Working capital management

Decisions relating to working capital and short term

financing are referred to as working capital management. These involve
managing the relationship between a firm's short-term assets and its short-
term liabilities. The goal of working capital management is to ensure that the
firm is able to continue its operations and that it has sufficient cash flow to
satisfy both maturing short-term debt and upcoming operational expenses.

Decision criteria

By definition, working capital management entails short term decisions -

generally, relating to the next one year periods - which are "reversible".
These decisions are therefore not taken on the same basis as Capital
Investment Decisions (NPV or related, as above) rather they will be based on
cash flows and / or profitability.

• One measure of cash flow is provided by the cash conversion cycle -

the net number of days from the outlay of cash for raw material to
receiving payment from the customer. As a management tool, this
metric makes explicit the inter-relatedness of decisions relating to
inventories, accounts receivable and payable, and cash. Because this
number effectively corresponds to the time that the firm's cash is tied
up in operations and unavailable for other activities, management
generally aims at a low net count.

• In this context, the most useful measure of profitability is Return on

capital (ROC). The result is shown as a percentage, determined by
dividing relevant income for the 12 months by capital employed;
Return on equity (ROE) shows this result for the firm's shareholders.
Firm value is enhanced when, and if, the return on capital, which
results from working capital management, exceeds the cost of capital,
which results from capital investment decisions as above. ROC
measures are therefore useful as a management tool, in that they link
short-term policy with long-term decision making. See Economic value
added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of policies

and techniques for the management of working capital. These policies aim at
managing the current assets (generally cash and cash equivalents,
inventories and debtors) and the short term financing, such that cash flows
and returns are acceptable.
 • Cash management. Identify the cash balance which allows for the
business to meet day to day expenses, but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows for
uninterrupted production but reduces the investment in raw materials -
and minimizes reordering costs - and hence increases cash flow.
Besides this, the lead times in production should be lowered to reduce
Work in Progress (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid over production - see Supply
chain management; Just In Time (JIT); Economic order quantity (EOQ);
Economic quantity
• Debtors management. Identify the appropriate credit policy, i.e. credit
terms which will attract customers, such that any impact on cash flows
and the cash conversion cycle will be offset by increased revenue and
hence Return on Capital (or vice versa); see Discounts and allowances.
• Short term financing. Identify the appropriate source of financing,
given the cash conversion cycle: the inventory is ideally financed by
credit granted by the supplier; however, it may be necessary to utilize
a bank loan (or overdraft), or to "convert debtors to cash" through
"factoring".

Concept of Working Capital

There are two definitions of working capital (1) Gross working capital (2) Net
working capital

Gross working capital refers to working capital as the total of current assets,
whereas the net working capital refers to working capital as excess of
current assets over current liabilities. In other words net working capital
refers to current assets financed by long term funds.

Accordingly,

Gross working capital = Total current assets

Net working capital = Current assets – Current liabilities

The net working capital position of the firm is an important consideration, as

this will determine the firm’s profitability and risk. Here the profitability
refers to profits after expenses and risk refers to the probability that a firm
will become technically insolvent where it will be unable to meet obligations
when they become due for payment.

A finance manager has to make an appropriate financing mix, which will limit
the risk and increase the profitability. Financing mix refers to the proportion
of current assets financed by current liabilities and long term funds.
There are two approaches which determine the financing mix (1) Aggressive
approach (2) Conservative approach.

According to aggressive approach the long term funds are used to finance
only the core or fixed portion of current assets (e.g., minimum level of
finished goods inventory, raw material etc) and the other portion i.e.
temporary and seasonal requirements are financed by short term funds. This
is of high risk and high profit financing mix.

According to conservative approach the total current assets are financed

from long term sources and short term sources are used only in emergency
situation i.e. when there is an unexpected cash outflow. This is of low-risk
and low-profit financing mix.

As we observed two methods of financing mix, one method is of high risk

high profit and other is of risk low profit. A finance manager has to trade off
between these two extremes.

Operating Cycle:

The objective of financial management is to maximize the shareholders

wealth. So it is needed to generate sufficient profits. The profits generated
depend mainly on sales volume. When the goods are being sold on credit as
is the normal practice of business firms today to cope with increased
competition the sale of goods cannot be converted into cash instantly
because of time lag between sales and realization of cash.

As there is a time lag between sales and realization of receivables there is a

need for sufficient working capital to deal with the problem which arises due
to lack of immediate realization of cash against goods sold. The operating
cycle is the length of time required for conversion of non-cash assets into
cash. This operating cycle refers to the time taken for the conversion of cash
into raw material, raw materials into work-in-progress, work-in-progress into
finished goods, finished into receivables into cash and this cycle repeats.

The operating cycle length differs from firm to firm. If a firm has lengthy
production process or a firm has liberal credit policy the length of operating
cycle will be more. On the other hand, if a firm does not extent credit or the
firm is not a manufacturing concern i.e. where cash will be converted into
inventory directly then the length of operating cycle will be reduced to a
greater extent.

The length of operating cycle can be calculated by calculating periods of raw

material storage, work in process, finished gods storage and debtors
collection period.
1. Raw materials storage period

= Average stock of raw materials and stores/ Average daily consumption of

raw material and stores
2. Work in process period

= Average work in process inventory /Average cost of production per day

3. Finished goods storage period

= Average finished goods inventory / Average cost of goods sold per day

4. Debtors collection period

= Average book debts / Average credit sales per day

Length of operating cycle = 1+2+ 3+4
–

Meaning of Operating Cycle

The average length of time between when a company purchases items

for inventory and when it receives payment for sale of the items. The
operating cycle is equal to the average age of inventories plus the average
collection period. A long operating cycle tends to reduce profitability by
increasing borrowing requirements and interest expense. Also called normal
operating cycle. See also cash conversion cycle.

The factors affecting the Composition of Working Capital are:-

1. Nature of Business

Different companies operating in different Industries have different Working

Capital requirements. A purely Trading Organization will basically have
finished goods Inventory, Accounts Receivable and Cash as Current Assets
and Accounts Payable as Current Liability.
On the other hand, Capital Goods manufacturing and Trading Companies will
have a high proportion of Current Assets in the form of inventory of Raw
Materials and Work-in-Progress.
Thus, the nature of Business is directly linked to the requirement of Working
Capital.

2. Nature of Raw Material Used

The nature of Raw Material used in the manufacture of finished goods greatly
influences the quantum of Raw Material Inventory. For example, if the raw
Material is an agricultural product whose availability is pronouncedly
seasonal in character, the proportion of Raw Material Inventory to Finished
Goods Inventory will be quite high.
Similarly companies using Imported Raw Materials with long lead time tend
to have a high proportion of Raw Material Inventory. In the case of Capital
Goods Manufacturing Company the demand for whose product is growing
over time, the tendency will be to have high Inventory of Raw Material and
Components.

3. Process Technology Used

In case the Raw Material has to go through several stages during the process
of production, the Work-in-Progress Inventory is likely to be much higher
than any other item of the Current Assets thereby increasing the need of
Working Capital.

4. Nature of Finished Goods

The nature of Finished Goods greatly affects the amount of finished goods
inventory. For example, if the finished goods have a short span of 'shelf-life'
as in the case of cigarettes the finished goods inventory will constitute a very
low percentage of current assets.
In the case of companies the demand for whose finished goods is seasonal in
nature, as in the case of fans, the inventory of finished goods will constitute
a high percentage of total current assets. This is mainly because from the
point of view of the fixed costs to be incurred by the company it would be
more economical to maintain an optimum level of production throughout the
year than by stepping up production operations during the busy season.

5. Degree of Competition in the Market

When the Degree of Competition in the market for finished goods in an

industry is high, then companies belonging to the Industry may have to
resort to an increased credit period to its customers, partially lowering credit
standards and similar other practices to push their products. These practices
are likely to result in a high proportion for Accounts Receivables thereby
increasing the need for Working Capital.
6. Growth and Expansion

As the company grows, it is logical to expect that a larger amount of working

capital is required. It is, of course, difficult to determine precisely the
relationship between the growth in volume of business of a company and the
increase in the working capital. The composition of working capital also shifts
with economic circumstances and corporate practices. Other things being
equal, growth Industries require more working capital than those that are
static. The Critical fact however, is that the need for increased working
capital funds does not follow the growth in business activities but precedes
it. Advance planning of working capital, is therefore a continuing necessity
for a growing concern.

Impact of Inflation on working Capital

When the inflation rate is high,it will have its direct impact on the
requirement of working capital as explained below :
1 Inflation will cause to show the turnover figure at higher level
even if there is no icrease in the quantity of sales.The higher the sales
means the higher levels of balances in receivables.
2 Inflation will results in increase of raw material prices and hike
in payment for expenses and as a result,increase in balances of trade
creditors and crediters for expenses.
3 Increase in valuation of closing stocks result in showing higher
profits but without its realization into cash caushing the firm to pay higher
tax,dividends and bonus.This will lead the firm in serious problems of funds
shortage and firm may unable to meet its short term and long term
obligation.
4 Increase in investments in current assets means the increase
in requirement of working capital without corresponding increase in sales or
profitability of the firm.
5 Keeping in assessment of working capital requiremnt and its
management.Unless proper planning is done,the business is likely to face
condition known as technical insolvenct.

Strategies for Financing Working Capital

 Working capital is an indicator of a company's financial health in
the short-term. It is the difference between current assets--cash, accounts
receivable and inventory--and current liabilities. Working capital
demonstrates to investors the firm's ability to meet current financial
obligations with current assets. Organizations may be profitable but still
show negative working-capital measures, since customers do not pay
immediately after receiving orders: credit terms could vary between 30 days
and 120 days.

Accounts Receivable Selling

 Organizations may meet working capital needs by selling their accounts
receivable--the amounts owed by customers--to financial institutions or
investors. They usually sell such accounts receivable at a discount. In other
words, amounts received from buyers are lower than accounts receivable
face values. This type of financing allows firms to receive cash immediately
and also removes the financial risk of customer non-payment or default. For
instance, if Company A has $1 million in accounts receivable due in three
months, it may opt to sell such receivables for $950,000 to a bank--a
$50,000 discount.

Credit with suppliers

 Organizations also may finance working-capital requirements by asking
for credit extensions on orders. Suppliers ship goods to such organizations
and are paid beyond regular credit terms. This type of financing is based on
transaction history, customer importance in suppliers' client rosters, and
credit availability in financial markets. For example, Company B might ask its
suppliers to ship $1 million worth of goods to be paid in six months. It can
then sell finish products made from those goods at $1.5 million to customers
on two-month credit terms.

Equity issuance
 Organizations listed in securities exchanges may issue equity shares--or
stocks--to investors. This type of financing is conducted through corporate
finance departments and investment banks. Entities not listed in stock
exchanges also may conduct private share placements to institutional
investors such as asset managers, hedge funds and pension funds.

Debt issuance
 Organizations also may issue debt securities to raise financing for
working capital. They may sell bonds--which are long-term financing tools, or
short-term instruments such as commercial paper, which are unsecured
promissory notes due in 270 days or less. "Unsecured" means that borrowers
have not pledged collateral--or assets--before receiving loan proceeds.
Entities also may borrow directly from banks by applying for loans, lines of
credit or overdraft agreements.

Hybrid Financing
 Corporate finance specialists also may help firms issue convertible bonds
or preferred shares. This type of financing is referred to as hybrid financing,
and such instruments are known as quasi-debt because they hold equity and
debt features. Convertible bondholders receive periodic interest payments
similarly to regular bondholders. Preferred shareholders are paid periodic
dividends and make profits when share prices increase.