Working Capital Management
Working Capital Management
Working Capital Management
final project1.doc (Size: 593.5 KB / Downloads: 15) THEORETICAL BACKGROUND INTRODUCTION TO WORKING CAPITAL Empirical observations show that the financial managers have to spend much of their time to the daily internal operations relating to current assets and current liabilities of the firms. As the largest portion of the managers time is devoted to working problems, it is necessary to manage working in the best possible way to get maximum benefit. The effective management of the business, among other things primarily depends upon the manner in which the short-term assets and short run sources of financing are managed. The management or current assets management consists of inventories, accounts receivable and cash & bank balances as the major components. There is a difference between current assets and fixed assets in terms of their liquidity. A firm requires many years to
recover the initial investments in fixed assets such as plant and machinery and land and buildings. On the contrary, investments in current assets are turned over many times a year. Investments in current assets such as inventories and book debts are realized during the firms working capital cycle, which is usually less than a year. Working capital is that proportion of a companys total capital, which is employed in short-term operations. Even though, it is one segment of the capital structure of a business, it constitutes an interwoven part of the total integrated business system. Therefore, neither it can be regarded as an independent entity, nor, can the working capital decisions be taken in isolation. Thus, a study in this field is of major importance to both internal and external analysis, for its close relationship with the dayto-day operations of a business. There are many aspects of working capital management, which form an important function of a financial manager: Working management represents a large portion of the firms investment in assets. Working management
has greater significance not only for small firms but also for large firms. The need for working capital is directly related to sales growth. Most of the work dealing with working capital management in confined to the balance sheet, which is directed towards optimizing the levels of cash and marketable securities, receivable and inventories. For the most part, optimization of these current assets is isolated from the optimization of the other current assets and the overall valuation of the firm. The decision concerning cash and resources, receivable, investments and current liabilities is with an objective of maximizing the overall value of the firm. Once decisions are reached these areas, the levels of working capital are also reduced. An appropriate level of working capital is to be maintained as the excessive working capital interrupts the smooth flow of the business activity and curbs profitability. Also, there are a lot of circumstances where shortage of working capital has proved to be the major factor for business failure. Operating plans are out of control and the corporate objectives get
blurred. The suppliers and the creditors give the firm an adverse credit rating and tighten up credit terms. The problem of managing working capital has got a separate entity as against different decision-making issues concerning current assets individually. Working capital has to be regarded as one of the conditioning factors in the long run operations of a firm, which is often inclined to treat it as an issue of short-run analysis and decisionmaking. The management of working capital hence involves constant vigilance to ensure that the right quantum is available on a continuing basis to support and promote the activities. Sound financial and statistical techniques, supported by judgment, should be used to predict the quantum of working capital needed at different time periods.
DEFINITIONS OF WORKING CAPITAL Working capital has been in several ways as given below. Operating capital: - As the working capital is the capital required to operate the business and is the capital invested in
the current assets, it is called as operating capital. Circulating capital: Interchangingly used word for working is circulating capital. Gerestenberg gas suggested this item circulating capital as all the assets of business change from one form to another.
CONCEPTS OF WORKING CAPITAL Conceptually, working capital is either explained as: - Net Working Capital or Gross Working Capital. These concepts are not exclusive; rather they have equal significance from management viewpoint. Gross working capital refers to the firms investment in current assets. Net working capital refers to the difference between current assets and current liabilities. GROSS WORKING CAPITAL CONCEPT It is called as qualitative aspect of working capital and focuses attention on two aspects of current assets management: 1. Optimum investment in current asset It is conventional rule to maintain the level of current assets twice the level of current liabilities to constitute a margin or
buffer for maturing obligation of a business. 2. Financing of current asset Another aspect of gross working capital points to the need of arranging funds to finance current assets. NET WORKING CAPITAL CONCEPT Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital mean excess current liabilities over current assets.net working capital being the difference between current assets and current liabilities, is qualitative concept and hence it: 1. Indicates the liquidity position of the firm: - A weak liquidity position poses a threat to solvency of the company and makes it unsafe and unsound. 2. Suggests the extent to which working capital needs may be financed by permanent sources of funds:- i.e., it covers the question of judicious mix of long term and short term funds for financing current assets. Thus, it may be emphasized that both gross and net concepts of working capital are equally important for the efficient management of working
capital.
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of funds has a great scope, in finance and profit planning, for the most effective utilization of enterprise resources, the fixed and current assets have to be combined in optimum proportions. Working capital in simple terms means the amount of funds that a company requires for financing its day-to-day operations. Finance manager should develop sound techniques of managing current assets. WHAT IS WORKING CAPITAL? Working capital refers to the investment by the company in short terms assets such as cash, marketable securities. Net current assets or net working capital refers to the current assets less current liabilities. IMPORTANCE OF WORKING CAPITAL
Working capital may be regarded as the lifeblood of the business. Without insufficient working capital, any business organization cannot run smoothly or successfully.In the business the Working capital is comparable to the blood of the human body. Therefore the study of working capital is of major importance to the internal and external analysis because of its close relationship with the current day to day operations of a business. The inadequacy or mismanagement of working capital is the leading cause of business failures. Implications of Net Working Capital: Net working capital is necessary because the cash outflows and inflows do not coincide. In general the cash outflows resulting from payments of current liability
are relatively predictable. The cash inflows are however difficult to predict. More predictable the cash inflows are, the less NWC will be required. But where the cash inflows are uncertain, it will be necessary to maintain current assets at level adequate to cover current liabilities that are there must be NWC. PLANNING OF WORKING CAPITAL: Working capital is required to run day to day business operations. Firms differ in their requirement of working capital (WC). Firm s aim is to maximize the wealth of share holders and to earn sufficient return from its operations. Operating cycle: The working capital cycle refers to the length of time between the firms paying the cash for materials, etc.,
entering into production process/stock & the inflow of cash from debtors (sales), suppose a company has certain amount of cash it will need raw materials. Some raw materials will be available on credit but, cash will be paid out for the other part immediately. Then it has to pay labour costs & incurs factory overheads. These three combined together will constitute work in progress. After the production cycle is complete, work in progress will get converted into sundry debtors. Sundry debtors will be realized in cash after the expiry of the credit period. CASH MANAGEMENT: Cash management is one of the key areas of WCM. Apart from the fact that it is the most liquid asset, cash is the common denominator to
which all current assets, that is, receivables & inventory get eventually converted into cash. Cash is oil of lubricate the ever-turning wheels of business: without it the process grinds to a shop. CASH IS MAINTAINED FOR FOUR MOTIVES: Transaction motive: Transaction motive refer to the holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in a variety of transactions to accomplish its objectives which have to be paid for in the form of cash. E.g. payment for purchases, wages, operating expenses, financial charges like interest, taxes, dividends etc. Thus requirement of cash balances to meet routine
need is known as the transaction motive and such motive refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts.
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