Paradigms of Working Capital Management
For increasing shareholder’s wealth a firm has to analyze the effect of fixed assets and current assets on its return and risk. Working Capital Management is related with the Management of current assets. The Management of current assets is different from fixed assets on the basis of the following points:
1. Current assets are for short period while fixed assets are for more than one Year.
>2. The large holdings of current assets, especially cash, strengthens Liquidity position but also reduces overall profitability, and to maintain an optimum level of liquidity and profitability, risk return trade off is involved holding Current assets.
3. Only Current Assets can be adjusted with sales fluctuating in the short run. Thus, the firm has greater degree of flexibility in managing current Assets. The management of Current Assets helps affirm in building a good market reputation regarding its business and economic condition.
Now first let us discuss the paradigms of Working Capital Management.
CONCEPT OF WORKING CAPITAL:
The concept of Working Capital includes Current Assets and Current Liabilities both. There are two concepts of Working Capital they are Gross and Net Working Capital.
1. Gross Working Capital: Gross Working Capital refers to the firm’s investment in Current Assets. Current Assets are the assets, which can be converted into cash within an accounting year or operating cycle. It includes cash, short-term securities, debtors (account receivables or book debts), bills receivables and stock (inventory).
2. Net Working Capital: Net Working Capital refers to the difference between Current Assets and Current Liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year. It includes creditors or accounts payables, bills payables and outstanding expenses. Net Working Copulate can be positive or negative. A positive Net Working Capital will arise when Courtney Assets exceed Current Liabilities and vice versa.
Concept of Gross Working Capital
The concept of Gross Working Capital focuses attention on two aspects of Current Assets’ management. They are:
a) Way of optimizing investment in Current Assets.
b) Way of financing current assets.
a. Optimizing investment in Current Assets: Investment in Current Assets should be just adequate i.e., neither in excess nor deficit because excess investment increases liquidity but reduces profitability as idle investment earns nothing and inadequate amount of working capital can threaten the solvency of the firm because of its inability to meet its obligation. It is taken into consideration that the Working Capital needs of the firm may be fluctuating with changing business activities which may cause excess or shortage of Working Capital frequently and prompt management can control the imbalances.
b. Way of financing Current Assets: This aspect points to the need of arranging funds to finance Country Assets. It says whenever a need for working Capital arises; financing arrangement should be made quickly. The financial manager should have the knowledge of sources of the working Capital funds as wheel as investment avenues where idle funds can be temporarily invested.
Concept of Net Working Capital
This is a qualitative concept. It indicates the liquidity position of and suggests the extent to which working Capital needs may be financed by permanent sources of funds. Current Assets should be optimally more than Courtney Liabilities. It also covers the point of right combination of long term and short-term funds for financing court Assents. For every firm a particular amount of net Working Capital in permanent. Therefore it can be financed with long-term funds.
Thus both concepts, Gross and Net Working Capital, are equally important for the efficient management of Working Capital. There are no specific rules to determine a firm’s Gross and Net Working Capital but it depends on the business activity of the firm.
Working capital management is concerned with the problems that arise while managing the current assets the current liabilities and the interrelationship that exits between them. Thus, the WC management refers to all aspects of a administration of both current assets the current liabilities.
Every business concern should not have neither redundant nor cause excess WC nor into should be short of W.C. both condition are harmful and unprofitable for any business. But out of these two the shortage of WC is more dangerous for the well being of the firms.
Impact/Harm of Redundant Or Excessive Working Capital
* Excessive WC means idle funds, which earn no profits for the business, cannot earn proper rate of return on its investment.
* When there is a redundant WC, it may lead to unnecessary purchasing and accumulation of inventories causing more chances if theft, waste and losses.
* Excessive WC implies excessive debtors and defective credit policy, which may cause higher incidences of bad debts.
* It may result into overall inefficiency in the organizations.
* When there is excessive WC relation with banks and other financial institutions may not be maintained.
* The redundant WC gives rise to speculative transaction.
* Due to low rate of return on investments the value of shares may also fall.
* In case of redundant WC there is always a chance of financing long terms assets from short terms funds, which is very harmful in long run for any organization.
Dangers of Short or Inadequate Working CapitalØ A concern, which had adequate WC, cannot pay its short-term liabilities in time. Thus it will lose its reputation and should be not be able to get good credit facilities.
* It cannot by its requirements in bulk and cannot avail of discounts. It stagnates growth.
* It becomes difficult for the firms to exploit favorable market conditions and undertake profitable projects due to non-availability of WC funds.
* The firm cannot pay day-to-day expenses of its operations and its credit inefficiencies, increases cost and reduces the profits of the business.
* It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds thus the firms profitability would deteriorate.
* The rate of return on investments also falls with the shortage of WC.
* Operating inefficiency creeps in and it becomes difficult to implement operating plans and achieve the firms profit targets.
Need for Working CapitalFor earning profit and continue production activity, the firm has to invest enough funds in Current Assets in generating sales. Current Assets are needed because sometimes sales do not convert into cash instantaneously and it includes an operating cycle.
Operating Cycle: Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. Investment in current assets such as inventories and debtors is realized during the firm’s operating cycle, which is usually less than a year.
The operating cycle of a manufacturing company involves three phases: –
1. Acquisition of resources such as raw material, labor, power and fuel etc.
2. Manufacture of the product which includes conversion into work-in-progress into finished goods.
3. Sale of the product either for cash or on credit.
These phases affect cash flows because sometimes sale is done on credit and it takes sometimes to realize.
Length or Duration of the Operating Cycle: The length of the operating cycle of a manufacturing firm in the sum of the following:
1.Inventory Conversion period
2. Debtors Conversion periods.
The total of Debtors Conversion Period and Inventory Conversion Period is referred to as Gross Operating Cycle.
1. Inventory Conversions Period: The Inventory Conversion Period is the total time needed for Producing and selling the product. It includes:
a. Raw Material Conversion Period.
b. Work-in-progress Conversion Period.
c. Finished Goods Conversion Period.
2. Debtors Conversion Period: It is the time required to collect the outstanding amount from the customers.
Net Operating Cycle: Generally, a firm may resources (raw materials) on credit and temporarily postpones payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in Courtney Assets.
The length of the time in which the firm is able to defer payments on various resource purchases is Payables Deferral period. The deference between Gross Operating Cycle and payables Deferral Period is called Net Operating Cycle. If depreciation is excluded from Net Operating Cycle, the computation repercussion represents Cash Conversion Cycle. It is net time interval between cash outflow.
Operating Cycle also represent the time interval over which additional funds, called Working Capital, should be obtained in order to carry out the firm’s operations. The firm has to negotiate Working Capital from sources such as banks. The negotiated sources of Working Capital financing are called non-spontaneous sources. If net Operating Cycle of a firm increases it means further need for negotiated Working Capital.
Calculation of Operating Cycle: The calculation of operating cycle helps to know the exact period of WC turnover i.e. how long it takes to convert cash again into cash? Through this calculation one can ascertain the WC period.
FORMULA: -Raw Material Holding Period = Avg. Stocks of Raw Material
Avg. cost of consumption per day
Work in progress Conversion Period = Avg. work in progress
Avg. cost of Production per day
Finished goods holding period = Avg. stock of finished goods
Avg. cost of goods sold per day
Receivables & Debtors collections Period = Avg. book debts.
Avg. credit sales per day
Credit period allowed by creditors = Avg. creditors
Avg. credit purchase
DURATION OF OPERATING CYCLE
GOC = RM + WIP + FG + D + R
NOC = GOC-C
Where GOV = Gross operating cycle.
NOC = Net operating cycle
RM = Raw material conversion period.
C = Credit period available
WIP = WIP conversion period
FG = FG holding period
D & R = Detors and receivables collection period.
- 360 working days in a year are taken to calculate per day average.
- Avg. means opening + closing /2
- Depreciation is excluded while calculating cost of production & sales as it is a non-fund expense and does not require working capital.
Permanent and Variable Working Capital
There is always a minimum level of current Assets, which is continuously required by the firm to carry on its business operations. The minimum level of Current Assets is referred to as permanent of fixed Working Capital. It is permanent in the same way as the firm’s fixed assets are. The extra Working Capital, needed to support the changing production and sales activities is called fluctuating or variable or temporary Working Capital.
Both Kinds of Working Capital, permanent and temporary, are necessary to facilitate production and sale through the operating Cycle.
Estimating Working Capital Needs: Working Capital needs can be estimated by three different methods, which have been successfully applied in practice. They are follows:
1. Current Assets Holding Period: To estimate Working Capital requirements on the basis of average holding period of Current Assets and relating them to costs based on the company’s experience in the previous years. This method is based on the operating cycle concept.
2. Ratio of Sales: To estimate Working Capital requirements as a ratio of sales on assumption that Current Assets change with sales.
3. Ratio of fixed Investment: To estimate Working Capital requirements as a percentage of fixed investment.
The most appropriate method of calculating the Working Capital needs of firm is the concept of operating cycle. There are some limitations with all the three approaches therefore some factors govern the choice of method of Working Capital.
Factors considered are seasonal variations in operations, accuracy sales forecasts, investment cost and variability in sales price would generally be considered. The production cycle and credit and collection policy of the firm would have an impact on Working Capital requirements.
Current Assets Financing
A firm can adopt different financing policies for Current Assets Three types of financing used can be:
1. Long-term financing such as shares, debentures etc.
2. Short-term financing such as public deposits, commercial papers etc.
3. Spontaneous financing refers to the automatic sources of short-term funds arising in the normal course of a business such as trade credit (suppliers) and outstanding expenses etc.
The real choice of financing Current Assets is between the long term and short-term sources of finances. The three approaches based on the mix of long and short-term mix are:
1. Matching Approach: When the firm follows matching approach (also known as hedging approach), long term financing will be used to finance Fixed Assets and permanent Current Assets and short-term financing to finance temporary or variable Current Assets. The justification for the exact matching is that, since the purpose of financing is to pay for assets, the source of financing and the assets should be relinquished simultaneously so that financing becomes less expensive and inconvenient. However, exact matching is not possible because of the uncertainty about the expected lives of assets.
2. Conservative Approach: The financing policy of the firm is said to be a conservative when it depends more on long-term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary Current Assets with long term financing. In the periods when the firm has no need for temporary Current Assets, the idle long-term funds can be invested in the tradable securities to conserve liquidity. Thus, the firm has less risk of shortage of funds.
3. Aggressive Approach: An aggressive approach is said to be followed by the firm when it uses more short term financing than warranted by the matching approach. Under an aggressive approach, the firm finances a part of its permanent current assets with short term financing. Some firms even finance a part of their fixed assets with short term financing which makes the firm more risky.
Managing Current Assets: Management of Current Assets is done in three parts. They are:
1) Management of cash and cash equivalents.
2) Management of inventory.
3) Management of accounts receivable and factoring.
Thus, the basic goal of WC management is to manage the current assets the current liabilities of the firm in such a way that a satisfactory level of WC is maintained, i.e. it is neither inadequate nor excessive WC management policies of a firms have a great effect on its Profitability, Liquidity and Structural health of the organization.
WC management is an integral part of overall corporate management. For proper WC management the financial manager has to perform the following basic functions:-
· Estimating the WC requirement.
· Determining the optimum level of current assets.
· Financing of WC needs.
· Analysis and control of WC.
WC management decision are three dimensional in nature i.e. these decisions are usually related to these there sphere or fields.
· Profitability, risk and liquidity.
· Composition and level of current assets.
· Composition and level of current liabilities.
PRINCIPLES OF WORKING CAPITAL
There are four principle of working capital management. They are being depicted as below :
(i) Principle of Risk Variation: – The goal of WC management is to establish a suitable trade between profitability and risk. Risk here refers to a firm’s ability to honor its obligation as and when they become due for payments. Larger investment in current assets will lead to dependence. Short term borrowings increases liquidity, reduces risk and thereby decreases the opportunity for gain or loss On the other hand the reserve situation will increase risk and profitability And reduce liquidity thus there is direct relationship between risk and profitability and inverse relationship between liquidity and risk.
(ii) Principle of Cost Capital: – The various sources of raising WC finance have different cost of capital and the degree of risk involved. Generally higher the cost lower the risk, Lower the risk higher the cost. A sound WC management should always try to achieve the balance between these two.
(iii) Principle of Equity Position: – This principle is considered with planning the total investment in current assets. As per this principle the amount of WC investment in each component should be adequately justified by a firms equity position Every rupee contributed current assets should contribute to the net worth of the firm The level of current assets may be measured with the help of two ratios. They are:
· Current assets as a percentage of total assets.
· Current assets as a percentage of total sales.
(iv) Principle of Maturity Payment: – This principle is concerned with planning the source of finance for WC. As per this principle a firm should make every effort to relate maturities of its flow of internally generated funds in other words it should plan its cash inflow in such a way that it could easily cover its cash out flows or else it will fail to meet its obligation in time.
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