Working Capital Management

Working Capital Management refers to the management of a company’s short-term assets and liabilities to ensure it has sufficient cash flow to carry out day-to-day operations.

Formula:

Concepts of Working Capital

Gross Working Capital

Refers to total current assets of the business.
Focuses on investment in current assets.

Net Working Capital

Difference between current assets and current liabilities.
Indicates company’s liquidity position.

Permanent Working Capital

Minimum amount of working capital required to keep the business running.
Constant over time, not dependent on sales volume.

Temporary (Variable) Working Capital

Extra working capital required to meet seasonal or special needs.
Fluctuates based on business activity.

Objectives of Working Capital Management

Maintain liquidity to meet short-term obligations.
Ensure smooth operations without interruptions.
Minimize the cost of capital and maximize returns on current assets.
Manage inventory, receivables, and payables efficiently.

Principles of Working Capital Management

1. Principle of Consistency

Follow a consistent working capital policy for stability and predictability.

2. Principle of Risk-Return Trade-off

Higher investment in current assets = low risk but low return.
Lower investment = high return but high liquidity risk.

3. Principle of Matching Maturities

Match the maturity of assets and liabilities.
Short-term assets should be financed by short-term funds.

4. Principle of Cost of Capital

Use the cheapest source of finance for working capital needs to reduce cost.

5. Principle of Liquidity vs. Profitability

Maintaining high liquidity (cash) can reduce profitability.
Must balance between earning returns and staying solvent.

6. Principle of Optimization

Aim to optimize investment in working capital — not too much, not too little.

Importance of Working Capital Management

Need for Working Capital

Working capital is essential to ensure smooth business operations and to meet short-term financial obligations. A company cannot run efficiently without adequate working capital.

Key Needs

Daily Operational Expenses

– Payments for wages, salaries, rent, utilities, etc.

Purchase of Raw Materials

– Advance payments to suppliers.

Maintain Inventory Levels

– To ensure uninterrupted production and sales.

Credit Sales to Customers

– Businesses often sell on credit; hence funds are tied up in receivables.

Meet Unexpected Contingencies

– Emergencies or sudden price hikes.

Smooth Cash Flow

– To bridge the gap between cash inflow and outflow.

Classification of Working Capital

Working Capital is classified based on concept and time period:

A. Based on Concept

B. Based on Time Period

Sub-types of Permanent Working Capital

Regular Working Capital: Constantly needed.
Reserve Working Capital: For unforeseen circumstances.

Sub-types of Temporary Working Capital:

Seasonal Working Capital: For seasonal demands.
Special Working Capital: For one-time bulk orders or campaigns.

Importance of Working Capital

Working Capital Cycle (WCC)

The Working Capital Cycle is the time it takes for a business to convert its net current assets and liabilities into cash.

Cycle Flow

Cash → Raw Materials → Work-in-Progress → Finished Goods → Sales (Credit) → Accounts Receivable → Cash

Formula: WCC=Inventory Conversion Period+Receivables Collection Period−Payables Deferral Period.

Components:

Goal:

Shorter working capital cycle = Faster cash recovery = Better liquidity

Inventory Management

Inventory Management involves controlling the quantity and quality of stock to minimize holding cost and avoid stock-outs.

Types of Inventory

Raw Materials
Work-in-Progress (WIP)
Finished Goods
Maintenance/Spare parts

Objectives

Ensure adequate stock for smooth production/sales.
Avoid overstocking and understocking.
Reduce holding and storage costs.

Key Techniques

Cash Management

Cash Management refers to the planning, monitoring, and control of a firm’s cash inflows and outflows to maintain adequate liquidity.

Objectives

Ensure sufficient cash for day-to-day expenses.
Maintain liquidity without holding excess idle cash.
Optimize the return on surplus funds.

Functions of Cash Management

Cash Management Techniques

Prepare Cash Budget
Use Cash Flow Statements
Maintain Minimum Cash Balance
Invest in Marketable Securities

Summary Table

Accounts Receivable Management

Accounts Receivable Management involves the monitoring and managing of outstanding customer invoices to ensure that payments are collected promptly and efficiently.

Objectives

Maximize cash flow by collecting dues quickly.
Minimize the risk of bad debts.
Maintain a healthy credit relationship with customers.

Key Techniques

Factoring

Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a third party (called a factor) at a discount in exchange for immediate cash.

Advantages

Immediate cash flow: Quick access to cash without waiting for payment.
Reduces credit risk: The factor assumes the risk of bad debts (in non-recourse factoring).
Outsource collections: Factors often take over the responsibility of collecting payments.

Types of Factoring

Credit Policy

Credit policy refers to the guidelines and terms a company sets to decide who qualifies for credit, how much credit to extend, and the terms of repayment.

Key Elements of a Credit Policy

Objectives of Credit Policy

Minimize bad debts and delays in payments.
Increase sales while managing credit risk.
Optimize the credit terms to balance customer satisfaction and risk.

Financing Working Capital

Financing Working Capital refers to the process of securing funds to meet a business's short-term financial needs (working capital), such as purchasing inventory or paying for overhead costs.

Sources of Financing Working Capital

Types of Working Capital Financing

Permanent Working Capital Financing:
Long-term financing to meet the minimum level of working capital.
Typically funded by long-term loans or equity.
Temporary Working Capital Financing:
Short-term funds used for seasonal spikes or temporary needs.
Can be funded by short-term borrowings or bank overdrafts.

Working Capital Management