Module 2 – WORKING CAPITAL MANAGEMENT AND CASH MANAGEMENT

1. What is Working Capital?

2. Objectives of Working Capital Management
3. Analysing Working Capital & Working Capital Strategies
4. Cash Management

1. What is Working Capital?

Working capital refers to the capital or cash reserves of a business that is utilized to conduct its day-to-
day operations.

Working capital is calculated as: Current Assets – Current Liabilities

Current Assets are those assets that are intended to be converted to cash by the business within one
year:

1) Inventories
2) Trade Receivables
3) Cash and Bank Balances
4) Short term investments/Marketable Securities

Current Liabilities are those liabilities that are expected to be paid off within one year:

1) Trade Payables
2) Outstanding expenses
3) Short-term loans and advances/ bank overdraft

Positive working capital is considered to be good and indicates that the company can pay off its short-
term obligations immediately. Negative working capital can cause companies to fail, even though they
may be profitable, because companies do not have enough current assets to even settle their current
liabilities. However, even within the elements of working capital, it is important to analyse each
component in detail.

Therefore, proper management of working capital is essential for a firm to be able to survive and
prosper.

2. Objectives of Working Capital Management

The goal of working capital management is to manage the firm’s current assets and liabilities in such a
way that a satisfactory level of working capital is maintained. If the firm cannot maintain a satisfactory
level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. In this
process, the business must also ensure that its working capital management results in liquidity and
profitability – that is to ensure that a company has sufficient liquid resources to continue in business
(liquidity) and to increase its profitability.
Every business needs adequate liquid resources to maintain day-to-day cash flow such as wages and
payments to suppliers. Liquidity can be maintained such that the amounts of cash tied up in inventory
and receivables is not excessive.

However, cutting down inventory and receivables too much (adopting an aggressive approach to
working capital management to ensure cash is not unnecessarily tied up in inventory and receivables),
could also lead to trading problems, such as stock-outs and loss of customers, which would result in
lower profits.

Therefore, the key to effective working capital management is to find a good balance between the
liquidity and profitability objectives.

3. Analysing Working Capital & Working Capital Strategies

Working Capital can be analysed using either its absolute values or with the help of ratios:

3.1 The Working Capital Mix

Look at the mix of items making up Current Assets and Current Liabilities – refer note in copybook.

3.2 Liquidity and Efficiency Ratios

• Current ratio

This measures the adequacy of current assets to meet current liabilities as they fall due.

Current Ratio = Current Assets (measured in ‘times’ or ‘x’)

Current Liabilities

• Quick ratio/Acid-test ratio

This is a more strict analysis of liquidity by eliminating inventory (the least liquid asset) from the
current assets used in the calculation. It looks at whether the business has sufficient liquid current
assets (excluding inventory – i.e. cash and receivables) to meet its short-term obligations.

Quick Ratio = Current Assets- Closing Inventory

Current Liabilities

• Inventory days/Inventory holding period

This looks at how long (days) the inventory remains in the business before being sold.

Inventory-holding period (days) = Inventory x 365

Cost of sales
• Receivables Days/Receivables collection period

This shows on average, how many days it takes to collect cash from credit customers.

Receivable days = Receivables x 365

Sales

• Payables Days/ Payables payment period

This is the number of days the business takes to settle its trade creditors/payables.

Payables payment period (days) = Payables x 365

Purchases or Cost of Sales

*If purchases is n/a, use COST OF SALES

E.g. 1 – Using the financial statements of NIKE, analyse the liquidity position of the company for the
most recent two years.
E.g. 2

E.g. 3
From the following accounts, calculate the working capital and the working capital ratios for both years.
Comment on your findings.
E.g. 4
Analyse the working capital management of Walmart from its most recent financial statement extracts:
3.3 Working Capital Management Strategies – refer note in copy book

4. Cash Management

Cash refers to the physical money a business has in notes and coins, along with any money it has in the
bank. The management of cash is very important as cash allows a business to pay its bills. Cash is the
lifeblood of a business, and a business needs to generate enough cash from its activities so that it can
meet its expenses and have enough left over to repay investors and grow the business. Cash
management encompasses how a company manages its operations or business activities, financial
investments, and financing activities.

4.1 Objectives of Cash and Cash Management

There are two main objectives of cash management:

i. Meeting payments - A basic objective of cash management is to meet the payment schedule, that is,
to have sufficient cash to meet the cash disbursement needs of a firm. Holding adequate cash to meet
the firm’s requirements helps prevent bankruptcy/insolvency, helps to foster good relationships with
lenders and suppliers, can lead to a strong credit rating, can help the firm take advantage of
unforeseen opportunities/meet unexpected demands .

ii. Maintain adequate cash balances – This refers to not holding too much cash or too little cash. A high
level of cash balances implies that large funds will remain idle. A low level of cash balances, on the other
hand, may mean failure to meet the payment schedule. The aim of cash management, therefore, should
be to have an optimal amount of cash balances.
6.2 Motives for Holding Cash

There are four primary motives for maintaining cash balances: (i) Transaction motive; (ii) Precautionary
motive; (iii) Speculative motive; and (iv) Compensating motive

Transaction motive: This refers to the holding of cash to meet routine cash requirements to finance the
transactions which a firm carries on in the ordinary course of business. A firm enters into a variety of
transactions to accomplish its objectives which have to be paid for in the form of cash. These receipts
and payments constitute a continuous two-way flow of cash but these do not always perfectly match.
The requirement of cash balances to meet routine cash needs is known as the transaction motive and
such motive refers to the holding of cash to meet anticipated obligations whose timing is not perfectly
synchronised with cash receipts.

Precautionary Motive: At times, a firm may have to pay cash for purposes which cannot be predicted or
anticipated. The unexpected cash needs at short notice may be the result of: Floods, strikes and failure
of important customers; Bills may be presented for settlement earlier than expected; Unexpected slow
down in collection of accounts receivable; Cancellation of some order for goods as the customer is not
satisfied; and Sharp increase in cost of raw materials. The cash balances held in reserve for such random
and unforeseen fluctuations in cash flows are called as precautionary balances.

Speculative motive: is a motive for holding cash/ near-cash to quickly take advantage of opportunities
typically outside the normal course of business. The speculative motive helps to take advantage of: An
opportunity to purchase raw materials at a reduced price on payment of immediate cash; A chance to
speculate on interest rate movements by buying securities when interest rates are expected to decline;
Delay purchases of raw materials on the anticipation of decline in prices; and Make purchase at
favourable prices.

Compensating Motive: Banks provide a variety of services to business firms, such as clearance of
cheque, supply of credit information, transfer of funds, and so on. While for some of these services
banks charge a commission or fee, for others they seek indirect compensation. Usually clients are
required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilised by
the firms for transaction purposes, the banks themselves can use the amount to earn a return. Such
balances are compensating balances.

6.3 Factors Determining Cash Needs

• Nature of the business

• Seasonality of Operations
• Production Policy
• Market Conditions
• Supply Conditions
• Amount of Obligations Due
• Collection Policy with Receivables
• Expansion Plans
6.4 Cash Management: Basic Strategies.

Cash management strategies are intended to minimise the operating cash balance requirement. The
basic strategies that can be employed to do the needful are as follows:

(a) Stretching Accounts Payable - One basic strategy of efficient cash management is to stretch the
accounts payable. In other words, a firm should pay its accounts payable as late as possible without
damaging its credit standing. It should, however, take advantage of the cash discount available on
prompt payment.

(b) Efficient Inventory-Production Management - Another strategy is to increase the inventory turnover,
whilst avoiding stock-outs, and maintain sufficient inventory levels.

(c) Speedy Collection of Accounts Receivable - Yet another strategy for efficient cash management is to
collect accounts receivable as quickly as possible without losing future sales because of high-pressure
collection techniques. The average collection period of receivables can be reduced by changes in (i)
credit terms, (ii) credit standards, and (iii) collection policies.