HOW TO IMPROVE THE WORKING CAPITAL OF A COMPANY

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1 Volume 3, Issue 5 (May, 2014) Online ISSN Published by: Abhinav Publication Abhinav National Monthly Refereed Journal of Research in HOW TO IMPROVE THE WORKING CAPITAL OF A COMPANY Hemanshu Kapadia Proprietor, Practicing Company Secretaries, Hemanshu Kapadia and Associates, Mumbai, India ABSTRACT Working capital is also called as Circulating Capital. It is that part of capital which is required for meeting the day-to-day expenses of a business unit. A managerial accounting strategy focusing on maintaining efficient levels of both the components of working capital that is current assets and current liabilities. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. To improve working capital cycle company has to take various measures like improve the debtors and creditors cycle, accept advance payment, equity financing, focus on factoring and letter of credit discounting etc. Keywords: Working Capital Management; Financial Management INTRODUCTION According to Field Backer Malott, Working capital means a sum of current assets only. Working capital is the life blood of all businesses and is the primary indicator of business health. In financial accounting working capital is also known as Statement of Working capital. In an ideal business cycle, you will always have more cash inflow than cash outflow. In a simple experiment, a sign of healthy working capital is always having funds available to pay creditors on time, but when business cannot do this, then they face a problem of cash crises, which result downfall of business organization. To overcome from such problem there must be required an excellent team to manage effective working capital. In a credit crunch environment, where access to liquidity is restricted, cash management becomes critical to survival. The effect of working capital is real, immediate and, if mismanaged, totally unforgiving. OBJECTIVES OF THE STUDY 1. To understand the review of literature in the related area. 2. To understand the importance and cycle of working capital in a business organization. Working capital Cycle The working capital cycle means time taken to convert net current assets and current liabilities in to cash. Every business unit uses cash to acquire resources like purchase of material, payment to outstanding expenses and payment to routine expenses etc. All resources are put to work and goods and services produced. These are then sold to customers and we collect payments and again we invest such fund in new resources, and so the cycle repeats. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies strive to reduce its working capital cycle by using factoring facility, letter of credit discounting, managing receivables and payables, giving pricing discount to consumer, equity financing, inventory Available online on 9

2 management, bank overdraft, cash credit facility, packing credit facility for exporters, commercial paper and so on. Component of Working Capital Net Working Capital It represent excess of total current assets over total current liabilities and it is measured by current ratio 2:1, indicate greater solvency while a very low ratio indicates insolvency. Net working capital = Current Assets (cash + marketable assets + accounts + bills receivable + inventories + securities) minus (-) Current Liabilities (trade dues + sundry creditors + provision + taxes + loans + bills payable) Gross Working Capital It is equal to total sum of current assets and may represent both owned capital and loan capital. The gross concept gives only quantitative information about the company s finance minus (-) circulating assets. The concept of gross working capital is financial concept while that of net capital is an accounting concept. Advantages of managing a good Working capital 1. Liquidity With strong cash in hand or at bank position solve the problem of liquidity at the maximum extent. Such surplus plays very significant role to get the price benefit from creditors and it improves the credit worthiness of the company. 2. Productivity When working capital is under control then managing financial operations such as accounts creditors outstanding payment, banks interest and timely repayment of principle loan etc. are very easy, and management can easily focus on company s productivity and their business developments. 3. Re-invest in the business Improved working capital can help the company to earned money back into the business. Such money is useful to expand the business, recruit new employee, expand current assets, build new facilities, and invest in new processes and technologies to make our business more productive, profitable and competitive. 4. Reduce Debt Surplus cash allows us to pay down debt, reducing monthly financial commitments such as highinterest rates and potential late-payment fees. 5. Peace of Mind In each organisation the condition of management to handle effective working capital is always stressful. But if the company has surplus of working capital, then definitely it creates the peace of mind which makes managements to be ready for whatever opportunities or challenges lie ahead. VOL. 3, ISSUE 5 (May 2014) 10

3 Ratios Abhinav National Monthly Refereed Journal of Research In Ratio plays very significant role to analyze the company s financial data. There are various ratios which plays an important role for maintaining a good Working capital cycle. Current Ratio Liquidity Ratio Profit/Sales Ratio Debtor s days Sales outstanding Creditor s days Sales Sources to improve Working capital Low Risk Average Risk High Risk Over Under 1.0 Low Risk Average Risk High Risk Over Under 0.75 Low Average High Under 3% 3-10% Over 10% Low Average High Under 55 days days Over 85 days Low Average High Under 45 days days Over 60 days The important key elements to improve effective working capital are as follows. Factoring The Factoring is a financial option for the management of receivables to improve the Working capital cycle. Factoring means conversion of credit sales into cash for the short term period i.e. for 15, 30, 60, 90days or maximum up to the approved trade cycle. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 70% to 90% of the amount immediately of the invoice value. Factoring company pays the balance 10% to 30% (after deducting finance cost i.e. Interest Cost & Invoice handling charges and Service Tax) to the customer when the factor received 100% amount on the due date from the client s debtors. Factoring Works VOL. 3, ISSUE 5 (May 2014) 11

4 Advantages of Factoring There are various advantages of factoring; some of the important advantages are as given below: 1. Helpful for arranging immediate short term finance. 2. Helpful for reducing operating expenses. 3. Smooth flow of working capital and quicker access to working capital. 4. Better financial standing, creditworthiness, and solvency. 5. Factoring is helpful for enhancing the potentiality of balance sheet. Letter of Credit (LC) Letter of Credit is a commercial document helpful for maintaining a good Working capital cycle. Because it is issued by a bank in normal course of business which carries a payment guarantee obligation in case of adverse situation arises. A bank issue LC on the request of its client in favor of a third party (beneficiary). It is important instrument to the extent that it smoothens & secures the transactions ensuring to the party in whose favor the LC is opened that if any adverse situation arises and its client failed to make the payment than the issuing bank will pay subject to the terms and conditions mentioned at the time of issue of LC. This document is most important in case both the parties doing business first time. These parties can do business without any or very low risk, as bank gives a safety assurance to both the parties, involved with the transaction. Issuance of Letter of Credit Buyer/Importer 1 Beneficiary/Exporter 2 4 Request for a Advising of Letter Letter of Credit of Credit Payment under Letter of Credit Request to advice and possibly confirm the Letter of Credit Issuing Bank 3 Advising /Confirming Bank Applicant/Importer 1 Beneficiary/Exporter Shipment of Goods Documents Payment Documents Payments 6 Payment Issuing Bank 3 Documents Advising/Confirming Bank VOL. 3, ISSUE 5 (May 2014) 12

5 Handling Receivables (Debtors) Receivables plays very significant role to maintain effective working capital in a company. Slow payment has a crippling effect on business, specially for the small and medium size industries. The following measures will help to manage your debtors: 1. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves. 2. Establish clear credit practices as a matter of company policy. 3. Make sure that these practices are clearly understood by staff, suppliers and customers. 4. Be professional when accepting new accounts, and especially larger ones. 5. Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc. 6. Establish credit limits for each customer and stick to them. 7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector. 8. Keep very close to your larger customers. 9. Consider charging penalties on overdue accounts. 10. Consider accepting credit /debit cards as a payment option. 11. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old. Managing Payables (Creditors) Managing Creditors are a vital part to maintain effective working capital in a company. Improper or wrong time Purchase initiates cash outflows and an over-zealous purchasing function can create liquidity problems. The following measures will help to manage your Creditors: 1. Maintaining good credit relations with suppliers. 2. Who authorizes purchasing in your company - is it tightly managed or spread among a number of (junior) people? 3. Are purchase quantities geared to demand forecasts? 4. Do you use order quantities which take account of stock-holding and purchasing costs? 5. Do you know the cost to the company of carrying stock? 6. Do you have alternative sources of supply? If not, get quotes from major suppliers and shop around for the best discounts, credit terms, and reduce dependence on a single supplier. 7. How many of your suppliers have a returns policy? 8. Are you in a position to pass on cost increases quickly through price increases to your customers? 9. If a supplier of goods or services lets you down can you charge back the cost of the delay? 10. Can you arrange (with confidence!) to have delivery of supplies staggered or on a just-in-time basis? There is an old adage in business that if you can buy well then you can sell well. Management of your creditors and suppliers is just as important as the management of your debtors. It is important to look after your creditors - slow payment by you may create ill-feeling and can signal that your company is VOL. 3, ISSUE 5 (May 2014) 13

6 inefficient (or in trouble!). So the company must take suitable measures to handle their creditor s cycle properly, and if this handle properly then definitely it will gives boost to manage working capital cycle properly. Inventory Management Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business and insufficient stocks can result in lost sales, delays for customers etc. Important point in inventory management is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factor would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them. To manage effective inventory cycle then there should be follow following measures: 1. Review the effectiveness of existing purchasing and inventory systems. 2. Know the stock turn for all major items of inventory. 3. Apply tight controls to the significant few items and simplify controls for the trivial many. 4. Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it. 5. Consider having part of your product outsourced to another manufacturer rather than make it yourself. 6. Review your security procedures to ensure that no stock "is going out the back door!" Pricing Discounts This option plays very significant role to improve company s working capital cycle very quickly. It means giving offer of discounts to your customers if they pay early. While this practice may impact your profit margin, it may help your management of working capital by incentivizing customers to make payments earlier than billing cycles typically require. Your company may also take advantage of this with suppliers and others that you owe, but be careful that your early payments of debt don't leave you with a working capital shortfall. Equity Financing A company can finance its operation by using equity, debt, or both. Equity financing means cash paid into the business either the owner's own cash or cash contributed by one or more investors. The main advantage of Equity financing to the company is saving of interest cost which leads to improve the working capital cycle. In this case investors put cash into a company in the hope of sharing in its profits and in the hope that the value of the stock will grow (appreciate). They can earn dividends of course (the share of the profit) but they can realize the value of the stock again only by selling it. Bank Overdraft Bank overdraft facilities consist of an agreed line of credit on which a small business entrepreneur can draw current account cheques. Commercial banks generally provide overdraft facilities to small enterprises for a period 6 to 12 months. The period of overdraft is generally arranged in conjunction with a cash requirement of the firm. Cash Credit This represents the overdraft facility on the hypothecation of inventories and book debts. Periodic inventory and debtor statement have to be submitted to the bank. VOL. 3, ISSUE 5 (May 2014) 14

7 Packing Credit facility for Exporters The commercial banks in India offer packing or Pre-Shipment finance to the exporters on the basis of confirmed export order and/or letter of credit issued by the importer s bank. Commercial Paper Commercial paper represents short term unsecured promissory notes issued by firm which enjoy a fairly good credit rating. Generally, well established companies with sound financial background are to issue commercial paper. The maturity period normally ranges between 90 to 180 days. Commercial paper is sold at a discount from its face value and redeemed at its face value. CONCLUSION A company can use a working capital statement to forecast future working capital, which helps with matters in budgeting. For investors, the working capital shows company's financial health whether the company is financially sound or not, and if the company is financially not sound then there is a need of maintaining effective working capital cycle. In this article as per my knowledge I include all the key elements which are very important for improving the working capital cycle and if the company follows this system then definitely such company will never face working capital problem. REFERENCES 1. Chartered institute of management, London Text Book: Entrepreneurship & management of small & medium enterprises, Vipul Prakashan, Romeo S. Mascarenhas. VOL. 3, ISSUE 5 (May 2014) 15

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