective working capital policy carefully
balances the need to have sufficient liquidity with the need to earn an attractive return on
invested capital. Firms may adopt more aggressive working capital management policies that
have less of a drag on firm profitability, but at higher levels of risk.

Working capital management involves determining the firm’s policy for managing its working
capital, i.e., the firm’s current assets and current liabilities. The basic 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. It involves
managing the firm’s cash, marketable securities, receivables, inventories, accounts payable, and
other short-term payables. Gross working capital refers to the firm’s current assets used in

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operations, including such items as cash, marketable securities, accounts receivable, and
inventory. Net working capital refers to a firm’s current assets minus its current liabilities.
When managing working capital accounts, financial managers want to do the following:
 Delay paying accounts payable as long as possible without suffering any penalties.
 Maintain minimal raw material inventories without causing manufacturing delays.
 Use as little labor as possible to manufacture the product while producing a quality
product.
 Maintain minimal finished goods inventories without losing sales.
 Offer customers the most attractive credit terms possible on trade credit to maximize
sales while minimizing the risk of nonpayment.
 Collect cash payments on accounts receivable as fast as possible to close the loop.

2.1. The Concept of Working Capital

You can understand working capital in two different but interlinked senses. In the first sense,
working capital refers to gross working capital and in second sense it is understood in terms of
net working capital.
 Gross working capital (simply
( referred to as working capital). It refers to the firm’s
investment in current assets. Current assets are the assets, which can be converted into cash
within an accounting year or within an operating cycle. You can include here cash,
marketable securities, accounts receivable, and inventory.
 Net working capital. But the net working capital refers to the difference between current
assets and current liabilities. Current liabilities are those claims of outsider, which are
expected to mature for payment within an accounting year & include creditors, bills payable
& the outstanding expenses. In other words you can say that this is the excess of current
assets over current liabilities.
2.2. Components of Working Capital
Working capital consists of four main components: cash, marketable securities, inventory, and
accounts receivables. For each type of asset, firms face a fundamental trade-off: Current assets
(that is, working capital) are necessary to conduct business and the greater the holdings of
current assets, the smaller the danger of running out, hence the lower the firm’s operating risk.
However, holding working capital is costly-if inventories are too large, then the firm will have

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assets that earn a zero or even negative return if storage and spoilage costs are high. And, of
course, firms must acquire capital to buy assets such as inventory; this capital has a cost, and this
increase the downward drag from excessive inventories (or receivables or even cash). So there is
a pressure to hold the amount of working capital to the minimum consistent with running the
business without interruption.

2.3. Kinds of Working Capital

The operating cycle creates the need for current assets (working capital). However, the need does
not come to an end after the cycle is completed. It continues to exist. To explain this continuing
need of current assets, a distinction should be made between permanent and temporary working
capital.
Permanent working capital. This component represents the value of the current assets required
on a continuing basis over the entire year, and for several years. Permanent working capital is the
minimum amount of current assets, which is needed to conduct a business even during the dullest
season of the year. The minimum level of current assets is called permanent or fixed working
capital as this part is permanently blocked in current assets.
This amount varies from year to year, depending upon the growth of the company and the stage
of the business cycle in which it operates. It is the amount of funds required to produce the goods
DO LLAR AM O UNT

Permanent
Permanent
Working
Working Capital
Capital
The
The amount
amount ofof current
current assets
assets required
required to
to
meet
meet a firm’s
firm’s long-term
long-term minimum needs.
needs.

Permanent
Permanent current
current asset
asset s
s

TIME

and services, which are necessary to satisfy demand at a particular point of time. It represents the
current assets, which are required on a continuing basis over the entire year. It is maintained as
the medium as continue the operations at any time.

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Temporary working capital: Contrary to the above you will find that temporary working
capital represents a certain amount of fluctuations in the total current assets during a short period.
These fluctuations are increased or decreased and are generally cyclical in nature. Variable
working capital is the amount of additional current asset that are required to meet the seasonal
needs of a firm, so is also called as the seasonal working capital. For example: additional
inventory will be required for meeting the demand during the period of high sales When the peak
period is over variable working capital starts decreasing or very little during the normal period. It
is temporarily invested in current assets. Say for an example a shopkeeper invests more money
during winter season because he/ she require to keep more amount of stock of woolen cloths.
The same happens in a sugar factory how: the factory manager buys more quantity of sugarcane

Temporary
Working Capital
The amount of current assets that varies
DOLLAR AM OUNT

with seasonal requirements.

Temporary current assets

Permanent current assets

TIME
during the harvesting season and they continuously stops for some time.
an operating cycle involved in the conversion of sales into cash.

2.4. Determinants of Working Capital

A firm should plan its operations in such away that it should have neither too much nor too little
working capital. The total working capital requirement is determined by a variety of factors.
These factors, however, affect different enterprises differently. They also vary from time to time.
In general, the following factors are involved in a proper assessment of the quantum of working
capital required.

Nature of business. The working capital requirements of an enterprise are basically related to
the conduct of the business. Public utility undertakings like Electricity, Water supply, Railways,
etc. need very limited working capital because they offer cash sales only and supply services, not
products and as such no funds are ties up in inventories and receivables. But at the same time

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have to invest fewer amounts in fixed assets. The manufacturing concerns on the other hand
require sizable working capital along with fixed investments, as they have to build up the
inventories.

Terms of sales and purchases: Credit sales granted by the concerns to its customers as well as
credit terms granted by the suppliers also affect the working capital. If the credit terms of the
purchases are more favorable and at the same time those of sales less liberal, less cash will be
invested in the inventory. With more favorable credit terms, working capital requirements can be
reduced.

Manufacturing cycle: The length of manufacturing cycle influences the quantum of working
capital needed. Manufacturing process always involves a time lag between the time when raw
materials are fed into the production line and finished goods are finally turned out by it. The
length of the period of manufacture in turn depends on the nature of product as well as
production technology used by a concern. Shorter the manufacturing cycle; lesser the working
capital required.

Rapidity of turnover. If the inventory turnover is high, the working capital requirements will be
low. With a better inventory control, a firm is able to reduce its working capital requirements.
When a firm has to carry on a large slow moving stock, it needs a larger working capital as
against another whose turnover is rapid. A firm should determine the minimum level of stock,
which it will have to maintain throughout the period of its operation.

Business cycle. Cyclical changes in the economy also influence quantum of working capital. In a
period of boom i.e., when the business ism prosperous, there is s need of larger amount of
working capital due to increases in sales, rise in price etc and vice-a-versa during period of
depression.

Changes in technology. Changes in technology may lead to improvements in processing of raw

materials, savings in wastage, greater productivity, and more speedy production. All these
improvements may enable the firm to reduce investments in inventory.

Seasonal variation. The inventory of raw materials, spares and stores depends on the condition
of supply. If the supply is prompt and adequate the firm can manage with small inventory.

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However, if the supply were unpredictable and scant then the firm, to ensure the continuity of
production, would have to acquire stocks as and when they are available and carry larger
inventory on an average.
Market conditions. The degree of competition prevailing in the market place has an important
bearing on working capital needs. When competition is keen, a larger inventory of finished
goods is required to promptly serve customers who may not be inclined to wait because other
manufacturers are ready to meet their needs.
Seasonality of operation.
operation. The requirement of working capital fluctuates for seasonal business.
Firms, which have marked seasonality in their operations usually, have highly fluctuating
working requirements. The working capital needs of such businesses may increase considerably
during the busy season and decrease during the slack season. Ice creams and cold drinks have a
great demand during summers, while in winters the sales are negligible.
Dividend policy. It has a dominant influence on the working capital position of a firm. If the
firm is following a conservative dividend policy, the need for working capital can be met with
retained earnings.
The assessment of the working capital should be accurate even in the case of small and micro
enterprises where business operation is not very large. We know that working capital has a very
close relationship with day-to-day operations of a business. Negligence in proper assessment of
the working capital, therefore, can affect the day-to-day operations severely. It may lead to cash
crisis and ultimately to liquidation. An inaccurate assessment of the working capital may cause
either under-assessment or over-assessment of the working capital and both of them are
dangerous.

2.5. Approaches for Managing Working Capital

The nature of many businesses may cause seasonal variations in a firm’s current assets. Working
capital management approaches differ in terms of how the firm finances these seasonal variations
in current assets. Three common ways of dealing with such seasonal variations are the maturity-
matching, conservative, and aggressive approaches.
Maturity Matching Approach: Financing strategy that attempts to match the maturities of
assets with the maturities of the liabilities with which they are financed. By matching its
seasonal variations in current assets with current liabilities of the same maturity, the firm
essentially hedges against changes in short-term interest rates. Under the maturity -matching

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approach, all of the fixed assets and the permanent current assets are financed with long-term
debt and equity provided by the firm’s owner’s.

Aggressive Approach: All current assets, both temporary and permanent, are financed with
short-term financing. This approach relies more heavily on short-term financing than do the
other approaches. Only fixed assets are financed with long-term debt and equity funds. This
could result in liquidity problems if sales decline in the future.

Conservative Approach: Except for automatic or “spontaneous” financing provided by

accounts payable and accrued liabilities. All financing is done through long-term debt and
equity funds. This approach relies more heavily on long-term financing than do the other
approaches. At times, firms will have excess liquidity, when available funds exceed necessary
current asset levels. During this time the firm will have large cash balances and will probably
seek to invest the excess cash in marketable securities.

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How would an increase in short-term interest rates affect a firm under the conservative, maturity-
matching, and aggressive approaches to managing working capital?
 Under the maturity-matching approach,
approach, the firm has essentially hedged against unexpected
changes in short-term interest rates. If short-term interest rates increase, the increases in the
return earned on an equal amount of short-term current assets should offset the increased
cost of short-term funds.
 Under the aggressive approach,
approach, increases in short-term interest rates will require the firm to
refinance more current assets at the new higher rates. The firm could be in jeopardy of
being shutoff by suppliers.
 Under the conservative approach,
approach, the firm uses more long-term financing and less short-term
financing to finance current assets and is therefore less vulnerable to increases in short-
term rates than under the other approaches. If short-term interest rates rise, the firm has
fewer short-term sources that it will need to refinance at the higher rates.

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