MANAGEMENT OF WORKING CAPITAL Rts 10.1 MEANING AND CONCEPT OF WORKING CAPITAL In accounting term working capital is defined as the difference between current assets and current liabilities. If we break down the components of working capital ‘we will find working capital as follow: Current Assets: An asset is classified as current when (i) It is expected to be realised or intends to be sold or consumed in normal ‘operating cycle of the entity or within twelve months after the reporting period whichever is longer; and (ii) The asset is held primarily for the purpose of trading in the ordinary course of business. For the purpose of working capital management, current assets of an entity can be grouped into the following categories: (@)_ Inventory (raw material, work in process and finished goods) (b) Receivables (trade receivables and bills receivables) (©) Cash or cash equivalents (including short-term marketable securities) (d) Prepaid expenses ‘Other current assets may also include short term loans or advances, any other accrued revenue ete. Current Lia S: A liability is classified as current when: (i) Itis expected to be settled in normal operating cycle of the entity or within twelve months after the reporting period whichever is longer; and (ii) Itis settled either by the use of current assets or by creation of new current liability. For the purpose of working capital management, current liabilities of an entity can be grouped into the following categories: ‘© The Institute of Chartered Accountants of Indiaey FINANCIAL MANAGEMENT (a) Payable (trade payables and bills payables) (b) Outstanding payments (wages & salary, overheads & other expenses etc.) Other current liabilities may also include short term borrowings, current portion of long-term debts, short term provisions that are payable within twelve months such as provision for taxes etc. Working Capital Management is process which is designed to ensure that an ‘organization operates efficiently by monitoring & utilizing its current assets and current liabilities to the best effect. Primary objective is to enable a company maintaining sufficient cash flows in order to meet its day to day operating expenses and its short-term obligations. The concept of working capital can also be explained through two angles. Working capital On the basis of Value (On the basis of Time Gross Net Permanent " Flactuating (a) Value: From the value point of view, Working Capital can be defined as Gross Working Capital or Net Working Capital Gross working capital refers to the firm's investment in current assets. ‘Net working capital refers to the difference between current assets and current liabilities. A positive working capital indicates the company's ability to pay its short-term liabilities. On the other hand, a negative working capital shows inability of an entity to meet its short-term obligations. (b) Time: From the point of view of time, working capital can be divided into two categories viz, Permanent and Fluctuating (temporary). Permanent working capital refers to the base working capital, which is the minimum level of investment in the current assets that is carried by the entity at all times to carry its day to day activities. It generally stays invested in the business, unless the operations are scaled up or down permanently which would also result in increase © The Institute of Chartered Accountants of India,MANAGEMENT OF WORKING CAPITAL Bits or decrease in permanent working capital. It is generally financed by long term sources of finance. Temporary working capital refers to that part of total working capital, which is required by an entity in addition to the permanent working capital. It is also called variable or fluctuating working capital which is used to finance the short-term working capital requirements which arises due to fluctuation in sales volume. For instance, an organization would maintain increased levels of inventory to meet increased seasonal demand. The following diagrams shows Permanent and Temporary or Fluctuating or variable working capital: oO \ / \ / Temporary Permanent Account of Working Capital ‘Account of Working Capital Time Time Both kinds of working capital ie. permanent and fluctuating (temporary) are necessary to facilitate production and sales through the operating cycle. G 10.2 SIGNIFICANCE OF WORKING CAPITAL 10.2.1 Importance of Adequate Working Capital Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available is neither too large nor too small for its requirements. ‘A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds that are used to invest in surplus working capital. Another way to look at it is that there is an opportunity cost involved where the company could have invested the surplus funds in long term investments and earned some return on the same. ‘© The Institute of Chartered Accountants of IndiaMI 2 ciat wanacement Various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of resources. ‘On the other hand, if the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities. It may also mean that a company may not be holding enough inventory in order to meet the customers’ demand and hence would lose sales and eventually some reputation as well, ‘An organization, therefore, has to be very careful in estimating its working capital requirements. Maintaining adequate working capital is not just important in the short-term, sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. When businesses make investment decisions, they must net only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g. > Increased production leads to holding of additional stocks of raw materials and work-in-progress. An increased sale usually means that the level of debtors and the finished goods inventory requirements will increase. ‘A general increase in the firm's scale of operations tends to imply a need for greater levels of working capital. ‘A question then arises what is an optimum amount of working capital for a firm? ‘An organization should neither have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the Tequirements ot working capital carefully and determine the optimum level of investment in working capital. 10.2.2 Optimum Working Capital If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly. Not being able to meet, © The Institute of Chartered Accountants of India,MANAGEMENT OF WORKING CAPITAL Xs its short-term obligations, company shall eventually lose its reputation and not many vendors would like to do business with them. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. A higher ratio may indicate inefficient use of funds and a lower ratio would mean liquidity issues as mentioned above. This is supplemented by Quick Ratio or Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one) which would imply that there is a comfortable liquidity position if liquid current assets are equal to current liabilities (where quick assets / liquid current assets refer to current assets less inventory & prepaid expenses). Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound or where the nature of finished goods are perishable in nature like a restaurant, then also the organization cannot afford to hold large amount of working capital. On the other hand, an organization dealing in products which take a longer production time, may need a higher amount of working capital. In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous. © 10.3 DETERMINANTS OF WORKING CAPITAL Working capital management is concerned with: (2) Maintaining adequate working capital (managing the level of individual current assets and the current liabilities) and © The Institute of Chartered Accountants of India,EEE vanciat manacement (b) For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is known as Working Capital Management. jancing of the working capital. Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required at different times. ‘Some of the factors which need to be considered while planning for working capital requirement are: 1. Cash: Identify the cash balance which allows for the business to meet day- to-day expenses but reduces cash holding costs (example - loss of interest on long term investment had the surplus cash invested therein). 2. Inventory: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow. The techniques like Just in Time (JIT) and Economic order quantity (€OQ) are used for this. ‘© The Institute of Chartered Accountants of IndiaMANAGEMENT OF WORKING CAPITAL Ro 3. Receivables: Identify the appropriate credit policy, ic. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). The tools like Early Payment Discounts and allowances are used for this. 4, Short-term Financing Options: Inventory is ideally financed by credit granted by the supplier. However, depending on the cash conversion cycle, it may be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash’ through “factoring” in order to finance working capital requirements. 5. Nature of Business: For e.g. in a business of restaurant, most of the sales are in Cash, Therefore, need for working capital is very less. On the other hand, there would be a higher inventory in case of a pharmacy or a bookstore. 6. Market and Demand Conditions: For e.g. if an item's demand far exceeds its production, the working capital requirement would be less as investment in finished goods inventory would be very less with continuous sales. 7. Technology and Manufacturing Policies: For e.g. in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production throughout the whole year or rather may choose a policy of production only during the demand season. 8. Operating Efficiency: A company can reduce the working capital requirement by eliminating waste, improving coordination, process improvements etc. 9. Price Level Changes & Exchange Rate Fluctuations: For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are required. Therefore, the effect of rising prices is that a higher amount of working capital is required. Another example would be unfavorable exchange rate movement in case of imported raw materials would warrant additional cost of same. G 10.4 MANAGEMENT OF WORKING CAPITAL The importance of working capital for an entity can be compared to importance of life blood for a living body or of a lubricant/ fuel for an engine. Working capital is required for smooth functioning of the business of an entity as lack of this may interrupt the ordinary course of activities. Hence, the working capital needs adequate attention and efficient management. When we talk about the © The Institute of Chartered Accountants of India,EERE vanciat manacement management, it involves 3 Es i.e. Economy, Efficiency and Effectiveness and all these three are required for the working capital management. The scope of working capital management can be grouped into two broad areas: (i) Liquidity and Profitability (i) Investment and Financing Decision. ‘Scope of Working Capital Management Liquidity and Profitability Investment and Financing 10.4.1 Liquidity and Profitability For uninterrupted and smooth functioning of the day to day business of an entity, it is important to maintain liquidity of funds evenly. As we have already learnt in previous chapters that each rupee of capital bears same cost. So, while maintaining liquidity the cost aspect needs to be borne in mind. Also, a higher working capital may be intended to increase the revenue & hence profitability, but at the same time unnecessary tying up of funds in idle assets not only reduces the liquidity but also reduces the opportunity to earn better return from a productive asset. Hence, a trade-off is required between the liquidity and profitability which increases the profitability without disturbing the day to day functioning. This requires 3Es as discussed above ie. economy in financing, efficiency in utilisation and effectiveness in achieving the intended objectives. The trade-off between the components of working capital can be summarised as follows: Fewer stock-outs | Use techniques increase the | like EOQ, JIT etc. profitability. to carry optimum level of inventory. Lower inventory requires less capital but endangered stock-out and loss of goodwill, Inventory ‘© The Institute of Chartered Accountants of IndiaMANAGEMENT OF WORKING CAPITAL as Receivables | Higher Credit | Evaluate the | Cash sales provide period attract | credit policy; use | liquidity but fails to customers and] the services of | boost sales and increase revenue debt revenue (due to management lower credit period) (factoring) agencies. Pre- Reduces uncertainty | Cost-benefit Improves. or payment of | and profitable in| analysis required | maintains liquidity. expenses _| inflationary environment. Cash and | Payables are | Cash budgets and | Cash can be invested Cash honoured in time, | other cash|in some other equivalents | improves the | management investment avenues goodwill and | techniques can be helpful in getting | used future discounts. Payables | Capital can be used | Evaluate _the | Payables are and in some other | credit policy and| honoured in time, Expenses _| investment avenues | related cost. improves the goodwill and helpful in getting future discounts. 10.4.2 Investment and Financing Working capital policy is a function of two decisions, first is investment in working capital and the second is financing of the investment. Investment in working capital is concerned with the level of investment in the current assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organisation objectives (i.e. Effectiveness of fund). Financing decision concerned with the arrangement of funds to finance the working capital. It gives the answer ‘Where from’ fund to be sourced at lowest cost as possible (ie. Economy). Financing decision, we will discuss this in later unit of this chapter. Investment of working capital: How much to be invested in current assets as working capital is a matter of policy decision by an entity. It has to be decided in the light of organisational objectives, trade policies and financial (cost-benefit) considerations. There are not set or fixed rules for deciding the level of investment © The Institute of Chartered Accountants of India,Pott FINANCIAL MANAGEMENT in working capital. Some organisations due to its peculiarity require more investment than others. For example, an infrastructure development company requires more investment in its working capital as there may be huge inventory in the form of work in process on the other hand a company which is engaged in fast food business, comparatively requires less investment as inventory is of perishable nature & most sales are cash sales. Hence, level of investment depends on the various factors listed below: (a) Nature of Industry: Construction companies, breweries etc. requires large investment in working capital due long gestation period. (b) Types of products: Consumer durable has large inventory as compared to perishable products. (©) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory i.e. raw material, work-in-process and finished goods whereas a trading and a service entity has to maintain inventory only in the form of trading stock and consumables respectively. (d) Volume of sales: Where the sales are high, there is a possibility of high receivables as well. (e) Credit policy: An entity whose credit policy is liberal has not only high level of receivables but may require more capital to fund raw material purchases as that will depend on credit period allowed by suppliers. 10.4.3 Approaches of working capital investment Based on the organisational policy and risk-return trade off, working capital investment decisions are categorised into three approaches ie. aggressive, conservative and moderate. (a) Aggressive: Here investment in working capital is kept at minimal investment in current assets which means the entity does hold lower level of inventory, follow strict credit policy, keeps less cash balance etc. The advantage of this approach is ‘© The Institute of Chartered Accountants of India