Unit 8: Working Capital Management

The Concept of Working Capital

Working Capital basically refers to the money utilized by companies in their daily activities or operations. It is also defined as the available capital for day-to-day production of goods to be sold by a company represented by its net current assets. The management of working capital is critical for the financial health of businesses of all sizes.

The working capital is explained from two different perspectives. e first one focuses on value, and conceptualizes working capital in two different forms; Gross Working Capital and Net Working Capital. The gross working capital refers to the total current asset holdings of a company which can be converted into cash in less than a year time. Net Working Capital refers to the difference between the current assets and the current liabilities. The current liabilities are those claims to be paid in less than 1 year time. Net working capital is a measure of company’s liquidity and ability to survive in case the only funding source is current assets. In this regard, a positive net working capital means that the company is able to meet its short- term liabilities, whereas a negative working capital means that the company currently is unable to meet its short-term liabilities.

From the “time” perspective, the working capital is conceptualized in two different forms: Permanent and Temporary. The permanent working capital represents the minimum level of investment in the current assets that is carried by the business at all times to carry out its activities. Temporary working capital, on the other hand, refers to that part of total working capital over its permanent working capital. It is also named as variable working capital as it fluctuates depending on the level of business activities. As a general rule, the temporary working capital is financed by short-term sources.

The Level of Adequate Working Capital

Maintaining adequate working capital is important in the short-term, but also liquidity must be maintained in order to ensure the survival of the business in the long-term as well. In case the opportunity cost of keeping working capital increases, then the companies pretend not to see the promising investment decisions which have the potential to motivate the business activity. In this framework, each company should determine the optimal working capital level. Optimal level of working capital maximizes the firm’s value, hence a trade-off between liquidity and profitability.

Some of the factors affecting the level of working capital are:

• Nature of business
• Length of period of manufacture
• Volume of business
• The proportion of the cost of raw materials to total cost
• Use of manual labor or mechanization
• Inventory level for raw materials of finished goods
• Turnover of working capital
• Terms of credit
• Short term financing options
• Seasonality of product demand
• Price level changes

Working Capital Management

Working Capital Management means managing the balance between a firm’s short- term assets and its shortterm liabilities. It ensures that the company is able to continue its operations by meeting the payment requirements sourced by the short-term debt and operational expenses. It is observed that many manufacturing companies have large amount of investments in working capital, as well as substantial amounts of short-term payables especially to the suppliers as a course of financing. In this framework, working capital management has the following four dimensions: Time, investment, credibility, growth.

Working Capital Management Policies

The working capital policy of a company should focus on maintaining sufficient liquidity. The decision on how much working capital to be maintained and especially the funding of it is a very important strategic decision. Generally, three types of working capital policies are accepted, Hedging Policy, Conservative policy and Aggressive policy each of which describes different financing strategies to meet the working capital requirements.

Hedging policy, which is also named as matching policy, proposes a strategy by which the fluctuating part of the current assets are financed by the current liabilities. Consequently, the fixed and permanent current assets are financed through long-term sources. Such a policy creates a medium level of risk and should be managed accordingly.

Conservative policy aims to minimize the risks associated with the financing of the current assets. It proposes to finance a higher proportion of current assets by the longterm sources. e company not only matches the current assets with current liabilities but also keeps some excess amount to meet any uncertainty in the working capital requirements. While the conservative policy of working capital management creates the lowest level of risk, it fails to ensure optimum utilization of funds.

Aggressive policy is specified as the most risky working capital financing policy as a higher proportion of current assets including permanent ones is financed by the shortterm debt. To apply such a policy, the company should ensure that the receivables are supposed to be collected on time and payments to the creditors are easily made as late as possible.

Cash Management

Cash management is the process to reduce the cash conversion cycle as short as possible. This achievement reduces financing cost such as lost opportunities due to lack of fund, as well as the interest costs incurred for the borrowings to meet the cash requirements. Under the framework of cash management, the operating cycle is defined as the length of time it takes the inventories are sold and the proceedings are collected in cash from customers. e net operating cycle (or the cash conversion cycle) is the length of time it takes the inventories are sold to generate cash, considering that some or whole of the inventory is purchased using credit. The length of the company’s operating and cash conversion cycles determines the level of liquidity. e cash cycle calculation is as given on page 227.

Cash Management Models

There exist two basic methods for the determination of the optimal cash level for a company. These are Boumal and Miller-Orr Models.

The Baumol model finds a balance by combining holding cost and transaction costs, so as to minimize the total cost of holding cash by the using the formula given on page 228. According to Baumol’s Model, at the optimum cash level, holding costs of cash and the transaction cost are equal. Cash holding cost is defined by referring to the opportunity cost concept as the interest foregone on marketable securities. Transaction costs are the costs incurred in getting the marketable securities converted into cash or vice versa.

Unlike Baumol, Miller and Orr model (1966) assumes that the cash ow of a company has a stochastic structure, as different amounts of cash payments are made on different points of time. It is assumed that the movements in cash balance occur randomly. Miller and Orr also suggest that there exist control limits, which sets control points for time and size of transfers between Investment Account and Cash Accounts. It is proposed that when cash balance touched the upper control limit, securities are brought up to an amount the return point of cash is reached. When cash balance touches lower control limit, marketable securities are sold in amount to reach the return point. Equations for this model are given on page 229.

Cash planning is a strategic part of strategic planning and involves cash flows forecasts as the base of cash management. Information sources for cash forecast preparation are historical records, corporate aim and objectives, inputs from business units/departments, previous period forecast and errors therein and experts judgmental inputs. Cash flows forecast is an vital early warning tool for financial management and serves for proactive financial management to make sure that a company does not run out of cash.

In order to build the most realistic cash flow statement, Cash Position Report has great importance. It is a good memorandum record and explains daily cash movements. Cash/Bank Reconciliation is a methodological procedure of comparing two sets of related cash/ bank accounts or records gathered from either internal systems or from the banks. It includes the all the activities for categorizing and analyzing any differences, and making needed amendments.

Inventory Management

The basic objective of managing inventory is to determine and maintain the level of inventory that is sufficient to meet demand, but not more than necessary. The inventory includes a vast spectrum of materials that is being transferred, stored, consumed, produced, packaged and sold. The inventory management processes should balance two different tasks, one of which is having enough inventories to fulfill orders and the other is minimizing the inventory carrying costs for maximizing the company`s profitability. Effective inventory management is realized by fixing up a sound inventory control and management system. Inventory control means having accurate, complete and timely inventory transactions records to avoid any difference between accounting entries and real inventory levels.

Kinds of Inventories

Inventories can be classified into five major categories: Raw Material, Work in Progress, Consumables, Finished Goods, Spares.

Holding inventory requires financing, mainly for the costs of production costs, but also for the inventory-related costs. These are:

1. Holding (or Carrying) Costs
2. Setup (or production change) costs
3. Ordering costs
4. Shortage costs

Inventory management techniques may be classified into various types such as the ones based on the order quantity of inventories, based on the classification of inventories and techniques on the basis of records. Techniques based on the order quantity of inventories are Stock Level, Minimum Level, Re-order Level, Maximum Level, Danger Level, Average Stock Level.

Techniques based on the classification of the inventories are ABC analysis and Aging Schedule of Inventories.

Techniques on the basis of records are Inventory Budget, Inventory Reports, and Just-in-Time or Zero-Inventory.

Receivable Management

Management of Receivables is mainly the process of managing the trade credit. It is a fact that apart from cash and inventory, receivable management constitutes the third component of working capital management. Receivables are generally represented by acceptance; bills or notes and the like due from others at an assignable date in the due course of the business. In many markets, receivables act as tools to attract potential customers and retaining the older ones at the same time by keeping them away from the competitors. Receivables also contribute to accelerate the velocity of distributions.

Costs of Maintaining Receivables

Receivables can be regarded as a type of investment made by a company. However, despite all the contributing benefits of granting credit to the buyers, there exist many types of costs incurred in the course of receivables management: Administrative cost, capital cost, delinquency cost, default cost.

Factors Affecting Size of Receivables

The size of receivables of a company is determined by a number of factors including but not limited to the following: Stability of Sales, Terms of Sales, The Volume of Credit Sales, Credit Policy and Bills Discounting and Endorsement.

Receivables Management

e primary objective of management of receivables should not be limited to expansion of sales but should involve maximization of overall returns on investment. So, receivables management should not be the only focus on the collection within the shortest possible period but also other possible related benefit and costs should be considered.

Credit Policy

A credit policy establishes guidelines to follow in the decision to grant or reject credit to a customer as well as the terms and conditions of the grant. By that definition, it directly affects the volume of investment a company makes in receivables. It should be prepared by the involvement of sales and finance managers of the company by taking into account the requirements of competition, industry and general economic conditions. The cost of trade credit (C) is calculated by the formula given on page 238.

Working Capital Finance

After the determination of the level of the working capital for a firm, the next step is to determine a policy to finance the working capital requirement. There exist two main sources of financing which are short–term and long–term. Short-term financing refers to borrowing funds or raising credit for a maximum of 1 year period. On the other hand, long term financing refers to the borrowing of funds or raising credit for one year or more. The finance manager has to mix funds from these two sources optimally to ensure profitability and liquidity.

Financing Sources of Working Capital

The firms may create financing alternatives from internal (mainly in the form of accruals) and external sources: accruals, trade credit, working capital advance by commercial banks, letter of credit, factoring.