Management of Working Capital

International Journal of Computer Science & Management Studies, Vol. 13, Issue 03, May 2013 Management of Working Capital Arti Rani Assistant Professor Kanya Mahavidhyalya, Kharkhoda, Sonepat, Haryana (India) Abstarct Working capital management holds an important place in the theory of finance. A large number of tools and techniques have been developed in the past to ensure optimum allocation of funds. More than eighty percent time of a finance manager is spent in dealing with day to day problems which are part and parcel of working capital requirement of an enterprise. Efficient use of working capital has a direct bearing on profitability of an enterprise. Working Capital in the life of every concern, whether manufacturing or non manufacturing, without adequate working capital, there can be no progress in industry. Inadequate working capital means shortage of inputs whereas more of it leads to extra cost. So the amount of working capital in every concern should be neither more nor less than what is actually required. This paper concentrates on the factors such as understanding the concept of working capital correctly, analyzing the importance and need thereof and determination of its adequacy, keeping the influencing factors into considerations. The management have to see that fund invested as working capital in their organization earn at least as much as they would earned if invested any where else. Keywords: Working Capital, Manufacturing Cycle, Business Cycle. Introduction Working capital may be regarded as the life blood of a business. Its effective provisions can do much to ensure the success of a business. While its inefficiency can lead to ensure mismanagement that can lead not only loss the profit but also great downfall of what otherwise might be considered as a promising concern. Working Capital Management is an integral part of overall corporate management. It is concerned with the problem that arise in attempting to manage the current assets and the current liabilities and their relationship that exists between them. The term current assets refers to those assets which, in the ordinary course of business, can be or will be turned into cash with in one year without undergoing a diminution in value and without disrupting the operations of the firm. The major current assets are marketable securities, account receivables and inventory. Current liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary course of business, within one year out of current assets or the earning of the concern. The basic current liabilities are account payables, bank overdraft and outstanding expenses. The goal of working capital management is to manage the firm current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, It is likely to become and may even be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high level of anyone of them. Each of the short term sources of the financing must be continuously managed to ensure that they are obtained and used in the best possible way. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of working capital management. Definition of Working Capital According to board of American Institute of certified accountants Net Working Capital is represented by the excess of current assets over relatively liquid portion of the total enterprises capital which constitutes a margin of buffer for maturing obligations with in the ordinary operation cycle of the business. 85

International Journal of Computer Science & Management Studies, Vol. 13, Issue 03, May 2013 According to Corine T. Morgard Working Capital is defined as the difference between the company current assets and current liabilities. The accounts which belongs to this group is usually the most active in the company. Unlike fixed assets, they reflect the company daily activities. Objective of Working Capital Management The objective of working capital management is to arrange the needs at right time, from right resource and for right period so that a trade off between liquidity and profitability may be realized. The greater the amount of the working capital, more will be the liquidity of the firm and lesser will be its profitability. On the other hand, lesser the amount of working capital, more will be the profitability. This is true to a certain limit. After this limit, lesser liquidity will reduce the profitability. The following are the two main objectives of working capital management : 1) To make payment according to payment schedule. 2) Better Utilization of resources and maintain optimum balance of working Concepts of Working Capital There are two concepts of working capital : 1) Gross Working Capital 2) Net Working Capital Gross Working Capital : This concept refers to the total of current assets. Current assets are the those assets which are convertible into cash in the ordinary course of business within a year. It is also known as circulating capital or current Net Working Capital : This concept defines the most common definition of net working In this concept, it is the difference between current assets and current liabilities. Current liabilities are those liabilities, which are expected to be paid in the ordinary course of business with in a year. Types of Working Capital Fixed or Permanent Working Capital : Permanent Working Capital is the minimum amount which is required to ensure effective utilization of Fixed Facilities and maintaining the circulation of current assets. There is always a minimum level of current assets which is continuously required by enterprise to carry out its normal business operation. For Example : Every firm has to maintain a minimum level of raw material, work in progress, finished goods and cash balance. This balance varies from year to year, depending upon the growth of a firm and the stage of business cycle in which it operates. The amount of permanent working capital is needed to conduct a business during the dullest season of the year. That is why it is known as Permanent/Fixed/Regular Working Capital. Temporary/Variable Working Capital : In certain months of the year, the level of business activities is higher than normal, therefore, additional working capital may be required along with Permanent Working Capital. It is known as Variable or Temporary working This part of the working capital is required due to chanages in Demand and Supply of goods on account of change in seasons etc. e.g. : In Boom Period, stock is to be kept to fulfill the demand and amount of debtors increases due to more sales. Similarly, due to depression, the amount of stock and debtors decline. Variable working capital is required for a short time. Operating Cycle of Working Capital Operating Cycle is the time lag between the acquisition of goods or services entering the production process and the final realization of the cash through sale of the end product. Thus, the operating cycle describe the lag of immediate realization of cash. Therefore, sufficient amount of working capital is necessary to sustain business activities. The continuing flow from cash to supplier, to inventory, to account receivable and back into cash is called the operating cycle. For example, 86

International Journal of Computer Science & Management Studies, Vol. 13, Issue 03, May 2013 a company buy raw material for cash, process them into work-in-process, to finished goods by spending money on wages, salaries and other administrative and factory overheads. Goods are sold on credit which results in account receivable. When the customers pay their bills, the firm draws out its profit and replenishes the cash balance. In the operating cycle, following events are included : 1) conversion of cash into raw materials, 2) conversion of raw material into workin-progress, 3) conversion of work-in-progress into finished goods, 4) conversion of finished goods into account receivables, 5) conversion of account receivables into cash. The operating cycle approach is quiet useful both, in controlling and forecasting working If greater the period of operating cycle, more will be the requirement of working If business enterprises are engaged in trading activities only, operating cycle duration will be of small period and thus, lesser the requirement of working Mathematically, operating cycle is defined as O = R + W + F + B C Where, O = duration of operating cycle, R = raw material, store and storage period, W = work-in-progress period, F = finished goods storage period, D = Debtors collection period, C = Creditors payment period The components of the operating cycle are calculated as Average stock of Raw Materials and Stores R = ----------------------------------------------------- Average Raw Material Consumption per day Annual consumption of Raw Material = Opening Stock of Raw Material + Purchases Closing Stock of Raw Material Average work in progress inventory W = ------------------------------------------- Average cost of production per day Annual Cost of Production = Opening stock of work-in-progress + Consumption of Raw Material + Manufacturing Cost such as : wages and salaries Closing stock of work-in-progress. Average Finished Goods Inventory F = -------------------------------------------- Average Cost of Goods Sold per day Annual Cost of Goods Sold = Opening Stock of Finished Goods + Cost of Production + Selling and Distribution Cost Closing stock of Finished Goods Average Book Debts D = ------------------------------------ Average Credit Sales per day Average Trade Creditors C = ---------------------------------------- Average Credit Purchases per day Average figures are obtained by dividing the opening and closing figures of respective items by 2. Factors Affecting Working Capital Business should prepare its financial plan in such a way that it has neither surplus nor inadequate working The amount of working capital of any business depends upon various factors. Generally, the following factors must be considered while determining the requirement of working 1) NATURE OF BUSINESS : Nature of business affects the working capital requirements of the business. Railways, transport, electricity, water and other public utilities require relatively lower working capital because the demand for their services is regular and fixed. On the other hand, the trading institutions require more working capital because they have to keep adequate stock, cash and debtors. In Financial institution and banks, the need for working 87

International Journal of Computer Science & Management Studies, Vol. 13, Issue 03, May 2013 capital is much more than that of permanent 2) MANUFACTURING CYCLE : It is said that longer the manufacturing cycle of a product, the larger is the requirement of working The reason is that a large amount of inventory is tied up on it manufacturing. 3) BUSINESS CYCLES : Recession or boom in economy will affect working capital requirement to a large extent. During recession, firms tend to keep more inventory due to general slow down in the economy. Consumer have less spending power hence, postpone their purchases. Receivables are delayed because of slow movement of goods. 4) TERMS OF PURCHASE AND SALES : If, for instance, the undertaking purchase its material on credit basis and sales of finished goods on cash basis. It requires less working capital over an undertaking which is following the other way of purchase on cash basis and sales on credit basis. 5) CREDIT POLICY OF THE FIRM : The credit policy of the concern affects the working capital by influencing the level of book debts. A liberal credit looking without rating the credit worthiness of the customers will lead to unnecessary tie up of funds in the book debts and dull collection procedures can increase the balance of bad debts. Thus, liberal policy will raise the level of working capital and vice-versa. 6) AVAILABILITY OF BANK CREDIT : A firm will need less working capital if liberal credit terms are available to it and vice-versa. 7) OPERATING EFFICIENCY : Efficiency of management is also an important factor to determine the working Management can reduce the working capital requirements by the efficient use of resources. It can increase working capital turnover by enhancing the speed of cash cycle. 8) CHANGE IN TECHNOLOGY : Technology development related to the production process have a sharp impact on the need for working capital changes. It needs 88 additional amount of working capital due to fresh investment in new fixed assets. 9) LEVEL OF TAXES : The payment of taxes is a short term liabilities payable in cash. Higher the tax liabilities, higher the amount of working capital and vice versa. 10) DIVIDEND POLICY : When dividend paid in cash, it has unfavorable affect on working Payment of dividend consumes cash resources and there by, affect working capital to that extent conversely, if the firm does not pay dividend but retain the profit, working capital will increase. All the above factors should be carefully considered while determining the working capital requirement. Some of the factors may increase the permanent working capital requirement, but, to some extent, it may reduce the extent of variability in the temporary working capital, while other factors may lead to lesser core working capital but greater temporary working Financing of Working Capital After determining the level of working capital, a firm has to consider how it will be financing the working capital requirements of a concern. It can be classified as:- 1) Permanent Working Capital Requirement : In any concern, a part of working capital investment is as permanent as investment in fixed assets. This is so because there is always a minimum level of current assets which is continuously required by the enterprises to carry out its day to day operations and this minimum level can not be expected to be reduced, at any time. This minimum level of current assets gives rise to permanent or fixed working Fixed working capital is permanently blocked in current asset sources because permanent working capital is called long term sources. There are two types of long term sources : A) Owned Sources : a) Issue of Share capital b) Retained Earnings c) Sales of Fixed assets

International Journal of Computer Science & Management Studies, Vol. 13, Issue 03, May 2013 d) Retiring current liabilities below book value e) Reserves B) Borrowed Sources : a) Debentures b) Long Term Debts 2) Variable Working Capital Requirement : Similarly, some amount of working capital may be required to meet the seasonal demand and some special exigencies such as rise in price, strikes etc. This proportion of working capital gives rise to variable working capital which cannot be permanently employed gainfully in business. This type of working capital requirement may be met from the short term sources to Short Term sources are classified into two parts : A) Internal Sources : a) Depriciation funds b) Provision for Taxation c) Outstanding payments B) External Sources : a) Trade Credits b) Credit Papers c) Bank Credit d) Public Deposits e) Advance from customers f) Finance Companies g) Native Money Lenders h) Loan from Executive Directors i) Government Assistances j) Securities of employers Analysis of Working Capital The working capital position of the firm is analysed by Internal and External Parties. In the External parties, Creditors, Banks, Financial Institution, Debenture holders and Existing and Prospective shareholders are included. The main objective of analysis of working capital is to evaluate the liquidity of the business. It helps in finding out whether the working capital deployed in the business is adequate or not, whether it is being used efficiently or not. Following are the methods of working capital analysis. 1) Schedule of changes in working capital 2) Ratios : a) Current Ratio b) Inventory Turnover Ratio c) Working Capital Turnover Ratio d) Debtors Turnover Ratio e) Creditors Turnover Ratio f) Liquid Ratio 3) Fund Flow Statement 4) Cash Flow statement Conclusion The discussion taken place in this paper has analyzed the concept of working capital, objectives and importance of working capital, types of working capital, operating cycle of working capital, Factors affecting working capital and financing of working capital in order to understand the profitability risk trade off associated with each other assuming that all other factors are held constant. Adequacy of working capital is very essential for a business to run it smoothly. Keeping all factors as discussed in this paper into consideration, Optimum and Effective working capital policy should be designed and implemented for the successful running of any business or industry. References [1] K.V.Smith MANAGEMENT OF WORKING CAPITAL, New York : West Publishing Company 1974, P.181. [2] P.V.Kulkarni, FINANCIAL MANAGEMENT, Bombay Himalaya Publishing House, India 2 nd Edition,1983,P.387. [3] I.M.Pandey, FINANCIAL MANAGEMENT, New Delhi : Vikas Publishing Pvt. Ltd,P.337. [4] T.Nagard Cornie. MANAGEMENT ACCOUNT, Fngleinood Cliffs : N.I.Prentice Hall of India Pvt. Ltd.1985,P.668. [5] Frce Weston and Eugence F. Bridhan MANAGEMENT FINANCE,P.144. [6] O.Donell and Goldbrey. ELEMENTS OF FINANCIAL ADMINISTRATION, New Delhi :Prentice Hall of India Private Limited,1964,P.55. [7] Narender Kumar Jain, WORKING CAPITAL MANAGEMENT, A.P.H.Publishing Corporation, 2004,P.77. 89