Module IV: Working Capital Management
Module IV: Working Capital Management
Module IV: Working Capital Management
Working capital management: Concept of working capital, Need for working capital, Types of
working capital, Sources of working capital, Management of Cash – Motives for holding cash,
Objectives of cash management - Management of inventories – Kinds of inventories, Risks and
costs associated with inventories, Management of accounts receivables – Purpose of receivables,
Costs of maintaining receivables, Factors of affecting the size of receivables, Optimum size of
receivables.
Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to their most effective use.
● The efficiency of working capital management can be quantified using ratio analysis.
● Working capital management requires monitoring a company's assets and liabilities to
maintain sufficient cash flow to meet its short-term operating costs and short-term debt
obligations.
● Working capital management involves tracking various ratios, including the working
capital ratio, the collection ratio, and the inventory ratio.
● Working capital management can improve a company's cash flow management and
earnings quality by using its resources efficiently.
The amount of fixed working capital required by a business depends upon the size and the
growth of the business. For instance, minimum cash or stock required by a firm to undertake the
operational activities of the business.Now, permanent working capital can be further subdivided
into two categories:
2. Regular Working Capital
This is defined as the least amount of capital required by a business to fund its day-to-day
operations of a business. Examples include payment of salaries and wages and overhead
expenses for the processing of raw materials.
The short-term internal sources of working capital include provisions for tax and dividends.
These are essentially current liabilities that cannot be delayed beyond a point. All companies
make a separate provision for making these payments. These funds are available with the
company until these payments are made. Hence, these are called the internal sources of working
capital. However, this value is relatively small and thus not that significant.
On the other hand, the short-term external sources of working capital include capital from
external agencies like banks, NBFCs, or other financial entities. Some of the primary sources of
short-term external sources of working capital are listed below:
Loans from Commercial Banks: Businesses, mostly MSMEs, can get loans from commercial
banks with or without offering collateral security. There is no legal formality involved except
creating a mortgage on the assets. Repayment can be made in parts or lump sum at the time of
loan maturity. At times, banks may offer these loans on the personal guarantee of the directors of
a country. They get these loans at concessional rates; hence it is a cheaper source of financing for
them. However, the flip side is that getting this loan is a time-consuming process.
Public Deposits: Many companies find it easy and convenient to raise funds for meeting their
short-term requirements from public deposits. In this process, the companies invite their
employees, shareholders, and the general public to deposit their savings with the company. As
per the Companies Act 1956, companies can advertise their requirements and raise money from
the general public against issuing shares or debentures. The companies offer higher interest rates
than bank deposits to attract the general public. The biggest of this source of financing is that it is
simple and cheaper. However, its drawback is that it may not be available during the depression
and financial stringency.
Trade Credit: Companies generally source raw material and other items from suppliers on credit.
The amount payable to these suppliers is also treated as a source of working capital. Usually, the
suppliers grant their buyers a credit period of 3 to 6 months. Thus, they provide, in a way,
short-term finance to the purchasing company. The availability of trade credit depends on various
factors like the buyer’s reputation, financial position, business volume, and degree of
competition, among others. However, when a business avails trade credit, it stands to lose the
benefit of cash discount, which they would earn if they make the payment within 7 to 10 days of
making the purchase. This loss of cash discount is treated as an implicit cost of trade credit.
Bill Discounting:Just as business buys goods on credit, they offer credit to their buyers. The
credit period may vary from 30 days to 90 days and sometimes extends, even up to 180 days.
During this period, the company funds get blocked, which is not good. Instead of waiting that
long, sellers prefer to discount these bills with a bank or NBFC. The financial entity charges
some amount as commission, called ‘discount’ and makes the balance payment to the sellers.
This discount compensates them for the time gap between disbursing and collecting the money
on the maturity of the bill. This ‘discount’ charged by the bank is treated as the cost of raising
funds through this method. Businesses widely use this method for raising short-term capital.
Bank Overdraft:Some banks offertheir esteemed customers and current account holders a
facility to withdraw a certain amount of money over and above the funds held by them in their
current account with the bank. The bank charges interest on the amount overdrawn and the
period it is withdrawn. The overdraft facility is also granted against securities. The bank sets this
limit and is subject to revision anytime, depending upon the customer’s creditworthiness.
Advances from Customers: One effortless way to raise funds to meet the short-term requirement
is to ask customers for some payment in advance. This advance confirms the order and gives
much-needed cash to the business. No interest is payable to the customer for this advance. Even
if any business pays interest, it is very nominal. Hence, this is one of the cheapest sources of
raising funds to meet companies’ short-term working capital requirements. However, this is
possible only when the customers do not choose the terms of sellers.
Like short-term sources, long-term sources may also be classified as internal and external
sources. Retained profits and accumulated depreciation are internal sources wholly earned and
owned by the company itself. These funds are available to a company without any direct cost.
The external sources of long-term sources of working capital are listed below:
Share Capital: The Company may raise funds by offering the prospective shareholders a stake in
their business. These shares may be held by the general public, banks, financial institutions, or
even other companies. The response depends on several factors, including the company’s
reputation, the perceived profit potential, and general economic condition. In return, the
company offers dividends to their shareholders, which along with the floating cost, is treated as
the cost of sourcing. However, the company is not legally bound to pay this dividend. Also, no
rule prescribes how much dividend is to be given. All this makes this a very cheap source of
working capital. But, in reality, most companies do not use this for meeting their working capital
needs.
Long-term Loans: Also called Working Capital Loans, these long-term loans may be temporary
or long-term. The long-term here is generally 84 months (7 years) or more. This loan is not taken
for buying long-term assets or investments and is used to provide working capital to meet a
company’s short-term operational needs. Experts advise using long-term sources for permanent
needs and short-term sources for temporary working capital needs.
Debentures: Like shares, debentures also include generating money from the general public,
financial institutions, and other companies. However, unlike shares, in the case of debentures, the
company has to declare the interest they will pay to their lenders openly. The company is legally
bound to pay the agreed interest. So, here, if the funds are unused or even if the company runs
into losses, they have to pay the lenders.
Cash Management
Cash management is the process of collecting and managing cash flows. Cash management can
be important for both individuals and companies. In business, it is a key component of a
company's financial stability.
Cash is the primary asset individuals and companies use to pay their obligations on a regular
basis. In business, companies have a multitude of cash inflows and outflows that must be
prudently managed in order to meet payment obligations, plan for future payments, and maintain
adequate business stability.
1) Transaction motive:
Business firm as well as individuals keep cash because they require it for meeting demand for
cash flow arising out of day to day transactions. In order t meet the obligations for cash flows
arising in the normal course of business , every firm has to maintain adequate cash balance. A
firm may require cash for making for purchase of goods & services.
These cash outflows are met out of cash inflows arising out of cash sales or recovery from the
debtors. Further, the cash inflows & outflows are not fully and exactly synchronized, a firm is
always required to maintain a minimum cash balance with it. The necessity of keeping a
minimum cash balance to meet payment obligations arising out of expected transactions, is
known as Transactions motive for holding cash.
2) Precautionary motive :
The precautionary motive for holding cash is based on the need to maintain sufficient cash to act
as a cushion or buffer against unexpected events. A firm should maintain larger cash balance
than required for day to day transactions in order to avoid any unforeseen situation arising
because of insufficient cash. The necessity of keeping a cash balance to meet any emergency
situation or unpredictable obligation, is known as precautionary motive for holding cash.
The amount of cash, a firm must hold for transaction & precautionary depends upon;
a) Degree of predictability of its cash flows
b) Its willingness and capacity to take risk of running hot of cash, and
c) Available immediate borrowing powers.
3) Speculative motive:
Cash may be held for speculative purpose in order to take advantage of potential profit making
situations. A firm may come across an unexpected opportunity to make profit, which is not
possible in normal business routine. The motive to keep balance for these purpose is obviously
speculative in nature. The firm’s desire to keep some cash balance to capitalize an opportunity of
making an unexpected profit is known as speculative motive. The speculative motive provide a
firm with sufficient liquidity to take advantage of unexpected profitable opportunity that may
suddenly appear ( and just suddenly disappear if not capitalize immediately.)
4) Compensation motive:
Commercial banks require that in every current account , there should always be a minimum
cash balance. This minimum cash balance is generally not allowed by the bank to used for
transaction purpose and therefore , it becomes a sort of investment by the firm in the bank. In
order to avail the convenience of holding a current account , the minimum cash balance must be
maintained by the firm and this provides the compensation motive for holding cash.
Out of different motives, the transactions motive is the most obvious one and is found in every
firm. Even the precautionary motive is common & a firm maintains cash balance both for the
transactions motives & the precautionary motive. However , the speculative motive is a
subjective one may differ from one firm to another. Generally, the speculative motive is the least
important component for a firm’s preference for liquidity. The transaction & precautionary
motives account for most of the reasons why affirm holds cash balance. The compensation
motive may be a compulsion and the firm may not have many options. The cash held for
transaction motive is necessary, the cash held for precautionary motive provides a margin of
safety, but holding a cash does not generate any explicit monetary return, rather it involves a
cost. The main cost of holding cash is the loss of interest which the firm could otherwise earn by
investment of cash elsewhere.
Your cash management system allows you to optimize your cash levels, creating better liquidity.
A good example is your store float. If you’re unsure what your inflows will look like for the day,
you might set the float higher than you need to. That money then sits in your petty cash fund or
smart safe, when it could be paying down debts or sitting in a deposit account earning interest.
Conversely, if you put all your cash on deposit, you’ve hampered your liquidity. When an
unexpected cost crops up, you may find you don’t have the cash to cover it.
Cash management software has many functions that will help optimize your cash levels,
including:
Cash analytics: Provide data around the movement of cash from tills to vault holdings. This
allows you to manage cash balances, reconciliation, and deposit reporting more effectively.
Cash forecasting: Provides insights into trends to forecast your cash needs and replenishments,
while enabling you to see cash on hand and what you need on a frequent basis to operate your
business efficiently.
Cash status: Gives you a view into your available cash on hand and frequency of denomination
usage. You’ll better understand which notes and coins are most in demand, so you always have
enough cash on hand.
Automated cash management systems collect and provide data, which helps you make more
informed decisions. With the right system, you will stop worrying about cash shortages and
multiple deposits running up the costs of doing business.
Having the right cash management system in place is key here. A good management system
allows you to see cash as it flows through your business, giving you a bird’s eye view of where
cash is leaving the business and where it’s entering.
Inventory Management
Inventory management helps companies identify which and how much stock to order at what
time. It tracks inventory from purchase to the sale of goods. The practice identifies and responds
to trends to ensure there’s always enough stock to fulfill customer orders and proper warning of a
shortage.
Once sold, inventory becomes revenue. Before it sells, inventory (although reported as an asset
on the balance sheet) ties up cash. Therefore, too much stock costs money and reduces cash flow.
Public companies must track inventory as a requirement for compliance with Securities and
Exchange Commission (SEC) rules and the Sarbanes-Oxley (SOX) Act. Companies must
document their management processes to prove compliance.
Saves Money:
Understanding stock trends means you see how much of and where you have something in stock
so you’re better able to use the stock you have. This also allows you to keep less stock at each
location (store, warehouse), as you’re able to pull from anywhere to fulfill orders — all of this
decreases costs tied up in inventory and decreases the amount of stock that goes unsold before
it’s obsolete.
Satisfies Customers:
One element of developing loyal customers is ensuring they receive the items they want without
waiting.
What Is Inventory?
Inventory is the raw materials, components and finished goods a company sells or uses in
production. Accounting considers inventory an asset. Accountants use the information about
stock levels to record the correct valuations on the balance sheet.
1. Raw Materials
Materials that are needed to turn your inventory into a finished product are raw materials. These
inventory items are bits and pieces of component parts that are currently in stock but have not yet
been used in either work-in-process or finished goods inventory.
There are two types of raw materials: direct materials—which are used directly in finished
goods, and indirect materials—which are part of overhead or factory costs.
Inventory example: For example, direct raw materials might be leather to make belts for your
company would fall under this category. Or, if you sell artificial flowers for your interior design
business, the cotton used would be considered direct raw materials, too.
Indirect raw materials might be lightbulbs, batteries, or anything else that indirectly contributes
to keeping your shop running.
2. Work-In-Process
Inventory that is being worked on is Work-In-Process (WIP), just like the name sounds. From a
cost perspective, WIP includes raw materials (plus, sometimes labor costs) that are still “in
production” when the accounting period ends.
In other words, whatever direct and indirect raw materials your business is using to create
finished goods is WIP inventory.
Inventory example: If you sell medical equipment, the packaging would be considered WIP.
That’s because the medicine cannot be sold to the consumer until it is stored in proper packaging.
It’s literally a work-in-process.
Another example would be a custom wedding dress that’s not quite finished when the end of the
fiscal year rolls around. That lace, silk, and taffeta are no longer raw materials, but they’re not
quite a “finished goods” wedding dress, either.
3. Finished Goods
Maybe the most straightforward of all inventory types is finished goods inventory. That
inventory you have listed for sale on your website? Those are finished goods. Any product that is
ready to be sold to your customers falls under this category.
4. Overhaul / MRO
Also known as Maintenance, Repair, and Operating Supplies, MRO inventory is all about the
small details. It is inventory that is required to assemble and sell the finished product but is not
built into the product itself.
Depending on the specifics of your business, this inventory might be in storage, at a supplier, or
in transit out for delivery.
Inventory example: For example, gloves to handle the packaging of a product would be
considered MRO. Basic office supplies such as pens, highlighters, and paper would also be in
this category.
2. Risk of obsolescence
The is a risk of inventory becoming obsolescence. The inventory may become obsolete/outdated
due to improved technology, improvements in product design, changes in customers’ taste etc.
3. Purchase cost
A firm has to pay high price for managing inventory. Inventory management has to take into
account of the price paid to the suppliers and the expense of transport for bringing the material to
stores, insurance and transportation cost.
4. Ordering cost
Cost of ordering is one another factor that a firm has to consider in Inventory management.
Ordering costs includes cost of requisitioning, preparation of purchase order, transportation of
inventory, receiving the supplies at the warehouse etc.
5. Carrying cost
Carrying cost includes the cost of storing the inventory in warehouse, handling expenses,
insurance and rent paid for managing the inventory, opportunity cost locked up in stocks etc.
Opportunity cost here refers to the alternative use of funds that the firm would have used to
invest in stocks.
Measurement of shortage cost is relatively difficult because of its intangible nature. In practice,
the lost contribution resulting from failure to meet demand provides a reasonable approximation.
In cases where stock out does not result in loss in business, additional cost for crash procurement
etc. may be considered as shortage cost.
● Credit rating i.e the paying ability of the customers shall be reviewed before agreeing to
any terms and conditions
● Continuously monitoring any risk of non-payment or delay in receiving the payments
● Customer relations should be maintained and thus to reduce the bad debts
● Addressing the complaints of the customers
● After receiving the payments, the balances in the particular account receivable should be
reduced
● Preventing any bad debts of the receivables outstanding during a particular period.
The basic purpose of the firm’s receivable management is to determine effective credit policy
that increases the efficiency of a firm’s credit and collection department and contributes to the
maximization of the value of the firm. The specific purposes of receivable management are as
follows:
● To evaluate the creditworthiness of customers before granting or extending the credit.
● To minimize the cost of investment in receivables.
● To minimize the possible bad debt losses.
● To formulate the credit terms in such a way that results in maximization of sales revenue
and still maintaining a minimum investment in receivables.
● To minimize the cost of running a credit and collection department.
● To maintain a trade-off between costs and benefits associated with credit policy.