Discuss the followings in relation to the Working Capital Management with suitable examples.

1.1 Importance of Working Capital Management

Working capital is money available to company for day to day operation. Working capital is
common measure of a company’s liquidity, efficiency and overall health. Its include cash,
inventory, account receivable, account payable, portion of debt due one year and other short term
account. A company’s working capital reflects the result of the company activities including
inventory management, debt management, revenue collection and payments to suppliers. Positive
working capital generally indicates that a company able to pay off its short term liabilities almost
immediately while negative working capital generally indicates a company is unable to do so. One
of the most significant uses of working capital management is inventory; the longer inventory sits
on the shells of the warehouse. The longer the company’s working capital is tired up. When not
manage carefully working capital storages cause many businesses to fail. Working capital is
varying for industry to industry specially considering how different industry depends on expensive
equipment. Use different accounting method and approach other industry specific matters. If we
finding ways keep working capital stable is particularly difficult for manufactures and other
companies that require a lot of upfront costs for these reasons comparison of working capital is
generally most meaningful among companies within the same industry. The definition of high ratio
of low ratio should be made within this contact.

Importance of the working capital management

 Higher return of capital

 Improved credit profits and solvency
 Higher profitability
 Higher liquidity
 Increase business value
 Favorable financing condition
 Uninterrupted production
 Ability to face shocks and peak demand
 Competitive advantage

Higher return of capital

Firm with lower capital will post a higher return on capital so shareholders will benefit from higher
return for every cent invested in the business.

Improved credit Profits and solvency

The ability to meet short-term obligation is a pre-requisite to long-term solvency and often a good
indication of counterparty’s credit risk. Adequate working capital management will allow a
business to pay on time its short-term obligations which could include raw materials, salaries and
other operating expenses.

Higher Profitability

The management of account payable and receivable is an importance driver of small businesses
profitability.

Higher liquidity

A large amount of cash can be tied up in working capital, so a company it efficiently could benefit
from additional liquidity and be less dependent on external financing. This is especially important
for smaller business as they typically have a limited access to external funding sources.

Increase business value

Firms with more efficient working capital management will generate more free cash flows which
will result in a higher business valuation and enterprise value.

Favorable financing condition

A firm with a good relationship with its trade partners and paying its supplies on time will benefit
from favorable financing terms such as discount payments from its suppliers and banking partners.

Uninterrupted Production

A firm paying its suppliers on time will also benefits from a regular flow of raw materials, ensuring
that the production remains uninterrupted and clients receive their goods on time.

Ability to face shocks and peak demand

An efficient working capital management will help a firm to survive through a crisis or ramp up
production in case of an unexpected large order.

Competitive Advantage

Firm with an efficient supply chain will often be able to sell their product at a discount versus
similar firms with inefficient sourcing.

1.2 Components of Working Capital

The main components working capital are cash, accounts receivable, inventory, marketable
securities, trade credits and loans from Life Insurances etc.

Current Asset

Inventory

Account receivable

Prepaid expenses

Accrued income

Cash & cash equivalents

Current liabilities

Account payable

Unearned income

Accrued expenses

Overdraft and short term financing

Inventory

Inventory is commonly thought of as the finished goods a company accumulates before selling
them to end users. But inventory can also describe the raw materials used to produce the finished
goods, goods as they go through the production process or goods that are "in transit."

It can be separate as identifiable and indistinguishable, Identifiable goods which is each unit is
unique it can be separately identifiable for some serial number batch number. ex some raw
material, working progress, finished goods. Value of each item reflect the cost of raw material and
also the cost of direct labor and the finally share of the manufacturing overheads. Indistinguishable
inventory is quite different its individual item cannot be told apart. Ex gas, oil, steel, copper, etc..
there are three possible way to value this inventory are, based on most recent price paid, based on
oldest price paid, based on an average cost.

Account receivable

Account receivables invoices to customers that they haven’t paid yet. It means promise to pay in
future by customers.

Accrued income
Accrued income is income that a company will recognize and record in its journal entries when it
has been earned, even though cash has not been received

Prepaid expenses

Payment made in advance by customers to suppliers for services delivered us a future time. Most
prepayments are for services of product switch delivery within next 12 months therefore recoded
as current asset. One of the most common example of the airline ticket.

Account payable

Account payable is invoice from suppliers that you haven’t paid yet. Basically company get the
raw material from supplier with the promise of pay in future.

Accrued expenses

Consume services before they invoice its current liability to the customers and current assent for
the supplies most Easley recognize example for accrued expenses are utility bill, gas and water.

Cash & cash equivalents

Cash equivalents, in general, are highly liquid investments having the maturity of three months or
less. To be classified as a cash equivalent an item must be unrestricted so that it is available for
immediate use.

Examples of cash equivalents include the following items with maturity dates that are typically
three months or less:

 Banker’s acceptance
 Commercial paper
 Treasury bills
 Other liquidity investments that mature within 3 months.

Companies may elect to classify some types of their marketable securities as cash equivalents.
This depends on the liquidity of the investment and what the company intends to do with such
products. Typically, this will be disclosed in the footnotes of a company’s financial statements.

1.3 Relationship with liquidity and Profitability

Profitability

It reflects a company’s ability to generate revenue and earns as compared with cost and losers over
a period of time.

Liquidity

This refers to the ability of a business to keep its current assets balance to pay its current liabilities
so that operations are not disrupted by cash shortfalls.

Profitability and Liquidity are two important variables that provide information about the
performance of any business unit. Profitability and liquidity for long-term and healthy growth
should be comparable to each other. Profitability is one of the main goals of any business. It is not
possible to stay this business without being profitable and business development will be more
difficult. To generate profit, the business needs short-term funds to meet the daily needs and others.
It will be more beneficial if activity operate through short time of funding, not by external debt.
Therefore liquidity tells the business about the commercial potential to meet the needs of short-
term funds and the business's profit-making rate tells about the benefits arising from business
practices.

Profitability helps in taking decisions and constructing policies Liquidity tells about the firm’s
ability to meet short-term need of funds. Efficient liquidity management has a great significance
for a business to run smoothly.

Normally a high liquidity is considered to be a sign of financial strength; however a high liquidity
can be as undesirable as a low. This would be a consequence of the fact that current assets are
usually the less profitable then the fixed assets. It means that the money invested in current assets
generates less returns then fixed assets, representing thus an opportunity cost. Besides that, the
amounts employed in current assets generate additional costs for maintenance, reducing thus the
profitability of the company.

Furthermore, increasing profits can lead to an increase in market value, thereby increasing the
capital. The ability to maintain a company's short-term debt-paying ability for all users of financial
statements is important if the company cannot keep long-term debt-paying qualifications, nor will
it make its stockholders satisfy. A manufacturing company may also be bankrupt if it fails to fulfill
its obligations to short-term creditors. The ability to pay current liabilities is also related to the
company's ability to cash in when it is due.

1.4 Determinants of Working Capital Requirement in manufacturing oriented organization

There are not set rules or formulae to determine the working capital requirements of firms. A Large
number of factors, each having a different importance, influence working capital needs of firms.
The importance of factors also changes for a firm over time. Therefore, an analysis of relevant
factors should be made in order to determine total investment in working capital. The following is
the description of factors which generally influence the working capital requirements of
manufacturing oriented organization.

Nature of business

Working capital requirements of a manufacturing oriented organization are basically influenced

by the nature of its business. Some manufacturing oriented organization have a very small
investment in fixed assets, but require a large sum of money to be invested in working capital.
Some manufacturing businesses, such as tobacco manufacturers and construction firms, also have
to invest substantially in working capital and a nominal amount in fixed assets. In contrast, public
utilities may have limited need for working capital and have to invest abundantly in fixed assets.
Their working capital requirements are normal because they may have only cash sales and supply
services, not products. Thus no funds will be tied up in debtors and stock (inventories). For the
working capital requirements most of the manufacturing companies will fall between the two
extreme requirements of trading firms and public utilities. Such concerns have to make adequate
investment in current assets depending upon the total assets structure and other variables.

Technology

The manufacturing firms comprise of the purchase and use of raw materials and the production of
finished goods. Longer the manufacturing cycle, larger will be the firm’s working capital
requirements. Therefore the technological process with the shortest manufacturing cycle may be
chosen. Once a manufacturing technology has been selected, it should be ensured that
manufacturing cycle must be completed within the specified period. This needs proper planning
and coordination at all levels of activity. Any delay in the manufacturing process will result in the
accumulation of waste in product and waste of time.

In order to minimize their investment in working capital, some firms, specifically those
manufacturing industrial products, have a policy of asking for advance payments from their
customers. Non manufacturing firms, services and financial enterprises do not have a
manufacturing cycle.

Availability of credit from suppliers

The working capital requirements of a manufacturing firm are also affected by credit terms granted
by its suppliers. A firm will needless working capital if liberal credit terms are available to it from
suppliers. Suppliers’ credit finances the firm’s inventories and reduces the cash conversion cycle.
In the absence of suppliers’ credit the firm will borrow funds for bank.
The availability of credit at reasonable cost from banks is crucial. It influences the working capital
policy of the firm. A firm without the suppliers’ credit, but which can get bank credit easily on
favorable conditions, will be able to finance its inventories and debtors without much difficulty.

Operating efficiency

The operating efficiency of the firm relates to the optimum utilization of all its resources at
minimum costs. The efficiency in controlling operating costs and utilizing fixed and current assets
leads to operating efficiency. The use of working capital is improved and pace of cash conversion
cycle is accelerated with operating efficiency. Better utilization of resources improves profitability
and thus, helps in releasing the pressure on working capital. Although it may not be possible for a
firm to control prices of materials or wages of labor, it can certainly ensure efficient and effective
utilization of materials, labor and other resources.

Market and demand conditions

The working capital needs of a firm are related to its sales. However, it is difficult to precisely
determine the relationship between volumes of sales and working capital needs. In practice, current
assets will have to be employed before growth takes place. It is, therefore, necessary to make
advance planning of working capital for a growing firm on continuous basis.

Growing manufacturing firms may need to invest funds in fixed assets in order to sustain growing
production and sales. This will, in turn, increase investment in current assets to support enlarged
scale of operations. These firms need funds continuously. They use external sources as well as
internal sources to meet increasing needs of funds. These firms face further problems when they
retain substantial portion of profits, as they will not be able to pay dividends to shareholders. It is,
therefore, imperative that such firms do proper planning to finance their increasing needs of
working capital.

Sales depend upon demand conditions. Large number of manufacturing firms experience seasonal
and cyclical fluctuations in the demand for their products and services. These business variations
affect the working capital requirement, specially the temporary working capital requirement of the
firm. When there is an upward swing in the economy, sales will increase; correspondingly, the
firm’s investment in inventories and debtors will also increase. Under boom, additional investment
in fixed assets may be made by some firms to increase their productive capacity. This act of firms
will require additions of working capital. To meet their requirements of funds for fixed assets and
current assets under boom period, firms generally resort to substantial borrowing. On the other
hand, when there is decline in the economy, sales will fall and consequently, levels of inventories
and debtors will also fall. Under recession, firm try to reduce their short term borrowings.

Seasonal fluctuations not only affect working capital requirement but also create production
problems for the firms. During peak periods of demand, increasing production may be expensive
for the firm. Similarly, it will be more expensive during the slack periods when the firm has to
sustain its working force and physical facilities without adequate production and sales. A firm
may thus follow a policy of level production irrespective of seasonal changes in order to utilize its
resources to the fullest extent. Such a policy will mean accumulation of inventories during off
season and their quick disposal during the peak season.

Credit policy

The credit policy of the firm affects the working capital by influencing the level of debtors. The
credit terms to be granted to customers may depend upon the norms of the industry to which the
firm belongs. But a firm has the flexibility of shaping its credit policy within the constraint of
industry norms and practices. The firm should use discretion in granting credit terms to its
customers. Depending upon the individual case, different terms may be given to different
customers. A liberal credit policy, without rating the credit worthiness of customers, will be
detrimental to the firm and will create a problem of collection later on. The firm should be prompt
in making collections. A high collection period will mean tie up of large funds in debtors. Slack
collection procedures can increase the chance of bad debts. In order to ensure that unnecessary
funds are not tied up in debtors, the firm should follow a rationalized credit policy based on the
credit standing of customers and other relevant factors. The firm should evaluate the credit
standing of new customers and periodically review the credit worthiness of the existing customers.
The case of delayed payments should be thoroughly investigated.

Price level changes

The increasing shift in price level make functions of financial manager difficult in manufacturing
oriented organization. He should anticipate the effect of price level changes on working capital
requirement of the firm. Generally, rising price levels will require a firm to maintain a higher
amount of working capital. Same levels of current assets will need increased investment when
prices are increasing. However, companies that can immediately revise their product prices with
rising price levels will not face a severe working capital problem. Further, firms will feel effects
of increasing general price level differently as prices of individual products move differently. Thus,
it is possible that some companies may not be affected by rising prices while others may be badly
hit.

Inflation

Inflation has a bearing on level of working capital. Under inflationary conditions generally
working capital increases, since with rising prices demand reduces resulting in stock pile-up and
consequent increase in working capital.

1.5 Working Capital Financing Policies.

There are three types of sources of working capital financing there are short term, long term and
spontaneous source

Short term sources provide funds for the period generally less than one year long term sources are
provides funds for a longer period generally more than one year spontaneous source are not
specifically taken by the firm but eventually arrives during the causes of business.

Short term source of finance

 Trade credit
 Bank credit
 Factoring
 Commercial papers

Long term source of finance

 Equity shares
 Preference share
 Debentures
 Term loans

Spontaneous source of finance

 Accrued expenses
 Deferred Income

Policies that related to current liabilities are called financing policies of working capital.

Aggressive Policy

This policy, as the name suggests, is a high-risk one. Owing to the risk factors, returns are also
higher. To follow this, a business must minimize its current assets or the amount of debt it’s owed
to. Here, there are no debtors- payments are collected in time and are eventually invested in
business. Creditors’ payments are delayed to the maximum. Doing so sometimes might land up
with possibilities to sell out company assets to clear debts.

Conservative policy

Businesses with low-risk appetite are mostly inclined towards such a policy. In this policy, credit
limits are pre-set to a specific amount. Also, such policies refrain doing business on credit with
any debtor who defaults. Generally, a conservative working capital policy is followed to keep the
company assets and liabilities in sync with each other, with the assets value on the higher side, in
case of sudden exigencies.

Matching policy
Businesses generally follow this policy when they want their working capital to be less; thereby
utilizing or investing the money elsewhere. Here, the current assets of the balance sheet are
matched with the current liabilities and less cash is kept in hand. This in turn, enables the rest of
the finance to be used for expanding business, increasing production scale, etc.

High risk, high return working capital investment and financing policies are referred to as
aggressive and lower risk, lower return policies are called conservative. Aggressive working
capital investment policy has an expectation of higher profitability but greater liquidity risk. It
minimizes the investment in current assets versus long term investments. Besides this a more
conservative policy invests a greater proportion of capital in current assets but with the sacrifice
of some profitability. Current asset to total asset ratio is used to measure the degree of
aggressiveness. Lower ratio reveals a relatively more aggressive policy and vice versa. The degree
of aggressive financing policy is measured by the current liability to total asset ratio. High ratio
reveals the more aggressiveness. There is an interrelation between the aggressive working capital
investment policies corresponding to conservative working capital financing policy.