7 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.

1 | March’2015

A GOAL PROGRAMMING MODEL FOR WORKING CAPITAL

MANAGEMENT

Mihir Dasha and Rani Hanumanb

"Alliance University, Bangalore, India"
"Vijaya Krishna Spice Farms, Bellary, India"

ABSTRACT: This paper proposes a goal programming model for working capital management.
Goal programming is necessary to model the working capital decision, as a balance has to be
achieved between the conflicting objectives of liquidity and profitability. The model determines, for
given working capital turnover and fixed assets turnover ratios, how funds should be maintained
between working capital/current assets and fixed assets to achieve targeted levels of liquidity and
profitability, whilst minimizing the opportunity cost/loss of excess liquidity.

Keywords: Goal programming, working capital, liquidity, profitability, trade-off.

INTRODUCTION
Proper planning is necessary for the efficient working of any organization. This can be in terms of
marketing, production/operations, human resource, and financial plans. There should be proper flow
of funds for running any business. This fund is called working capital. If at any point of time the
organization does not have sufficient funds to meet its short-term debts such as creditors and salaries
as well as day-to-day expenses it may become technically insolvent. On the other hand, if it is very
conservative it will have a surplus of working capital, which will adversely affect profits. The trade-
off between profitability and risk is the key to working capital management. Too little working
capital increases profit but reduces liquidity, as current assets are more expensive than fixed assets.
For instance if a management feels that worker training is a cost they will apportion less funds for it.
If on the other hand a management sees it as an investment in manpower, the funds allocated would
increase substantially. It is applicable in any case either for procurement, inventory, storage,
processing, distribution and human capital and other investment decisions1.

Businesses must continuously innovate and transform themselves to stay ahead of competition in this
fast growing world. An efficient working capital management system has to be designed to run the
business and make profits in the long run. As costs are ever-increasing, companies have to make
efficient use of funds in managing the procurement, inventory, processing and distribution of
finished product to the existing customers, and it is common in many business decision-making
situations that certain goals or objectives of the firm can only be met at the expense of other goals. If
it is not possible to quantify the exact cost-benefit trade-offs among these goals, it may be necessary
for decision makers to rank order the various goals so that the less important goals are pursued only
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8 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

after the more important goals are achieved or when no further progress toward goal achievement is
possible.
This paper formulates the working capital decision as a goal programming model, balancing the
conflicting objectives of liquidity and profitability. The model determines, for given working capital
turnover and fixed assets turnover ratios, how funds should be maintained between working
capital/current assets and fixed assets to achieve targeted levels of liquidity and profitability, whilst
minimizing the opportunity cost/loss of excess liquidity.
1. REVIEW OF LITERATURE
Goal programming techniques have been widely used in many diverse fields, including operations,
marketing, human resources, and finance. Aksoy (1990) presented a bibliography of multiple
objective decision-making models applied in various disciplines. He proposed that there was a trend
towards utilizing interactive techniques for solving the multiple objective decision making problem,
allowing the involvement of the decision-maker throughout the decision process.

A variety of goal programming models have been applied in the operations contexts, usually
interlinking operations, marketing, human resource, and financial decisions. Rifai (1996) discussed
the limitations of linear programming in decision-making, and suggested the use of goal to handle
problems with multiple objectives. He advocated caution in using the goal programming, since an
improper structure of a goal programming model can induce misleading results.

Schniederjans and Hoffman (1999) proposed a goal programming model for downsizing in order to
cut operation costs, based on a thorough analysis of the firm’s prioritized opportunities and their
limited economic resources to achieve them. They provided a new methodological approach that can
be used to determine previously hidden goals in a manufacturing linear programming model of the
downsizing problem. Their model illustrated how an optimal allocation of production resources can
be achieved while providing useful information in which to ensure other prioritized goals and their
economic tradeoffs.

Coskun et al (2008) studied integrative methods for improving business processes. Their approach
involved determining and analyzing the weak points and reducing the weakness degrees. They
suggested a four-phase business process improvement framework: start-up, self analysis, defining
improvement strategy for making changes, feedback, and continuous improvement. They found that
decision problems in process improvement could be structured to provide input data suitable for
multi-criteria decision making techniques.

Lee and Kang (2008) developed a model for inventory management for multiple periods, considering
not only the usual parameters, but also price/ quantity discounts, and storage and batch size
constraints. The model is formulated as a mixed binary integer programming problem minimizing
the total cost of materials in the system, and the optimal solution determines an appropriate inventory
level for each period and the optimal purchase amount in each period.

Several studies have addressed the problem of working capital, and have developed a variety of
models to assess the efficiency of working capital management. Rafuse (1996) argued that attempts
9 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

to improve working capital by delaying payment to creditors are counter-productive, and that altering
debtor and creditor levels for individual tiers within a value system will rarely produce any net
benefit. He proposed that stock reduction generates system-wide financial improvements and other
important benefits, and suggested that, to achieve this, companies should focus on stock management
strategies based on ―lean supply-chain‖ techniques.

Cote and Latham (1999) explored the limitations of the traditional measures of working capital
management and presented alternative measures based on earlier work in the finance literature. They
also proposed a new ratio, the ―merchandising ratio,‖ which measured the net effect of a firm's
working capital management strategy.

Filbeck et al (2005) suggested that firms should be able to reduce financing costs and/or increase the
funds available for expansion by minimizing the amount of funds tied up in current assets. They
found significant differences in working capital measures between industries across time, and
significant changes in these working capital measures within industries across time.

Garcia-Teruel and Martinez-Solano (2007) studied the effects of working capital management on the
profitability of a sample of small and medium-sized Spanish firms. They found that managers can
create value by reducing their inventories and the number of days for which their accounts are
outstanding. Moreover, shortening the cash conversion cycle also improves the firm's profitability.

Chakraborty (2008) evaluated the relationship between working capital and profitability of Indian
pharmaceutical companies. He pointed out that there were two distinct schools of thought on this
issue: according to one school of thought, working capital is not a factor of improving profitability
and there may be a negative relationship between them, while according to the other school of
thought, investment in working capital plays a vital role to improve corporate profitability, and
unless there is a minimum level of investment of working capital, output and sales cannot be
maintained - in fact, the inadequacy of working capital would keep fixed asset inoperative.

Singh (2008) found that the size of inventory directly affects working capital and its management.
He suggested that inventory was the major component of working capital, and needed to be carefully
controlled.

Agarwal (1988) formulated the working capital decision as a goal programming problem, giving
primary importance to liquidity, by targeting the current ratio and quick ratio. The model included
three liquidity goals/constraints, two profitability goals/constraints, and, at a lower priority level, four
current asset sub-goals and a current liability sub-goal (for each component of working capital). In
particular, the profitability constraints were designed to capture the opportunity cost of excess
liquidity (in terms of reduced profitability).

The literature of goal programming in operational/financial decisions is quite extensive, though only
a few studies have directly focused on working capital decisions. Agarwal’s (1988) study was a step
10 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

forward, but no further refinements to his model have been proposed. This paper proposes certain
modifications in Agarwal’s (1988) model.

2. LIQUIDITY-PROFITABILITY TRADE-OFF MODEL:

The goal programming model proposed in this paper examines the trade-off between liquidity and
profitability. Goal programming is appropriate because liquidity and profitability represent
conflicting objectives of a firm.

The decision variables for the model are the usual components of working capital, viz. cash,
marketable securities, accounts receivable, inventory, current liabilities, fixed assets, sales, and
profit. Each of these variables is assumed to have well-defined target levels. Additionally, the current
ratio, profit margin, working capital turnover ratio, and fixed assets turnover ratio are assumed to
have stable target levels. These variables and targets are represented in Table 1.

Table 1: variables and target parameters

Variable Target
Cash x1 C
Marketable Securities x2 MS
Accounts Receivable x3 AR
Inventory x4 I
Current Liabilities x5 CL
Fixed Assets x f FA
Sales y S
Profit  P
Current Ratio 

Profit Margin m
Working Capital Turnover Ratio 

Fixed Assets Turnover Ratio 

Highest priority is given to maintaining liquidity, turnover, and profitability, built into the model via
the current ratio, the working capital and fixed assets turnover ratios, and the profit margin, followed
by the targeted levels of each of the variables. The different priority coefficients (Pi) assigned to each
of the different goals are represented in Table 2.
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Table 2: priority levels assigned to constraints

Constraints Priority Deviation Variables
 
Liquidity P1 d1
, d1

 
Working Capital Turnover P2 d2
, d2

 
Fixed Assets Turnover P3 d3
,
d 3

 
Profit Margin P4 d4
, d 4

 
Opportunity Cost P5 d5
,
d5

 
Cash P6 d6
,
d6

 
Marketable Securities P7 d 7
,
d 7

 
Accounts Receivable P8 d8 d8
,
 
Inventory P9 d9
,
d9

 
Current Liabilities P10 d 10
,
d 10

 
Fixed Assets P11 d 11
, d 11

 
Sales P12 d 12
, d 12

 
Profit P13 d 13
,
d 13

The goal programming formulation for the problem is given below:

13


 
min w  Pj (d j
 d j
)
j 1
,
subject to the constraints:
(1) Total assets: x 1  x 2  x 3  x 4  x 5  x f  C  MS  AR  I  CL  FA

(2) Liquidity: 
x 1  x 2  x 3  x 4  d 1  d 1   .CL


 
(3) Working Capital Turnover: y  w ( x1  x 2  x 3  x 4  x 5 )  d 2  d 2  0
 
(4) Fixed Assets Turnover: y  x f  d 3  d 3  0

(5) Profit margin:  

  my  d 4  d 4  0
 
(6) Opportunity cost:   m  [ x1  x 2  x 3  x 4  x 5  y / w ]  d 5  d 5  P

(7) Cash: 
x1  d 6  d 6  C


(8) Marketable securities:  

x 2  d 7  d 7  MS
 
(9) Accounts receivable: x 3  d 8  d 8  AR
 
(10) Inventories: x4  d 9  d 9  I

(11) Current liabilities:  

x 5  d 10  d 10  CL
12 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

 
(12) Fixed assets: x f  d 11  d 11  FA
 
y  d 12  d 12  S
(13) Sales:
 
  d 13  d 13  P
(14) Profit:
(15) Non-negativity:  
x 1 ,... x 5 , x f , y ,  , d 1 ,... d 13  0

The model formulated above addresses a few limitations of Agarwal’s (1988) model. Agarwal’s
model has an inbuilt over-emphasis on liquidity, through its liquidity goals and once again through
its current assets and current liabilities sub-goals; in fact, the profitability goals also have an inbuilt
liquidity target. Also, the profitability goals in Agarwal’s model are somewhat ambiguous: profit as a
variable seems to be unrelated to the other (working capital) variables, and the cost of capital term in
the profitability goals is not very clear.
The proposed model tries to address some of the limitations of Agarwal’s model. In order to relate
the profit variable with working capital variables, the model introduces variables for fixed assets and
sales, and interlinks the variables via the working capital turnover ratio, the fixed assets turnover
ratio, and the profit margin goals. Liquidity remains as a major goal, and Agarwal’s profitability goal
is replaced by a profitability goal which functions to balance funds between working capital and
fixed assets, in accordance with the targeted turnover ratios. The resulting opportunity cost is the
profit forgone by excess/deficiency of liquidity (as determined by the turnover ratios).

3. APPLICATION OF THE MODEL

The goal programming model presented in preceding section was applied to the input data of the firm
Vijaya Krishna Spice Farms Pvt. Ltd., a food-processing company mainly involved in the storage of
different varieties of chilly and the processing of the same into chilly paste. The financial data
required for analysis was obtained from the company, for the five year span from 2004-2009. The
target values of the current ratio, working capital turnover ratio, fixed assets turnover ratio, and net
profit margin were set approximately at their five-year averages, to eliminate chance fluctuations for
a particular period. The optimal working capital position (assuming equal priorities of all goals and
sub-goals) of the firm for the year 2008-09 is detailed in Table 3.
Table 3: results of the two models
Agarwal’s
Targets Data Solution Proposed Model Solution
Cash 3,721,056.00 3,721,056.00 3,721,056.00
Marketable Securities 33,098,161.00 33,098,161.00 33,098,161.00
Accounts Receivable 89,186,217.00 89,186,217.00 89,186,217.00
Inventory 51,884,584.00 51,884,584.00 48,911,465.21
Current Liabilities 33,433,346.00 33,433,346.00 33,433,346.00
Fixed Assets 20,265,723.00 - 23,238,841.79
Sales 322,370,524.00 - 348,582,626.88
Profit 31,782,509.00 34,809,474.76 34,858,262.69
(Opportunity Cost) 3,026,965.76 3,075,753.69
Current Ratio 2.00 5.32 5.32 5.23
Working Capital Turnover Ratio 2.50 2.23 - 2.46
Fixed Assets Turnover Ratio 15.00 15.91 - 15.00
Profit Margin 0.10 0.10 - 0.10
13 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

The results from Agarwal’s model indicate a Rs. 3,026,965.76 opportunity loss due to excess
liquidity, while the results the proposed model indicate a Rs. 3,075,753.69 opportunity loss. The
results of the proposed model suggest that excess liquidity (in the form of Rs. 2,973,118.79 of
inventory) be converted to fixed assets in order to improve profitability. It is observed that, in the
solution, while the working capital turnover ratio, the fixed assets turnover ratio, and the profit
margin are close to their targeted values, the current ratio is not.

The deviation variables in the optimal solution are presented in Table 4 (for simplicity, only non-zero
values are displayed).

Table 4: deviational variables in the optimal solution

Constraints Deviation Variables
d 1  108,050,207.21

Liquidity
Working Capital Turnover d

2
 5,126,256.15
Fixed Assets Turnover
Profit Margin
Opportunity Cost
Cash
Marketable Securities
Accounts Receivable
Inventory d

9
 2,973,118.79
Current Liabilities
Fixed Assets

d 11  2,973,118.79
Sales

d 12  26,212,102.88
Profit

d 13  4,075,753.69

The deviation variables indicate over-achievement of liquidity far in excess of the targeted level,
under-achievement of working capital turnover, and over-achievement of sales. Further, the
deviation variables d 9 and d 11 indicate excess liquidity (inventory) that is to be converted to fixed
assets.

The sensitivity analysis of the model to different parameters is presented in Table 5.

14 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

Table 5: sensitivity analysis of the optimal solution

Opportunity Cost %Change Elasticity
Cash
+5% 3,110,638.59 1.13% 0.2268
+2.50% 3,093,196.14 0.57%
0% 3,075,753.69 0.00%
-2.50% 3,058,311.24 -0.57%
-5% 3,040,868.79 -1.13%
Marketable Securities
+5% 3,386,048.95 10.09% 2.0177
+2.50% 3,230,901.32 5.04%
0% 3,075,753.69 0.00%
-2.50% 3,230,901.32 -5.04%
-5% 2,765,458.43 -10.09%
Accounts Receivable
+5% 3,911,874.47 27.18% 5.4369
+2.50% 3,493,814.08 13.59%
0% 3,075,753.69 0.00%
-2.50% 2,657,693.30 -13.59%
-5% 2,239,632.90 -27.18%
Inventory
+5% 3,562,171.66 15.81% 3.1629
+2.50% 3,319,045.81 7.91%
0% 3,075,753.69 0.00%
-2.50% 2,832,544.70 -7.91%
-5% 2,589,335.71 -15.81%
Current Liabilities
+5% 2,762,334.39 -10.19%
+2.50% 2,919,034.88 -5.10% -2.0381
0% 3,075,753.69 0.00%
-2.50% 3,232,472.50 5.10%
-5% 3,389,191.31 10.19%
Fixed Assets
+5% 3,265,744.84 6.18% 1.2354
+2.50% 3,170,749.26 3.09%
0% 3,075,753.69 0.00%
-2.50% 2,980,758.11 -3.09%
-5% 2,885,672.11 -6.18%
15 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

It is observed that the results of the proposed model are highly sensitive to changes in accounts
receivable (with elasticity +5.4369), followed by inventory (with elasticity +3.1629), current
liabilities (with elasticity -2.0381), marketable securities (with elasticity +2.0177), fixed assets (with
elasticity +1.2354), and, least of all, cash (with elasticity 0.2268).

4. DISCUSSION
Several studies have stressed the importance of effective working capital management. Agarwal
(1988) had formulated a goal programming model for working capital decisions, but it had some
serious limitations, especially its over-emphasis on liquidity. The model proposed in this paper
extends the scope of Agarwal’s model, whilst retaining the concept of a liquidity-profitability trade-
off.
The results of the model suggest that working capital, and inventory in particular, should be
streamlined to profitability. This approach is thus in conformance with several studies, including
Rafuse (1996), Cote and Latham (1999), Garcia-Teruel and Martinez-Solano (2007), Filbeck et al
(2005), and Singh (2008). In particular, the relationship between different components of working
capital, fixed assets, sales, and profits needs to be examined in greater depth and modeled
accordingly. Further, the role of inventory and of inventory turnover needs to be made explicit in the
model.
The scope of the proposed model is also a question that has to be examined more carefully. In
particular, the nature of the industry may determine the scope of applicability of the model. This
would be the case, as the working capital problems of manufacturing companies are quite different
from those of, for example, trading companies. Also, the model does not take into account such
aspects as seasonality, which would play a role in some industries, especially agro-industries. These
could perhaps be addressed by considering an industry-specific priority structure in the model.
Another important determinant would be that of operations strategies. For example, it would be
interesting to apply the model for companies that operate on ―negative working capital,‖ with no
investment at all in inventory and receivables, thereby reducing costs and enhancing profitability.
There is vast scope for extending the model proposed in this paper. The proposed model is a static,
aggregate-level model; a dynamic/multi-stage micro-model, with appropriate inter-linkages between
the different variables, incorporating the working capital cycle concept and time value of money,
would give more detailed results. Also, the proposed model has some limitations: it considers a
specific form of liquidity and profitability goals/constraints, which may not have taken some other
relevant parameters into consideration; and it assumes stable turnover ratios, which may limit its
applicability in practice. Further, the proposed model is a linear programming model, and thus deals
only with the linear behavior of working capital; non-linearities are not taken into consideration.
16 Journal of Management and Science ISSN: 2249-1260 | e-ISSN: 2250-1819 | Vol.5. No.1 | March’2015

5. REFERENCES
[1] Agarwal, J.D. (1988), A goal programming model for working capital management, Finance
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[3] Chakraborty, K. (2008), Working Capital and Profitability: An Empirical Analysis of Their
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[4] Coskun, S., Basligil, H. and Baracli, H. (2008), A weakness determination and analysis model for
business process improvement, Business Process Management Journal 14(2), 243-261.
[5] Cote, J.M. and Latham, C.K. (1999), The Merchandising Ratio: A Comprehensive Measure of
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[6] Filbeck, G., Krueger, G. and Krueger, T.M. (2005), An Analysis of Working Capital
Management Results across Industries, Mid-American Journal of Business 20(2), 11-18.
[7] Garcia-Teruel, P.J. and Martinez-Solano, P. (2007), Effects of working capital management on
SME profitability, International Journal of Managerial Finance, 3(2), 164-177.
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[9] Rafuse, M.E. (1996), Working capital management: an urgent need to refocus, Management
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