WORKING CAPITAL MANAGEMENT

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1 WORKING CAPITAL MANAGEMENT What is Working Capital Working capital management is the set of activities that are required to run day to day operations of the business to ensure that cash is adequate to meet short term debt and upcoming operational expenses. Working Capital is also known as circulating capital or revolving capital. It is a measure of company s operational efficiency, liquidity and short-term solvency. Working capital is defined in terms of Net Working capital, i.e, Current assets - Current liabilities. Working Capital Ratio refers to how much capital a company should maintain to achieve zero or possibly lower risk in conducting its daily operational activities. In order to better understand working capital management, lets have a brief look at Current Assets and Current Liabilities. Current assets are those short-term assets that can be converted into cash easily and current liabilities are those liabilities, which are due in near future generally, within a year. Working Capital Formula The Working capital formula can be understood with the help of the following: As per Balance Sheet: Net Working capital = Current Assets Current Liabilities (excess of current assets over current liabilities, also known as net current assets) As per Operating Cycle / Working Capital Cycle: A company s operating cycle or working capital cycle typically consists of the following activities: 1. Purchases for business 2. Produces the product (Inventory) 3. Sells the product (Receivables) 4. Collect Money Thus, Operating cycle or working capital cycle is nothing but the period taken by the business to convert cash (paid for purchases) back to the cash (received from selling the goods). It is also known as circulating capital because current assets of the firm are changed from one form to another, in an ordinary course of business. Thus, when the firm refers to negative working capital they are basically referring to shortage of current assets to meet current liabilities. Working Capital Management Ratios 1. Working Capital Ratio 1: Current assets / Current liabilities This is also known as the Current Ratio. This ratio tells us whether the company has adequate short-term assets to cover its short term liabilities. Ratio below 1 indicates negative working capital. If the ratio is around 2 it is considered satisfactory.

2 Current assets = $ 250,000 Current liabilities = $ 150,000 Working capital Ratio = $ 250,000/ $ 150,000 = 1.67 In this example, working capital ratio of 1.67 indicates that current liabilities are secured by 1.67 times of the business current assets and it shows a health liquidity position. Working capital ratio above 2 indicates underutilized assets and bad working capital management. Working capital ratio less than 1 indicates that the firm s current assets are not capable of meeting its short term liabilities and that the business is in Jeopardy. In that case, it s known as negative working capital (excess of current liabilities over current assets) 2. Working Capital Ratio 2 - Inventory Conversion period: Average Inventory / Cost of sales/365 This indicates the average time to convert inventory into sales. Inventory is not sold as it is manufactured. Thus stocking of inventory involves cost. Inventory conversion period represents the efficiency of the company s working capital management in holding the goods. They should not overstock and pay higher maintenance costs and at the same time, they should maintain enough stock so as to meet demands. Less conversion period is better because the inventories are converted faster into sales. This working capital ratio is very important for companies who deal in perishable stocks like food industry. Greater the time it takes to sell the goods higher is the risk of obsolescence. Opening Inventory = $ 50,000 Closing Inventory = $ 80,000 Cost of Goods Sold = $ 400,000 Average Inventory = (50,000+80,000)/2 = 65,000 Therefore, ICP = 65,000/400,000/365 = approximately 60 days Thus, it takes 60 days for a company to convert its inventory into sales. 3. Working Capital Ratio 3 - Receivable Conversion period: Average Receivables / Net Credit sales/365 It is also known as average collection period. It represents how quickly the debtors can be converted into cash during the period. In other words, it represents the average time between the sale of the goods on credit and cash receipts of the same. A fundamental concept of time value of the money is money received today is better than money to be received in future. Cash sales are always better as the money comes to you today itself, however, business may have to provide credit period to his debtors so as to increase its turnover, thus it involves an opportunity cost and of course default risk but at the reward of increasing sales. Opening Receivables = $ 20,000 Closing Receivables = $ 25,000 Credit Sales = $. 500,000 Returns = $ 20,000 Average Receivables = (20, ,00)/2 = 22,500

3 Net Credit Sales = 500,000 20,000 = 480,000 Therefore, ACP = 22,500/480,000/365 = approximately 17 days It means cash is received on an average within 17 days of the credit sales. This can be compared with normal credit policies of the business, which is generally laid down in the notes to financial statements of the companies. Say if the credit policies specified is more than 17 days, it represents the efficient collection management system and vice versa. 4. Working Capital Ratio 4 - Payable Turnover Ratio: Net Credit Purchases/Average Payables It indicates the speed with which the payment is made to the supplier for the credit purchase during the period. If this working capital ratio is declining over the period, it may signal worsening financial condition. Average Payables = $ 50,000 Net Credit Purchases = $ 350,000 Payable Turnover Ratio = 350,000/50,000 = 7 times To calculate the average number of days unpaid during the period, the Payable Turnover Ratio is divided by 365 days, i.e, 365/7 = 52 days. Therefore, on average the company repays amount to its creditors after 52 days of the credit purchases. Thus Operating cycle is Inventory conversion period + average collection period average payment period In this case = = 25 days Thus, it takes 25 days for the business to convert the cash back to cash. Operating cycle is continuous and not discrete. Working Capital Management Case Study. Let s review a real life example of HUL Hindustan Unilever Limited (Consolidated) Working Capital Ratios Year 2013 Year 2012 Current Ratio Quick Ratio Inventory Turnover Ratio Debtors Turnover Ratio Working Capital Days Working Capital Case Study Analysis Current Ratio has decreased from 0.86 to 0.78 and Ratio is below 1 which indicates that the current assets are inadequate to meet its short term liabilities and it does not in favor healthy short term financial condition. It is to be noted that though current ratio has decreased, quick ratio is intact. It implies that the decrease in current ratio is because of inventories {Quick ratio is nothing but (Current assets Inventories Prepaid Expenses)/Current liabilities} For 2013 Average conversion period = 365/9.98 = 37 days Average collection period = 365/29.14 = 13 days Average Payment period = X = -27 days, i.e, 77 days

4 For 2012 Average conversion period = 365/10.02 = 36 days Average collection period = 365/25.78 = 14 days Average Payment period = X = -17 days, i.e, 67 days From the above figures, it can be seen that there is no significant change in conversion and collection period, however working capital has increased from -17 days to -27 days, which I relate to increase in average payment period from 67 days to now 77 days, which is again not in the favor of the company. Working Capital Management Strategies Working capital management directly affects the firm s long term growth and survival. A company may be profitable and it may have sufficient assets, but short of liquidity may endanger its goodwill. Management should make sure that they have adequate working capital so as to manage its daily activities and upcoming operational expenses. There is high risk and uncertainty involved in managing the working capital since your debtors may not pay you at the time when you have to pay to your suppliers. At the same time, management cannot keep excess capital as it leads to opportunity loss of the excess capital blocked and shortage of it can lead to irreparable damage to the company in terms of lost suppliers due to delay in payments or lost customers due to not meeting the demands as and when required which may also result in poor returns, high amount of bad debts and low market value of shares. Effective working capital management allows the company to invest in future growth, repay its current liabilities as and when they become due and reduce financing costs. Thus, working capital management will involve managing cash, inventories, receivable and short term financing. Cash Management Management needs to identify the cash balance required for the smooth functioning of the daily activities of the business but at the same time also reduces cash holding costs. Inventory Management Management needs to identify the level of inventory which will allow smooth production but at the same time also reduces ordering and carrying costs. Inventories should not be over produced as well so as to lower management costs. Management resorts to practices like Just in time and Economic order quantity for efficient Inventory Management purposes. Debtors Management Management should identify the appropriate credit policy which will attract the sales such that any impact on the cash flows will be offset by higher sales. Short Term Financing Management should also identify the appropriate source of financing. They should also compare the interest rate paid on borrowings with Return on capital so as to take correct financing and investment decisions

5 Sources of Working Capital 1. Own Funds 2. Bank Borrowings 3. Sundry Creditors 4. Advance from customers 5. Deposits due in a year 6. Pre received Income 7. Other Current Liabilities Working capital management is more critical for those industries which seek higher liquidity for their daily operational activities or by nature whose operating cycle is higher - such as technology firms because goods take time to produce and it is reasonable to expect these firms to have a large value of inventories with long production processes. Financial Analysts manage and optimize working capital without compromising on the company s potential sales and profits. The Analyst should forecast the amount required to acquire fixed assets and meet working capital needs and can carry out sensitivity analysis and assess the severity of underinvestment due to negative working capital. It may also be possible that at point of time the short term solvency of the company is not good but that does not mean that it is a bad management or bad investment. For eg. If company today is not able to pay their supplier that does not mean it will not pay in future. In such cases, the analyst will have to look at the true picture of the financial conditions, quality of management and make their own judgements. They should implement processes and systems to evaluate inventory productivity, minimize costs and maximize working capital.

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